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Riding a tiger

Hitching a ride on a virtuous cycle of liquidity has been a boon for central banks and investors. Dismounting may call for some deft footwork.

If the 1960s was the era of labour shocks, and the 1970s and 1980s the era of oil shocks, the 1990s onwards can be characterised as the era of increasing liquidity shocks. Two important changes to the financial system over the past 30 years have meant that central banks look increasingly like the tail being vigorously wagged by the market dog. In spite of appearances, jutting-jawed “whatever it takes” speeches and rapt attention from the financial media, central banks react to markets rather than lead them.

The two key changes that have taken place concern how debt is funded and how it is used. The first change is a move away from bank finance towards wholesale markets. The second is an increasing use of debt to refinance existing debts rather than to fund new projects.

It’s bigger than that – it’s large

But first, let’s talk about scale. If the volume of debt in the world had not grown to such vast proportions, neither of these changes would have been so significant. The term “large” struggles to be more than an understatement when describing the scale of the size and growth in global debt. Total debt, including government, corporate and household debt, has risen to around US$296tn in mid-2021. This is equivalent to 355% of global GDP (source IIF) and is more than double the level of debt in the late 1970s.[1]

The 70s were the decade when the financial world was adjusting to life beyond Bretton Woods, the post-war agreement that tethered all major currencies to the US dollar and the US dollar to gold. We can look back at the Bretton Woods era as one of halcyon decades of strong post-war growth and few financial crises. It was an era where the high street bank ruled. They do no more. For loans are now more likely to be sourced from wholesale markets. According to a recent book (Capital Wars: The Rise of Global Liquidity by Michael J. Howell), wholesale markets have steadily outpaced the banking sector and, on conservative estimates, equate to three-quarters of global GDP.

Source: Euro area accounts. Non-MFIs include insurance companies and pension funds (ICPFs), investment funds (IFs), and other financial intermediaries (OFIs). MFIs exclude the Eurosystem. Calculations based on market values. Latest observations are for Q1 2021. Published in ‘The rise of non-bank finance and its implications for monetary policy transmission’, speech by Isabel Schnabel, Member of the Executive Board of the ECB, at the Annual Congress of the European Economic Association (EEA), August 2021.

Wholesale markets, the world’s pawnbrokers

Wholesale markets have doubled in size since the Global Financial Crisis of 2008. One of the defining features of much of what goes on in the wholesale market is that it looks a lot like a pawn shop. Take the US repo market, that US$10tn pool in which you can borrow over short periods – provided you hand over one of your assets (a short-term US treasury bill, perhaps) for safe keeping.

That is very different from a simple bank loan in which the bank will lend you money on trust. If lending depends not on trust, but the quality of the asset you hand over in exchange, then that asset really starts to matter. If the wholesale market “pawnbroker” turns up his nose at what you bring in, then we have a problem.

And so we come to the second big change in markets. The scale of debt described above has an obvious consequence. There is so much more debt around than there was 50 years ago, that you are much more likely to find wholesale market “pawnbroker” customers coming into the shop in need of refinancing than looking for money for a new project. You can see this difference in the steady increase in the gross funding requirement versus net funding requirement.

So there is more refinancing taking place and greater focus on the quality of collateral. Both are problems for a central bank. In the mid-1980s, raising rates just cooled the economy down. Loans were mainly to invest, not to refinance old debts. These loans did not rely on the quality of any collateral, but the trust which a banker had in your prospects. Higher rates simply led to a postponement of future plans.

But what happens in today’s world when you raise rates? Rising rates mean falling asset prices, assets on which a whole chain of lending depends because collateral is now key. “Liquidity”, that word which describes the ease of getting a loan, will quickly dry up as people hoard good assets, and no-one wants to lend against assets with falling prices. If you need to refinance your debts, and you can’t find the money, it is not just a future project that is delayed: you go bust.

