Awakening the Giants of Inflation and Illiquidity
Perhaps the most widely held belief amongst market prognosticators over the past year was that virtually all public market assets were generally expensive and that volatility was expected to increase. So to many, it was no surprise when equity markets began oscillating over the past few weeks with percentage moves we had not seen in years, driven by the volatility in the Treasury market. Professional investors, especially those who focus on historical relationships of asset values, have been anxiously awaiting the “normalization” of interest rates after a decade of Central Bank intervention. That time appears to be now, and despite the long awaited arrival, it comes at a time when federal budgetary needs are going to be sizable and underlying financial market liquidity is misunderstood. The silver lining is that recent volatility should remind investors why they invest with active money managers who focus on diversification and quality assets, and why managers have been modestly conservative over the past few years. After a long stretch of not being rewarded for this approach, we believe we have entered a point in the cycle when prudence, portfolio flexibility and proper diversification will once again prove valuable.
Tiedemann has long been concerned with the magnitude of debt transferred from the banking sector during the 2008 financial crisis to the federal government, and how this may rear its ugly head as an issue for markets. The U.S. Treasury market is an important foundation for pricing across all capital markets. At a time when Federal budgetary needs are reaching historic levels and requiring robust new treasury issuance (i.e. supply), this foundation may be vulnerable. If this concern materializes and interest rates move higher toward more normalized levels, it may have a leveraged effect on all other asset classes (corporate, high yield and emerging market debt, real estate, equities, etc.). This is because other assets, have historically been linked directly or indirectly to treasury rates. As a result, there should be heightened sensitivity to the adjustment of treasury rates as they rise, and the speed at which they rise.
We have long pointed out that it is unknown how this process of normalization will unfold. Will interest rates rise as a result of expanding economic forces and gradual rise in inflationary pressures (the optimal and traditional outcome), or will it be caused by negative issues like the U.S. budget and concerns over the sheer size of the country’s debt burden? The former is preferred and the Federal Reserve has had a favorable environment to maintain interest rates “lower for longer” as inflationary pressures have been virtually non-existent over the past five years. This environment was aided by declining commodity prices, an absence of wage pressure (typically attributed to the influence of technology replacing human labor), a modestly growing U.S. economy, and a deleveraging global banking system (due to regulations). In our view, these factors are no longer deflationary, but have reversed course and are beginning to put upward pressure on interest rates and are forcing the Federal Reserve to adjust base rates higher.
These actions would be acceptable under most market conditions, but the U.S. Administration has simultaneously chosen a path to implement tax reform to accelerate the U.S. economy’s growth and corporate profitability to re-energize the job market and income levels. Viewed in isolation, this reform could be considered a constructive plan of action, but this increases the budget gap by an estimated $1.5 trillion, only adding to the large Treasury supply already scheduled for this year. As interest rates rise, the mere cost of servicing this additional debt will become a budgetary issue on its own, and the buyers of this debt may likely demand higher yields given the expected level of future issuance. The importance of foreign buyers (China, Japan, etc.) to supplement internal demand and the pursuit of protectionist trade policies by the administration has the ability to further complicate the situation.
Higher rates coincide with an issue we’ve written about for years and has emerged in the securities market over the past few weeks: regulations and technology are causing structural changes in the true liquidity of capital markets. Over the past five years, the flow of assets into passive instruments has been extremely powerful and well documented. This constant flow of capital has masked the true underlying liquidity of markets, which we believe is far less than most understand it to be. In a world with fewer “market makers” (fiduciary bodies with a role to provide orderly liquidity in markets), incoming capital flows have been the primary liquidity provider. However, declining corporate profit margins caused by higher cost of capital may cause the momentum of capital flows into risk assets to become less one-sided. We believe we are entering a new phase of the market cycle.
While we can seek comfort in a deleveraged banking system, a major recent change in the markets is that the vast majority of equity volume throughout the typical trading day is now performed by algorithmic trading systems which follow and participate with the trend of the market. When stocks sell off and volume increases, these algorithmic trading systems can exacerbate the sell off by selling more, thereby creating a vicious cycle. This can occur very quickly as we’ve witnessed the last few weeks. However, this is not an equity market issue alone as the lack of liquidity providers and the pervasiveness of algorithmic trading across all assets can prove to be a problem, and we believe the lack of real liquidity may make markets feel more leveraged than they are in reality resulting in higher volatility.
These awakening giants of inflation and illiquidity do not necessarily result in negative outcomes but will undoubtedly force market participants to re-evaluate their approach and positioning. At Tiedemann, our client portfolios are relatively conservative and well positioned to address these broader issues, which should leave room for opportunistic investments as they present themselves. We have historically differentiated ourselves during more challenging markets, and we are already evaluating opportunities that recent volatility has provided.
This information is provided to discuss general market activity, industry or sector trends, or other broad-based economic, market or political conditions. This material is for informational purposes only, is not a solicitation and no action is being solicited based upon it. It does not take into account the particular investment objectives, restrictions, tax and financial situation or other needs of any specific client. This material is based upon information which we consider reliable, but we do not represent that such information is accurate or complete, and it should not be relied upon as such. Information and opinions are as of the date of this material only and are subject to change without notice. © February 2018 Tiedemann Advisors