Let’s assume we are in fact late-cycle.
Some folks will tell you that’s not the case and they’ll roll out all kinds of cherry picked metrics to support their contention that “mid-cycle” is a better description of where things stand. One thing worth noting about those arguments is that they are incomplete if the person making them doesn’t at least acknowledge that central banks are the X-factor here – if we aren’t late cycle it’s only because central banks are keeping things in limbo. The goal posts keep getting moved. It’s no longer clear what it is central banks are targeting. It’s a never-ending fight to achieve something that’s not well-defined. This has the effect of changing or at least suspending the rules. For instance, earlier this year Citi noted that although “the corporate leverage clock has marched on to Phase 3, central banks have managed to hold the credit spread clock back in Phase 2.”
As risk premia compress further on the back of the global hunt for yield engineered by central banks, investors are pushed out the risk curve and/or down the quality ladder and/or into illiquid assets – anywhere they can locate some semblance of yield. All of that creates distortions – in the credit market for instance, it’s manifested itself in a rather glaring disconnect between spreads and measures of corporate leverage.
In any event, if one characteristic of late-cycle environments is an increasingly desperate search for yield, well then it’s probably fair to say that we’re checking at least one late-cycle box.
This week, Goldman was out with their list of “top 10 themes” for 2018 and number 10 on that list is “Late-Cycle Imbalances: Illiquidity Is the New Leverage.”
Goldman starts by recapping what they correctly note has become a narrative so ubiquitous that it barely bears repeating. “In the last cycle, the search for yield drove investors to apply high leverage to structures that featured some pretty dramatic mismatches between maturity and liquidity,” the bank writes, adding that “when runs on funding forced an unwind of those structures and trade positions, it set in motion a downward spiral in prices.”
Ok, so the idea is that most people have learned something from that and have thus eschewed the application of leverage in favor of piling into the most illiquid of assets or, as Goldman puts it, “anything without a Cusip.” To wit:
This time around, illiquidity is the new leverage. In the current expansion, the search for yield has been equally intense, but the lessons learned in the crisis have discouraged a repeat of past mistakes.
Instead of seeking levered exposure to low-spread assets with high Sharpe ratios, the search for yield has driven investors to earn incremental yield by leaning harder into liquidity premium. Examples include private equity, private debt, direct lending, and commercial real estate (CRE), among others. The compensation for owning illiquid assets has consequently compressed, which you can see, for example, in the differential rate of return between CRE and real Treasury yields (Exhibit 11). This decline in the liquidity premium has shown some restraint, but has nonetheless fallen to levels lower than all but the pre-crisis lows of 2006-2007.
Does that ring a bell? It should.
Recall that back in September, Deutsche Bank’s Aleksandar Kocic penned a piece that detailed “the dark side if liquidity“. In addition to a truly masterful discussion of how liquidity in credit markets effectively makes it possible for everyone to pretend as though the concept of default doesn’t exist as long as debt is salable, Kocic also discussed how the post-crisis environment has created a buildup of latent illiquidity. Here are the relevant excerpts:
While liquidity on the exchanges has been on the rise, there has been a buildup of illiquidity due to structural and regulatory changes and dealers’ disintermediation. Nominally, policy response a la post-2008 can create something that resembles tail risk – that part seems almost unavoidable because risk had not disappeared, it had only been moved around across different balance sheets. As a part of deleveraging process, leverage of financial and household balance sheets has been considerably reduced, while government and corporate leverage has increased. The figure below shows the leverage across different sectors of the economy expressed as a percentage of GDP.
As a result of these changes and eight years of accommodation, there is currently more than $2tr of duration parked in mutual funds, not all of it very liquid. This is happening at the same time as regulatory restrictions are limiting dealers’ ability to extend liquidity in a way they used to. If we use the ratio of mutual funds to dealers’ holdings as an expression of latent liquidity deficit, we see what appears as an alarming trend: This ratio has been on a steady rise since 2007 and has increased from about 3 to nearly 30 during the last ten years.
For their part, Goldman doesn’t think this necessarily poses a problem. I would note that their rationale for asserting that seems to kind of assume away the very thing they started off talking about and also appears to rely on a rather generic assumption about dip-buyers “seizing opportunities” with “cash on the sidelines.” Anytime people start justifying a contention that a problem isn’t a problem by reference to a poorly-defined group of dip-buyers and an assumption about “sideline” cash, it’s usually best to take it with a grain of salt.
The bottom line here would appear to be precisely what Kocic said it was in his September piece – namely that this state of affairs can persist in perpetuity as long as the Fed is not compelled by inflation to force a disorderly unwind via the reinstatement of the fourth wall. Because revoking the market’s license to co-author the policy script when the landscape is littered with tail risk is a decidedly dicey proposition.