KostasPanagiotoualcDec03 on Liquidity

8/2/2019 KostasPanagiotoualcDec03 on Liquidity

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Asian Liquidity CyclesA Monthly Flow-of-Funds Guide to Asian Equity Markets

Back to 1994?

The unfolding macro-situation paints a scenario for equity markets whichis similar to that of 1994. Its main elements include a major and highlysynchronised surge in global demand, a downturn of the liquidity cycle and

rising long and short-term interest rates.

What is different between now and 1994, is the market ownership situation,which looks a lot less onerous than it was ten years ago. This should limitthe downside potential on any liquidity-driven price correction.

The result could be a protracted period of choppy and range-bound priceaction in Asian bourses.

Kostas Panagiotou

(65) 6336 3666

[email protected]

Market Report

Date: 23 December 2003

Char t o f the Mont h

MSCI Asia Free ex-Jap an Index

please see related comment on page 5

Reg iona l Equ i ty Marke t sMITA (P) : 065/01/2003www.research.kimeng.com

KIM ENG

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Market Report 23 December, 2003

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Contents

Page

Performance Tables ................................................................................................................ 3

Summary Market Ranking ....................................................................................................... 4

Back to 1994? .......................................................................................................................... 5

Asian Liquidity Matrix.............................................................................................................. 10

Hong Kong ............................................................................................................................. 12

Indonesia ................................................................................................................................ 14

Japan ..................................................................................................................................... 16

Korea ..................................................................................................................................... 18

Malaysia ................................................................................................................................. 20

Philippines .............................................................................................................................. 22

Singapore ............................................................................................................................... 24

Taiwan ................................................................................................................................... 26

Thailand ................................................................................................................................. 28

USA........................................................................................................................................ 30

Appendix I Asian Liquidity Cycles Explained .................................................................... 32

Appendix II Flow-ofFunds Explained ................................................................................. 34

The investment conclusions in this report are based on flow-of-funds and technical analysis.Market valuation methods based on conventional criteria, such as price/earnings, price/cashflow and price/book ratios may yield different conclusions.


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Equi ty Mark e ts Per fo rmanc e - Loca l Cur rency

I ndex % Change

Leve l 1 Mt h 3 Mt hs 6 Mt hs 12 Mt hs YTD

Hong Kong (HSI) 12,488 5.5 14.1 28.3 30.5 34.0

Indonesia (JCI) 674 9.3 14.6 33.2 58.5 58.7

Japan (TPX) 1,015 4.2 -2.7 12.3 23.4 20.4

Korea (KOSPI) 805 4.4 11.9 19.3 16.4 28.2

Malaysia (KLCI) 775 -1.2 5.2 13.2 21.3 20.0

Philippines (PCOMP) 1,421 6.5 9.1 15.5 40.9 39.5

Singapore (STI) 1,722 3.9 8.4 15.5 29.0 28.4

Taiwan (TWSE) 5,835 0.1 2.7 18.6 27.6 31.1

Thailand (SET) 718 17.1 26.9 56.6 104.9 101.5

USA (SPX) 1,093 5.6 6.9 9.8 22.0 24.2

Pricing date: 22/12/2003. Source: Bloomberg

Equi ty Mark et s Per form anc e - US$

I ndex % Change

% Change Leve l 1 Mt h 3 Mt hs 6 Mt hs 12 Mt hs YTD

Hong Kong (HSI) 12,488 5.5 13.9 28.7 30.9 34.4

Indonesia (JCI) 674 9.6 13.7 30.3 63.2 64.1

Japan (TPX) 1,015 5.9 1.7 21.8 35.5 30.9

Korea (KOSPI) 805 5.1 8.2 18.9 17.0 27.5

Malaysia (KLCI) 775 -1.2 5.1 13.2 21.3 19.9

Philippines (PCOMP) 1,421 6.7 8.1 11.8 37.1 36.1

Singapore (STI) 1,722 4.8 10.1 17.2 30.9 30.0

Taiwan (TWSE) 5,835 0.1 1.7 20.1 29.8 32.8

Thailand (SET) 718 17.7 28.1 61.4 113.4 110.2

USA (SPX) 1,093 5.6 6.9 9.8 22.0 24.2

Pricing date: 22/12/2003. Source: Bloomberg


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Count ry Rank ing Table - Decem ber 2003

