The money supply is rapidly shrinking, something that rarely, if ever, happens. In the United States, the money supply is shrinking by more than 4 per cent on an annual basis. And while there is an endless debate whether you should look mainly at the money supply or the money supply, as far as I am concerned, the latter is the most important.
In most cases, the change in the money supply is related to inflation, which of course is also a change, in this case of the price level. And it may be clear which way the recent contraction of money supply points, even if it should be mentioned that this relationship - contrary to what many economists and macro investors believe - is far from perfect. In any case, take into account a sharp fall in total inflation (core inflation is another story).
But looking only at inflation does a disservice to the money supply. The chart below shows a measure o “excess liquidity,” partly based on US M2 Money Supply, plotted against the change in the forward P/E ratio of the S&P 500 Index.
Excess liquidity is defined here as the difference between money supply growth minus US nominal GDP growth. The idea behind this is simple. When money growth exceeds economic growth, excess liquidity flows into financial markets. Conversely, when nominal growth exceeds money growth, money is withdrawn from the markets. The valuation of equities is a result of the difference between the two macro indicators.
Not surprisingly, money is currently being withdrawn from equity markets at an unprecedented rate, suggesting that the valuation of the S&P 500 Index should fall. However, the opposite is happening. Much of the decline in the 2022 forward P/E has been reversed this year. The forward P/E would have to fall to 16 from above 19 to push the valuation even slightly in the right direction. Based on current gains, that puts you at an S&P 500 Index of just above 3,500 points. Incidentally, I still assume that profits will continue to fall. Valuation is firm from a liquidity perspective, to say the least.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week appears every Monday on Investment Officer Luxembourg.