Strained Liquidity Conditions Compound Erratic Market Behavior

Liquidity shocks in US equities have well surpassed that of 2008.

The ramifications of the supply-cum-demand shock have become particularly pronounced in recent weeks as the global economy descends far beyond intermittent corrections and into the bear market. The Federal Reserve has moved to progressively crisis-era government spending injections to stabilize dismal capital markets.

Market swings have imposed an enormous strain on liquidity conditions, wherein countries of the likes of Spain and France liquidity ratios have reached near free-fall. Growing concerns are mounting that the appropriate stabilizing measures have not been employed on liquidity shocks respective to their projected impact on the equities market, as it is likely underestimated.

Liquid assets are being rapidly sold in the United States market, reflected in volatility indexes such as VIX where closings are reaching highs, exceeding those experienced in the 2008 financial crisis. Narrowing liquidity has proved to be especially turbulent for the United States equity market.

As VIX continues well above its long-term equilibrium, investment firms and traders have remained alarmed and wary of relief rallies, thus limiting minute rebounds in securities. With surprising clarity, Ryan Hammond and David Kosti from Goldman Sachs released the statement,

“Our illiquidity ratio, which measures the price impact of trading volumes, shows that liquidity has evaporated within U.S. equities.”

Despite extreme market irregularity, many investment firms have posed differing sentiments regarding annual returns on projected liquidity management. For example, Goldman Sachs has also stated,

“Some of the strongest S&P 500 returns have come during illiquid bear markets. We believe that thin liquidity, along with uncertainty and positioning, increase the risk that the S&P 500 overshoots its fundamentals in the near-term.”

“For longer-term investors, accepting liquidity risk presents an opportunity. A strategy of buying illiquid stocks and selling liquid stocks has generated a 4% annualized return since 1976, with a 63% annual hit rate of outperformance.”

The following model was provided by the firm as well.

S&P 500 futures have decreased by nearly 90% since the first substantial indications of the Covid-19 pandemic hitting the equity market. The turmoil in liquidity is far more conspicuous than in 2008. For one, futures market drops reached roughly 60% on a date adjusted average. As noted previously, volatility indexes are peaking in the United States despite high government expenditures and other demand-side fiscal policies.

Evidence attributes this disparity to the nature of the crises, wherein the present pandemic, global supply chains that have well-integrated themselves in Chinese production in the past decade have faced unprecedented cuts. While market volatilization following a global economic downturn is by no means unique, it is peculiar in regards to its present extent.

Exchange-traded funds have demonstrated surprising resilience in the wake of the crisis. Within the secondary market, the flood of securities due to panic selling has not corresponded to large volumes of stock redemption. Rather, the ETF liquidity has not thinned out.

The United States has not reached its third proposal of government spending, once again indicating increasing market instability. The Federal Reserve and other financial institutions are also approaching near-zero interest rates and announcing the mass purchases of bonds. However, it is unlikely that such measures will do more than temporarily buoy the world economy in the second quarter.

Direct monetary policy is a blunt tool and may not reflect the appropriate correctional measures for the vast number of financial instruments. The Federal Reserves will present several further proposals in the coming months during which the pandemic crosses its peak.

When the pandemic resides, the liquidity conditions will relax and thus witness a natural upheaval of our volatile bear market. It is the period within that obviously entails the largest potential for damage, where firms and investors should be wary of supposed relief rallies and keen for opportunities in purchasing illiquid stocks.