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Liquidity risks and opportunities arrive quickly and are shortlived, as the banking crisis of March so aptly demonstrated.REBECCA NOBLE/AFP/Getty Images

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A potential liquidity crisis is looming over financial markets. To prepare, investors must change how they think about liquidity in their portfolios. The past will not be a guide.

There are three reasons driving this concern. First, the macroeconomic environment has shifted profoundly, moving from the quantitative easing stimulus programs of central banks to tightening on a co-ordinated basis.

Second, elevated uncertainty over monetary policy is leading to heightened rate volatility. The focus of central banks on avoiding 1970s-style inflation is clashing with expectations of a sharp economic contraction that will require a return to easing.

Third, changes in the U.S. Treasury market have raised liquidity concerns. The Treasury market has exploded in size, growing more than fivefold over the past 15 years, according to J.P. Morgan Securities Inc. data.

However, J.P. Morgan Securities found the number of primary dealers to facilitate trading has stalled and market depth in U.S. Treasuries declined by almost 60 per cent in 2022 to levels only seen in times of a crisis. In practice, this means liquidity is more elusive than commonly assumed. This stress is visible in historically wide bid-ask spreads for larger block trades, even in the most liquid asset class in the world, according to Bloomberg LP data.

What are the implications for investors? They need to think more broadly about how they’re exposed to acute liquidity risk. Many of the most damaging market events are liquidity driven, yet they’re also prime opportunities for those with ready cash to pick up assets at attractive prices.

Past cycles are not a guide for liquidity dynamics in today’s markets. Investors need to adopt a shorter-term cycle mindset. In the past, they could plan on market and economic cycles that would play out over many years, so they could prepare portfolio reallocations with longer lead times. This cycle, due to exogenous shocks such as the Ukraine war, continues to be compressed with higher-intensity market moves. Liquidity risks and opportunities arrive quickly and are shortlived, as the banking crisis of March so aptly demonstrated.

So, investors should keep an eye out for “air pockets” of market volatility. Balance sheets are not as liquid as they were. And the U.S. Federal Reserve Board has removed liquidity from the market by selling bonds. In stress points, markets might move more quickly than investors liquidating positions may hope.

How should investors prepare given these challenges? They need to be nimble, develop a framework to stress test their assumptions on future liquidity and retain access to cash-like holdings to take advantage of liquidity-driven opportunities.

Fortunately, innovation in markets and access to liquidity pools are helping investors adapt. In fixed income, for example, expanded market access by way of electronic trading has lowered costs to access liquidity. Product innovation has introduced many liquid investment vehicles – exchange-traded funds, for one. These have helped both institutional and retail investors to trade efficiently and at more transparent pricing.

Improved risk-management tools provide another important solution. Investors should proactively identify areas of stress through monitoring of key indicators such as true trading volumes at pinch points, costs and fund flows while keeping a close examination of market areas that have suffered stress in the past. If a potential risk issue is identified, risk teams need swift measures to mitigate matters.

Investors should also prepare a thorough review of their weakest counterparties – particularly those that are overexposed to some pockets of the market – and stay in close contact with their clients to anticipate future behaviour.

Diversification across sources of liquidity remains imperative. In the past several years, we have learned that what’s generally considered liquid has turned out to lack those properties when most needed. Liquidity is a far broader concept that hinges as much on market structure as it does on credit quality or maturity.

Finally, investors should also review their allocations to illiquid assets. A significant amount of money has flowed into private credit, private equity and other asset classes. As uncertainty around capital calls mounts for those investments, investors must hold liquid assets to keep up with any demands.

Done well, managing liquidity can enable investors to harness opportunities while avoiding downside risks to preserve capital. It has seldom been more important.

Lori Heinel is global chief investment officer at State Street Global Advisors in Boston.

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