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June
13
2019

Warning: Some of the Market's Vast Liquidity Is a Mirage
Mohamed A. El-Erian

A star fund manager’s stumble over liquidity is just a beginning. Far more will fail the test when there’s a downturn.

Beware of learning too few lessons from the difficulties facing Neil Woodford’s equity fund in the U.K. The takeaway is not simply to watch out for other open-ended funds with lots of inherently illiquid holdings. The case is also a warning to look seriously at the market as a whole – elements of which have grown too comfortable and too complacent operating in the ample liquidity pumped in by years of unconventional central bank policies. An economic downturn or a financial shock could create liquidity-induced dislocations that would heighten investor insecurity and complicate companies’ access to capital.

But it hasn’t happened yet. Regulators have a chance to recognize this and reduce the threat, lest the growing risk of structural financial instability also inflict economic damage.

The proximate cause of the demise of the Woodford Equity Income Fund was a mismatch between the desire of its investors to withdraw their capital and the ability of the investment manager to sell holdings in order to generate cash to meet the withdrawal requests. This funding mismatch became crippling in the face of a self-fueling redemption process. With the fund facing a high probability of immediate demise, Woodford put on gates on the almost $5 billion still in the Fund. The idea is to limit investors’ access to their capital while seeking an orderly process for the disposal of security holdings that would subsequently allow for orderly redemption without costly fire sales.

This is not the first time that a fund has resorted to gates. Indeed, a few used them in the 2008 global financial crisis. This episode is especially damaging to Woodford because his is happening in the context of ample system-wide liquidity and relatively low financial volatility.

The U.K.’s Financial Conduct Authority is said to be looking into the problem of excessive illiquid holdings in open-end fund structures – that is, investment vehicles that, by design, impose no long-dated constraints on holders’ ability to redeem. And yet financial regulators in general are not thinking big enough; the recent erosion in system-wide liquidity risk has gone well beyond some open-ended funds taking on too many illiquid assets.

Enjoying ample liquidity and conditioned by central banks to expect this to continue, both the sources and users of funds have felt comfortable venturing into the more leveraged and less liquid segments of the marketplace. The investment decisions of the Woodford fund is but one of many examples of money going to less liquid instruments. The phenomenon has been met, on the supply side, by a willingness of the industry to lower the structural barriers to such investing.

The proliferation of ETFs is a case in point. The main selling point to investors is the ability of exchange-traded funds to provide instantaneous liquidity at reasonable bid-offer spreads. Yet, in recent years, ETFs have also been offered on inherently less-liquid asset classes.

Another example is a change in investment-grade debt.

Encouraged by artificially low interest rates, a significant number of corporations have issued debt in order to buy back stock. Their resulting downgrade to a BBB credit rating has not been very costly; BBB companies do not currently face substantially higher borrowing costs that their single-A counterparts. Also, access to funding is not an issue these days. But, in this process, the number of BBB companies in the investment grade benchmarks has grown significantly, creating quite a risk of “fallen angels”: high-grade companies that end up being downgraded into high yield, aka junk.

Any significant downturn in the economy would most likely drag down ratings of many BBB companies. Investment-grade debt has a significantly larger base of dedicated investors; in the high-yield asset class, these companies would quickly exhaust the appetite of investors. The resulting high likelihood of quite a disorderly price adjustment, accentuated by investors with guidelines that preclude junk holdings, would aggravate the widening in credit spreads associated with the weaker economic outlook.

Unlike the leveraged interdependence of banks that made the 2008 financial crisis particularly dangerous, this trend of higher-liquidity risks among non-banks does not pose a threat of a “sudden stop” that would tip the real economy into a great recession or even a depression. But it does contribute to a higher probability of financial instability, and it could well spill over to corporate and household activity.

While central banks inadvertently enabled this accumulation of liquidity risk, they are not well placed to counter it. Not only do they lack the ability to buttress mutual funds but any attempt to do so would likely cause a political outcry. Indeed, the risks exposed by the Woodford fund could be just a small example of the extent to which financial risk has morphed and migrated beyond the heavily regulated banking system. Major threats to financial stability now reside in a non-bank financial sector that is less well understood and less scrutinized by regulators – for now.

 

 

Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. His books include “The Only Game in Town” and “When Markets Collide.”

 

 

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