Staying invested during a liquidity drought

As the US Federal Reserve and other central banks move away from long-running policies of near-zero interest rates, the chilling effect on liquidity is compounding the strain on markets already rattled by high inflation and slowing growth.

Liquidity in a trading context is essentially a gauge of the ease with which assets and securities can be bought and sold without moving the market price. Liquidity conditions on Wall Street deteriorated sharply in the first half of 2022, according to US regulators, with relatively small trades triggering large price swings even in the world’s biggest and most liquid markets.[1]

The crunch has been exacerbated by regulations introduced in the wake of the 2008 financial crisis that require banks to hold bigger capital cushions to protect their balance sheets during periods of volatility. As a result, banks hold smaller inventories of stocks and bonds for market-making, reducing their ability to add liquidity to financial markets.

There was a short-lived liquidity crisis in March 2020, when Covid-19 prompted an abrupt shutdown of the global economy. But central banks quickly stepped in with a massive injection of liquidity into the financial system to counter the economic effects of the pandemic, kicking off a year-and-a-half-long bull run. That run, of course, has come to an end because of soaring inflation, which has forced the Fed and other central banks to start reining in liquidity.

An abrupt turn in the tide of liquidity

As the Fed highlighted in its latest Financial Stability Report, liquidity has been falling since late 2021 in various markets, including in US Treasuries and futures contracts on the S&P 500 index and oil.[2] According to large investors and banks, liquidity across US markets at the start of the second half of 2022 was at its worst level since the early days of the pandemic.

Policymakers have identified possible fundamental structural issues that might exacerbate liquidity shocks.[3] In response, they have proposed several promising measures to ensure secondary markets can supply adequate liquidity to all when investors most need it. The proposals include changing how much capital banks must hold as a percentage of their assets, studying the potential benefits of central clearing of trading to reduce intermediaries’ exposure to counterparty risks, promoting direct trading between buyers and sellers without using banks as middlemen, and reviewing the regulation of market participants who provide substantial liquidity.

It will take time for these proposals to be accepted and enacted, however, and in the meantime, markets are vulnerable to a potential evaporation of liquidity.

Thin liquidity wreaks havoc during bear markets

Economist and influential financial commentator Mohamed El-Erian believes that although markets have already priced in interest rate risk, they have yet to adequately factor in credit, liquidity and market-functioning risks.[4] As he points out, as all the leveraged positions built on the back of the Fed’s liquidity injections are unwound, markets will face additional selling pressure. With liquidity conditions as tight as they are, it could prove especially costly for investors to exit those positions.

In past bear markets, the best strategy for investors has consistently been to take the long view and maintain their positions rather than sell and return to the market at some point in the future.[5] Apart from the futility of trying to time the bottom of the market, sellers in a weak, illiquid market will likely have to accept substantially lower prices for their assets.

There are, however, opportunities for those who can act with confidence in uncertain times. Investors who now wish to raise capital to go bargain hunting, diversify their portfolios or for other purposes can consider securities-based lending. This tactic provides them a stable source of capital without sacrificing the upside potential of their core holdings,and allows them to hold onto their positions until liquidity improves and selling them becomes less costly. When confidence returns, liquidity will, too, as those sitting on the sidelines return to markets.

How long that will take remains unclear. Though many have offered confident predictions on what lies ahead for markets in coming months, even those are prefaced with an acknowledgement that economic and geopolitical uncertainty prevails.[6] There are simply no clear answers to the big questions facing the global economy, including how long inflation will persist and how far demand will decline in taming it.

Whatever transpires, liquidity-related factors could make the second half of 2022 just as challenging as the first for investors. By offering fixed-interest loans on competitive terms, Equities First makes it easier for long-term shareholders to ride out those challenges.








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