May the Force be with you

Liquidity as a financial phenomenon has risen to become one of the most important market parameters.

What is liquidity?

Liquidity means the availability of cash or how quickly something can be converted to cash. So if you own a house worth £500,000, to turn it into cash would take weeks or months to get it valued, put it on the market, then complete the sale. It’s an illiquid asset.

If you have £500,000 in cash under your mattress, then you have a highly liquid asset; the cash is instantly accessible. The disadvantage is that inflation erodes its real value.

We can consider three types of financial liquidity:

  • Systemic liquidity – how much cash or cash equivalents  is circulating in the broad economy
  • Funding liquidity – how much money is being lent to non-financial companies by banks
  • Trading liquidity – how quickly you can sell a share or bond.

The importance to investors

The global economy is in a potentially vulnerable position in which systemic liquidity could fall and pull other forms of liquidity down with it creating instability and substantial losses.

The background

Over recent years, systemic liquidity has been buoyed by what has been termed, “quantitative easing” (QE). This is the equivalent of printing money but doing so through electronic rather than paper means. Since the financial crisis in 2008, central banks such as the Bank of England, Bank of Japan and the US Federal Reserve (“Fed”) have used QE to inject huge amounts of money into their respective national financial systems which, in turn, affects the global financial system as a whole. For the most part, they have done this by buying government bonds from large financial institutions including banks.

The theory is that with this substantial injection of money, banks are increasingly encouraged to lend to businesses and customers who will spend much of that money, which should lead to economic growth.

What is inevitable with this form of QE is that the increased demand for government bonds pushes their prices up and their yields down2. This drives yield-hungry investors towards higher risk assets such as corporate bonds and equities which, in turn, pushes their prices up.

Meanwhile, the prevailing low interest rates constitute a double-edged sword. For debtors, the real value of the amount that they owe is gradually reduced by inflation. This works to the benefit of governments with substantial deficits that they are trying reduce. On the flip side, savers see the value of their savings either falling in real value, or growing very slowly. This acts as a disincentive to save, so deposits with banks are affected as is the banks’ ability to lend (funding liquidity).

The vulnerability

The trouble is, a great deal of  money from QE has not flowed through to the man on the street. Banks held on to much of the money in order to improve their balance sheets following the financial crisis. So asset prices have been distorted but the trickle-down effect on economic growth has been limited.

Since 2012, banks have been offering to lend more money, but the demand for borrowing has receded. People and businesses have been less keen to borrow more so, once again, the trickle-down effect has been stifled and liquidity restricted.

What’s more, liquidity levels could be on the verge of a significant fall as they face an array of potential challenges.

To begin with, the steady flow of money into financial institutions from central banks is slowing, as made evident by the fact that the total value of assets held by central banks in aggregate has stopped growing in recent weeks. Most notably, the Fed has ceased its bond-buying programme and has implemented  an increase in interest rates.

But this development could have severe consequences. Firstly, the departure of the central bank from the bond-buying market removes the biggest, most dependable buyer. So the market has to adjust to lower demand, and with lower demand comes lower pricing.

Secondly, as money is pumped into the financial system, it can boost inflation (more money chasing the same number of goods and services pushing the prices up). As this stimulant is withdrawn, especially if it is combined with the expectation of rising interest rates, there is less money circulating, and inflation could fall or even turn to deflation (falling prices) which can cause severe economic disruption (lower wages, less spending money, less investment).

Thirdly, the fickle beast that is investor sentiment can enter the fray. An investor worrying that bond prices could fall might sell his bonds in order to avoid a loss. If enough investors feel the same way or expect others to feel that way, then the very expectation of a falling bond market is enough to make it a reality. This same fulfilment of expectation can apply across all elements of markets. So with the exodus of the central bank, investor sentiment becomes a significant risk factor that can be very difficult to manage.

A further challenge is that funding liquidity is barely growing globally. In the eurozone, lending to small- and medium-sized enterprises is falling significantly, while borrowing seems to have peaked in China and the US.

Furthermore, there are growing concerns over trading liquidity. For example, traditional market makers (which guarantee a minimum level of trading liquidity) have become less active due to increased regulation. Meanwhile, financial institutions that tend to hold on to investments for the medium- to long-term are holding a larger proportion of the corporate bond market. This undermines liquidity because it effectively takes these corporate bonds off the market.

