Liquidity fuels asset prices or as they say in Economics 101, asset prices have to rise when demand exceeds supply
AT a point in time when there is so much pessimism on the stock market, anyone who suggests that conditions are primed for a sustained period of rapid appreciation in asset prices would surely be looked at with incredulity by most investors. And yet that seems to be the message that our analysis of the liquidity situation is telling us.
Liquidity fuels asset prices or as they say in Economics 101, asset prices have to rise when demand exceeds supply. This is a truism but nevertheless, worth repeating, as there seems to be an under-appreciation in our local investment community on the weight of money argument on share prices, in my view.
Obviously any assessment of market trends will not be complete without an analysis of market fundamentals.
However, given that views on such are quite easy to come by, for the purpose of this article, let us just focus on a new angle, the liquidity aspect.
In this context, it is good news for the market that we seem to be coming into a period of a massive liquidity build-up. The contributory factors are a structurally high savings rate, current account in surplus, weak investment environment and a closed capital market.
Let us try and figure to the rate of liquidity build-up in the system. We know that Employees Provident Fund (EPF) raked in around RM700 million net per month last year, insurance companies RM500 million, unit trust companies RM300 million and individuals, after contributing to pension, insurance, investments (capital market and properties) and deducting household expenditure, still have RM1.5 billion left over to be deposited in banks each month.
Estimating the aggregate net operating cash flow for corporates poses a slightly tougher challenge, and requires some guesstimate work. With the Kuala Lumpur Stock Exchange's (KLSE) capitalisation at RM500 billion and the forward price earnings (PE) at 13x, listed companies as a whole are estimated to earn approximately RM38 billion net profit this year, or over RM3 billion a month.
This figure has to be adjusted to deduct estimated capital expenditure investments and dividends to be paid, while depreciation has to be added back. Using somewhat arbitrary, but conservative estimates, we project net cash flow generation by corporates of over RM1 billion a month on average, excluding that of the non-listed companies.
Putting everything together, you are looking at RM4 billion funds being generated per month, or RM48 billion per annum. And this figure is likely to expand significantly if the strong corporate earnings growth projections for the next few years come true, and if the maturing demographics of Malaysia’s young population contribute strongly to aggregate discretionary savings as we expect.
A maturing population would mean not only a larger portion of the population in the work force, but also more savings per capita as the population’s median age moves closer to 40, the age at which most Malaysians seem to start saving in earnest.
But hasn’t Malaysia always enjoyed a high savings rate and haven’t corporates been just as profitable in the 1990s? If so, why this talk of rapid asset price inflation now and not in the 1990s for the same reason? What’s the difference this time round?
Well, the first difference is the dearth in direct investment opportunities for businesses today compared to back then, no thanks to the over-investment during the past decade. So while most of the deposits placed with banks were on-lent to companies who needed funding for their investments in those days, there are less opportunities for banks to play this intermediation role today, resulting in the build-up of surplus funds in the system.
Second, much fewer chunky listings and rights issues are expected for the KLSE going forward, compared to the early-90s. With less paper being issued, the only reason why share prices are not adjusting to the steady buying by the likes of EPF and institutional fund managers is that the demand keeps being filled by supply coming from the selling by foreign and retail investors. Once interest in the market returns, I believe this lack of new script supply could contribute to a rapid adjustment in share prices.
In contrast, the bond market has seen a surge in fund raising, seemingly helping to take up some of the slack of the equity market. However, as the bulk of these funds raised were used for the refinancing of either existing bonds or bank loans, the new debt paper issues did not effectively absorb that much of the surplus funds in the system.
Third, there is no longer a sizeable leakage of surplus funds from the system through a current account deficit, as we saw in the early to mid-90s. In fact, with the current account in surplus and likely to remain so a while, it is actually contributing to the build-up of surplus funds in the system.
Finally, we have in place today tight exchange controls that prevent businesses and individuals from repatriating funds offshore in search of better opportunities. This has resulted in the surplus funds being largely held captive onshore, unlike the pre-capital control days when reverse investments and retail outflows exacerbated the leakage caused by the current account deficits.
As a result of all the above, a wall of liquidity has started to build up and is likely to continue to do so over time. Already, Bank Negara has sterilised some RM60 billion from the system, a measure taken in order to prevent interest rates from collapsing. As long as interest rates are not allowed to fall naturally to a lower level (depending partly on US$ interest rate movements), the central bank will have no choice but to continue with its sterilisation efforts if the conditions described above remain in place.
While the central bank is hurting by the day earning little to no return for this money borrowed from the market, it seems to have a pretty high pain threshold. On the other hand, I cannot imagine banks operating under commercial considerations being equally willing to make the same sacrifice – absorbing the negative carry arising from earning a lower return in the inter-bank or money market from its surplus funds, compared to what it pays depositors in fix deposit (FD) rates.
I believe at some point, Bank Negara will have to protect the banks and allow deposit rates to fall, or the banks themselves will likely find ways of turning down deposits wherever possible. Either way, this will shift the equilibrium, resulting in more funds trying to seek a home elsewhere, be it in capital market instruments such as shares and bonds, or properties, or even businesses and direct investments.
As it is, the premium in yield of equities (8 per cent net i.e. the inverse of 13x PE) and bonds (6 per cent-plus for 5-year A paper) over FD rates seem attractive, and could become more so should interest rates drop. The case for a rally in property prices is, however, less compelling, because the lower supply argument that we made for shares and bonds does not apply as strongly here, except selected properties in some very prime locations.
The adverse effect of a significant lowering of domestic interest rates vis-à-vis US$ rates is that with the differential in interest rates narrowed, some of the surplus funds could at the margin find their way offshore, exchange controls notwithstanding.
Nevertheless, short of another crisis which results in a massive funds outflow, there should still be enough funds moving into these other assets, putting upward pressure on prices. And this process could be accelerated once investors’ risk appetite improves with the resolution of geopolitical uncertainties, and once the economy starts to show clearer signs of a recovery.
Of course continued asset inflation leads to asset bubbles, and asset bubbles run the risk of being punctured at a price to the economy, as we saw in early 94. However bubbles are created only after a prolonged period of asset inflation, and we have not even begun to see any signs of such yet. Let us enjoy the ride first if there is one.
l Yeoh Keat Seng, keatseng @commercetrust.com.my is the CEO of Commerce Trust
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