by David Robertson, CFA
October 2018
After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.
It wasn't that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms, "Central banks are pitiless executioners of long-lived booms and monetary policy has shifted." Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.
Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.
Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don't even notice it. Because investors have been living in a sea of liquidity, they don't even notice it. As he notes, "The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets."
Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.
One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes, "But everything for me has never been about earnings. It's never been about politics. It's always about liquidity." Not earnings or politics, but liquidity.
While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes, "we'll [the Fed will] be shrinking our balance sheet $50 billion a month," and, "at the same time, the ECB will stop buying bonds." Cole describes the same phenomenon in his terms, "Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates." Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]: "In terms of global liquidity, it's currently falling at the fastest rate that we've seen since 2008 ..."
For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out, "It's going to be the shrinkage of liquidity that triggers this thing." He goes on, "And my assumption is one of these hikes- I don't know which one- is going to trigger this thing. And I am on triple red alert because we're not only in the time frame, we're in the part ..." He continues, "There's no more euro ECB money spilling over into the US equity market at the end of the year ..."
Or, as Zerohedge reported [here], "We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air)."
As the Economist notes, "Shifts in America's monetary stance echo around global markets," and there is certainly evidence this is happening. Cole notes, "The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing."
Howell also chimes in, "You're also seeing emerging markets central banks being forced to tighten because of the upward shock to the US dollar." He concludes, "Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment."
The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that "Emerging markets face a dollar double whammy" in the Financial Times [here]. He describes, "The upheaval stems from the coincidence of two significant events: the Fed's long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts." He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, "Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable."
Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes, "The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world." As a result, there are a lot of crosscurrents that confound simple analysis.
For example, Zerohedge reports [here], "When 'QT' [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased ..." The story continues, "The markets evidently never 'missed' the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions."
Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights "the huge amounts of money of flight capital that have come into the US over the last four years" and quantifies it as "something like $4 trillion."
But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, "This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk." However, by the end of September, "the interbank market's cross-currency 'basis swap' for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp." Dizard summarizes the likely consequences: "That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery."
Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, "China has shown no appetite for buying further US dollar assets over the last 18 months." He concludes, "We think they've now stopped. And they're redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending."
Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes, "What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector."
Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: "The banks' woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market."
This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.
In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here], "With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets."
Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, "we're kind of at that stage of the cycle where bombs are going off," which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says, "And until the bombs go off in the developed markets, you would think the tightening will continue."
Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says, "Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate." He also warns, "[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market... THAT is the systemic risk.”
If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.
In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war: "We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a -- a defeat for the free world -- that was related to the rise of China -- and it was a total misreading of a pivotal event -- which cost us very dearly."
In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.
Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.
A recent story in P&I [here] articulated the challenge well: "Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm." More specifically, "The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity"
This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet: “You know the drill. In face of market volatility, keep calm and stay the course."
“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions.
If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects "a crisis to occur between 2019 and 2021,” a market decline has very different information content.
Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here], "Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market." Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments, “You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.”
Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller's own actions. As he puts it, "I also have bear-itis, because I made-- my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%."
Based on what he is seeing now, he is ready to pounce: "I ... kind of had this scenario that the first half would be fine, but then by July, August, you'd start to discount the shrinking of the balance sheet. I just didn't see how that rate of change would not be a challenge for equities ... and that's because margins are at an all time record. We're at the top of the valuation on any measures you look, except against interest rates ..."
So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.
Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: "When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents." So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily.
October 2018
After a rocky first quarter markets posted a solid second quarter and improved steadily through the third quarter. The US economy is currently rolling along at a pretty healthy pace as GDP grew at 4.2% in the second quarter and earnings have been strong. Unemployment clocked in at 3.7% for September which is incredibly low by historical standards. Indications of inflation are starting to creep into wages, materials, and transportation and many manufacturers have been able to offset them by raising prices. Through the lens of economics, investors are in good shape.
It wasn't that long ago, however, that investors looked past a feeble economic recovery and took cheer in the large volumes of liquidity major central banks around the world infused to support financial assets. Now the time has come to reverse course. As the Economist states [here] in no uncertain terms, "Central banks are pitiless executioners of long-lived booms and monetary policy has shifted." Investors who view these conditions exclusively through the lens of economics risk misreading this pivotal event: global liquidity is falling and will bring asset prices down with it.
Liquidity is one of those finance topics that often gets bandied about but it is often not well understood. It seems innocuous enough but it is critical to a functioning economy. In short, it basically boils down to cash. When there is more cash floating around in an economic system, it is easier to buy things. Conversely, when there is less, it is harder to buy things.
Chris Cole from Artemis Capital Management has his own views as to why investors often overlook liquidity [here]. He draws an analogy between fish and investors. Because fish live in water, they don't even notice it. Because investors have been living in a sea of liquidity, they don't even notice it. As he notes, "The last decade we’ve seen central banks supply liquidity, providing an artificial bid underneath markets."