* Ranking Scale: most attractive = +80; least attractive = -80

Indicators

This Last This Last Domestic Mom-Adj. Net Capital Output Market

Month Month Month Month Country Liquidity Liquidity Flows Gap Ownership

1 1 62 62 Malaysia Rising Rising Inflow Negative Lightly

accelerating widening over-owned

2 7 42 -2 Philippines Falling Rising Inflow Negative Lightly

accelerating widening under-owned

3 2 38 38 Hong Kong Rising Rising Inflow Negative Lightly

accelerating narrowing over-owned

4 3 38 38 Taiwan Rising Rising Inflow Negative Lightly


5 5 24 24 Indonesia Rising Peaking Outflow Negative Lightly

decelerating widening over-owned

6 4 14 38 Korea Rising Rising Inflow Negative Lightlydecelerating narrowing over-owned

7 6 -10 0 Singapore Rising Falling Outflow Negative Lightly

decelerating narrowing over-owned

8 8 -72 -40 Thailand Falling Falling Outflow Negative Heavily


17 20

31 31

38 38 Japan Rising Rising Inflow Negative Lightly


50 72 USA Rising Rising Inflow Negative Lightly

decelerating widening under-owned

Rank Score*

Asian-8 Median

Asian-8 Average


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Back to 1994?

We see many parallels between the currently unfolding macro-economic

environment and that of 1994. These similarities provide important cluesabout the likely outlook for global equity markets during the coming year.Remember that 1994 was characterised by a major decline in bond prices andtrend-less equity markets (see Figure 1). For Asian equities, 1994 marked the

end of the 1993 super-bull market, not with a major trend reversal, such asthat of the 1997-98 Asian crisis or that of 2001, but with relatively modestdeclines and a marked increase in volatility (see Chart of the Month on the

cover page).

2004 a deja-vu of1994

Figure 1. US Stock & Treasury Bond Performance

We believe that in 1994, bonds and equities were responding adversely to atightening of global liquidity conditions, brought about by a vigorousacceleration in the pace economic activity. In the 1992-94 period, the OECD

economies were recovering from the early-1990s recession. At first, therecovery appeared patchy and fragile, but by 1994, it picked up steamunexpectedly and spread throughout the OECD region. This led to a lessliquid financial environment world-wide and gave rise to an "inflationary

scare", which hit bond markets particularly hard. Below, we illustrate thesimilarities between the current business cycle and that of 1993-94, with the

use of several charts.

Figure 2 shows the industrial production cycle of the US, Europe and Japan

since 1993. Now, as in the early-1990s, the global economy is graduallyrecovering from the 2001 recession. The initial recovery stalled in the fist halfof 2003, but its pace is re-accelerating as the year comes to an end.

The growth scareof 1994

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S&P500 Index 10-yr TBond (price)

Growthre-accelerating aftera soft patch in 1H03


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Figure 2. G3 Industrial Production (Trend)

Leading indicatorspoint to red-hoteconomy in 2004

Led by the US, the OECD leading indicators of economic activity have been

on a steep uptrend since early this year (see Figure 3). The leading index forthe total OECD region is rising at a pace close to the peak of the 1994 cycleand will most likely move higher in the coming months. The message from theleading indicators is that the pace of global growth should strengthen

considerably in the course of 2004, like it did ten years ago.

Figure 3. G3 Leading Indicators

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US EU (15) Japan

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Figure 4. USA: SMI New Orders Index

Manufacturingorders are risingvertically

The monthly survey of US purchasing managers, conducted by the Supply

Management Institute, underlines the strength of the current recovery. InNovember this year, the New Orders Index of the manufacturing surveysurged to levels last seen in the early-1980s (see Figure 4).

