Amin Rajan: You claim that so-called liquid assets are not as liquid as investors think. If anything, liquidity is in the eye of the beholder. Can you develop this surprising thesis?
Pascal Blancque: Liquidity is influenced by the ability and willingness to trade. The capacity depends on the monetary resources available to investors. Willpower, in turn, is influenced by the powerful forces of time, memory and forgetting, which ensure that investors are overly influenced by their past experiences. Subjectivity means that liquidity is anything but static. And labeling assets as “liquid” or “illiquid” is, at the very least, a misnomer, if not outright a bad sell.
AR: Why do psychological forces play such an important role in liquidity dynamics?
DB: Our daily economic life is determined by commerce and transactions. It follows that, for anything to be liquid, there must be a willingness to exchange. People form expectations and discount the future in the same way that they remember and forget the past.
For example, market participants today still have vivid memories of the “liquidity crunch” that marked the 2008 financial crisis. vicious that could dry up the market. Liquidity is also a monetary process involving the exchange of money, ensuring that monetary and psychological factors determine the amount of liquidity in circulation.
AR: This brings me to a long-standing economic debate. Neoclassicals argue that the value of an asset is influenced only by its fundamentals. As such, they come before liquidity, as stated in modern portfolio theory. New Keynesians think it’s the other way around. Why are these two points of view so diametrically opposed?
DB: In the neoclassical approach, individuals establish value through utility – their personal preferences – independent of the market, and liquidity follows passively. So, value drives liquidity, because everything is deemed to be fully liquid. In the New Keynesian approach, the reverse is true: liquidity precedes and reflects value. Here, liquidity takes the form of transactions that generate self-referential prices. Both have limits. In the first case, value is entirely attributable to utility; the second lacks a fundamental theory of value.
It is important to overcome these limitations and integrate them into a unified theory. In particular, I see liquidity as a point of contact with the world, with a strong psychological dimension. Liquidity reveals value through prices, which are simply discrete “moments” of value in an ongoing process. In this sense, liquidity does not precede value, but rather trade unveils value at different “moments of liquidity”. In the extreme, it becomes impossible to create value in the event of a liquidity crisis in the absence of buyers.
AR: The implication is that the commonly held distinction between ‘liquid’ and ‘illiquid’ markets is illusory, so how can investors slice the liquidity profiles of their so-called ‘liquid’ assets?
DB: The illusion can, and often does, break with changes in the environment, market infrastructure, psychological benchmarks, and market narratives. A central bank policy error leading to a deep recession could be one such trigger. Therefore, in the current environment, the assessment of liquidity must be at the forefront of investors’ concerns.
Memories of past liquidity environments will continue to influence investors, and they should be aware of this when slicing the liquidity profiles of their portfolios. There is no guarantee that a seemingly liquid market will be built on solid valuation foundations, as evidenced by the regular formation of bubbles. The proposition that “the higher the total illiquidity, the higher the premium” is misleading, as it relies on the assumption that value precedes liquidity. Therefore, investors should consider liquidity at the total portfolio level as a key dimension of risk.
Five key suggestions
- Include liquidity considerations in asset allocation and consider increasing the share of high quality liquid bonds as a liquidity buffer.
- Avoid bunching up in crowded trades and consider the dimension of liquidity when selecting investment ideas.
- Avoid investments with excessive leverage.
- Assess the liquidity risk processes of internal and external managers.
- Exploit the opportunities of assets carrying significant liquidity premiums when they arise.
AR: You identify paradoxes. Two of them are relevant for investing in retirement plans. The first is that, like diversification, liquidity is notable for its absence when it is most needed, such as in a bear market. Why is liquidity disappearing and causing market turmoil that hurts investors’ portfolios?
DB: This is a challenge for investors, especially in the aftermath of the financial crisis. The belief that the benign liquidity conditions of a normal market environment will persist could lead to a lack of preparedness for future shocks. The abundant macroliquidity conditions of the past decades have lulled investors into a false sense of security. While the current excessive monetary policy tightening indicates that future market liquidity will be weaker, most market participants seem to ignore the reality.
For example, market segments characterized by crowded leveraged trading are potentially subject to liquidity events and drains. To some extent, the market corrections in the first half of 2022 helped eliminate some market excesses at a time when the risk of recession was not on the horizon. This can be useful to reduce the number of crowded areas. The situation is further complicated by a fragile economic outlook; however, not all market segments are equal and understanding the dynamics of liquidity in times of crisis is not easy given the multitude of players involved and the diversity of their experiences.
AR: The second key paradox is that despite abundant liquidity throughout the system, there have been instances of severe liquidity shortages in individual market segments. This has been evidenced by risk/off-risk trading over the past decade. What has prevented macro-level liquidity from flowing into micro-markets, as expected?
DB: When macroliquidity deteriorates, as is currently the case, microliquidity deteriorates even more. Confusion between them may mean investors are underestimating potential liquidity issues.
Macro-liquidity has strong macroeconomic characteristics that are linked to monetary aggregates such as the monetary base and central bank balance sheets. Micro-liquidity, on the other hand, refers to the market. It is defined as the ability to trade a large order on a given financial instrument without generating a significant price impact.
AR: Like other risks, liquidity cannot be diversified. Yet, as you imply, it gives oxygen to the markets. How can retirement investors incorporate liquidity filters into their asset allocation without making it too complex? Is it justified to treat liquidity, alongside risk and return, as a third pillar of portfolio construction?
DB: Yes, the traditional risk-return framework is insufficient. Investors should consider adding a third dimension – liquidity – to their valuations, particularly in fixed income securities. This is crucial for mitigating liquidity risk, while tactically taking advantage of market opportunities. Liquidity is not only a defensive tool, it is also a vector of diversification because it is not perfectly correlated with the other risks of the portfolio.
We are now in an end-of-cycle phase, characterized by imminent recessionary risks. In such an environment, market sentiment becomes more fragile, especially as geopolitical uncertainty remains high. Liquidity strains will no doubt intensify future corrections when the economic cycle turns into a recession.
Pascal Blanqué is President of the Amundi Institute and Amin Rajan is CEO of CREATE-Research. Both are members of Club 300