Relying on liquidity risks leaving investors in hot water


Economic and political headwinds are poised to frustrate profitable strategies

Long spoiled by the comforting support of central banks, investors are getting a feel for what it would be like when economic concerns, rather than central banks’ monetary policies, take a bigger role in determining asset prices. 

With trade tensions more likely to grow than ease, investors now need to reassess whether further monetary policy loosening will again allow liquidity to push markets forwards, or instead prove less effective in countering economic and political headwinds.

Conditioned by years of ample and predictable liquidity, markets have come to expect — and also feel entitled to — central banks countering virtually any sign of market volatility. This year’s dramatic policy U-turn from the Federal Reserve has only strengthened this, as has the speed with which central banks elsewhere have followed the Fed’s lead.

This conditioning was illustrated last week by how stocks bounced back on Thursday morning as asset prices quickly reset to demand deeper rate cuts, this after the prior day’s communication slip by Fed chair Jay Powell (namely, the reference to a “mid-cycle adjustment”) was interpreted as just a “one-and-done” cut. It was subsequently tested by President Donald Trump’s announcement of tariffs on $300bn of imports from China, as well as Beijing’s retaliatory steps.

Up to now, markets have confidently placed overwhelming emphasis on what economists call the global liquidity factor — that is, continuous injections of funds, both direct and indirect — to push asset prices higher. 

This view has persisted despite weak traditional economic arguments for lower rates in the US, stretched asset prices, and the limited impact of looser monetary policy on economic activity. 

It is an approach that has proven profitable, underpinning a “buy-the-dip” mentality that has rendered market corrections more infrequent, less intense and shorter.

With recent developments, however, investors need to reconsider seriously two other widely held hypotheses: that trade tensions are temporary and reversible; and that a more-indebted global economy would navigate them without serious setbacks.

The best that can be realistically hoped for on trade is a series of ceasefires rather than an end to hostilities. The more likely outcome is further escalation, given that the drivers have shifted from economics to also include national security concerns that are harder to resolve.

In addition, with China having miscalculated its initial response by refusing to make quick concessions, the temptation in Beijing may be to wait for next year’s US presidential election, betting that economic weakness would dent Mr Trump’s re-election prospects. 

Meanwhile, it could well be only a matter of time until the US also focuses on Europe (despite the recent US-EU deal on meat exports), where Germany runs considerable surpluses and the European Central Bank is set to loosen financial conditions by cutting rates, resuming its asset purchase programme and weakening the euro.

All this is part of a process of weaponising economic tools now that politics have a larger influence on economics. It comes at a time when Europe’s growth is set to dip below 1 per cent, pushing a few of its economies into recession and reigniting debt and banking system concerns for some. 

China is also getting closer to the point where additional short-term stimulus would undermine the country’s longer-term reforms and development.

All of which means that portfolio positioning just for the beneficial effects of more liquidity will be challenged more than in the past.

Specifically, the further appreciation of risk assets (from stocks to high-yield bonds and emerging markets) is becoming more dependent on other policies also being supportive, were it not for messy politics.

They include fiscal expansion where there is room (such as Germany and the Netherlands) and a meaningful round of pro-growth structural reforms (particularly in Europe and China, but also via a US infrastructure plan).

In most scenarios, including that of persistent general pressure on stocks due to a trade war, US securities will probably still outperform in relative terms due to America’s greater economic strength, higher adaptability and less dependence on international trade. The dollar, which is the ultimate “relative price”, will also benefit.

As the Fed loosens its policies, and it will do so in the months ahead, other central banks will either choose or be forced to do even more. 

The possible timing mismatches and heightened “unusual uncertainty” that accompany all this will probably lead to higher volatility, also calling for a larger slice of tactical positioning to supplement investors’ secular and structural portfolio construction.

Mohamed El-Erian is Allianz’s chief economic adviser and president-elect of Queens’ College, University of Cambridge


Financial Times logo

© The Financial Times Limited 2019. Tous droits réservés.
Veuillez ne pas copier-coller les articles du FT pour les distribuer par courriel ou les publier sur le Web.