Central banks have become liquidity providers

On upshot of all this is that the role of central banks has changed over the decades. Are central banks still the guardians of a nation’s currency? Or are they the ring-masters of the financial circus, whipping inflation into place? Are they perhaps the upholders of employment? Well, yes, they are all these things. But, above all else, they have become the world’s liquidity providers.

In the midst of the Global Financial Crisis, quantitative easing (QE) was born, the most powerful tool yet deployed by central banks to help liquidity flow in markets. In buying high quality assets the central banks hoped to provide lots of liquidity to keep the funding taps flowing. It worked, above all in expanding what people counted as money, giving a wider range of assets a mantle of “money-ness”. By sucking up all the best quality assets, on the face of it, it did the wholesale pawnbrokers a disservice by withdrawing some of the best collateral from the market. In its place wholesale markets have had to make do with not quite such good collateral to lend against.

Liquidity’s virtuous and vicious cycles

“Money-ness” has increased, thus making the whole system more liquid by giving market participants confidence in all types of collateral. This produces a virtuous circle, with rising collateral values being used as yet more avenues against which you can lend against. But to this liquidity bliss comes a problem. Take Greensill Capital. Its business model depended on clients trusting in the “money-ness” of trade receivables against which it could borrow. In the case of Greensill, when that “money-ness” was questioned it collapsed.

In this new world, collateral is all. It is now very important that all the interconnected strands of lending in wholesale markets have trust in the “money-ness” of the collateral. If they do not, then a virtuous circle turns into a vicious one, where good collateral is hoarded and no-one any longer trusts the flakier end of the collateral spectrum. People cannot refinance, leading to the need to sell assets when everybody else is selling theirs, putting ever greater pressure on collateral values. Liquidity rapidly dries up.

And so, to equities

What has all this got to do with equities? Simply that the greater liquidity provided by QE makes everyone more trusting. You don’t need safe assets and prefer those with a bit more risk. Equities go up. Michael Howell argues that the 30-year bull run in equities has got much more to do with the rising need for liquidity in a debt-fuelled financial system than it has to do with the intrinsic merits of the companies themselves. In a similar way, occasional sharp falls over that period have less to do with the business cycle than a sudden liquidity drought.

 As central bankers mull over “transitory” inflation, they have to keep an eye on the central role that the value of collateral has in keeping liquidity flowing. Don’t expect them to be in any hurry to raise rates. But markets anticipate the future, so be prepared for some choppy times as markets worry whether liquidity is heading lower as rates go higher. With wholesale markets relying on the value of collateral taking centre stage in financial markets, a lot depends on the answer.

The central banker’s conundrum

Central banks are in a bind as they are being dragged kicking and screaming into a position where they have to acknowledge that inflation is less transitory than they would like.  And they don’t want to acknowledge it because, six years on from the taper tantrum, it gets ever more difficult to avoid a credit crunch if they do tighten policy. First, the amount of debt in the global economy can’t stop growing. Secondly, the proportion of debt used to refinance rather than initiate new projects can’t stop going up. Thirdly, wholesale markets are now much bigger part of the financing pie, and wholesale markets rely on the quality of collateral rather lending on trust.

If you raise rates and cut back on QE, you also reduce the value of collateral on which a whole chain of refinancing depends and a credit crunch can ensue very quickly. Hence central banks’ desire to delay tightening for as long as possible. As a result, you have the prospect of sharply negative real rates, which should be good for equities. However, markets are looking through that and worrying about the prospect of a tightening future.

The question is therefore whether tightening leads to a rapidly developing credit crunch and whether that in turns feeds through to a rapid fall-off in inflation. If this is the case, then the result would be rapid easing, which would again be good for equities.

 

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CLI01990 Expiry on 02/11/2022

 

[1] Unless stated otherwise, all data quoted in this article from Capital Wars: The Rise of Global Liquidity by Michael J. Howell, published by palgrave macmillan, 2020.