Figure 5. US New Orders of Capital Equipment (Non-defence - excl aircraft)

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New Orders Trend

The recovery is fast spreading into the capital spending area of the economy,as shown by the double-digit growth of New Orders of Capital Equipment in

the US (up 13% from a year ago in October 2003). This comes after a massive23.5% year-on-year decline in mid-2001 (see Figure 5). The annual growthof Japanese machinery orders also surged to 13.3% in October 2003 from a

cyclical low of -21.6% in October 2001.

Capital spending isjoining in the cyclicalupswing


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Figure 6. US Yield Curve

The steepness ofthe yield curve is aspronounced as itwas in the early1990s

The current steep upward slope of the US yield curve (which is the spreadbetween long and short-term interest rates), also confirms the bullish mes-sage of the other leading indicators of the business cycle. Over the last two

years, the spread between the 10-year Treasury bond yield and the 3-monthTreasury note expanded in a very similar fashion to that of the early-1990s,which foreshadowed the 1994 surge in economic activity world-wide (seeFigure 6).

Figure 7. US Interest Rates

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3-Mth T Bill 10-Yr T Bond

The underlying interest rate structure that brought about the positive widen-

ing of the yield curve is again very similar to that of 1993-94. In response tothe 2001 recession and the subsequent feeble recovery, short-term rates arebottoming out, after a long period of decline. Long-term rates have started to

move higher in a measured way, reflecting current uncertainty of marketparticipants about the sustainability of the economic expansion (see Figure7). We expect short-term interest rates to start rising by mid-2004, as thefirming of economic recovery will deprive central banks of any justification for

continuing with their current loose monetary policies. Bond yields shouldalso move higher during the course of the year, as the uncertainty about the

strength of the recovery gives way to a growth scare and an associatedinflationary scare. However, even before we see the lifting of official interest

Interest rates waitingfor take off


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rates, the global pool of excess capital should start to dissipate on the back

of increased capital spending that is staring to accompany the cyclicalupswing. The expected monetary tightening will simply speed up the depletion

of liquidity, which by then would be underway.

Figure 8. S&P500 Earnings Per Share

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EPS Trend

What about earnings? Surely company profits are on the rise and should

continue to grow in line with the accelerating pace of economic recovery.Wouldnt rising profits improve equity valuations and keep the stock marketrally going? Not necessarily. In the absence of rising liquidity, improvedearning fundamentals may not be able to sustain the rally. In fact, the earnings

up-cycle of the early 1990s did not peak until 1995 (see Figure 8). Moreover,

the subsequent slowdown of earnings growth during the mid-1995 to mid-1998 period did not prevent the major bull-market in US equities from taking

hold. There is simply no consistent relationship between the corporate profitcycle and equity market indices. In our view, the liquidity cycle is the main

determinant of stock markets movements (see Appendix II).

The unfolding macro-situation paints a scenario for equity markets similar to

that 1994. Its main elements include a major and highly synchronised surgein global demand, a downturn of the liquidity cycle and rising long and short-term interest rates. The end of the liquidity up-cycle should come about by the

increased funding needs of the expanding economy and the tightening actionof major central banks in the OECD and Asia. What is different between now

and 1994, is the market ownership situation, which is a lot less onerous thanit was ten years ago. In absolute terms, the ratio of the market capitalisation-

to-quasi money is now much lower than it was in early-January 1994, whichmarked the peak of the 1993 rally in Asian equities. In relative terms, theposition of the ratio relative to its long-term trend line places the market

ownership indicators at the lightly over-owned section of their respectivecharts (see Figures 5 & 6 of individual countries at the County Profiles section

of this report). The only notable exception is Thailand, with her marketownership indicator well into the heavily over-owned area of its chart. Weexpect the relatively undemanding levels of Asian market ownership to limit

the downside potential of any price correction, which may arise from the moredifficult liquidity environment ahead. The result could well be a protracted

period of choppy and range-bound price action in the regional bourses.

Will earnings savethe rally?

