How investors should deal with the liquidity dilemma

Summary

CIOs’ Insights

The paradox of liquidity (it dries up when most needed) remains one of the key challenges for investors on the aftermath of the great financial crisis and it is resurfacing in this late financial cycle phase.

Assuming that different asset classes should remain liquid at any time can fuel a false sense of security and result in a lack of preparation for future possible tensions. This issue is in part due to the fact that liquidity has been poorly defined, with confusion between macro (the systemic liquidity provided by central banks) and micro (market liquidity at asset class levels) liquidity.

On the central bank (CB) side, concerns regarding global liquidity may be overdue, as CB are now turning more dovish. The speed and path of quantitative tightening now look more uncertain and central banks are likely to be extremely cautious to avoid excessive tightening of liquidity and financial conditions, which could disrupt markets and accelerate potential for recession.

Even if risks of excessive tightening in macro liquidity recede, assessment of micro (market) liquidity continues to be paramount. Micro liquidity depends on supply/demand dynamics, but it also ultimately is a proxy for risk-on or risk-o. sentiment and/or trust in markets being able to secure trading. Last year’s revamp in volatility revealed areas of the markets where liquidity has deteriorated (namely, in corporate and emerging market bonds).

The further we advance in the cycle, the more financial markets start to discount the risk of a recession and market sentiment becomes more fragile, with possible episodes of risk-on/risk-o. reversal, especially as geopolitical uncertainty remains high. Liquidity tensions will arguably intensify future corrections when the cycle turns into recession.

In this environment, investors should be ready to grasp opportunities that o.er good rewards for bearing liquidity risk, but also reinforce liquidity risk management to avoid a liquidity trap that could force them to sell valuable assets in times of market stress.

In our view, big asset managers with solid liquidity management in place and global trading organisation that can ensure the best mix of connectivity to liquidity venues and relationships with counterparties will be best positioned to serve their clients when liquidity will be most necessary.