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.
[1] https://www.ft.com/content/8bf44db8-8c6b-4376-b11c-b59422c0604e
[2] https://www.federalreserve.gov/publications/files/financial-stability-report-20220509.pdf
[3] https://www.ft.com/content/8bf44db8-8c6b-4376-b11c-b59422c0604e
[4] https://www.bloomberg.com/news/articles/2022-07-01/el-erian-says-receding-liquidity-is-biggest-risk-to-markets#xj4y7vzkg
[5] https://www.morganstanley.com/articles/top-5-investor-mistakes
[6] https://www.reuters.com/markets/europe/sp-500-seen-little-higher-by-end-2022-strategists-2022-08-24/
Disclaimer
Past performance does not guarantee future returns, and individual returns are not guaranteed or warranted.
This Document is intended solely for accredited investors, sophisticated investors, professional investors, or otherwise qualified investors, as may be required by law or otherwise, and it is not intended for, and should not be used by, persons who do not meet the relevant requirements. The content provided herein is for informational purposes only and is general in nature and not targeted to any specific objective or financial need. The views and opinions expressed in this Document have been prepared by third parties and do not necessarily reflect the views and opinions of EquitiesFirst. EquitiesFirst has not independently examined or verified the information provided herein, and no representation is made that it is accurate or complete. Opinions and information herein are subject to change without notice. The content provided does not constitute an offer to sell (or solicitation of an offer to purchase) any securities, investments, or any financial products (“Offer”). Any such Offer shall only be made through a relevant offering or other documentation which sets forth its material terms and conditions. Nothing contained in this Document shall constitute a recommendation, solicitation, invitation, inducement, promotion, or offer for the purchase or sale of any investment product by First Holdings, LLC or its subsidiaries (collectively, “EquitiesFirst”), nor shall this Document be construed in any way as investment, legal, or tax advice, or as a recommendation, reference, or endorsement by EquitiesFirst. You should seek independent financial advice prior to making an investment decision about a financial product.
This Document contains the intellectual property of EquitiesFirst in the United States and other countries, including, without limitation, their respective logos and other registered and unregistered trademarks and service marks. EquitiesFirst reserves all rights in and to their intellectual property contained in this Document. The Document should not be distributed, published, reproduced or otherwise made available in whole or in part by recipients to any other person and, in particular, should not be distributed to persons in any country where such distribution may lead to a breach of any legal or regulatory requirement.
EquitiesFirst make no representation or warranty with respect to this Document and expressly disclaim any implied warranty under law. You acknowledge that EquitiesFirst is not liable under any circumstances for any direct, indirect, special, consequential, incidental, or punitive damages whatsoever, including, without limitation, any lost profits or lost opportunity, even if EquitiesFirst has been advised of the possibility of such damages.
EquitiesFirst makes the following further statements that may be applicable in the stated jurisdiction:
Australia: Equities First Holdings (Australia) Pty Ltd (ACN: 142 644 399) holds an Australian Financial Services Licence (AFSL Number: 387079). All rights reserved.
The information contained on this Document is intended for persons located in Australia only and classified as a Wholesale Client only as defined in Section 761G of the Corporations Act 2001. The distribution of information to persons outside this criteria may be restricted by law and persons who come into possession of it should seek advice and observe any such restriction.
The material contained in this Document is for information purposes only and should not be construed as an offer or solicitation or recommendation to buy or sell financial products.
The information contained in this Document is intended to be general in nature and is not personal financial product advice. Any advice contained in the Document is general advice only and has been prepared without considering your objectives, financial situation or needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation and needs. You should seek independent financial advice and read the relevant disclosure statements or other offer documents prior to making an investment decision about a financial product.
Dubai: Equities First Holdings Hong Kong Ltd (DIFC Representative Office) at Gate Precinct Building 4, 6th Floor, Office 7, Dubai International Financial Centre (commercial license number CL7354) is regulated by the Dubai Financial Services Authority (“DFSA”) as a Representative Office (DFSA Firm Reference No.: F008752). All rights reserved.
The information contained in this document is intended to be general in nature, and, to the extent that it is perceived as advice, any advice contained in this document is general advice only and has been prepared without considering your objectives, financial situation, suitability of the financial products or your needs.
The material contained in this document is for information purposes only and should not be construed as financial advice, including an offer or solicitation or recommendation to buy or sell financial products. The information contained in this document is intended to be general in nature and any advice contained in this document is general advice only and has been prepared without considering your objectives, financial situation, suitability of the financial products or your needs. Before acting on any information, you should consider the appropriateness of the information provided and the nature of the relevant financial product having regard to your objectives, financial situation and needs. If you do not understand the contents of this document, you should consult an authorised financial adviser.
This document relates to a financial product which is not subject to any form of regulation or approval by the DFSA. The DFSA has no responsibility for reviewing or verifying any documents in connection with this financial product. Accordingly, the DFSA has not approved this document or any other associated documents nor taken any steps to verify the information set out in this document, and has no responsibility for it.
Hong Kong: Equities First Holdings Hong Kong Limited is licensed under the Money Lenders Ordinance (Money Lender’s Licence No. 1659/2024) and to carry on the business of dealing in securities (Type 1 licence) under the Securities and Futures Ordinance (“SFO”) (CE No. BFJ407). This Document has not been reviewed by the Hong Kong Securities and Futures Commission. It is not intended as an offer to sell securities or a solicitation to buy any product managed or provided by Equities First Holdings Hong Kong Limited and is only intended for persons who qualify as Professional Investors under the SFO. This document is not directed to individuals or organizations for whom such offers or invitations would be unlawful or prohibited.
Korea: The foregoing is intended solely for sophisticated investors, professional investors or otherwise qualified investors who have sufficient knowledge and experience in entering into securities financing transactions. It is not intended for, and should not be used by, persons who do not meet those criteria.
United Kingdom: Equities First (London) Limited is authorised and regulated in the UK by the Financial Conduct Authority (“FCA”). In the UK, this Document is only being distributed and made available to persons of the kind described in Article 19(5) (investment professionals) and Article 49(2) (high net worth companies, unincorporated associations etc.) of Part IV of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (‘’FPO’’) and any investment activity to which this presentation relates is only available to, and will only be engaged in with, such persons. Persons who do not have professional experience in matters relating to investment or who are not persons to whom Article 49 of the FPO applies should not rely on this document. This Document is only prepared for and available to persons who qualify as Professional Investors under the Markets in Financial Instruments Directive.
