Illiquidity: the watch-word for 2023

Hello and Happy New Year. The year-end balance sheets have been struck and the P&Ls have been reset to zero. Apart from that, it’s the same old world with the same old issues, some good, some bad, and nothing that had not been resolved by last Friday will now have suddenly, as if by magic, disappeared from the agenda.

The first message for the year comes from Germany where calls are rising for the defence minister, Christine Lambrecht, to resign over her New Year recording – taken in the streets of Berlin against a backdrop of celebratory fireworks – in which she declared 2022 to have been a year of great interest in which she had met many excellent people. Erm? She’s supposed to be the defence minister of Western Europe and the EU’s most powerful nation when there is a brutal war going on just a few hundred miles to the East in which the most basic of democratic tenets which she is supposed to defending are under threat. Was she not the woman whose idea it was in the spring of last year to come to the aid of the invaded Ukraine by offering 5,000 helmets?

My point? This is not a Hollywood or maybe even more appropriately a Bollywood movie in which love prevails and all strands end up being neatly tied up for the best of all possible outcomes. Smiling sweetly and uttering vacuous assurances no longer works. This not only applies to politicians but to us too. We, the people, have over the past half century become accustomed to standing back in the light of problems and to call upon our governments to get things sorted for us. And on our behalf, they have promised to throw a little bit of money at the matter on the table and when it has not gone away they have promised to throw a little bit more. Structural flaws in both the social and the economic edifice were hidden under a pile of cash and the cheaper the cash, the bigger the pile has become. One might not see them quite so closely but the flaws remain

2022, with the end of the free money cycle, the return of inflation which then found itself turbo charged by the Russian invasion of Ukraine and the disastrous failure of China’s zero-Covid strategy, laid bare many of the critical fault lines in the global consumption driven growth algorithm and 2023 threatens to be the year when socio-economic models find themselves in need of being fundamentally recalibrated. And for that both governments and central banks will have to clench their buttocks and call spade a spade.

The first line of the fightback has to be “We’re sorry but there is no more money”. Who will be the first one to have the courage to utter that phrase? Again and again one comes back to those immortal words of Jean-Claude Juncker, erstwhile Muppet in Chief, which were: “We all know what to do, but we don’t know how to get re-elected once we have done it.” As apposite and comical as that line is, it remains one which reflects the size of the cliff facing our leaders. Whether they are standing at the top or at the bottom of the cliff is moot. Maybe they are perched on a ridge with the cliff rising on one side of them and dropping away on the other. Either way, some hard decisions will have to be taken and promising to write further cheques is not a sustainable part of the solution.

Over the past couple of weeks during which I have written next to nothing but have had time to do a little more reading, I have tried to keep up with the endless stream of forecasts for markets in the New Year. They all make eminent sense as long as the stars align in the way the forecasters need them to for their predictions to play out as they suggest. B will follow A, as long as A occurs. If not, file B under D for delete. Of course, nobody who is paid a few hundred grand a year to make predictions is going to shrug their shoulders and admit that they really have no idea. Some of the forecasts are painfully vague and dependent on developments which are impossible to nail down. The very best of them reckon that one or maybe two more moves by the Fed are to be expected – most probably for 25 bps each – but that then the FOMC will sit back for a while to come. An easing of monetary policy, or “pivot” if you prefer, is not to be expected. As I said, the old year’s issues will be carried over into the new one as they were.

What did strike me was a piece in the FT which referred to a warning offered up by the OECD to pension funds and highlighted the risks inherent in illiquid assets. The problem is as simple as could be. In a period of rising interest rates and falling asset prices, funds might find themselves obliged to raise cash by disposing of assets in order to meet liabilities. So that asset allocations can be maintained in balance, lesser liquid assets will need to be sold as well and anybody who has spent more than five minutes in the asset management game will know that the mark-to-market price of an illiquid asset can find itself miles away from the bid price when it comes to finding a buyer for the piece.

As far back as 2007 and the beginning of the GFC, the starting gun of which was fired by BNP when its investment arm had to admit that it owned a bunch of structured notes to which it could no longer apply a realistic price, I have argued that liquidity risk is either undervalued or, in most cases, not valued at all. All I can ask is firstly, what has taken the OECD so long and secondly, does anybody really care what the OECD has to say on the subject?

