Liquidity: The share market safety net

Don’t be concerned about liquidity risk in an equity downturn. With underlying fundamentals strong, value investors will be aggressive buyers.

Summary: Amid a pull-back in equities and volatility reaching its highest levels in two and a half years, investors may be concerned about whether they can exit the market if a sell-off occurs. After all, when there was a sudden drop in liquidity during the GFC, shareholders were left stranded. But this time is different. Even if a bond crash were to occur from a hike in US interest rates, the equity market would be insulated.

Key take-out: As equity investors, we don’t need to worry about liquidity drying up in the event of a correction. Unlike the bond market, equities aren’t in a bubble and are less prone to government intervention. And with the global economy doing well and company earnings well supported, value investors will snap up shares aggressively if the market were to fall.

Key beneficiaries: General investors. Category: Shares

Market volatility has spiked sharply over the last week, with the VIX Index surging to its highest point in about two and a half years. Foreign exchange markets are whipped around on a daily basis, while equities and commodities have slumped.

It would be nice to think that this would satisfy the somewhat unusual call by central bankers around the globe for a little less complacency in the market. Yet somehow I don’t think it will.

Chart 1: Volatility has surged

Go back a few days to the speech from Guy Debelle, the RBA Assistant Governor for Financial Markets. His timing was perfect, having said: “the sell-off…could be relatively violent when it comes.” Market ructions intensified.

Yet how worried should we be – as equity investors – about a slump in liquidity once a sell-off starts?

Well, as long as you’re not holding government bonds I don’t think we need to be too worried – especially about sudden drop off in liquidity for equities. At least not in the way bond investors should be concerned.

The backdrop is this: The world’s major central banks are trying their best to monetise debt – or at least the interest rate component of that debt – to shore up bank balance sheets and keep the cost of issuing new debt as low as possible for as long as they can.

In order to do that successfully, they need to manage market expectations. They want to encourage risk appetite, sure, but also moderate it, when necessary, in a world of free money. This is to prevent the trillions of dollars currently on central bank balance sheets from ending up in the broader economy – or in asset markets.

In that regard, communications policy becomes critical. It was interesting that in a recent interview, the former US Federal Reserve chair, Ben Bernanke, said that he wished he had paid much more attention to communications policy earlier on and especially during the GFC. That is, managing expectations, jawboning markets – PR basically. A lot of the rhetoric that we’ve seen from the Fed – first talking up rate hikes, then talking them down, has to be seen in that regard.

It’s that rhetoric which has caused much of the recent surge in volatility – certainly for currency and bond markets, although equities appear to be playing a different game (a confluence of negative news as best I can tell, overlayed with Fed rhetoric).

With that in mind, I suspect that even if the Fed were to hike, liquidity wouldn’t drop out of the equity market like it would in, say, the bond market. This is because the stock market is by its nature much deeper and more liquid – as an actual market. Sure, the bond market is much larger than the equity market – and notionally deeper and more liquid – but it is dominated by central banks, sovereign wealth funds and investment banks – a select group.

Central banks need bonds to monetise debt, and banks need bonds to hold as capital. Yet when the Fed hikes, central banks will need to offload their bonds to someone – but whom? Banks can’t take it all as capital. Governments increasingly act as both issuer and end buyer, certainly over recent years. 

The equity market is different. It is a market in the more traditional sense. US equities, for instance, are at least 70% owned by private players, be they households (about 50%), private pension funds, life insurance companies, etc. And, importantly, stock markets aren’t in a bubble.

This is important. To see this, think about what would happen if a bond crash were to occur. As Robert Gottliebsen noted last week, it’s unlikely that if there was a sudden bond crash that equities would escape harm. A correction would be likely. But then again, corrections happen – it’s a part of equity investing.

A correction is a very different reaction to a sudden drop in liquidity though. In that instance selling action becomes exacerbated as buyers dry up. We probably saw that during the GFC. But then why would we see that now? If bonds crash on a rate hike move, that’s likely because the US and global economy more broadly is doing very well and earnings will be well supported. It wouldn’t make sense for liquidity to dry up – eventually value investors would soon come in aggressively and stocks wouldn’t have to fall much for that to happen. Bonds in contrast would have to fall a very long way before value became apparent – which is why liquidity would dry up quickly.

Consider what happened during the 1994 bond crash. As bonds slumped, the S&P500 index did indeed correct – well, pull-back to be more precise – falling about 8.7% over three months from peak to trough. Having said that, it was only a few months later that stocks were nearly back to the level they had been before the bond crash. By early 1995, stocks were pushing new highs and went on to rally about 35% higher through 1995 (see chart 2).  

Chart 2: Stock market moves during the 1994 bond crash

Think about it. Liquidity is hardly going to drop out of the foreign exchange or equity market, especially as no one is really referring to the latter as a bubble. In any case, after the quite sizeable falls we’ve seen in some cases, value is beginning to reappear.

The bigger issue, however, and the reason we as equity investors need not be concerned about liquidity drying up – or investors being unable to sell their stock if they won’t in a correction – is because the market dynamics for the stock market are very different. The market is less prone to government intervention and value would become apparent much more quickly, even after modest falls.

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