Assumptions about global liquidity are wrong and market activity could freeze up quickly, according to the chief executive of Swiss bank UBS.
Last month, the Dow and S&P 500 equity indices recorded their worst December performance since 1931 – the era of the Great depression. It was also the biggest of any monthly loss since February 2009.
Stocks got dumped amid concerns of an economic slowdown and fears the Federal Reserve might be tightening conditions to a point where liquidity in markets could dry up. For investors, liquidity is the ability to sell an asset reasonably quickly and at a price close to where it last traded.
Speaking Thursday, on a CNBC-moderated panel at the World Economic Forum in Davos, UBS chief executive officer, Sergio Ermotti, said the December sell off was due to a convergence of macro and political fears as well as a growing understanding that the financial system may not let investors move capital as easily as before.
“The implied assumption that we hear about liquidity being there, being able to step in and function the levelling out tensions, is the wrong assumption,” he said before adding “liquidity can freeze very easily, like the water in Davos.”
Ermotti said that among its US investor base at the end of the fourth quarter in 2018, there was an historic high of 24 percent cash asset allocation as investors pulled back from the market.
“This is not liquidity that is there for reinvestment. This is there because people fear that things will go wrong,” he warned.
The Swiss banker said many of the world’s bigger investors were now managing money for others and, unlike banks, they not might stand by willing and able to trade an asset just to ensure markets run smoothly.
The panel, moderated by CNBC’s Geoff Cutmore, also included Mary Callahan Erdoes, J.P. Morgan’s asset & wealth management chief executive. The asset allocator, who also sits on the Federal Reserve Bank of New York’s Investor Advisory Committee, said a lack of liquidity is “what we all worry about.”
Callahan Erdoes told the Davos audience that since 2008, an additional $11 trillion worth of assets had been pumped into the financial system which had thrown up strange pricing levels. As an example, the U.S. banker noted the situation in 2017 when 85 percent of the Italian high yield market traded below the yield of U.S. treasuries.
In typical conditions, the yield on U.S. treasuries should be lower than Italian high yield as it is considered a much safer investment.
The J.P. Morgan executive said these market anomalies ought to “get cured” when the capital was eventually redeployed but warned that people could find danger amid a lack of market makers and a gap in liquidity.
The Volcker rule — a post-crisis regulation to curb banks making big bets with their own money — has been criticized by banks for reducing market liquidity. Others see it as a necessary piece of regulation to ensure that financial institutions cannot repeat the financial meltdown of 2008.
Callahan Erdoes said with the diminished role of the banks and investment dealers as investors and market makers, it would then fall to the shadow banking system, such as private equity and hedge funds, to grease the wheels of the global market.
“They have a lot of capital that could be deployed but they are not going to go in to make markets in the way banks used to. They are going in as a fiduciary, to make money for their investors, and those are the dynamics that everyone is struggling with,” she said.