Date
21 November 2018
With liquidity tightening as the Fed shrinks its balance sheet, the US stock markets have seen a major selloff in recent weeks. Photo: Reuters
With liquidity tightening as the Fed shrinks its balance sheet, the US stock markets have seen a major selloff in recent weeks. Photo: Reuters

Understanding the current equity market slide

Ray Dalio, founder of the world’s largest hedge fund Bridgewater Associates, has said all cycles are credit cycles. The market now is behaving exactly as he described.

Take a look at the impact of US monetary policy on the economy.

Before the financial crisis in 2008, the Fed had been boosting its balance sheet by 2-3 percent and the US economy was able to grow steadily.

The Fed then resorted to some dramatic measures in the wake of the financial turmoil. It more than doubled its balance sheet within one year, and further expanded it in 2010, 2011, 2013 and 2014. The US economy gradually returned to growth.

Having confirmed the economy is back on solid track, the Fed started to shrink its balance sheet this year.

The dampening impact has eventually hit the stock market and even internet stocks, which had acted as engine of the decade-long US bull market, have shown signs of running out of steam.

Money supply is indeed a key factor determining all asset prices.

Fed now holds around US$4.2 trillion worth of balance sheet. If the central bank reduces the balance sheet by US$50 billion per month, that’s equivalent to 1 percent decline in money supply per month.

In such an environment, it will be hard for asset prices to perform. So, when will the equity market bottom out?

The US stock market has already pulled back 10 percent from its peak. People may accept moderate asset price corrections, but a crash is a different story. That’s why Fed might reverse its tightening move by the middle of next year.

Given that stock market typically leads real economy by 3-6 months, the bull market could return in the first quarter of 2019.

While tech firms are being battered by the market sell-off, it’s largely due to tightening liquidity, rather than anything wrong with the companies themselves.

I still believe the tech sector will continue to be very innovative and that it will create a lot of value. Hence, it will be among the best investment choices when the next market uptrend starts.

This article appeared in the Hong Kong Economic Journal on Oct 29

Translation by Julie Zhu

[Chinese version 中文版]

– Contact us at [email protected]

RC

Columnist at the Hong Kong Economic Journal

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