Part 1: Why Reduce DM Liquid Market Exposures.
It is not always the case that the intelligent thing is to do the stupid thing first. The herd can not only be wrong but can trap you from getting out.
Bubbles and Risks in Developed Markets
Given the youthful demography of the City and Wall Street, many investors and bankers beetling away in the established developed world asset classes have no experience of a bear market. Quantitative Easing has not only given us something more than the ‘Greenspan put’ – a warm complacency of knowing central banks will do “whatever it takes” – but has also distorted markets and dulled our senses.
Those trying to front-run the US bond market can no longer compete with the Fed’s status as the largest player and driver of expectations in the market. Low volatility is not a sign of low risk but of smothering.
The monolithic nature of official bond purchases kills non-consensus investment strategies and focuses attention almost exclusively on interpretation of central bank newspeak. It appears at times futile to caution against bubbles as the herd relentlessly pushes developed market stocks and junk bonds to ever new heights.
Not satisfied with absurd equity valuations and a staggering $12 trillion of government bonds with negative yields (a child can work that one out), asset inflation has also extended to the likes of bitcoin, for which the dominant investment rationale appears now to be its price momentum (conveniently forgetting that central banks still have the legitimate monopoly on currency issuance, and that money laundering is generally frowned on by regulators).
Investors have been in a rut for the best part of ten years now, with the occasional shock to the system followed by further complacency. The result has been ever increasing homogeneity in thinking and asset allocation. This in itself is a warning signal.
However, occasional panic and despair interrupts the nagging sense of unease. This psychological burden is borne by many with experience or even basic perception of:
- No, a little bit of growth pick-up in 2018 does not suddenly change everything, and
- Global imbalances have not gone away;
– Monetary economics
- Yes, developed world currencies are still overvalued, despite the substantial dollar decline already, and
- A switch from deflation to inflation is not only likely at some point but could be very fast, and
- The current gradual move up in rates is a period of great danger; or
- Consider the possible impacts from current US fiscal, trade, monetary, or foreign policy (take your pick), and
- Muse on the low likelihood of a smooth transition to a functional Federal EU with strong central institutions and large fiscal transfers legitimised and supported by domestic electoral majorities (the alternative being an eventual messy and systemically tumultuous break-up of the Eurozone … at least).
Yet the perception of huge risks ahead in the developed economies has not translated into much preventative action in asset allocation. Too many are boxed in by personal and collective prejudice.
This needs to change. The nature of New Year’s resolutions is, following some introspection, to refresh one’s thinking and take action. Most will not, as shedding prejudice is much harder than acquiring knowledge, but this means the arbitrage will be a long and beneficial one. Standing aside from the herd does sometimes pay – not least with numerous cliffs ahead. But we know that however much information and analysis is out there, the bulk of investors will continue to herd into the developed world bubbles until they crash.
Liquidity Curse Risk
Whilst some may be able to see the imminent warning signs and exit, many may be surprised, given the highly homogenous positioning of the market, at how fast liquidity can evaporate in the very places it is not meant to. One of our most entrenched behavioural biases is overconfidence.
We tend to differentiate risk and market dynamics overwhelmingly in terms of financial assets rather than by the behaviours of the particular set of market participants, their world views and incentives, at any particular time. The reason we do so comes from our conscious or subconscious tendency to believe markets are somehow not only efficient, but, intrinsic to this idea of efficiency, responsive to a vast and smooth (i.e. differentiable) range of competitive sources of both supply and demand from economic actors with, collectively, both highly sophisticated information processing abilities, and the desire to act fast to arbitrage out any market inefficiencies.
The reality is more sobering. Markets are not efficient and economic modeling which assumes all consumers are alike, and all investors likewise, are incapable of capturing Minsky moments or other extreme dynamics in their full terrifying complexity. We ignore at our peril the current mass homogenisation of investor beliefs and behaviour, the skewed incentives faced by agents directing the investments of others, and the role of governments and central banks with conflicting objectives to savers, and the consequent incentives to differentiate between maximum and optimal transparency.
Liquidity is under threat – from homogeneity of investor bases, extensive but systematically skewed world views (including what I have called Core/Periphery Disease), QE distortions, and the growth of ETFs. Yet the response of concentrating in fewer and fewer sources of remaining liquidity, whilst seemingly rational for the individual investor, spells ever greater risks from a macro perspective.
Rather than assessing (given a range of scenarios) the desirable maturity ranges to match investments against, investors have tended to see liquidity as a simple unalterable scale, with different values assigned to different assets and asset classes. A certain quantum of liquidity is then acquired irrespective of both the cost and risk of obtaining it.
I have written elsewhere about the impossibility for central bank reserve managers to obtain the level of liquidity they aim for through their over-concentration in US Treasuries – to the extent that they should change their objective function and put a lower priority on liquidity. Some have done so – in particular by starting to move to trade-weighted allocations. The argument similarly holds for other institutional investors.
The costs of over-emphasising the liquidity goal are twofold: not just the obvious cost of low return and high volatility, which is typically understood and taken into account, but the less appreciated cost of the liquidity disappearing when most needed – in turn a function of who else is thinking the same way and is likely to all want to access the same liquidity at the same time.
Just as in Africa and elsewhere discovery of a natural resource can cause Dutch Disease or, worse, a resource curse, so investors should be wary of a potential liquidity curse. The more an asset is bought for the sole purpose of providing liquidity, not being otherwise attractive, so the more homogenous (in its motives if not also in other characteristics) the investor base will become and the greater the risk of liquidity evaporating when needed.
The dominance of such investors curses the asset insofar as its high pricing (caused by herding and the liquidity premium being paid) puts off other investors – and thus a source of investor base heterogeneity and insurance against major liquidity loss.
The upshot is that many investors have paid a premium to acquire too much short term liquidity (which may be imprudent as this liquidity may be illusory in certain most critical scenarios). They have sub-optimal allocations to illiquid and long term investments which better meet their liability durations and can provide for future cash needs without paying a liquidity premium or taking liquidity curse risk.
Part 2 will make the case for EM Private markets – and how much.
Dr. Jerome Booth in London