The Liquidity Crisis to Come - How to Prepare

Fri 02 Feb 2018

By Brian Dennehy

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Market commentary


In recent weeks we have focussed on the problem of liquidity. In this blog we re-cap and also look at liquidity at a fund level. In particular, when you want to sell will anyone want to buy? Will it be possible for you to trade funds at all? How can you mitigate these risks?

magnifyLiquidity is the oil lubricating the economy, markets, and individual investments and funds.  When liquidity is skewed in one direction, rather than toing and froing, it has extreme effects.  
For example, when central banks swamped certain parts of the economic and market apparatus with cash from 2008/9, it pushed markets higher, and higher, and squeezed out sellers – hence the collapse in volatility and extremely overvalued equity markets particularly in the US.  
The chart below illustrates the cash tsunami derived from quantitative easing or QE (as measured by the Federal Reserves balance sheet) versus the US stock market.  The correlation is clear.  On the right of the graph is plotted the expected pull-back in Federal Reserve generosity.  Which way do you think the stock market will go?
If you think that the much-heralded synchronised economic boom will come to the rescue of markets, think again – we covered that in the latest TopFunds Guide, “Confusing a boom with stock market potential”. 
S&P 500 vs Fed Balance Sheet
Our focus today is liquidity at a market and fund level.
Robots Dominate Stock Markets
Looking first at stock markets, the chart above gives a sense of how central bank-driven liquidity has driven the US stock market higher – and that tap is now being turned off.
The nature of those who have been buying is vitally important.  It was the same in 1987:
“In 1986 there were rumblings about the dangers of the use of computers set up to quickly trade large numbers of shares, so-called program trading. This took two forms. 
The first was portfolio insurance, where a computer model worked out how much to sell to limit losses when the stock market was falling.
The second type of program trading was “index arbitrage”. This was designed to make profits by exploiting price discrepancies between the value of shares in a stock market index and the value of the equivalent futures contract. 
Despite some concerns, there was no drive to understand these better… concerns were largely ignored because a lot of money was being made through these innovations.”  
The use of computers for trading was at a very early stage.  But they were absolutely pivotal to the speed and extent of falls – on Black Monday 1987 alone the market fell by 22.6%.
The role of computers is no longer fringe – to a large extent, computers and robots are the market. In January 2016 we highlighted that:
  • The US stock market was up 150% since March 2009…
  • …but volume had plunged, down 70% since 2004.
  • Only 15% of this volume was driven by humans.
  • 65% was high frequency trading.
  • 20% was ETFs, “passive” funds.
Though ETFs are probably now more significant (say 30% of trading), the overall picture is clear.  The volume of trading is driven by robots.
The timescale for such investments is very important.  High frequency trading takes place within fractions of a second.  Jack Bogle, founder of Vanguard and the passive fund industry in the 1970s, told us that the largest ETF tracking the US stock market (SPDR 500) is 90% held by banks and financial intermediaries, and the average holding period is roughly 12 days.
That has nothing to do with investing – rather it is out and out speculation, and it now dominates the US stock market.
The point is that these short term trades are relying on small incremental gains, and have absolutely no tolerance of sharp falls – which in their terms will be less than 5%, let alone anything worse.  Any rush for the exit will make Black Monday look like a tea party.
Robots don’t bluff.  Robots don’t hesitate, have long lunches, or get distracted by calls from home.  Robots sell rapidly.  They don’t panic, or worry about whether they will have a job tomorrow.  They stick to pre-programmed stop-loss limits.  In a downturn it will be machine against machine.
Liquidity was all in one direction, and the central banks had markets in the palm of their hand, when QE was fully operative.  Now the robots will take control and, at some point, they will reverse the direction of liquidity.
Bond Liquidity Inherently Horrible
Despite what was just said, liquidity is a breeze for stock markets compared to bond markets.  
You saw in the graph above how QE is morphing to QT (quantitative tightening), and the implied impact on stock markets.  The impact on bond markets could well be greater, in particular in the supply of bonds: 
  • Quantitative tightening (QT) will result in massive new supply of bonds 
  • i.e. bonds were being hoovered up by central banks, now they won’t be.
  • If you increase supply of something prices go down…
  • …in other words bond prices will fall.
Then there is the quality of bonds:
  • The quality in new high yield bond issuance is horrible. 
  • Covenant-lite bond issuance is rising…
  • …from 10% of the total 4 years ago to 30% today. 
  • Cov-lite means the bond issuer has more ways to wriggle out of its commitment.
As one broker in New York put it:
“Bond terms never got this bad in 2007. The contracts… are the worst they’ve ever been.”
You don’t get correction in these sorts of bonds – you just get wiped out
Crazy Junk Bond Valuations
Also on the quality of bonds, have a look at the chart below.  You can see how junk bond yields are now down to the level of US Treasuries, bonds issued by the US government. The crazy implication is that fringe European businesses (which often go bust) are no more likely to default on their obligations than the US government (which has never gone bust).

