When Liquidity Runs Dry

After the global financial crisis of 2008, the Federal Reserve Bank of the United States embarked on an unconventional form of monetary policy called quantitative easing (QE). After lowering interest rates to zero, policy makers created nearly $4 Trillion by purchasing government bonds and other financial instruments in order to add liquidity to the financial system, drive asset prices higher, and stimulate economic growth. This unconventional source of liquidity was extremely effective. The S&P 500 rose over 300%. Real estate prices mostly rose across the country. Asset prices of almost all varieties benefited and emboldened investors to put their money into riskier assets, like high yield debt and emerging markets in the search for higher yields. Now however, the unconventional policies in the US are being reversed. The excess financial liquidity is being drained away. Interest rates are rising, and money supply is being reduced. In 2018, the US Federal Reserve will destroy $380 billion of excess money supply. If QE’s liquidity caused asset prices to rise and economies to grow, what happens next when liquidity runs dry?

The problem with emerging markets

As rates have risen in the US, the US dollar has strengthened. This is bad news for countries and foreign corporates who have borrowed heavily in US dollars. Over leveraged countries who have issued debt in US dollars will now be forced to refinance at higher rates and repay debt at ever more expensive exchange rates. In the past, these periods of mis-matched currency liabilities have resulted in defaults, currency devaluations, and sharp economic recessions for these countries. This process is just beginning, as the US Fed is expected to continue raising rates well into 2019. One only has to look at recent events in Turkey and in Argentina to see what starts to happen as financial conditions begin to tighten. The Turkish lira has devalued over 25% relative to the dollar, and as foreign investors repatriate or choose not to re-finance maturing debt securities, the country and its corporates are likely to experience higher interest rates, higher default rates, and slower economic growth. Argentina is experiencing similar problems. The peso has devalued 37%, interest rates spiked to 40%, and the country is seeking support from the International Monetary Fund. When liquidity runs dry, avoid emerging markets.

The problem with high yield debt

Corporate debt and especially high yield corporate debt securities have several unattractive traits for fixed income investors. Credit risk is the risk of default and risk of failure to receive payments of interest and/or principal. Credit risk for high yield corporate debt is significantly higher than investment grade or government securities. In addition, illiquidity abounds in the high yield market, and many securities trade by appointment only. Furthermore, a high correlation to equities makes high yield debt a poor choice for portfolio diversification in times of economic recession or equity market declines, as both typically decline in unison. Finally, high yield securities typically have call features which pose a “heads the company wins, tails the investor loses” proposition for the holders of high yield corporate debt. More importantly, as interest rates rise, these riskier businesses are unable to refinance at viable interest rates, and defaults occur. When liquidity runs dry, avoid high yield debt securities.

Take advantage of higher US rates

As interest rates rise, there are opportunities to invest in newly issued short term securities that offer significantly improved rates of return than those of a year or two ago. When rates were zero, investors parked excess cash in checking accounts, bank sweep accounts, and savings accounts, earning almost zero, but now, as liquidity dries up, we recommend investors be proactive and earn something on the cash reserve, maintain an extra buffer of liquidity, and take advantage of higher rates by moving out of bank accounts and into United States Treasury Bills that yield between 1.89% and 2.25%. We also continue to recommend investors maintain a long-term equity-oriented focus and move away from the equities of riskier companies to those of high-quality companies with the capacity to pay and to grow dividend income. We recommend equity investors overweight global consumer staples companies whose prospects look strong and have experienced price corrections this year. We focus on globally diversified companies with good brands, good management teams, and consistent shareholder returns via dividends.
Contact your financial advisor for a portfolio review and make sure your exposure to emerging markets and high yield debt securities are still appropriate for you, and feel free to contact us for more information on the high-quality companies we recommend for dividend income-oriented investors.

D. Chris Tucker, CFA
Chief Investment Officer