April 8, 2018 Liquidity

Risk/Reward Vol. 388

THIS IS NOT INVESTMENT OR TAX ADVICE. IT IS A PERSONAL REFLECTION ON INVESTING. RELY ON NOTHING STATED HEREIN.

Another week, another roller coaster ride. This time it was talk of a trade war. Monday's downdraft was stemmed and reversed by the calming voice of Larry Kudlow. But saber rattling later in the week reinvigorated the bears. Tariffs may have been the topic this week, but at its core, the insanity in the market lays at the feet of (or more accurately at the mouth of ) The Donald. Not even a very interesting jobs report on Friday (discussed below) moved the needle. Next week it will be a government shake up or another mistress or a Mueller revelation or an improvident Tweet. Let's face it folks, he loves controversy. If none exists, even for a moment, either he or his detractors will create some. What a way to live.

Although lost in the tariff kerfuffle, the jobs report on Friday was a curious one. The number of new jobs fell short of expectation, but the unemployment rate remained at historic lows. Of more importance was the higher than expected growth in wages. Although still short of signaling the arrival of inflation, the trend is such that the Fed may have to act more aggressively should the Holy Grail of 2% inflation be exceeded any time soon. Remember, although the commentators proclaimed that only three rate increases are to be expected in 2018, they did so based upon the fact that 8 of 15 voting members of the FOMC so indicated on their March "dot plots." Seven indicated that four raises would be appropriate. Should inflation spike, that narrow majority could dissolve. Should the Fed be more aggressive in rate hikes it would have an adverse effect on equities. So heads up.

And speaking of heads up, I recommend that you Google and read Jamie Dimon's letter to the JPMorgan Chase stockholders. It is a comprehensive overview from an extremely knowledgeable man. He addresses a wide range of topics, but highlighting lack of liquidity (set forth below) about which I have written in the past is particularly noteworthy. Lack of liquidity creates a bottleneck which in turn promotes volatility which can lead to panics. Remember the Taper Tantrum of 2013.

Far more money than before (about $9 trillion of assets, which represents about 30% of total mutual fund long-term assets) is managed passively in index funds or ETFs (both of which are very easy to get out of). Some of these funds provide far more liquidity to the customer than the underlying assets in the fund, and it is reasonable to worry about what would happen if these funds went into large liquidation.

Market making is dramatically smaller than in the past (e.g., aggregate primary dealer positions of bonds — including Treasury and agency securities, mortgage-backed securities and corporates — averaged $530 billion in 2007 vs. an average of $179 billion today). While in the past that total may have been too high, virtually every asset manager says today it is much harder to buy and sell securities, particularly the less liquid securities.

Liquidity requirements, while much higher, now have an element of rigidity built in that did not exist before. Banks will be unable to use that liquidity when they most need to do so — to make loans or intermediate markets. They have a “red line” they cannot cross (they are required to maintain hard and fast liquidity requirements). As clients demand more liquidity from their banks, the banks essentially will be unable to provide it.