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ROBUSTNESS, FLEXIBILITY AND OPPORTUNISM IN LATE‐CYCLE INVESTING

Be Prepared to Provide Market Liquidity


The next downturn will be the first since the financial crisis of 2008 – 09. That is significant, because a post-crisis wave of regulation has left the structure of the financial market very different than it was going into previous recessions. Illiquidity poses risks, but may also generate opportunity.

Market liquidity has diminished

Amid the wave of regulation in the aftermath of the financial crisis, both Basel III and the U.S. Dodd-Frank Act incentivized or required investment banks to reduce their balance sheet risk. That has led them to hold fewer securities for proprietary trading, market making and liquidity provision. These measures have had their biggest impact in fixed income markets. But the structure of equity markets has changed beyond all recognition since the financial crisis, too, for two different reasons.


As liquidity-provision has moved off of broker-dealer balance sheets, where humans would take risk based on slower-moving value and mean-reversion indicators, it has moved onto the balance sheets of high-frequency trading funds, which take risk based on split-second changes in volatility-based risk parameters. Whereas the human liquidity provider would have seen opportunity for profit in volatile markets, algorithms tend only to see risk—which means they withdraw liquidity, in aggregate, just when it is most needed. The liquidity picture in equity markets has also changed due to the volume of invested assets that have migrated from traditional, value-focused, fundamental bottom-up portfolio management to a range of momentum- and volatility-focused quantitative, systematic and passive strategies.

Banks’ capacity to offer market liquidity has diminished
Net U.S. dealer positions in corporate credit, USD billions

Source: Federal Reserve Bank of New York.



For investors, this means three things.


  1. Overall market volatility and correlations are likely to be higher than they have been during past cycles, on average, with price changes more likely to be sudden and “gapping.” This has implications for portfolio risk management and also for the calibration of market price-based economic indicators.

  2. Counting on liquidity to exit from riskier positions when signs of a downturn become evident could be a painful strategy in this new environment.

  3. The combination of fragmented liquidity and brittle investor sentiment could present excellent long-term value opportunities for those who maintain the liquidity and flexibility to take them.
Maintaining a liquid portfolio component and a bias toward high cash-flow strategies

In equities, that suggests exposure to larger, more liquid stocks. Higher quality may also be desirable in the form of lower balance-sheet leverage, more visible earnings and higher free cash flow, as well as lower beta to the broad equity market.


In fixed income, quality and fundamental credit analysis is key—not only because balance sheets tend to deteriorate in the later stages of the cycle, but because the lack of liquidity increases the probability that investors will be forced to hold positions to maturity, or through the turn in the cycle.


This need not leave a portfolio entirely without liquidity. Cash flow can be optimized so that less-liquid or illiquid positions are constantly injecting large amounts of liquidity into a portfolio, by increasing the amount of principal being repaid alongside regular coupons. That can be done by favoring shorter-duration credit: because yield and credit curves are currently so flat, across many credit markets this can be done with little or no yield sacrifice. It can also be achieved by including an overweight to amortizing positions in commercial and residential mortgages, or to the debt or mezzanine tranches of collateralized loan obligations (CLOs).


Even in the most illiquid corners of a portfolio, in private markets, diversifying into short-duration, cash-generative private debt and taking full advantage of the secondaries market can help to maintain cash flow.

With nimble opportunism, liquidity providers may be able to benefit from volatile and gapping markets

Maintaining a liquid portfolio component and a bias toward high cash-flow strategies can help maintain the flexibility to be a provider rather than a demander of liquidity when volatility, price dislocation and price gapping strikes. We believe that particularly keen opportunities might open up in some of the less liquid corners of the credit markets through the course of the next downturn: prices here can drop substantially further than those for more liquid paper during periods of risk aversion.


The catalyst for that dislocation in high yield may be located in the ratings band just above it: the BBB rated part of the investment grade universe has grown considerably over recent years, and some its constituents have taken on substantial leverage. We believe the number of downgrades from BBB to high yield is likely to be lower than in previous cycle due to the predominance of defensive, cash-generative businesses in that ratings band. Nonetheless, the dollar value is likely to be substantial: 20% of the current $1.8 trillion BBB market could be at risk, which would equate to $360 billion, or an extra 33%, being added to the high yield market.


Investors that maintain a liquid portfolio component now will be able to take full advantage of any disruption this may cause. They may also wish to seek out fund structures that lock-up investor subscriptions for these opportunities, but charge fees only on capital that has been called and invested. At the more general level, governance structures that get dislocation strategies ready now, as well as the decision-making steps they require, are likely to be better prepared for opportunities that arise as the cycle matures and eventually turns.

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