I recall 20-odd years ago when I was at the top of my game in the corporate bond space explaining to a client how to successfully price and then invest in illiquid paper. There is no such thing as a bad asset, just a wrong price for it and therefore every risk has its price. This concept went to hell in a handcart when credit default swaps became the be all and end all and when the new crop of credit traders and above all their compliance desks believed that any bond for the same issuer could be generically priced off the CDS. Liquidity is not a function of how many two-way prices can be seen on a Bloomberg screen but of no more than one single trader, albeit hopefully more than one, knowing where bonds are held and who out there is an active buyer or seller and at what price they are prepared to deal. The price of a liquid and an illiquid bond, albeit for the very same issuer, will vary but if all of them are given a machine generated value based on the traded price of the liquid default swap, then the book value of any number of bonds will be wrong. It’s not rocket science but in the same vein as with Frau Verteidigungsministerin (German compound noun for a female defence minister) Lambrecht’s asinine and vacuous message, the time has come to acknowledge that there are no simple ways, or certainly not enduring ones, of circumscribing properly complex problems.

I had in my latter days at the sharp end of the market one client, a former London bond trader, who ran the fixed income book for an African sovereign wealth fund. He really understood how to price the embedded risk of illiquid paper issued by mainstream borrowers and in doing so made his employers a tidy fortune. Sadly, they grossly undervalued his skill and in a fit of pique and when they feared he might know too much about some of the less salubrious activities which were taking place within the organisation, they decided to part company with him. He had been experienced enough to understand that the prevailing “best of three prices” execution rules which were taking hold in many parts were nonsensical, counterproductive and geared more towards protecting the interests of the investment manager than those of their clients. Working with him on a trusted one-on-one basis was a pleasure which was conveniently also reasonably lucrative for both parties. Shortly after he had left, I decided that there was no more fun to be had and I too began to consider moving on.

Mastering illiquidity is not a quiz. But it requires experience and subtlety, neither of which have been in great demand across the investment industry in recent years when it had become prevailing thinking that a few coders with PhDs in maths or physics and a bit of on-line best execution could crush the performance game and in the process also the opposition.

Moving on, in terms of future monetary policy, I agree that there is nothing to be gained by comparing the situation faced by Fed Chairman Paul Volker from the late 1970s to the mid-80s and that confronting Jay Powell today. But the issue is not that Volker’s predecessors had eased policy too early and in doing so had re-opened the door to Mr Inflation. That seems to be the received wisdom in many of the circulating forecasts for monetary policy, going forward. The real issue is that US Federal Debt/GDP in 1981 was 31%. That number now reads 121%. Over the same period the Household Debt to Income ratio has risen from around 60% to over 95%, having peaked ahead of the GFC at close to 140%. For the record and for a reason to run screaming to the hills, the UK’s same debt to income ratio is hovering currently around 133%. The Fed is caught between a rock and a hard place as, to an even greater extent, is the Bank of England.

Meanwhile, President Volodymyr Zelensky is assuring us that Russia is about to be defeated. Well, he would, wouldn’t he? At the same time Vlad the Invader is being equally assertive in his intention not to rest until the Nazis in Kyiv have been unseated and hung from the highest lampposts. And while investment wizards are busily writing forecasts for 2023, not a single military strategist I have come across has been prepared to offer up any prediction whatsoever as to how that Ukraine scenario is going to play out either this year or in any year going forward. The only thing they would seem to agree on is that relations between Russia and the West are broken and will remain so for many years to come. Thus, the cost of energy remains the teddy bear in the woodpile and with the ongoing rearranging of the geopolitical deckchairs forecasting that factor remains a game of pinning the tail on the donkey.

I do, however, believe that the key to the coming year will be found in the price of commodities. President Xi’s volte face on Covid is quite simply aimed at regenerating growth in China’s struggling economy. Whether the push for growth is directed towards exports or towards the domestic economy is irrelevant for those involved with mining and minerals. I wrote to my dear friend Morris Sachs during the Christmas hiatus that my guess is that before 2023 is out, every investment manager, whether in bonds or in equities, will be tracking the price of iron ore as closely as that of the US 10 year or the S&P 500. In the same letter, I had suggested that the monster equity rally of the past decade and a half is not about to relaunch itself but that it would continue its journey to revert to mean.  In that vein, the old mainstream stocks which had looked tired and unloved for a while will prove to be the safe haven – current dividend stream rather than speculating on future dividend growth – while tech stocks probably still have a way to go. Ford is on a P/E ratio of 5.3x as is Mercedes Benz while BMW is on 3.15x. Tesla is, despite the massive fall last year of 63%, still trading at 38x. I rest my case.

So off we trot into a new, albeit foreshortened, week. Much is made of market illiquidity towards the end of the year but it is often forgotten that the early weeks of the new year are also highly technical as banks are busily rebuilding trading inventories which had been run down not year-end while investment firms have yet to have their Q1 investment committee meetings and the flow of new money has not kicked in. Experience has taught me not to take early January market movements too seriously and certainly not to extrapolate the customary rally into annualization. In the immortal words of Theodore Roosevelt, although not having been meant for traders and investors “Speak softly and carry a big stick.”

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