What happens when global liquidity dries up?

The rising tide of liquidity has led to the unprecedented growth of hedge funds and private equity deals. Yet what would happen in the markets if these popular investment vehicles came under threat?

In recent issues we have concentrated on the global liquidity story. This last two weeks the news has focused specifically on the yen based carry trade. The simple fact of the matter is that the massive growth in global liquidity has been outside the control of central banks'. A rising tide of liquidity, the scale of which dwarfs anything that has ever happened in the past. The outcome of this is crucial to the stability of the world's economies. Its emergence has caused a seismic growth in leverage and wealth, it has also caused an unprecedented growth in the number of hedge funds and private equity deals.

On 9th February the FT reported that US sub-prime problems might be an early warning signal of trouble for junk bonds. Martin Fridson, publisher of the Leverage World research service said that CCC rated US companies as a percentage of the high yield mix were 2% going into the 1990 recession. The latest figure he says is over 17%. There is according to him a 27% chance of CCC rated companies defaulting within 12 months of being given the rating. If the next recession is as deep as 1990 he says that US default levels will return to the levels of the Great Depression.

The latest edition of the World Economic Forum's Global Risk report identified 23 categories of global risk grouped under five headings which were: Economic, Environmental, Geopolitical, Societal (bird flu), Technological. No single risk, the report said became less severe during 2006. The headline of this article was "Investors are too used to living on the edge of a volcano".

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At RHAM we consider ourselves privileged to have access to the work of the economist H "Woody" Brock of Strategic Economic Decisions Inc. As clients of Woody we receive bi-annually his latest series of essays which are always of great value. Woody Brock, in one of his recent essays, considers the possible cause of global liquidity going away. He poses the question - what would cause a drying up of the liquidity and bring about the end of the new investment vehicle market? He suggests a number of different developments that could precipitate this. For example, institutional investors could stop being so optimistic about returns from alternative investment; the Fed and/or the Bank of Japan could unexpectedly raise interest rates far higher than expected; investors could be frightened away by a series of private equity defaults.

Unfortunately, the truth is that nobody knows what will eventually cause this to happen. However, what will happen is that demand will decline and those holding these investments will at some time become less enthusiastic to retain them and this is one of the important points that Woody makes. The number of new investment vehicle contracts in the market will remain the same even as demand falls, so the market becomes more illiquid and in Woody's own words "the investors will find it much more difficult to try to get their money out than before. Moreover on a flow-of-funds basis, the issuance of new deals and securities will fall sharply".

The future is coming towards us, at times slowly and other times rapidly. There is a time in that approaching future when these events will take place - they will be "rare events" and for that reason, remain largely ignored.

By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.

For more from RHAM, visit https://www.rhasset.co.uk/