Declining liquidityand relativelyundemandingmarket ownershipcould producechoppy and

trend-less equitymarkets


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Asian L iquid i ty Mat r ix - Dec em ber 2003

Domes t i c L iqu id i t y I ndex

Status Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand

Rising n n n n n n

Peaking

Falling n n

Bottoming Out

Momen t um -Ad jus t ed L iqu id i t y I ndex


Rising n n n n n

Peaking n

Falling n n

Bottoming Out

Net Cap i t a l Flow s


Inflow Accelerating n n n n

Inflow Decelerating n

Outflow Accelerating n n

Outflow Decelerating n

Mar ke t Ow ner sh ip


Heavily Under-owned

Lightly Under-owned n

Lightly Over-owned n n n n n n

Heavily Over-owned n

Out pu t Gap


Negative Widening n n n

Negative Narrowing n n n n n

Positive Widening

Positive Narrowing


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Count ry Pro f i les


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Hong Kongs capital accountsurplus is rising at anaccelerating pace.

Figure 1 : Hang Seng Index

Figure 3 : Net Capital Flows

The domestic liquidity indexis rising, together withits leading indicator, themomentum-adjusted index.

Hong K ong

Figure 2 : Domestic Liquidity Conditions

Current Previous

Rank 3 2Score 38 38Asian-8 Median 31 31

Both domestic and externalliquidity conditions remainvery supportive of HongKongs equity prices.

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Figure 4 : Output Gap

Figure 6 : Market Ownership

Figure 5 : Market Cap/Quasi Money Ratio

The economy continuesto operate below trend, butthe amount of excesscapacity has beendiminishing steadily over thelast two years.

lifting the marketownership indicator towardsthe upper end of the lightlyover-owned region of thechart.

The market cap/quasi moneyratio is has been movingup rapidly, increasing itsdistance from its long-term

trend and

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MC/QM Ratio Long-Term Trend


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IndonesiaCurrent Previous


Figure 1 : Jakarta Composite Index



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The capital account is indeficit, but the pace ofoutflow is decelerating.

The domestic liquidity indexcontinues to advance, butthe momentum-adjustedliquidity index appears tobe peaking.

Indonesias domesticliquidity conditions arebecoming slightly lessfavourable, but external fundflows are improving.


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The underlying conditionsfor domestic liquidity arefavourable, as the economyoperates with an expandingnegative output gap.

placing the marketownership indicator wellwithin the lightly over-owned range.

The market cap/quasi moneyratio has been hoveringabove its long-term trendline...

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JapanCurrent Previous

Score 38 38

The pace of net capitalinflows is accelerating ata furious pace.

Figure 1 : Tokyo TOPIX Index


Japanese equities are facinga favourable set of liquidityfundamentals.

The domestic liquidity indexhas finally turned up,following an earlierturnaround of its

momentum-adjustedcounterpart.


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Japan s negative output gaphas been diminishing, but itremains sufficiently large tosupport the rising pool ofdomestic liquidity.

placing the marketownership indicator intothe middle of the lightlyover-owned section ofthe chart.

The market cap/quasi moneyratio is cruising above itslong-term trend

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KoreaCurrent Previous


Koreas capital accountsurplus is now shrinking.

Figure 1 : KOSPI Index


Korean domestic liquidityflows continue to improve,but external fund flows arebecoming less supportive ofequity prices.

Both the domestic liquidityindex and the momentum-adjusted index are headingnorth, with the latter leading

the way.


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placing the marketownership indicator withinthe lightly over-ownedsection of the chart.

The market cap/quasi moneyratio has been rising aboveits long-term trend line

The rate of capacityutilisation has been rising,but not fast enough to derailthe upswing of the domesticliquidity cycle.

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Malays iaCurrent Previous


Internationally mobile capitalis flowing into Malaysia at anaccelerating pace.

Figure 1 : KLSE Composite Index


The KLSE is facinga favourable combination ofdomestic and externalliquidity conditions.

The momentum-adjustedindex is above the domesticliquidity index and they areboth moving higher.


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Malaysias large and growingnegative output gap is theultimate source of domesticliquidity.

placing the marketownership indicator at theupper end of the lightlyover-owned section of thechart.

The market cap/quasi moneyratio is rising above itslong-term trend line...


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Phi l ippinesCurrent Previous

Rank 2 7Score 42 -2Asian-8 Median 31 31

Net capital flows aremoderately positive and thepace of inflow is accelerating.

