About That Liquidity Crunch…

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Just as a fierce storm can change the shape of a shoreline, liquidity has drained away from the post-crisis financial markets, creating new and unfamiliar sandbars where investors can wind up shipwrecked if they’re not careful. To navigate the newly parched market, Credit Suisse’s Private Banking and Wealth Management division says that investors must not only pay much closer attention to liquidity risks in their portfolios, but also learn to use illiquidity to their advantage.   The new market conditions are more apparent in fixed-income assets than equities. While bid-ask spreads for sovereign and corporate bonds in the U.S. and Europe have narrowed significantly from the wide gulfs of 2008, they are still well above their pre-crisis lows. Sovereign bond markets have also become shallower since the U.S. Federal Reserve began tapering its asset purchases in 2014 – and even markets that look deep based on trading volume can bottom out fast during bouts of volatility. That’s what happened on October 15, 2014, when U.S. 10-year Treasury bond yields fell 16 basis points and then recovered within 12 minutes, fluctuating 37 basis points over the course of a single trading day. Moves of that magnitude have occurred just three times since 1998.   Even for U.S. large-cap stocks, where bid-ask spreads are at their lowest levels since 2007, trades are increasingly clustered in the most liquid hours of the day. One in six S&P 500 stock transactions occurred in the last hour of trading in 2014, compared to one in 10 in 2007. It also seems to be getting more difficult – and costly – to execute large equity orders. Block trades of more than 1,000 shares comprise just 10 percent of all transactions compared to one-third a decade ago. Bid-ask spreads for U.S. small-cap stocks have also widened relative to large caps.   How did this happen? After all, deregulation, technological advances, and relatively easy monetary policy had combined to steadily increased liquidity in the two decades before the financial crisis. Banks turned into increasingly enthusiastic market makers as regulators removed the wall between commercial and investment banking, loosened restrictions on derivatives trading, and reduced capital requirements for financial institutions. At the same time, the rise of online, algorithmic trading made it easier, faster, and cheaper to trade. Quoted bid-ask spreads in large-cap U.S. stocks declined from more than 100 basis points in 1994 to well below 10 basis points in 2007. Finally, monetary policy in the 1990s and 2000s was relatively easy compared to the inflation-busting rate hikes of the 1970s and 80s, a change that encouraged risk-taking.   But all three trends are reversing course. Dealer inventories fell dramatically after regulators raised banks’ capital reserve requirements and banned proprietary trading in the wake of the crisis. Total trading assets at the top 10 U.S. and European banks have fallen 17 percent since their 2010 peak. On the technology front, Credit Suisse says that “the marginal benefits of innovation in trading are receding” as high-frequency trading speeds push the boundaries of physics. And while zero interest rate policies in the developed world have supported risky assets since 2008, Credit Suisse believes rate hikes from the Federal Reserve and Bank of England could cause liquidity to evaporate from bond markets.   To thrive in a less liquid world, Credit Suisse suggests investors track overall liquidity conditions by considering the supply of money, cost of capital, credit conditions, central bank policy, and trading liquidity. But the bank’s analysts also say investors also have to determine how susceptible their portfolios are to liquidity shocks by assessing both the volatility and autocorrelation of their holdings. Autocorrelation compares the recent trading behavior of a security with its own history, and illiquid assets tend to be more positively autocorrelated than more liquid ones, given the tendency to sharp reversals. Such price movements can offer compelling buying opportunities, but once owned, they can also puncture a hole in a portfolio’s returns.   Using those principles, Credit Suisse created a model portfolio comprised of 42.5 percent equities (36 percent in developed markets), 32.5 percent bonds (26 percent U.S. investment-grade bonds and Treasuries), 20 percent alternative assets (10 percent hedge funds, 5 percent gold, 5 percent commodities) and 5 percent cash. The bank notes that investors with higher allocations of traditionally illiquid assets such as real estate, emerging market equities, and high-yield bonds are probably more vulnerable to higher volatility than history would lead them to believe.   The model portfolio doesn’t shun illiquid assets altogether. Instead, Credit Suisse suggests that liquidity itself is an excellent entry and exit signal for illiquid assets. During a freeze, investors may be able to pick up assets at a bargain and sell them when the shock passes and prices rebound. In other words, even if the big banks have retreated from playing market maker, that doesn’t mean investors have to do so. Those willing to take on such risk of can potentially reap great rewards – but like any captain steering through rocky shoals, they’ll need nerves of steel.

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