http://ggc-mauldin-images.s3.amazonaws.com/uploads/pdf/OTB_Nov_03_2017.pdf
... the next crisis will reveal
how little liquidity there
is in the
credit markets, especially in the high-yield, lower-rated space.
Dodd–Frank has greatly limited
the ability of banks to provide market-making opportunities and credit markets, a function that has been
in their wheelhouse for well over a century. Given the massive amount of high-yield bonds that have been
stuffed into mutual funds and ETFs, when the prices of those funds begin to fall, and the ETFs want to sell
the underlying assets to generate liquidity,
there will be no buyers except at extreme prices.
...As the saying goes,
when you need money in a crisis,
you sell what
you can, not what you want to. And if you can’t sell your high-yield, you end up
selling other assets (like
equities), which puts strain on them.
What Will the Next Crisis Look Like?
By Marko Kolanovic, PhD, and Bram Kaplan
October 3, 2017
...Central banks purchased ~$15T of
financial assets, mostly government obligations. This accommodation is now expected to reverse, starting
meaningfully in 2018. Such outflows (or lack of new inflows) could lead to asset declines and liquidity
disruptions, and potentially cause a financial crisis. We will call this hypothetical crisis the “Great Liquidity
Crisis” (GLC)....
... the main attribute of the next crisis will be
severe liquidity disruptions resulting from
market
developments since the last crisis:
> specifically the
decline of active value investors, reduces the ability of the market to prevent
and recover from large drawdowns.
> The
~$2T rotation from active and value to passive and
momentum strategies since the last crisis eliminated a large pool of assets that would be standing
ready to buy cheap public securities and backstop a market disruption.
> Tail Risk of
Private Assets: Outflows from active value investors may be related to
an increase
in Private Assets (Private Equity, Real Estate and Illiquid Credit holdings). Over the past two
decades, pension fund allocations to public equity decreased by ~10%, and holdings of Private
Assets increased by ~20%. Similar to public value assets,
private assets draw performance from
valuation discounts and liquidity risk premia. Private assets
reduce day-to-day volatility of a
portfolio, but
add liquidity-driven tail risk. Unlike the market for public value assets,
liquidity in
private assets may be disrupted for much longer during a crisis.
> Increased AUM of
strategies that sell on ‘Autopilot’....
> ... The
model of liquidity provision changed in a
close analogy to the
shift from active/value to passive/momentum. In
market making, this has been
a shift from human
market makers that are slower and often rely on valuations (reversion),
to programmatic liquidity
that is faster and
relies on volatility-based VAR to quickly adjust the amount of risk taking
(liquidity provision)...
>
Miscalculation of portfolio risk: Over the past 2 decades, most risk models were (correctly)
counting on bonds to offset equity risk. At the turning point of monetary accommodation, this
assumption will most likely fail. This increases tail risk for multi-asset portfolios...
>
Valuation Excesses: Given the extended period of monetary accommodation, most of assets are at
their
high end of historical valuations ... Sign
of excesses include multi-billion dollar valuations for smartphone apps or for ‘initial crypto- coin
offerings’ that in many cases
have very questionable value.
... If the standard rate cutting and bond purchases
don’t suffice,
central banks may more explicitly target asset prices (e.g., equities). This may be controversial
in light of the potential impact of central bank actions in
driving inequality between asset owners and
labor (e.g., see here). Other ‘out of the box’ solutions could include a negative income tax (one can call this
‘QE for labor’), progressive corporate tax, universal income and others....
technology companies... In many possible
outcomes,
inflation is likely to pick up....
...
social tensions that are likely to be amplified in the next
financial crisis.
