The Covid-19 crisis has triggered the deepest liquidity squeeze since 2008. Unlike the Great Financial Crisis (GFC), an unprecedented real economy shock led to extremely quick deterioration of financial conditions and showed that, under extreme circumstances, liquidity may dry up not only within risk assets, but also within risk free ones. The peak of this crisis hit in February/March. Market liquidity has improved noticeably since then, although it has not completely normalised yet and areas of weak liquidity remain.
The asset management industry has navigated this liquidity crisis and emerged mostly intact from it, despite having been hit by outflows and precipitous drops in asset prices. However, the liquidity crisis has highlighted once again the importance of a powerful and active liquidity management policy through liquidity buffers, swing prices, stress tests, and access to a wide and varied range of counterparties or instruments that may prove more liquid during market stress. This is crucial to fulfil the fiduciary duty and stand ready to meet all redemptions during liquidity squeezes while keeping the portfolio’s structure unchanged in the interest of remaining investors. By doing this, large international players with global trading organizations may ensure the best mix of connectivity to liquidity venues and relationships with counterparties. Under extreme circumstances, they could even become liquidity providers themselves.
Going forward, investors should not be complacent about liquidity. In our view, investors should hold more, not fewer, assets for liquidity purposes irrespective of valuations consideration (this is the case for US Treasuries) and despite the apparent tranquility in the market. The current situation is characterized by a decoupling between financial markets and the real economy. This will be a key vulnerability and a risk to the recovery if investors’ risk appetite fades. A second wave of the virus, geopolitical tensions – most likely involving US-China relations – or idiosyncratic stories on EM could trigger volatility and liquidity squeezes.
Regarding financial markets, areas to pay attention to include decelerating monetary stimulus (although central banks will remain very accommodative) over the next months that may cause a sort of taper tantrum in markets and a possible re-pricing of inflation expectations. Another risk is that speculative buyers who exploited market dislocations early this year could reduce their exposure to lock in strong returns. Moreover, some excesses in terms of valuations are building up in some sectors and may trigger some profit-taking and unwinding of heavy positions. Within the corporate sector, highly leveraged firms may lose market access, possibly causing a spike in insolvencies and defaults, negatively affecting banks’ balance sheets. These factors may put strains on market liquidity and need to be monitored carefully. This is why liquidity management should remain a focus for investors and for the asset management industry as a whole.
Liquidity must be integrated as a key dimension in the portfolio construction process, as it’s the third pillar in addition to risk and return. Investors should no longer consider liquidity as exogenous and ex-post, an irregularly measured static element, but as a constant ex-ante endogenous dimension of portfolio construction. Liquidity should become one of the portfolio construction metrics and investors should make assumptions on the future dynamics of market liquidity as they do for all other portfolio metrics. This requires a large effort: collecting data, building methodologies, and setting norms and measurements. Liquidity should be assessed at the overall portfolio level and include the monitoring of trade-offs, namely the liquidity vs return trade-off, but also the trade-off of liquidity vs return, quality and yield at this point in the cycle.
In portfolio construction, investors should keep in mind the distinction between what is liquid and what is listed, and analyse liquidity at the asset class, segment and single instrument level. Liquidity can also be used to play opportunities that can emerge in periods of market stress. This has happened during the Covid-19 crisis, when investors able to distinguish between liquidity and solvency have exploited the dislocations to gain higher risk-adjusted returns. Entering a period of higher default risk, credit research is key to assessing areas of potential capital impairment risk, but also securities where market valuation does not reflect the credit risk profile and therefore offer a liquidity premium. Finally, investors should consider that the liquidity management approach is not universal and should be tailored around investment objectives and liquidity tolerance.
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