Liquidity crisis feared in equity markets

Nervousness over liquidity — which popular opinion would place in the fixed-income market — is building in the equity markets.

The presence of new market participants, herding in certain stocks, the continued move toward passive investment and worries about paying off bond redemptions are bubbling away in the background, sources said.

“There are certainly market/industry structural changes that are increasing fragility and liquidity tension,” said Kristian West, global head of equity trading at J.P. Morgan Asset Management, in London.

“I'm not concerned per se because we are long-term investors and any short-term volatility should work its way out over time,” said one pension fund executive, who asked not to be named. “However, I am concerned about the implications of (exchange-traded funds and high-frequency traders) on individual stocks and sectors. Days when the Dow (Jones industrial average) opens down 500 or 1,000 points suggests that there are some unintended consequences from (algorithmic) and computer-driven trading strategies,” he said.

ETFs have driven liquidity toward the end of the day, said Mr. West, which “makes intraday liquidity more fragile and fleeting, and changes the participants one interacts with.”

“Sum this all up and there are real liquidity tensions. The U.S. market was trading 10 billion shares a day in 2010; and year-to-date average is 7 billion,” said Mr. West.

As for high-frequency traders, which long have been discussed by money management and pension fund executives for their potential to harm returns, Mr. West said: “HFT market-making isn't really market-making in the traditional sense — (it is) fine for retail flow but very fragile, fractious, momentum-enhancing and difficult to interact with for institutional investors.” He said on-screen liquidity was cut by as much as 90% in the runup to the Federal Open Market Committee's Dec. 16 rate increase announcement. “This has the potential to increase market volatility, "real' spreads and short-term execution costs.”

And a change in institutional investor behavior has had an impact, too, with a move toward passive and more quantitative approaches to trading. Money managers have tended to trade less to reduce frictional costs and performance drag, which has resulted in less liquidity, said sources.

“In general, concerns around liquidity are very warranted,” said Wouter Sturkenboom, London-based senior investment strategist at Russell Investments. “We are not yet seeing massive issues with trading equities. But market breadth is dropping, which has been happening for a couple of years. That indicates that underneath the surface, liquidity in the equity markets is in decline. We probably won't notice that until we get a shock, and investors try to trade out of” certain stocks.

While money management executives said they have not yet witnessed problems in trading equities, herding by institutional investors was highlighted by sources as a serious concern.

“Equities are liquid, but you will get a horrible price if everyone is heading for the exit at the same time,” said the pension fund executive. “(There are) some crowded trades around stocks with specific characteristics, for example low (volatility) or high yield, and if there's an unexpected negative surprise they will be hard hit for these reasons.”

Patrick Moonen, a senior strategist within the multiasset boutique of NN Investment Partners, in The Hague, Netherlands, said the herding behavior of investors will at certain times mean “everyone is running at the same time to the same side of the ship.” That has been seen in the fixed-income markets, and to a lesser extent in the equity markets. While “we have a bigger room (in equities), with more liquidity, the gates to get in or out are smaller. When you have big moves in the market you can see some panicky reactions. That is more of a concern for us. And I think that going forward into 2016, this kind of behavior will persist given that everyone is looking at the same data, and there is an increased amount of uncertainty in the market and that could create exaggerated moves.”

With valuations high, particularly in some markets, and slowing global growth, Mr. Sturkenboom can see reason for concern.

“I could totally understand (liquidity concerns in equities) if you are running a risk screen at the moment. The current situation, as we see it, is we have expensive valuations in equities, especially U.S. equities; from a business cycle perspective we have slowing growth globally; and momentum in financial markets is definitely waning. That is a risky set of circumstances.”

However, Mr. Sturkenboom said the business cycle element is not yet negative.

Institutional investors also are looking to the equity markets to provide liquidity in a time of crisis in other asset classes, particularly as bond market liquidity — with high yield standing out among sources as a main culprit — looks tight.

“We have had requests from clients over the past few months asking how quickly we could liquidate their equity portfolios, to compensate for the lack of bonds liquidity,” said Bruno Taillardat, investment director, equities, at Unigestion, based in Geneva, Switzerland. “Their perception is that if bonds were to suffer from a lack of liquidity, they need to make sure they can find it elsewhere. They need to be sure that if all of these big institutions have some form of investment in equities and all need to sell, they would not be stuck.”

Mr. Taillardat said Unigestion executives at first thought the notion counterintuitive, “but then the contagion effect began to ring a bell.”

Unigestion researches crowding in stocks to ensure it can still manage equity portfolios and risk, and to ensure these stocks are not all on the same books as many other managers. This research is conducted monthly.

And while equities were often used as a “cash machine” in the 2008 financial crisis, difficulty completing trades right now in the high-yield market is putting the focus back on the equity market, said Stuart Gray, senior investment consultant, manager research at Towers Watson & Co. in Reigate, England. “If investors have liquidity difficulties in credit markets, equities are where they may have to go if they have immediate liquidity needs.”

Mr. Gray said investors will often keep a mid- to large-cap passive equities allocation as a buffer in their portfolios to source cash when needed. “I haven't seen widespread evidence yet of people increasing their buffers, but liquidity is being discussed.”