Figure 1 : Philippines Composite Index


Domestic liquidity has beenshrinking, but favourableexternal fund flows enabledthe Manila bourse toparticipate in the regionalstock market rally of 2003.

The domestic liquidity indexremains on a downtrend,but its leading indicator,the momentum-adjusted

index is pointing to a moreliquid financial environmentin the coming months.


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The economy operatesbelow trend and the rateof capacity utilisation isdecreasing.

placing the marketownership indicator to theupper end of the lightlyunder-owned range.

The market cap/quasi moneyratio is in line with its long-term trend

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82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03


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SingaporeCurrent Previous

Rank 7 6Score -10 0Asian-8 Median 31 31

Figure 1 : Singapore Straits Times Index



External liquidity flowsare moderately supportiveof equity prices,as Singapores net capitaloutflow is decelerating.

Singapores liquidity profileis favourable, but there arehints of a less liquid financialenvironment in the periodahead.

The domestic liquidity indexremains on an up-trend.However, the momentum-adjusted index has turneddown, indicating a less

hospitable liquiditylandscape in the comingyear.

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The economy continues tooperate with a negativeoutput gap, but the rate ofcapacity utilization has beenedging higher over the lasttwo years.

placing the marketownership indicator intothe middle of the lightlyover-owned zone.

The market cap/quasi moneyratio is moving higher andaway from its long-term

trend line

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Ta iwanCurrent Previous


The pace of net capital inflowis accelerating at a furiouspace.

Figure 1 : Taiwan Weighted Index


Taiwan equities continueto enjoy strong support bothfrom domestic and externalliquidity flows.

The liquidity index andits leading indicator, themomentum-adjusted index,are heading north.


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Taiwans negative output gaphas been narrowing, butthere is plenty of slack leftto accommodate a risingpool of excess capital in thedomestic financial system.

placing the market owner-ship indicator within thelightly over-owned rangeof the chart.

The market cap/quasi moneyratio has been rising aboveits long-term trend

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84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

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84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03


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Thai landCurrent Previous

Rank 8 8Score -72 -40Asian-8 Median 31 31

Thailands capital accountdeficit has been narrowingrapidly for most of this year,but the pace of capitaloutflow is starting toaccelerate.

Figure 1 : Bangkok SET Index


The Bangkok marketcontinues to outperformthe other regional bourses,but Thailands liquidityconditions are startingto worsen.

Both the domestic liquidityindex and its momentum-adjusted derivative indexhave turned down.


-2

-1

0

1

2

3

US$bn

95 96 97 98 99 00 01 02 03

80

90

100

110

120

130

Level

95 96 97 98 99 00 01 02 03


2.2

2.4

2.6

2.8

3.0

3.2

LogScale

95 96 97 98 99 00 01 02 03


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The Thai economy continuesto operate below trend, withthe negative output gapgetting gradually narrowersince early 2002.

sending the marketownership indicatordeep into the heavily over-owned region of the chart.

Even though the market cap/quasi money ratio has beenrising together with its long-term trend line, the distance

between them is expandingrapidly

0.0

0.5

1.0

1.5

2.0

2.5

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

Times

85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03


-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03


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USACurrent Previous

Score 50 74

Figure 1 : Standard & Poor 500 Index



The pace of net capitalinflows into the US is staringto decelerate, on the back ofmuch reduced purchases ofUS securities by foreigninvestors.

Domestic liquidity conditionsremain positive for USequities, but external fundflows are starting to worsen.

The domestic liquidity indexis edging up, followinga much earlier turnaround ofits leading indicator,the momentum-adjusted

liquidity index.

0

20

40

60

80

100

120

140

US$bn

95 96 97 98 99 00 01 02 03

90

95

100

105

110

Level

95 96 97 98 99 00 01 02 03

Liquidity Index Momentum Adjusted

2.6

2.7

2.8

2.9

3.0

3.1

3.2

LogScale

95 96 97 98 99 00 01 02 03


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The US economy continuesto operate with a largenegative output gap.

placing the marketownership indicator into thelightly under-ownedsection of the chart.

