Ok, so I don’t think I should have to spend a ton of time making this point again because by now, even those who are predisposed to taking a persistently benign view of HY and EM begrudgingly admit that the post-crisis environment (characterized as it is by a Street that’s less willing to lend its balance sheet in a pinch) makes them vulnerable to a liquidity squeeze.
It just is what it is, and my contention – colloquially speaking – is that the liquidity mismatch in some HY and EM funds is going to come back and bite everyone in the ass at some point.
Ironically, one thing that could end up creating the conditions for an acute episode that tests HY and EM liquidity is the withdrawal of … wait for it … liquidity. Of course “liquidity” in that context means the normalization of DM monetary policy and more specifically, the cessation/slowing of the “flow” effect from QE.
The post-crisis policy response was designed to create a global hunt for yield and that, by definition, sent investors scurrying into corners of the market they might not otherwise have ventured into. Easy access to those markets via ETFs that promise intraday liquidity to retail investors against an underlying pool of inherently illiquid assets creates a rather precarious setup.
To be clear, nothing says this necessarily has to “snap” (as it were). It all depends on how acute a prospective stress event is. My only point is that in a fire sale scenario, there is nothing “magical” about the structure of ETFs that makes them immune.
Allow me to excerpt some passages from a post I ran last summer on this subject as it relates specifically to EM. What’s especially notable about the first paragraph excerpted below is that it could have just as easily been written yesterday. In fact, the points about Brazil, Turkey, the rolling back of DM accommodation and China deleveraging are even more relevant now than they were last July when I wrote the piece they’re from:
You’ve got DM central banks looking to roll back accommodation (so rising DM rates), you’ve got the situation in the Korean peninsula, you’ve got the political turmoil in Brazil, you’ve got the always dicey situation in Turkey, you’ve got the uncertainty surrounding crude prices, you’ve got China deleveraging, and you’ve got an EM rally that’s stretched to the absolute breaking point.
In short, this is laughably precarious. You can read a bit more on the DM normalization angle here.
So the question then, is what happens when the tide turns after all of this money has flowed into EM? The assumption that investors aren’t going to get completely fucked rests on the patently absurd contention that while money coming in equals bond buying, somehow money going out won’t equal bond selling.
Here’s iShares’ Brett Pybus to try and explain how that can possibly be true (from a piece in the Financial Times):
People say ETFs will be forced sellers [in a falling market] but that’s not the experience. ETFs are far more likely to adjust their holdings in kind, by handing over bonds to authorised participants than by selling bonds for cash.
The idea, as FT goes on to remind you, is that “if the share price of an ETF gets out of kilter with its net asset value such APs will quickly step in to buy its shares or its underlying bonds for arbitrage gains.”
But see that only works when shit isn’t going to hell in a handbasket. More simply (and more crudely): eventually someone will have to stop fucking around with these silly ETF units and sell the bonds. Here’s FT again:
Critics insist that, just as EM bond ETFs have bought billions of dollars of assets as money has flowed in, they — or their APs — will eventually have to sell them if money flows out.
Right. And the thing is, the APs aren’t going to be willing to inventory these things in a pinch. After all, would you want to take a bunch of illiquid bonds onto your balance sheet in a collapsing market?
“If you knew everything was coming up for sale, would you step in?” Eaton Vance’s Michael Cirami asks. “When the redemption basket gets passed on, the person it gets passed to is going to do some fundamental analysis, which the other guy [who bought the ETF] didn’t care about.”
And see that’s where the whole thing breaks down.
Robert Koenigsberger, chief investment officer of Gramercy, had this to say when FT asked him to weigh in:
There has been a tsunami of money coming into EM debt. [When the tide] goes out, the damage is going to be unprecedented.
It’s hard to predict when people will stop buying tulips. But there is going to be an ‘I told you so’ moment.
Anyway, that’s already deeper into the weeds than I wanted to get, but suffice to say that as DM central banks unwind stimulus and the hunt for yield becomes less desperate in character, there are questions about how EM assets will hold up.
These concerns were crystallized in a recent FT Op-Ed by the RBI’s Urjit Patel. If you want the full treatment on that, you can check out “Urjit Patel And The Dollar Liquidity Shortage Debate“.
For his part, Jerome Powell insists that DM accommodation hasn’t been the major driver of EM inflows. Recall the following comments he made at an IMF/SNB event early last month:
Monetary stimulus by the Fed and other advanced economies played a relatively limited role in the surge of capital flows to (emerging market economies) in recent years.
There is good reason to think that the normalization of monetary policy in advanced economies should continue to prove manageable for EMEs. Markets should not be surprised by our actions if the economy evolves in line with expectations.
That bolded bit is laughable. Sorry, but it is.
Whether or not the tide going out (so to speak) will mean a sudden reversal of those flows is debatable, but whether one of the primary drivers was the hunt for yield engendered by DM central bank policy isn’t really all that contentious a debate.
And look, even if you want to try and claim that Powell is basically right (i.e., that EM would have experienced large inflows anyway), would you really go so far as to echo his contention that Fed, ECB and BoJ accommodation “played a relatively limited role”? Probably not. That’s a shaky limb to go out on and if the last couple of months are any indication, that limb is starting to crack.
But as Goldman writes in a piece out Friday, EM credit may not be a “liquidity canary.”
“The underperformance of EM credit is indeed noticeable [and] unlike EM equity, which has been quite flat since March, or EM FX, which has also been more stable over the past month, EM credit spreads have widened to the highest levels of the year (EM local rates have moved higher, largely driven by Turkey and Brazil),” the bank notes, adding that given the track record of EM credit being ‘early’ more often than other EM asset classes, and the recent underperformance of the asset class, we are not surprised to see investors point to EM credit spreads as a canary for liquidity concerns.”
That said (and this is why they don’t necessarily think there’s a burgeoning crisis for EM as a whole), they chalk this up to compositional issues. Specifically, Goldman writes that “EM credit contains significant Frontier Market exposure – and we think this is a large driver of the recent underperformance.”
Ok, so that’s all fine and good to the extent it addresses one side of the liquidity problem – namely the issue of whether a reduction in the flow of DM central bank liquidity will lead to pronounced underperformance in prominent EMs.
However, it doesn’t address that other liquidity problem (the one mentioned here at the outset).
But BofAML does address it in a new note, and having just penned an “introduction” that is now at least 1,000 words longer than I intended it to be, I’ll just leave you with some short excerpts from the bank, whose David Hauner outlines the “big problem” for EM liquidity.
Near-term liquidity in EM is a big problem. Several factors are having an adverse impact, but some of that is improving.
EM EXD technicals are better now, long-term fundamentals are good, spreads have risen far more in EM than in HY and institutional mandates have not ceased, but risks are high. Dealer liquidity has fallen sharply while the market doubled in 6 years. Compared to last year or even to January 2018, dealers are less able to position the size clients need for three main reasons.
- First, there are fewer dealers than previously. Several major dealers have substantially reduced the size of their EM business and some have retreated from EM altogether.
- Second, the higher the volatility, the smaller the size of dealer trading books, making it extremely difficult for the Street to buy large positions.
- Third, over the last five years, EM-dedicated managers have become so large that the trade sizes that can be done in these illiquid markets are inconsequential to performance of a large fund compared to the market impact for trying.