As global equity markets hover near historic highs, investors face a critical question: can expensive valuations be sustained?
The answer may lie in the often overlooked dynamics of global liquidity. With central banks worldwide shifting their monetary stances, the flow of money through the financial system will likely determine whether markets extend their rally or face a correction.
Global markets are expensive, with the All Country World Index trading on an 18-time forward price earnings ratio (PE), 16% above its 15-year median and just above the one standard deviation point.
However, valuation in isolation doesn’t tell the whole story. Markets can stay expensive for longer than expected when supported by stronger underlying earnings growth and increased global liquidity.
At Flagship Asset Management our decision-making is informed by macroeconomic data and top-down analysis. One part of our framework we monitor closely is global liquidity.
Liquidity-markets connection
The accompanying chart shows global liquidity, as defined by M2 money supply, versus the S&P 500 Index. M2 is a broader measure of money supply in an economy than M1 and includes cash, checking deposits, savings deposits, small-denomination time deposits and retail money market funds. Economists often use the M2 to gauge inflation and economic health, and central banks rely on it to guide monetary policy decisions.
In this global liquidity calculation I’ve used the M2 money supply for the world’s 13 largest economies. The chart reveals a close relationship between global liquidity and the S&P 500 Index, which also holds for the All Country World Index.
The mechanism is straightforward: if central banks cut interest rates and/or start quantitative easing, money supply goes up. More money in circulation should support equity markets.
The other accompanying chart, dated September 2025, shows the net proportion of the world’s central banks whose last rate move was an interest rate cut stood at 80%, and was increasing.
Notice when central banks were hiking rates in 2022 to combat inflation, the S&P 500 was in decline.
Though markets were expensive in September 2025, increased global liquidity — combined with strong corporate earnings — supported the S&P 500, which gained 6% in the last quarter of 2025.
Current transition zone
We are currently in a liquidity transition zone:
- The US: The Federal Reserve has largely ended its quantitative tightening programme and is moving toward “reserve management purchases”, buying small amounts of US Treasuries to ensure adequate banking system liquidity. Interest rates sit in the 3.5% to 3.75% range.
- The eurozone: The European Central Bank has reached a “neutral” stance. After cutting rates through 2025 they are on hold at about 2%. The bank is not flooding the market with new cash, but it is no longer withdrawing it either.
- China: The People’s Bank of China is the outlier, actively pushing liquidity into its markets to combat a sluggish property sector. Rising consumer demand would prompt us to look more closely for opportunities in the Chinese equity market.
By mid-2026 liquidity is expected to be moderately higher, driven by normalisation.
Over the next six months the Fed is expected to deliver its final two rate cuts (likely in March and June), bringing the benchmark rate down to roughly 3% to 3.25%. This “neutral” level — where interest rates neither help nor hurt the economy — will lower borrowing costs for corporations, in effect “unlocking” stagnant cash.
One of the biggest drivers of liquidity in the next six months will be government spending. In the US and Europe, fiscal deficits remain high. As governments spend they push liquidity into the private sector. By mid-2026 we could see debt monetisation pick up, where central banks subtly support massive government debt issuance.
Key risks to the liquidity outlook
While the liquidity tap was being turnedback on in 2023, three specific risks could dry it up over the next six months:
- Persistent inflation: Inflation hovers around 3%, refusing to drop to the Fed’s 2% target. If it stays here, the Fed may pause rate cuts, causing a liquidity shock to overpriced stocks. Conversely, if inflation falls to around 2% it gives the Fed room to cut rates further. Key areas to watch are oil and gas prices, industrial metals and other commodities.
- Fiscal stress: High and growing government deficits are forcing central banks to manage debt rather than only the economy. This can lead to sudden volatility in the bond market. Governments need to grow GDP faster than debt to bring down debt/GDP ratios.
- Dollar strength. If global growth slows outside the US the dollar could strengthen sharply, historically draining liquidity from emerging markets and pushing down commodity prices.
With equity prices at historically high levels, the global liquidity picture will likely determine market direction in the coming months. The supportive monetary backdrop that propelled markets higher in late 2025 remains largely intact, but faces headwinds from persistent inflation, fiscal pressures and geopolitical uncertainty.
Investors should monitor central bank actions closely, particularly from the Fed. Any signal of pauses in rate cuts could trigger a repricing of risk assets. Conversely, if liquidity continues to rise expensive valuations may find further justification. The key is to remain alert. Any reduction in global liquidity could be the pressure valve that removes the froth from the equity market.
Short is global portfolio manager at Flagship Asset Management.
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