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Stock markets suffer liquidity squeeze

26 October 2018

During the recovery from February’s stock market correction, we wrote on these pages that the upsurge in equities – particularly in the US – felt a little uncomfortable. This was because the correction had not followed the usual pattern such corrections are known to follow, and therefore did not seem to provide a particularly solid base for a durable upturn. Sadly, our suspicion turned out to be justified.

After last week’s calming, the downdraft in equity markets returned with a vengeance this week. So much so that we even had to apply the latest regulatory reporting requirement, and write to investors in our highest risk portfolio style (Global Equity) to inform them that, over the course of Thursday, the value of their investments had at one point dipped to -10% below the value recorded at the beginning of the quarter.

While this sounds painful, it actually happens at a higher frequency in the case of global equity portfolios than one might think. Last time it happened was in February 2016 and before that in August 2015.<br />
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Nervous and less experienced investors might suspect that this second bout of stock market correction turbulence during 2018 may be the sign that good times for investors are finally coming to an end, after having enjoyed a choppy but very profitable uptrend for more than 9 years. We would disagree. But we also reiterate our message we first published in our 2018 outlook article: it is reasonable to expect that, in this late phase of the economic cycle, investors need to brace for slightly lower overall investment returns and higher levels of volatility.

Lower overall returns because fixed interest bond holdings – while still reducing risk – struggle to contribute positive returns when interest rates and yields rise back to more normal levels and profit margins of stock market quoted companies come under pressure (as rising wages from tightening labour markets and higher cost of capital increase the cost of business activity). It appears this insight has finally hit home with global equity investors, who – despite news of continued economic growth – have suddenly felt the urge to part company with their previously so cherished and profitable stock market investments. This has led to “a classic scenario of more sellers than buyers in the markets”.

This may sound overly simplistic, but is nothing more than a more colloquial description of a liquidity squeeze, where the sudden removal of previously plentiful liquidity leads to a string of self-enforcing rounds of equity market falls. This carries on until most opportunistic holders of shares have thrown in the towel and the more fundamentally judging investor community can see considerable profit upside in a return to the market.

As we wrote when the sell-off began, the trigger point was a step-up in longer term US bond yields, when bond investors began to price in US interest rates rising to the 3% level – as the US central bank had communicated for a while but had not been believed by markets. Just as in February, the prospect of removal of the very cheap credit equity markets had thrived on for the past decade was enough to stop and reverse their September rush to ever higher valuation heights. The chart at the top illustrates this. The February correction only returned stocks globally back to their previous trajectory, after they had clearly overshot over December and January. However, they continued more or less within the boundaries of their trend channel that started in 2016 and was predicated on the assumption of continued cheap credit.

The forced deleveraging of the Chinese financial sector at the behest of the government (see last week’s edition) has added to this liquidity squeeze. Not only have more nervous domestic investors cashed in their holdings, but there was additional forced selling by overseas Chinese equity investors, who need to raise cash to pay back loans they can no longer afford. To top this, the ‘stock-market-fuel’ of company share buybacks that pushed liquidity into markets over the summer is also currently absent, as companies are not permitted to buy their own shares during the so-called blackout period before their quarterly results announcements.

The interaction of these three factors makes it harder than usual to predict turning points in this stock market rout. We are therefore for the time being content to continue with the reduced risk positions we have held in portfolios throughout the year. But we will rebalance portfolios over the coming weeks to position them for the changed market environment.

This episode is painful for investors who have only recently invested from cash. For all other long term investors, it is just another period of volatility which is part and parcel of healthy capital markets and the risk discomfort factor that rewards equity investors with higher long term returns than lower risk bond investors. In the meantime, the fundamentals of the economy and corporate earnings have not changed direction or deteriorated in outlook since the beginning of October. It is therefore reasonable to expect that stock markets will eventually return to follow their lead – even if that is at a more realistic trajectory of expected future profit growth than had been the case in the US over much of the last 2 quarters.