As companies and investors painfully discovered in 2008, liquidity can be most elusive when you need it most.
Going forward, for both structural and operational reasons, there is every reason to believe that liquidity will become quite patchy when markets encounter the next major air pocket. The turmoil of recent weeks provided a vivid illustration that the global economy and financial markets are undergoing two transitions.
The first has to do with the shift from a prolonged regime of repressed financial volatility to an environment of increased instability. The primary reason is that central banks are less willing or able to act as suppressors of volatility. The second involves the ongoing move away from counter-cyclical balance sheets. Facing tighter regulation and sharply reduced market appetite for short-term earnings deviations, broker-dealers have shown they are a lot less willing to take on inventory when the market overshoots.
Yet liquidity still tends to be underappreciated by financial investors — both in an absolute sense and relative to corporations that even today are inclined to carry quite a bit of cash on their balance sheets.
There are two major reasons that financial investors have tended to place so little value on liquidity, thereby underappreciating the considerable optionality that comes with it.
First, they have been repeatedly conditioned to believe that central banks will step in to normalize markets — and do so at virtually the first signs of real stress.
Second, liquidity is “negative carry” in the sense that it usually involves forgoing some income (and possibly capital appreciation) potential relative to the other ways the money could be deployed — for example, earning nothing on cash while you could invest in a high-yield bond, but subject to a host of risk factors.
As valid as these arguments are, they should not be used to obfuscate structural realities on the ground. Moreover, the longer central banks continue to fill their role of the past decade as the “only game in town” — that is, following policies dedicated to repressing market volatility and artificially boosting asset prices — the greater the subsequent risk to their effectiveness and operational autonomy.
This is not to say that financial investors should rush to liquidate their positions and hold everything in cash. There is clear evidence that the distribution of potential outcomes from this period of transition is bimodal, with relatively high probabilities for both good and bad endpoints.
Instead, investors should strive for liquidity positioning attuned to this type of distribution as the global economy approaches a three-way intersection, or what the British call a T-junction.
The road that the global economy is currently traveling will effectively come to an end soon and will yield to one of two quite different, truly contrasting alternatives: a materially better state of the world or a materially worse one.
There is nothing inevitable about the path ahead. What corporations, governments and households do can have an important influence on what currently are finely balanced probabilities. Simply put, the major catalyst for taking the good road out of the T is a combination of better politics and turbochargers.
This can happen if national policymaking in a few systemically important countries experiences a “Sputnik moment” that unites politicians behind a common vision and a national objective. That would allow for the sustained implementation of measures including pro-growth structural reforms, more balanced aggregate demand and the lifting of stubborn debt overhangs, together with enhanced global policy coordination. The challenge is to ensure that the turn coming out of the neck of the T-junction points to a better, and not worse, economic and financial existence. Otherwise, the global economy will find itself mired in even lower growth, greater inequality and market instability — all of which would put pressure on social and political cohesion while increasing the risk of geopolitical tensions.
As hard as we try, and I have tried very hard, it is challenging to predict precisely either when we will get to the neck of the T, or which road we’ll take. But the current situation is less about destiny and more about alternatives that we collectively end up deciding on, either knowingly or unknowingly. As a result, a central question is how we are likely to react when the environment we have grown accustomed to gives way to a more uncertain one and what we can do now to enhance our probability of success.
A tempting approach is to wait for others to make things better for us. Exploiting the bridges that central banks have built at great expense and empowered by the political system, governments can and should do a lot to improve the probability distribution of future outcomes, both on their own, through better multilateral cooperation, and via public-private partnership.
And all of us can play an advocacy role. But this is not just about governments getting their act together. We can and should take action, and we can start by recognizing the changes ahead and what to do about them.
The emphasis should be on developing responses to unfamiliar bimodal distributions. When trying to anticipate future events, most of us rely on models containing well-behaved normal distributions that encompass a dominant probability of a certain outcome. As we enter a bimodal world, with its high probabilities for both good and bad outcomes, our habitual reactions will be a lot less effective, risking outright paralysis or active inertia.
Recognizing that change has begun and understanding this basic shift is the first step toward better navigating the landscape ahead. It is a necessary condition, but it is not sufficient. It needs to be supplemented by appropriate tools, revamped structures, updated processes, open mindsets and behavior modifications.
By Mohamed El-Erian
(Bloomberg)
Mohamed El-Erian is the chief economic adviser at Allianz. He is the chairman of Barack Obama’s Global Development Council and the former CEO of Pimco. His upcoming book is “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.” — Ed.