Another aspect of liquidity that can cause it to be under appreciated is that it is qualitatively different at scale. A drop of water may be annoying, but it rarely causes harm. A tsunami is life-threatening. Conversely, a brief delay in getting a drink of water may leave one slightly parched, but an extended stay in the desert can also be life-threatening. We have a tendency to take water (and liquidity) for granted until confronted with extreme conditions.
One person who does not take liquidity for granted is Stanley Druckenmiller. In an overview of his uniquely successful approach to investing on Realvision [here], he describes, "But everything for me has never been about earnings. It's never been about politics. It's always about liquidity." Not earnings or politics, but liquidity.
While not yet extreme, the liquidity environment is changing noticeably. Druckenmiller notes, "we'll [the Fed will] be shrinking our balance sheet $50 billion a month," and, "at the same time, the ECB will stop buying bonds." Cole describes the same phenomenon in his terms, "Now water is being drained from the pond as the Fed, ECB, and Bank of Japan shrink their balance sheets and raise interest rates." Michael Howell of CrossBorder Capital, a research firm focusing on global money flows, summarizes the situation in a Realvision interview [here]: "In terms of global liquidity, it's currently falling at the fastest rate that we've seen since 2008 ..."
For some investors, the decrease in liquidity is setting off alarms. Druckenmiller points out, "It's going to be the shrinkage of liquidity that triggers this thing." He goes on, "And my assumption is one of these hikes- I don't know which one- is going to trigger this thing. And I am on triple red alert because we're not only in the time frame, we're in the part ..." He continues, "There's no more euro ECB money spilling over into the US equity market at the end of the year ..."
Or, as Zerohedge reported [here], "We have previously discussed the market’s mounting technical and structural problems – we believe these are a direct result of the increasingly hostile monetary backdrop (i.e., there is no longer enough excess liquidity to keep all the plates in the air)."
As the Economist notes, "Shifts in America's monetary stance echo around global markets," and there is certainly evidence this is happening. Cole notes, "The first signs of stress from quantitative tightening are now emerging in credit, international equity, and currency markets. Financial and sovereign credits are weakening and global cross asset correlations are increasing."
Howell also chimes in, "You're also seeing emerging markets central banks being forced to tighten because of the upward shock to the US dollar." He concludes, "Emerging market currencies are very fragile. And emerging markets stock markets are falling out of bed. These are all classic symptoms of a tightening liquidity environment."
The governor of the Reserve Bank of India, Urjit Patel, highlighted these issues when he wrote that "Emerging markets face a dollar double whammy" in the Financial Times [here]. He describes, "The upheaval stems from the coincidence of two significant events: the Fed's long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts." He claims that if the Fed does not recalibrate the shrinkage of its balance sheet, "Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable."
Although there is evidence that liquidity is tightening, it has not done so uniformly yet. The Economist describes, "The integration of the global financial system has turned national financial systems into a vast single sea of money that rises and falls with changes in saving and investment around the world." As a result, there are a lot of crosscurrents that confound simple analysis.
For example, Zerohedge reports [here], "When 'QT' [quantitative tightening] started in September of 2017, outstanding Fed credit initially kept growing well into 2018, largely because reverse repos with US banks ran off faster than securities held by the Fed decreased ..." The story continues, "The markets evidently never 'missed' the liquidity tied up in these reverse repos, not least because high quality treasury collateral serves as a kind of secondary medium of exchange in repo markets, where it supports all kinds of other transactions."
Flows of capital into US markets have also temporarily concealed tighter conditions. Howell highlights "the huge amounts of money of flight capital that have come into the US over the last four years" and quantifies it as "something like $4 trillion."
But the turning tides of liquidity that have been so noticeable abroad are now also starting to wash up on US shores, as John Dizard demonstrates in the FT [here]. When rates are higher in the US, foreign investors can buy US Treasuries and hedge out the currency risk. He notes, "This made it possible for non-US institutions to hold large bond positions that paid a positive rate of interest without incurring foreign exchange risk." However, by the end of September, "the interbank market's cross-currency 'basis swap' for euros to US dollars rose by 30 basis points and the cost of yen-dollar basis swaps went up by 46 bp." Dizard summarizes the likely consequences: "That was the end of foreigners paying for the US economic expansion. It also probably marked the end of the housing recovery."
Additional factors further muddy the mix. Repatriation flows have disguised the decline in liquidity but will only do so temporarily. Further, China has historically been a large buyer of US assets., but that is changing too. As Howell notes, "China has shown no appetite for buying further US dollar assets over the last 18 months." He concludes, "We think they've now stopped. And they're redeploying their foreign exchange reserves into Central Asia in terms of real infrastructure spending."
Bill Blain points to yet another factor in his analysis of liquidity in Zerohedge [here]. He notes, "What’s happened since Lehman’s demise has been a massive transfer of risk from the banking sector – which means, so the regulators tell us, that banks are now safer. Marvellous [sic]. Where did that risk go? Into the non-bank financial sector."