The market cap/quasi moneyratio has been rising towardsits down-sloping long-term

trend

0.4

0.6

0.8

1.0

1.2

1.4

74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

0.5

1.0

1.5

2.0

2.5

3.0

Times

74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

MC/QM Ratio Trend

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03


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Append ix I : As ian L iqu id i ty Cyc les Exp la ined

This report assess the absolute and relative attractiveness of Asian equity markets onthe basis of liquidity conditions prevailing and likely to prevail in each country. Thefollowing markets are covered: Hong Kong, Indonesia, Japan, Korea, Malaysia, thePhilippines, Singapore, Taiwan, Thailand and the USA. As our main focus is ex-Japan

Asia, Japan and the USA are not ranked, but are included for reference only.

Five flow-of-funds indicators are used to derive a single score for each country, whichallows us to compare equity markets on the basis of their liquidity fundamentals. Thescore ranges from +80 (most attractive) to -80 (least attractive). To derive the score,

the following indicators are weighted according to their importance in shaping theoverall liquidity environment:

Domestic Liquidity Index: A proprietary index constructed from a number ofmonetary and credit aggregates. The index captures changes in the availabilityof excess capital in the domestic financial system. Excess capital is defined as theportion of financial resources in the system which exceeds the funding require-

ments of the real economy.

Momentum-Adjusted Liquidity Index: A leading indicator of domestic liquidityconditions. It is derived from adjusting the Domestic Liquidity Index by a momen-tum factor, which captures the speed by which liquidity conditions are improving

or deteriorating.

Net Capital Flows: The net amount of capital flows from abroad, derived from

balance of payments statistics. This measure captures all categories of capitalflows: official, private, foreign direct investment, portfolio, bank lending, as well aserrors & omissions. Obviously, we like countries with accelerating capital inflowsand dislike those with accelerating capital outflows. Between decelerating

outflows and decelerating inflows we prefer the former. This is because equitymarkets tend to perform better when outflows are getting smaller than when

inflows are getting smaller.

Output Gap: It measures the amount by which an economy operates above (i.e.

positive output gap) or below (i.e. negative output gap) its long-term growthpotential. The state of the output gap strongly influences the liquidity conditionsprevailing in each country. Liquidity tends to expand when the output gap is

negative and contract when it is positive. Numerous studies have shown thatequities perform consistently better when the economy operates with a sizeableamount of spare capacity.

Market Ownership:This is the valuation model of the flow-of-funds analysis. Weuse a ratio of stock market capitalisation over quasi-money (i.e. interest-bearingdeposits in the banking system) to capture the aggregate asset allocationbetween equities and cash. We then take the percentage deviation of this ratiofrom its long-term trend to derive a Market Ownership value. An equity market

is considered heavily over-owned when the market ownership value is at the


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upper end of its historical range and heavily under-owned when is at the lowerend of this range. Over-owned markets are more vulnerable to a downturn of the

liquidity cycle than under-owned ones. Conversely, during an upswing of theliquidity cycle, under-owned markets have greater upside potential than over-owned ones.

Most Attractive:To attain the top score (+80), a country has to have all of the following:Rising domestic liquidity index, rising momentum-adjusted liquidity index, increasing netcapital inflows, a widening negative output gap and a heavily under-owned equity market.

Least Attractive: The lowest score (-80) goes to countries which have all of thefollowing: Declining domestic liquidity index, declining momentum-adjusted liquidity

index, increasing net capital outflows, a widening positive output gap and a heavily over-owned equity market.


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Appendix I I : Flow -of-Fund s Ex pla ine d

Buffetts Wisdom

At Berkshire we focus almost exclusively on the valuations of individual compa-nies, looking only to a very limited extent at the valuation of the overall market.Even then, valuing the market has nothing to do with where its going to go nextweek or next month or next yearThe fact is that markets behave in ways,

sometimes for a very long stretch, that are not linked to value.

Warren Buffett. From Mr. Buffett on the Stock Market; article in FORTUNE magazine,

Nov 22, 1999.

