Financial depth or in over our heads?

Guambat has heard much about liquidity of late, and has muttered about it himself, though not with any real understanding. Many folks seem to think that there is just too much of it sloshing around, "artificially" or "unnaturally" raising asset values, which means inflation worries for those looking for nasty genies in the bottle.

John Mauldin, for instance, notes in his latest emissive that there is just so much of it coming from pension funds looking for any kind of yield that yields will have to come down from historic "normal" levels.

When Sam Zell is selling, the rest of the investment world should take notice. Sometimes they do ring a bell. But that is not what we ask today. The more pertinent question is why would investors accept such low future returns? Do they really think there is something that Sam Zell is missing? And who are those masked men with the billions?

Sam Zell sent a Christmas card to his friends with a song called Capital Keeps Falling on My Head to the tune of Raindrops Keeps Falling on My Head. You can listen at http://www.yieldsz.com. It is really worth the time. I mean, you really need to listen. It is quite thought-provoking as well as a lot of fun.

"What lies ahead: we're old -- the western world is aging, we'll need income from our pension funds, where's it coming from? The yields we see won't fuel no party... And there's one thing I know -- To get things back to normal it's a long haul that's global. Yields won't improve 'til growth soaks up this liquid freefall. Capital keeps raining on my head. So much is out there that the world is out of whack. When will we see balance back? It's gonna be a long time 'til returns meet expectations. We need to be prepared for slim annuities..."

"Nothing's worrying me," is how B.J. Thomas ends the original version. That ending keeps playing in my head. Investors cannot be worried by much to look at real estate at 22 times projected future earnings. Or emerging market debt at little more than what you get for US government debt. Yields on all manner of investments have been compressed.

How? As Zell says, "Illiquid assets have been alchemized into currency in play competing for returns."

But the smartest guys in the room over at McKinsey reckon as how this is all a good thing. By their reckoning, the total global value of all financial assets is now, at the beginning of 2007, worth US$ 140 Trillion, which is more than three times total world GDP. That's unprecedented but not the good news.

The good news, according to McKinsey, is that this value for the world's financial assets will grow another fifty percent (yep, 50%) in the next three years! (to US$ 217 Trillion by the end of this decade - in 2010). And they don't seem to have any inflation worries whatsoever. Because, they say, this merely adds financial depth, and that is a good thing.

[T]he value of the world's financial assets now exceeds global GDP by a factor of three—an unprecedented degree of financial depth, which largely bodes well for the world's economies.

For the most part, deeper financial markets are beneficial because they are more liquid [is that a circular argument?], give borrowers better access to capital [hell, the banks are trying to give the stuff away; Japan doesn't even charge interest], and offer more efficient pricing and increased opportunities for sharing risk [with hedge funds invading every balance sheet or traded instrument to leverage up the risk].

Equities accounted for nearly half of the growth in global financial assets in 2005.... [D]ebt was the main contributor to overall growth in the global financial stock after 1993, but this development mainly reflected the decline in global equity market values in the late 1990's; 2005 was the third straight year when equities were the largest contributor to the growth of global financial assets.

In 2005 the surprise element in US debt markets was ... the rapid expansion in private-debt securities.... Within this category, morgage-backed securities gained the most, reflecting the strong US housing market [and the alchemy of turning illiquid assets into currency]. In addition, the issuance of US asset-backed securities hit a record, owing to high levels of home equity lending, which was then securities [by more of the same alchemy].

Guambat's head is buzzing so much by these desparate spins on the same story that he reckons his blowflies have moved on around to the front. All those folks are much more savvy and informed than Guambat could ever be, yet they don't see eye to eye.

Dear o me o my.