Chart of the Week: Small-stock shocks predict liquidity squeeze

The spread between shocks to the returns from small-size value stocks (i.e., with low market capitalisation) and from growth stocks tracks investors’ expectations about monetary policy, and, in turn, reflects the economic cycle. When this spread breaks substantially above zero, at 1.5% or above, it indicates expectations of monetary tightening and slower growth, revealing that liquidity is expected to come at a higher premium. Investors started pricing in a significant monetary tightening almost a year before it actually began — the longest divergence on record between the equity market and the Fed on this measure. Historically, the market was either synchronised with the Fed (for example during the 2000-2001 ‘dot-com’ boom and pre-pandemic periods) or it predicted but then broke away from the Fed (as in the Global Financial Crisis). But it has not previously given such a strong signal, or for so long, about the Fed’s anticipated next rate move before the Fed has started to act. Value stocks continue to deliver above their required returns, and so far above the returns that growth stocks offer that it seems clear, at least to equity investors, that liquidity will be squeezed further in 2023. The conclusion for equity investors this new year is that money is likely to stay expensive for a bit longer.

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The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

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