In a world that is increasingly enthusiastic about the future, it is always useful to test the portfolio against potential downside scenarios. One of those is a significant drying up of liquidity. Such a scenario is not entirely inconceivable given that major central banks will start winding down a $10 trillion excess balance sheet over the next few years, the Chinese have reversed their positive credit impulse of +3% of global gross domestic product in 2014-2016 to -3% in 2017, rates are rising from zero, and the U.S. deficit of $1.3 trillion needs to be financed by the markets.
The question is where the pain from a liquidity crisis would be felt the hardest. In 2007/2008, it was at the banks. That is a lot less likely this time around, not only because the banks are better capitalised but also because they have changed their attitude to risk. A great example is the Credit Suisse VelocityShares Daily Inverse VIX Short-term ETN, which gained notoriety by losing 96% of its value in the recent spike in equity volatility. The remarkable thing is that Credit Suisse did not sustain material financial loss from this value destruction—except for the loss of a nice little income stream and some reputational damage. The bank also did its utmost to protect itself from litigation claims through strongly worded risk statements in the prospectus—which is well-worth a read.1
If it is not the banks, where is the problem most likely to occur? Liquidity is a bit like a New York rooftop bar. Whilst the night is balmy, people come up the elevator in small groups. When it suddenly starts to rain, everyone tries to get into the lift at one time, most of them already quite inebriated. The biggest crunch is likely to be in the most popular rooftop bars.
Since 2008, exchange-traded funds (ETFs) and other quantitative products have clearly been pulling in the punters. In 2007, MSCI World “index style” holders, as defined by FactSet, held on average 4% of the free float in the companies we hold. Today, it is 12% and unevenly distributed.2 In some names, index funds hold up to 25% of the shares.2 There is little experience of how these vehicles would behave in a sustained downturn, but what we have seen in recent flash crashes is that some of the vehicles sold off significantly more than their underlying assets.2 That may have to do with two factors: one is the relative ease with which these funds can be sold, even by retail investors, and secondly, the investment banks that manage the redemption and creation of the ETFs will require a very large spread before they can take the arbitrage risk during a sell-off.
Hence, it is likely that in a material liquidity shortfall, ETFs may sell off further than the underlying holdings, dragging down the underlying holdings below their fundamental values. The effect is likely most significant where the underlying holding is a lot less liquid than the ETF itself, namely, in corporate bonds. The Bank for International Settlements highlighted this issue in 2015, pointing out that bond ETFs provide an “illusion of liquidity” that is doubly hampered, first by the ETF market makers’ unwillingness to trade3 and furthermore by the shrunken inventory and risk appetite of market makers in the corporate bond markets. Whilst the bond market is likely the most challenged market in a liquidity squeeze, there are concerns about equities as well, particularly where the ownership of the stock is dominated by index-style products.
We have always taken liquidity into account when deciding whether a stock enters a portfolio and with the size of the position. With this in mind, we reviewed the share of index-style funds amongst the holders of companies. While we may experience some temporary setbacks in a liquidity scenario where ETFs sell off heavily, we would regard such a relative sell-off as a potential investment opportunity.
In the real world, liquidity constraints predominantly create problems for companies with material financial and operating leverage. More specifically, companies that have to refinance their debt will struggle in this scenario, as they did in 2008/2009, forcing them to cut dividends, sell their family silver and/or raise equity at the most dilutive moment. Quality companies, as we have been defining them for the last 20 years, have robust balance sheets and the ability to fund their growth mostly out of the existing cash flow. By being less susceptible to negative operating leverage, absolute earnings performance should remain stable, and relative outperformance should be significant in such a scenario. There is also a lot less probability of financial distress for the companies in our portfolio. In the event of a liquidity crisis, the combination of relative operating outperformance and relative derating should provide us with attractive potential investment opportunities.