The Liquidity Engine: How Money Supply Drives Markets
Why Global Liquidity Cycles Keep Re-rating Your Equity Portfolio
Key Takeaway:
Liquidity isn't the only thing that moves markets - but in the modern regime, it's often the first thing. When money supply accelerates, equity multiples expand. When it stalls, drawdowns follow.
🌍 What is global liquidity?
We define global liquidity as a combination of:
Monetary aggregates (M2) across major economies
Central bank balance sheets (Fed, ECB, BoJ, PBoC)
FX-adjusted totals to reflect true dollar-system liquidity
As of June 27, 2025:
Broad money growth is re-accelerating globally, even as QT continues in North America. The market sees this - and prices it in.
📈 Global Liquidity vs S&P 500
The S&P 500 and global liquidity have moved in lockstep since 2010. Periods of quantitative easing and monetary expansion coincide with multiple expansion and market rallies.
📊 The empirical link
From 2010 to 2025, the quarterly % change in global M2 shows a correlation of ~0.56 with next-quarter S&P 500 total returns.
During the top liquidity quartile (when M2 growth exceeds ~5% QoQ), the S&P historically delivered +8.4% average forward 6-month returns.
In the bottom quartile (near-zero or negative M2 growth), the average forward return fell to –2.1%.
This reflects how expanding liquidity lowers risk premia, inflates asset multiples, and boosts equity inflows. These are not precise trading signals - but they do define market regimes that shape valuation, capital allocation, and expectations.
🔍 Case studies: Liquidity and equity outcomes
Liquidity expansions have historically fueled large-cap upside. When liquidity contracts (QT), drawdowns follow.
💡 Why liquidity drives valuation
We see three primary channels:
Discount-rate effect - more reserves → lower real yields → higher DCF sensitivity
Collateral engine - CB assets = collateral backing for credit and derivative leverage
Risk-appetite shift - liquidity compresses ERP → multiple re-rating
This is why valuation multiples rise in liquidity booms even if earnings are flat.
🧭 Portfolio playbook
Our regime-specific playbook adjusts positioning, sector tilt, and option overlays to align with macro liquidity.
🥔 Potato Capital View (as of June 2025)
Our Liquidity Engine dashboard reads: 🟢 moderate expansion
Global M2 YoY: +6.9%
Net central bank liquidity still expanding, primarily due to easing in Asia
Base case fair-value P/E for the S&P 500 = 19–21×
📌 We also note the structural shift in U.S. monetary policy expectations following former President Trump's reelection in November 2024. Trump has made clear his intention to appoint a more dovish Fed Chair when Jerome Powell’s term ends in May 2026. Markets may begin pre-pricing a looser long-term rate stance - reinforcing the case for sustained equity multiple expansion.
Active trade tiles:
Accumulate SMH/SOXL on dips
Sell covered calls on QQQ into strength
Keep 10–15% tactical cash for policy shocks or CPI surprises
This is a macro-expansion regime. We remain constructive on risk, with disciplined tactical overlays.
📐 Our Fair Value Framework: Why 19–21×
We estimate a fair forward P/E of 19–21× for the S&P 500 - not from rigid math, but from how markets have historically priced equities in liquidity-driven expansions.
Here’s what supports that range:
Real yields (~1.6%) remain low by historical standards
Equity risk premium (ERP) compresses during global easing cycles - currently tracking ~3.5%
Nominal EPS growth expectations are stable around 5%
Rather than rely on fragile textbook math (which explodes when growth ≈ discount rate), we anchor our fair multiple to precedent:
In a world where real yields are steady, M2 is expanding, and central banks are no longer tightening aggressively, we believe 19–21× reflects a rational, liquidity-adjusted fair value for large-cap U.S. equities.
⚠️ Caveats
Liquidity ≠ earnings - this is a valuation tailwind, not a revenue driver
Macro data is lagged - second derivative inflections are the real signal
USD strength can mask non-USD M2 growth - FX-adjusted view is required
Fed policy remains highly sensitive to political turnover - we stay data-dependent
🧠 Final Take
Liquidity is not a catalyst. It’s a regime condition.
Ignore it, and you're mispricing the entire macro backdrop.
Potato Capital research is for informational purposes only and does not constitute investment advice.