This simple, but important observation by the world greatest value investor is routinely

ignored by most market strategists, who use valuation methods designed for stockpicking to predict the next move of the stock market index. It is not that value is irrelevant

to markets. As Buffett says in the same article: Sooner or later, though, valuecounts. But value becomes more relevant to market movements the further away wemove from the sooner towards the later.

In the short to medium term (6-12 months) the power of value on the market issuperseded by the power of money. More specifically, by the availability of money thatcan be invested in financial assets. Cheap markets can become cheaper when the

pool of investable funds shrinks, while expensive markets can become even moreexpansive when there is an abundance of capital for the purchase of securities. Below

we explain the Flow-of-Funds approach to investing with some reference to conventional

market valuation methods that most investors are familiar with.

A Monetary Phenomenon

It has long been accepted that consumer price inflation is a monetary phenomenon, inthe sense that it originates from changes in the monetary rather than the real side of

the economy. The flow-of-funds approach to investing stems from the proposition thatasset price cycles are monetary phenomena, very much like the price cycles of consumergoods. It is simply a case of too much money chasing too few apples, equities or bonds.

When this happens, the respective prises of these items will tend to rise. Conversely,prices will tend to fall when too many apples, equities or bonds have to compete for ashrinking pool of money.

Stocks and Bonds as a Store of Savings

The liquidity approach realises that financial assets act primarily as a store of accumu-

lated income (i.e. savings). When, for whatever reason, savings rise, so does thedemand for and the price of - financial assets. Their price is particularly responsive tosavings-driven demand, which tends to change a lot faster than their primary supply.Based on these considerations, the flow-of-funds approach focuses on the factors thatinfluence the availability of funds that can be invested in equity and bond markets.


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Fluctuating Capital

The conventional valuation approach implicitly assumes that there is a fairly fixed amount

of capital dedicated to investment in financial assets. When investors realise that equitymarket A offers better value than market B, money will leave market B for market A. Pricesin market A will rise and those in market B will fall. Equilibrium of some sort will be restored.The object of the exercise then becomes to discover the market(s) with the most attractive

valuations before other investors do.

However, we often see markets deemed to be expensive moving from strength tostrength and markets perceived as cheap stagnating or become even cheaper. Thefact that markets quite often refuse to comply with perceived valuation fundamentals

suggests that the implicit, but crucial, assumption of a fixed amount of investable capitalis not realistic. In real life, liquidity (i.e. the amount of capital available for investment infinancial assets) fluctuates over the course of the business cycle.

Misguided Application of a Sound Approach

Reflecting their relative fundamental strength, some stocks perform better than others,

irrespective of the general direction of the market. Conventional valuation methods arean indispensable tool for anticipating the relative performance of individual stocks (i.e.stock A versus stock B). However, they are not particularly helpful in forecasting the short

and medium term direction of the equity market.

By applying valuation techniques designed for individual stock selection on the stockmarket as a whole, the conventional wisdom invariably views an expanding economy aspositive and a slow or recessed economy as negative for equity prices. If investors buy

stocks for their earnings stream, strong economic growth should translate into strongearnings and increase their appeal to the investing public. An earnings-destroyingrecession gives rise to opposite sentiments.

Equity-Friendly Recessions and Equity-Hostile Expansions

However, historical experience suggests that rising equity prices and strong economies

do not always go hand in hand. Equity markets tend to perform strongly half way througha recession and the early stage of the economic recovery and perform poorly during thetail end of the economic expansion. This timing discrepancy is typically explained as a

discounting process, where far-sighted equity prices efficiently discount the goodnews of the emerging economic upswing, as well as the bad news of the impending

economic downturn.

The flow-of-funds approach sees things differently. It considers the lagged relationship

between equity prices and the business cycle not as one of foresight, perfect orotherwise, but one of liquidity. There are simply more funds available to be invested onpaper assets during the tail end of a recession than there are during the tail end of anexpansion. To understand why we have to look at the factors that cause liquidity to

expand and contract in a fairly regular cyclical fashion.


