Some Market Liquidity is Imaginary

A recent article by Bloomberg columnist Mohamed El-Erian warns investors to take a cautionary—and macro—view of a market that has “grown too comfortable and too complacent operating in the ample liquidity pumped in by years of unconventional central bank policies.”

El-Erian highlights the example of the recent demise of the Woodford Equity Income Fund (managed by UK-based Neil Woodford) due to a “mismatch between the desire of its investors to withdraw their capital and the ability of the investment manager to sell holdings in order to generate cash to meet the withdrawal requests.” According to El-Erian, the scenario was particularly problematic for Woodford given the market backdrop of ample liquidity and low volatility.

The takeaway, El-Erian argues, is not just that investors should beware of other funds with similar holdings. He writes, “An economic downturn or financial shock could create liquidity-induced dislocations that would heighten investor insecurity and complicate companies’ access to capital.”

Yet, he explains, both the “sources and users” of accessible funds have entered into more leveraged and less liquid segments of the marketplace while being met on the supply side by a “willingness of the industry to lower the structural barriers to such investing.” El-Erian notes the proliferation of ETF’s (which tout immediate liquidity) and the rise in lower-quality corporate debt ratings as two examples.

While the current market environment is not exposed to the “leveraged interdependence of banks that made the 2008 financial crisis particularly dangerous,” El-Erian concludes that it does contribute to a “higher probability of financial instability, and it could well spill over to corporate and household activity.” And, while central banks have paved the way, he adds, “they are not well placed to counter it.”