Almost as if on cue, the FT reported on liquidity issues at a shadow bank in India [here]: "The banks' woes have meant India has come to rely for credit growth increasingly on its shadow banking sector. Non-bank lenders accounted for 40 per cent of loan growth in the past year, according to Nomura, funding their expansion by relying heavily on the short-term debt market."
This case serves as a useful warning signal for investors because it is reflective of the global expansion of shadow banking and because it demonstrates the kind of pro-cyclical and mismatched funding that caused so many problems during the financial crisis.
In sum, although various transient factors have created some noise, the overall signal is fairly clear. Zerohedge reports [here], "With net Fed credit actually decreasing, an important threshold has been crossed. The effect on excess liquidity is more pronounced, which definitely poses a big risk for overextended financial markets."
Whether or not the big risk is immediate or not is open for some interpretation. As Druckenmiller puts it, "we're kind of at that stage of the cycle where bombs are going off," which suggests the time is now. However, he implicitly suggests developed market investors still have some time when he says, "And until the bombs go off in the developed markets, you would think the tightening will continue."
Problems for developed markets are on the way though, as liquidity is likely to get a lot worse. Cole says, "Expect a crisis to occur between 2019 and 2021 when a drought caused by dust storms of debt refinancing, quantitative tightening, and poor demographics causes liquidity to evaporate." He also warns, "[Y]ou should be VERY worried about how the bigger implicit short volatility trade affects liquidity in the overall market... THAT is the systemic risk.”
If it is still hard to imagine how a subtle and abstract thing like liquidity could overwhelm demonstrably strong economic results, perhaps a lesson from history can provide a useful illustration.
In Ken Burns’ Vietnam War documentary, Donald Gregg from the CIA captures the strategic perspective of the war: "We should have seen it as the end of the colonial era in southeast Asia, which it really was. But instead we saw it in Cold War terms and we saw it as a -- a defeat for the free world -- that was related to the rise of China -- and it was a total misreading of a pivotal event -- which cost us very dearly."
In other words, the subtle and abstract force of independence from colonial rule ultimately proved to be an incredibly powerful one in Vietnam. Many people wanted to believe something else and that led to very costly decisions.
Liquidity is playing the same role for investors today and investors who believe otherwise are also likely to suffer. The important lesson is that long-term investors don’t need to worry about getting all the day-to-day cross-currents just right. But they do need to appreciate the gravity of declining liquidity.
A recent story in P&I [here] articulated the challenge well: "Investors also must be more aware. Few recognize when conditions that could lead to a crisis are brewing, and those who do often misjudge the timing and fail to act to protect themselves and their clients from the full impact of the storm." More specifically, "The best laid plans for protecting investment gains, and even the corpus of a portfolio, could fail if attention is not paid to the likely shortage of liquidity"
This isn’t to say it will be easy to do or that the message will be uniformly broadcast. For example, after the significant market losses in the second week of October, the FT reports [here] that Vanguard notified clients via a tweet: “You know the drill. In face of market volatility, keep calm and stay the course."
“Keeping calm” is certainly good advice; it is even harder to make good decisions when one is wildly emotional and/or impulsive. However, “staying the course” makes some dubious assumptions.
If a market decline is just a random bout of volatility then it doesn’t make sense to change course. But when liquidity is declining and Druckenmiller sees “bombs going off” and Cole expects "a crisis to occur between 2019 and 2021,” a market decline has very different information content.
Staying the course would also make sense if your exposure to stocks is low and your investment horizon is very long, but the numbers say just the opposite. As Zerohedge reports [here], "Outside of the 2000 dotcom bubble, U.S. households have never had more of their assets invested in the stock market." Further, as Gallup documents [here], the 65 and older demographic, the one presumably with the shortest investment horizon, has actually slightly increased their stock holdings. As Bill Blain comments, “You’ve got a whole market of buy-side investors who think liquidity and government largesse is unlimited.”
Investors reluctant to heed the warnings on liquidity can consider one more argument — which comes from Druckenmiller's own actions. As he puts it, "I also have bear-itis, because I made-- my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%."
Based on what he is seeing now, he is ready to pounce: "I ... kind of had this scenario that the first half would be fine, but then by July, August, you'd start to discount the shrinking of the balance sheet. I just didn't see how that rate of change would not be a challenge for equities ... and that's because margins are at an all time record. We're at the top of the valuation on any measures you look, except against interest rates ..."
So, investors inclined to dismiss concerns about liquidity and who would be hurt if stocks should go down a lot, should know that on the other side is Stanley Druckenmiller, with an itchy trigger finger, ready to put his money where his mouth is.
Wrapping up, it is difficult to capture just how fundamentally important liquidity is to investing, but Chris Cole probably does it as well as anyone: "When you are a fish swimming in a pond with less and less water, you had best pay attention to the currents." So let’s hear it for liquidity: It is a powerful force that can boost portfolios and one that can diminish them just as easily.
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