What could happen?

A substantial fall in liquidity now could lead to a reversal of the processes described above: demand for bonds would fall leading to a knock-on effect for other assets; less money would be lent to businesses and individuals to spend; hence there would be less money circulating in the broad economy which probably would be detrimental to economic growth. One of the potential consequences could be intermittent demand and supply for assets. For example, an asset might previously have been available for sale at £101 and an offer to buy at £99, whereas with intermittent demand and supply the spread between those prices might extend to £105 and £95. Investors might be faced with the choice of losing money on a sale or purchase, or not participating in the market.

As an example of what can happen in a worst-case scenario, asset manager, Third Avenue, said at the end of  last year that it was taking the unusual step of blocking investors from getting their money out of its Focused Credit fund, an approach usually referred to as “gating”. The fund’s assets under management have been declining on the back of the recent dislocation in high yield bonds. As part of gating the fund, most of the money in the fund has now been put into a trust, which gives the asset manager more flexibility in selling positions.

The International Monetary Fund (IMF) has examined the liquidity risks facing trading in particular. In its October Financial Stability report, the IMF identified that, while apparently healthy, trading liquidity levels currently are more vulnerable to a negative shock than they were in 2007; that was the year in which liquidity levels plummeted giving rise to the “credit crunch” and substantial falls in the value of shares and bonds.

What’s more, retail banks generate up to seven times as much liquidity as central banks, but their role as liquidity providers has been diminished as has that of brokers and investment banks. That leaves central banks and other non-conventional forms of lending (also known as “shadow” banks) which don’t provide enough liquidity to make up for that lost through the reduction of QE.

Our positioning

We are monitoring liquidity very closely which, we believe, sets us apart from a number of our peers. Part of this monitoring process is to identify some of the more vulnerable parts of the global economy by examining how much more money is lent out as gross domestic product (a measure of a country’s entire economy) increases (known as the “credit impulse”) in different locations. The higher the credit impulse, the greater the vulnerability to a liquidity shock.

However, nothing is certain and 2016 could be a positive year for the global economy. Should this happen then liquidity levels are less likely to be threatened by a shock. However, the multiplier (mentioned above) is now operating at a lower level. That is to say, with less demand to borrow money and banks being required to retain higher amounts of cash against what they lend, the multiplier is less effective.

Time will tell how this pans out, but in the meantime, our overall  stance is  slightly equity friendly, meaning we still don’t have a strong preference for risky assets. We might reinvest more in equities, but only when we are sure that the conditions, including the levels of funding- and trading-liquidity, are right.

It should be borne in mind, however, that liquidity is just one of the indicators that we monitor. Others include inflation; how appropriately the values of investments are being reflected in market prices; the relevant levels of supply and demand; and technological developments that could upset the status quo. The way in which these and other factors influence a given investment and its environment, inform how we allocate resources and plan for the future.

Sources

  1. As the term implies, cash equivalents are highly liquid investment securities that tend to be short-term and have a high credit quality (i.e. low risk). They include treasury bonds and bank certificates of deposit.
  2. A bond offers a fixed payment known as the “coupon” usually paid every six months. In simple terms, if the coupon is £5 and the market price of the bond is £95 then the yield is (£5 ÷ £95) 5.26%. If demand increases pushing the price up to £100 then the yield falls to (£5 ÷ £100) 5.00%.

Important information

Forecasts are opinion only, cannot be guaranteed and should not be relied upon when making investment decisions. The forecast of future performance is not a reliable guide to actual future results. Past performance is not a guide to future performance. Investors may not receive back the full amount originally invested and the value of investments, and the income from them, may fall as well as rise.

No representation, warranty, express or implied, or undertaking is given or made as to the accuracy, reasonableness or completeness of the contents of this document or any opinions or projections expressed herein.

Investment markets and conditions can change rapidly and as such the views expressed should not be taken as statements of fact, nor relied upon when making investment decisions.

Any views expressed within this article  are our in house views as at 11th January 2016  and should not be relied upon as fact and could be proved wrong.

The information contained in this document has been derived from sources which we consider to be reasonable and appropriate.
This document may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) for any other purpose without prior written consent.

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