The 2008 Parallel

Liquidity in bond markets is inherently bad. Put another way, when a volume of investors want to sell, there is no one to buy – even before 2008.  In 2008 many investment-grade (let alone high yield) bonds could not find a buyer at any price – or at least not easily.  Bond fund managers were shaken very badly – it was never meant to be like this – after all, aren’t these lower risk investments?
The greatest problem now is in the inherently lower quality high yield bond market.  When there is a rush for the exit (there will be at some point- guaranteed) bond ETFs will suffer particularly badly as they have attracted disproportionate sums from those with shorter time horizons, and who will be inclined to sell at the first whiff of grapeshot. 
A good number of investment grade funds came close to suspending dealing in 2008/9.  Not only is liquidity inherently worse (investment banks in scale don’t provide liquidity and prices any more), but the eye of the storm has shifted to even lower quality bonds, and even hotter money. 
Of course many of the latter won’t be able to sell – so they will sell what they can sell – which is the higher quality bonds and equities. A nasty spiral.
Be wary of strategic bond funds, where many investors rush when more focussed bond funds are struggling. Where do strategic bond funds get most performance from?  High yield bonds.  Plus up to 20% in the stock market.
How Individual Funds Might React
If liquidity will be at the centre of the next market crisis, how might funds respond?
With unit trusts and OEICS, prices will be cut one-for-one with market prices.  With investment trusts price falls will be inherently steeper, as their prices are also driven by day to day supply and demand, not just the price of underlying assets.
Unit trusts can also suspend trading in extremis, and this is not well known. People usually just think of property funds in this regard, as it has not occurred with other types of unit trusts.  But they came close to suspending bond funds in 2008 (conditions are worse now).  If suspensions occur in bond funds and stock market-linked funds it will probably be due to what might be politely called “disorderly trading”, where it is difficult to fathom prices for underlying investments.  (This was the case for most bond funds in 2008/9, but by hook or by crook they managed to navigate those waters on that occasion, and avoid suspending trading, just).
Unit trusts can adjust prices against you in other ways.  For single priced funds there is the possibility of a dilution levy or dilution adjustment – for individual funds the annual fund statements set out more details on these, and whether and to what extent they were applied in the previous year.  We will cover these in more detail on another occasion, but they are minor issues relative to the risk of market-wide price falls and the risk of suspension.  Similar adjustments can be made with older-style dual priced funds, those with a bid offer spread – but again these are not significant relative to the other downside risks to prices.  
There is no single answer to limit the impact of sharp and rapid falls.  Three options are:
  • Have higher than usual cash levels
  • Don’t over-concentrate funds if possible
  • Have a clear stop-loss strategy
I covered cash levels in the December teleconference.  Personally I feel comfortable with 20% as a minimum.
How you concentrate your funds does depend on your particular strategy.  There is nothing wrong with just five big fund holdings.  But try not to have all five in one sector which could become quickly illiquid – such as bonds.  And if you have one large bricks and mortar property fund holding, why not stretch this to three?  Each will emphasise slightly different underlying assets, and will not all necessarily suspend trading, or not at the same time.
Be wary of the classical idea of diversification e.g. at its simplest having a mix of asset classes: stock market, bonds, and property.  In 2008/9 it was clearly illustrated that all asset classes are perfectly capable of all falling at the same time, with no hiding place.  In a crisis with liquidity at its centre this will be all the more so.
I have said many times now that you must have a stop-loss strategy.  Yet it is not perfect.  If you have a stop-loss of 10%, and the markets open down 20% what are you going to do?  The answer will be clearer at the time – there is no single right answer from the perspective of today.  This is where the teleconferences will be invaluable, and which we will put in place as soon as cracks emerge.
Here are some other tips, and do please share yours with us too:
  • Don’t go on holiday or similar and be out of contact with markets if you have large investment commitments.  
  • Make sure you have all your account details and holdings with you in paper form.  
  • If you normally only trade online, ensure your broker/adviser will have a telephone dealing service.  
  • Know what time of the day your broker/adviser trades in funds…
  • …if they trade funds at 8.30am and you ring at 9.00am, you are already 24-48 hours behind market prices.
On another occasion we will discuss how the authorities will respond to these events - OK, let's call it The Great Liquidity Crisis, get that in early.  In the meantime there is plenty in the above to enable you to keep building out your plan.


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