The liquidity landscape has changed
Dr Tano Pelosi, Portfolio Manager, Antares Fixed Income
The likely move towards further global monetary accommodation will see central banks walking further along the tight rope between supporting economic growth, and avoiding financial stability risks. Record low interest rates and quantitative easing have created a perception that global investment markets are reservoirs of liquidity that can support both a chase for yield and ever-rising valuations.
Market dislocations however, could be on the rise. As we saw last December equity markets plummeted and credit spreads pushed wider, while questions swirled around why the sell-off was so violent.
The answer has a lot to do with the nature of today’s liquidity. With each of the drawdown events we’ve seen in recent times, average liquidity has been declining. Many securities trade on secondary markets rather than listed markets, and these secondary markets have historically been a rich source of liquidity. But over-the-counter (OTC) markets, a secondary market, have seen slower turnover despite strong deal origination activity.
Fortunately, in recent years market depth and liquidity have yet to be really tested. This is due largely to the suppression of economic and market volatility resulting from highly responsive central bank policies and new technology. Benign conditions however will not last indefinitely, and investors should know what they are getting themselves into, particularly in terms of liquidity.
A latent risk
Market liquidity (or more accurately illiquidity) is a latent and non-transparent risk which appears episodically and which results in higher transaction costs and gapping valuations. It often coincides with tightening financial conditions as seen in late 2018, or where valuations have become disconnected from fundamentals. Over the years markets have seen varying degrees of illiquidity and dislocated markets. In the most extreme cases full blown liquidity crises have ensued, including: Long Term Capital in 1997, the period following the September 11 attacks, the 2000 tech-wreck, as well as the collapse of Lehman Brothers in 2008.
These event-driven liquidity crises have several features in common, from financial sector stress and escalating funding costs, to asset-liability mismatches, and, in the extreme, complete aversion to risk-taking and counterparty failure.
The nature of liquidity in the current market environment may appear less of a worry than the event-driven crises mentioned above. However, it’s important to understand that the playing field has changed. Current liquidity conditions have evolved in response to quantitative easing, and this has led to changes in the microstructure of global investment markets, most notably in the behaviour of banks.
Since the GFC banks have been less inclined to make-markets and ‘warehouse’ risk where they’re forced to hold more assets on their books, restricting their trading activity and ability to generate revenue. This decline in financial intermediation was a by-product of banking regulations such as the Volker rule and Basel’s new capital and liquidity requirements. With market capacity so greatly reduced, banks can no longer act as shock-absorbers in times of stress. Which means it’s vital to consider how liquidity conditions will affect investment performance when the cycle turns.
Just as illiquidity can drive valuations down on very little investment flow, it can have an equally dramatic effect to the upside. We’ve seen some of the more technical strategies, such as; corporate share-buybacks, investor short covering, and options hedging, supporting stock valuations. They can have an outsized impact on driving a recovery when there’s been a correction.
While secondary market liquidity has been patchy, this has not been reflected in the primary listed markets. We’ve seen heavily oversubscribed corporate bond deals, negatively yielding government bonds and Initial Public Offering transactions flying out the door even before the company can turn a profit.
Perversely though, what we are witnessing is a type of crowding effect which can amplify risks in a market downturn. Popular investments are seeing significant investment flows buoyed by easy financial conditions compelling investors to move higher up the risk curve. The weight of demand for these investments has continued to pull down future expected returns, and investors will ultimately be faced with risk-adjusted returns converging on the risk-adjusted returns of more traditional asset classes, but without the corresponding liquidity.
Central bank easing has driven significant asset performance in recent years, but this liquidity effect cannot be depended upon when markets become disorderly.
Expectations of future returns from many traditional asset classes have become depressed, and it’s created herding behaviour amongst investors. This amplifies liquidity risk in secondary markets and exposes the fragility of the financial system itself. This herding behaviour is evident in many facets of the markets today. It includes the dramatic shift towards passive investing and the rise of ETFs, but more importantly, it raises the sensitivity of asset markets to sudden changes in financial flows. This will leave markets more correlated with each other, which ultimately diminishes the inherent benefits of portfolio diversification.
If you’re concerned about your ability to draw down capital at short notice, the focus should be on the liquidity of the asset class you’re exposed to, as well as how it will perform in a potential stressed market scenario.
In the fixed income universe it is prudent to ask how much cash and cash-like securities the fund holds, what assets can be reasonably sold without incurring a hit to performance, as well as understanding what stress-testing is done to your portfolio, and the track record your investment manager has under their belt.
Many claims are made about liquidity, but in the end, it’s the scrutiny of investment managers that matters. When the next market disruption occurs central banks may not be able to bail markets out. It will be those investment managers who are both prepared and agile, who will be able to best navigate the vagaries of illiquid markets.
This communication is provided by the fixed income investment management division of nabInvest Capital Partners Pty Limited (ABN 30 002 641 661, AFSL 230705) ("NCP") known as Antares Fixed Income. NCP is a member of the group of companies comprised National Australia Bank Limited, its related companies, associated entities and any officer, employee, agent, adviser or contractor (“NAB Group”). An investment with NCP does not represent a deposit or liability of, and is not guaranteed by, the NAB Group. The information in the communication is of a general nature only and is not financial product advice. The communication is not intended to offer products or services provided by any member of the NAB Group. Opinions constitute our judgement at the time of issue and are subject to change. Neither NVP nor any member of the NAB Group, nor their employees or directors give any warranty of accuracy or reliability, nor accept any responsibility for errors or omissions in this communication.