What is liquidity?
Liquidity is an important concept in financial markets, but one that is subject to different definitions and interpretations. Liquidity is the ease with which an asset, or financial security, can be changed into ready cash without affecting its market price. Cash is the most liquid asset, while tangible assets, such as housing, are less liquid. A high amount of liquid assets in the economy can boost asset performance, while a lack of liquidity can detract from returns.
Why is liquidity important?
Liquidity is important as it contributes to the smooth running of financial markets, like the way oil lubricates an engine. The stock of liquidity in the financial system is something we look at closely, as when it dries up it can negatively impact stocks and bonds. Similarly, the liquidity of assets themselves can have important ramifications. For example, the US sub-prime crisis in 2008 occurred when domestic banks lent too much to borrowers who couldn’t repay their loans, and this started a fire sale of assets at discounted prices to meet creditors’ demands. The crucial point here is that it was not the bad loans that precipitated events in the US fifteen years ago, but the banks’ lack of liquid funds to prevent large, forced asset sales, often at prices far below their intrinsic value. If banks hold a liquid asset base, then they can be more patient in calling in loans and allowing asset prices to adjust more slowly to avert a crisis.
How liquidity is currently supporting stock markets
The good news is that we don’t think we are close to a 2008-style crisis. We see the collapse of some US regional banks in March as an idiosyncratic risk – see is Silicon Valley Bank a canary in the coal mine? Today, banks have stronger liquidity positions and lower levels of risky loans. Meanwhile, the Federal Reserve and regulators have taken strong actions to mitigate the negative fallout from these events.
Moreover, we see five reasons to expect the stock of liquidity to improve and drive financial markets.
- Federal Reserve bank loans
In March, when SVB and Signature Bank collapsed, the US Central Bank took an unprecedented step by providing loans to US banks through the Bank Term Funding Program. This action ensured that the US banks could meet the needs of their depositors by borrowing against the face value of agency and Treasury securities. The amount of cash available to banks is huge and while risks in the US banking system exist, depositors are well protected and that should support financial markets.
- Chinese stimulus
The Chinese Government is offering credit and loans to companies to aid in the country's economic recovery after abandoning its zero-Covid policy. This support is aimed at stimulating economic growth, as previous injections of money into its financial system have led to positive results.
- Easing inflation
UK inflation remains high but is expected to follow the US and Europe, where it has already started to slow. For example, US annual headline CPI has decelerated from a peak of 9.1% last June to 4.9% in April. As it comes down, the likelihood of higher interest rates eases. Inflation and interest rates directly affect liquidity. The former reduces real disposable incomes through higher prices, while the latter makes the cost of borrowing higher and therefore more money is taken out of the system to service existing loans while discouraging further borrowing.
- Recovering global growth
Economic data has generally been better than expected. The global manufacturing Purchasing Managers Index is on an upward trend and the services component continues to improve. Although concerns of recession never seem far away. Better economic activity is a sign of growing confidence and should also drive liquidity creation. This leads to more money flowing through the system, which boosts the coffers of both businesses and governments.
- US dollar depreciation
The US dollar has been weakening against a basket of currencies since the Autumn. This weakness is likely to continue as other countries’ central banks continue to increase their interest rates, while the Federal Reserve pauses on their hiking cycle. As US interest rates reach a peak, investors will look to put their money to work elsewhere. Money is flowing out of the US into the rest of the world and looking for a home in other asset classes. A weaker dollar also makes it easier for borrowers to pay their US-dollar denominated debts, allowing stock valuations to expand. In the past, a weak US dollar has provided a boost to non-US stock markets.
Market risks are not as severe as feared
There are a number of risks to our view: quantitative tightening, credit stress, deposit withdrawals from banks, loan growth concerns and weak money supply growth. However, we believe the liquidity drivers may outweigh these risks.
Central banks continue to withdraw money through their quantitative tightening policies. However, the impact this is having on the markets has been reduced. In the US, the Fed’s response to the collapse of SVB and Signature Bank was to increase the availability of money by more than they are taking out through quantitative tightening.
It was expected that the banking wobble in the US would cause banks to tighten their lending standards, driving up interest rates charged on loans and impacting businesses. But this effect has been tempered by the actions of many companies during the pandemic. Where possible, companies extended their debt maturity and locked in long-term, low-cost borrowing. The net result is that fewer companies have needed to go to the banks to borrow.
One area of concern is the withdrawal of deposits from banks. Savers are looking to move their money to alternatives that offer more attractive yields. Even though banks are losing deposits to money market funds, they’re being replaced by the Federal Reserve, so it’s less of a problem.
As it stands, stock market valuations are closer to fair value and arguably look attractive longer term, given it is our view liquidity is set to improve. We believe global liquidity drivers should offset the market risks and this should support equities. There are risks of course. While central banks drive financial market liquidity, commercial banks drive the real economy. If the banks get stricter on their lending, there could be downsides to the overall economy.
The world’s major economies still have high employment levels, so there is limited risk of tightening lending standards leading to a collapse in economic growth. Global economic estimates are being revised higher. On balance, we believe that the drivers of higher liquidity should offset risks from a tightening of credit conditions and continue to support the equity market.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
The value of an investment may go down as well as up and you may get back less than you originally invested.
This article is based on our opinions which may change.