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Bond / Equity

Markets

DomesticLiquidity

Pool

Central

Bank

Real

Economy

Global

FinancialSystem

A Hydraulic Definition of Liquidity

Simply defined, liquidity is the amount of money in the financial system that exceeds thefinancing needs of economy. The funding needs of the economy are set by the growth

rate of nominal output, while the local central bank determines the supply. When moremoney is supplied than the economy can absorb, there is a build up of surplus capital,

much of which finds its way into financial asset markets.

Think of the pool of domestic liquidity as a reservoir connected through a network ofpipes with: (1) the local central bank, (2) the countrys economy, (3) the global financial

system and (4) the local bond and equity markets (see diagram above). The directionand intensity of fund flows through this hydraulic system changes over the course of thebusiness cycle.

Recession Hydraulics

During a recession, the reservoir receives large amounts of liquidity from the central

bank, as the latter eases monetary policy. The idea behind the monetary easing is tokick-start a recovery by extending cheap credit to the economy. However, the centralbank cannot lend directly to the non-bank private sector. All it can do is raise the reserves

and deposit liabilities of the banking sector and hope that the banks will start lending tothe non-bank private sector. Its hopes are initially frustrated because recessions have

a habit of raising the perceived credit risk sky-high and sharply reducing profitableinvestment opportunities. As a result, banks become extremely reluctant to lend and theprivate sector equally reluctant to borrow. The pool of liquidity rises and overflows into

bond and equity markets. Asset prices advance, giving the impression that the marketcorrectly anticipates the cyclical prosperity ahead.


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Late Expansion Hydraulics

During the late stage of a cyclical expansion, perceived risks are low and credit expandsat a furious pace, driven by strong investment spending. Capacity constraints start to

develop, prompting the central bank to tighten monetary policy. With the economy andthe central bank both draining the pool of excess capital, financial asset markets areeventually starved of liquidity. Asset prices retreat, well before the flow of economic andearnings statistics turns bearish.

Mid-Expansion Rallies

In the previous two paragraphs we described liquidity conditions at or close to the turningpoints of the business cycle. What happens in-between? Mid-expansion rallies in bond

and equity markets are rather common, even though they tend to lack the vigour of their

early-cycle cousins. Often, several quarters into an economic recovery, economicgrowth rates start to decelerate, raising fears of recession. To these, central banks tend

to respond with expansionary monetary policies, which help to replenish the pool ofliquidity and drive up asset prices.

Global Liquidity and Net Capital Flows

The size of private cross-border capital flows has increased tremendously since the late-1980s. So has their impact on bond and equity markets, especially those of emerging

economies. The amount of capital that crosses international borders at any point in time,roughly corresponds to the ups and downs of the global liquidity cycle (defined in the

same way as its domestic counterpart). This is because perceptions of risk of investing

abroad are strongly influenced by the changing availability of capital on a global scale.When the global liquidity cycle is on an uptrend, the perceived risk of offshore investing

declines. International capital flows rise, as foreign investors become less discriminatingin their choice of countries or regions. Conversely, when the global liquidity cycle is ona downturn, risk premiums rise and countries or regions with questionable macro-fundamentals tend to suffer punishing capital outflows.

Pri va t e Ne t Capi t a l F low st o Emer g ing Coun t r i es

-50

0

50

100

150

200

250

US$bn

72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02Source: IMF


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Net Capital Flows and Domestic Liquidity

The effect of net capital flows on the domestic pool of excess capital depends very muchon the countrys foreign exchange regime and the actions of the central bank. When theauthorities operate a free-floating system, a capital inflow (outflow) will simply representan addition (subtraction) to the domestic amount of investable funds. However, under aregime of pegged exchange rates, not supported by a currency board a la Hong Kong,

a change in the direction of capital flows can have a disproportionately large impact ondomestic liquidity. This is because the central bank will try to resist the upward(downward) pressure on the currency generated from incoming (outgoing) capital.

Unless it is fully sterilised, the foreign exchange intervention will involve a rise (fall) inofficial external reserves and a corresponding increase (decline) in the domestic moneysupply. This is indeed the case in most developing countries, where inadequate

monetary tools at the disposal of central banks (such as minuscule and thinly traded

domestic bond markets) hamper fully sterilised forex intervention.


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