Global liquidity to tighten

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In this inter-connected, globalised economy, dollar liquidity is key. Its importance as the grease in the wheels of the global financial system is easily under-estimated. In simplistic terms, when dollar liquidity is abundant, global trade tends to be strong, the dollar is typically weak, commodity prices rise and equity markets do well. But when dollar liquidity tightens, all of these things go into reverse. In the post-financial-crisis world, these relationships seem to have become more pronounced.

Liquidity conditions in the global financial system deteriorated meaningfully in 2018, with central banks, led by the Federal Reserve (Fed), tightening monetary policy. The Fed increased interest rates four times in 2018, in response to a rapidly growing US economy, a strong domestic labour market and concerns about building inflationary pressures. Although that policy may have been justified from an American perspective, it increasingly caused problems for many other parts of the global economy, particularly in emerging markets, which borrowed heavily in dollars whilst they were cheap.

Meanwhile, the Fed’s quantitative tightening (QT) programme has drained considerably more liquidity from the global financial system, with huge implications for global financial markets and the world economy. The European Central Bank has also stopped its own form of extraordinary monetary policy – prematurely, in our view, because the European banks are not yet fit to lend.

The Fed’s most recent comments reflect growing unease about the health of the US economy. The next move in US interest rates may therefore be down and QT is due to end earlier than previously expected. Nevertheless, with the lagged effects of tighter monetary policy yet to be felt, the damage may already be done.

We expect tighter liquidity conditions to increasingly bear down on global economic activity over the remainder of 2019, with very few regional economies possessing enough internal momentum to withstand the slowdown that is already in train.

This, in turn, will make it difficult for many businesses to meet elevated profit expectations. Coupled with a backdrop of excessive valuation in stock markets, this is a potentially dangerous combination. The comfortable consensus view that prevails in equity markets globally is about to be challenged.

Neil's view

As the era of easy money draws to a close, with the Federal Reserve intent on steadily shrinking the size of its substantial balance sheet, the implications for global liquidity and the US dollar pose a hazard for financial markets that have been paying too little attention to risk.21 December 2017

Ten years on from the global financial crisis, we are witnessing the product of the biggest monetary policy experiment in history. Investors have forgotten about risk and this is playing out in inflated asset prices and inflated valuations. Whether it’s Bitcoin going through $10,000, European junk bonds yielding less than US Treasuries, historic low levels of volatility or smart beta ETFs attracting gigantic inflows – there are so many lights flashing red that I am losing count.1 December 2017

Signs of liquidity stress appearing in interbank lending market?

Source: Bloomberg, Woodford

The LIBOR-OIS spread is seen as a measure of financial stress within the banking system - a widening spread suggests that interbank funding costs are rising relative to the risk free-rate. As the chart illustrates, there has been a very specific rise in dollar funding costs recently, which is indicative of diminishing dollar liquidity, globally.

Global liquidity conditions have tightened aggressively - and are likely to worsen

Source: MacroStrategy, Woodford

Global liquidity expected to continue tighteningQE 1QE 2QE 3% change20102012201420162018200920112013201520172019Excess global US$ money supply (6m annualised)-20-15-10-505101520 ? Fed tapers China bank bailout Yellen talks down the US$ Debt ceiling raised

Chinese money supply growth already slowing

Source: Bloomberg, Woodford

Implied path of future US interest rates

Source: Bloomberg, Woodford

How the funds will benefit

As well as the Fed’s tightening of monetary policy, we also have the reduction of the European Central Bank’s (ECB) extraordinary monetary policy to contend with. In combination, we believe the impact of this deterioration in global liquidity conditions will act as a brake on economic growth and on financial asset prices around the world, with very few regions looking capable of escaping the fallout. With equity markets pricing in perfection for the global economy, this will come as a shock to a complacent consensus.

There is one developed economy, however, whose money supply growth outlook is not facing the impact of the withdrawal of extraordinary monetary policy. The UK economy has sustained nominal broad money supply growth of around 5% per annum recently – this, coupled with all the other positive trends in the UK economy that we have been highlighting, is enough to suggest that domestic growth can accelerate in the months ahead, leaving consensus expectations looking far too low.

Our contrarian strategy has actively avoided areas of the market that look most vulnerable to the withdrawal of liquidity, focusing instead on stocks, particularly domestically-focused companies here in the UK, that have not benefited from abundant liquidity. As always, valuation guides this disciplined investment approach.

LF Woodford Equity Income Fund (as at 31 August 2019)

Geographical allocation
Country Fund (%)
United Kingdom 84.50
United States 11.58
Switzerland 0.98
Norway 0.78
Luxembourg 0.73
Ireland 0.64
Sector allocation
Industry Fund (%) Benchmark (%)
Financials 29.81 25.30
Consumer Goods 26.89 14.71
Health Care 22.64 9.52
Industrials 8.09 11.64
Technology 5.72 1.07
Telecommunications 3.17 2.61
Consumer Services 2.18 11.81
Utilities 0.70 2.62
Oil & Gas 0.00 13.38
Basic Materials 0.00 7.32
Cash and near cash 0.79 0.00
Total 100.00 100.00

What are the risks?

  • The value of investments and any income from them may go down as well as up, so you may get back less than you invested
  • Past performance cannot be relied upon as a guide to future performance
  • The ongoing charges figure is charged to capital, so the income of the funds may be higher but capital growth may be restricted or capital may be eroded
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  • The funds and trust may invest in overseas securities and be exposed to currencies other than pound sterling – as a result, exchange rate movements may cause the sterling value of these investments and the income from them, to fluctuate
  • The LF Woodford Income Focus Fund will be invested in a concentrated portfolio of securities – the fund is not restricted by reference to any geographical region, sector or market capitalisation
  • The LF Woodford Equity Income Fund and the Woodford Patient Capital Trust may invest in unquoted securities, which may be less liquid and more difficult to value, because they are generally not publicly traded – the lack of an open market may also make it more difficult to establish fair value
  • The price of shares in the Woodford Patient Capital Trust is determined by market supply and demand, and this may be different to the net asset value of the trust. This means the price may be volatile in response to changes in demand
  • Long-term outcomes are more binary – extremely attractive rewards for success but some businesses will inevitably fail to fulfil their potential and this may expose investors to the risk of capital losses
  • Young businesses have a different risk profile to mature blue-chip companies – risks are much more stock-specific, which implies a lower correlation with equity markets and the wider economy – it can take years for young businesses to fulfil their potential, this investment requires patience

Important information

Before investing, you should read the Key Investor Information Document (KIID) for the fund – or Key Information Document (KID) for the trust – and the Prospectus which, along with our terms and conditions, can be obtained from the downloads page or from our registered office. If you have a financial adviser, you should seek their advice before investing. Woodford Investment Management Ltd is not authorised to provide investment advice.

The Woodford Patient Capital Trust currently intends to conduct its affairs so that its securities can be recommended by IFAs to ordinary retail investors in accordance with the FCA’s rules in relation to non-mainstream investment products and intends to continue to do so for the foreseeable future. The securities are excluded from the FCA’s restrictions which apply to non-mainstream investment products because they are shares in an investment trust.

The Woodford Funds (Ireland) ICAV (the “Fund”) has appointed as Swiss Representative Oligo Swiss Fund Services SA, Av. Villamont 17, 1005 Lausanne, Switzerland. The Fund’s Swiss paying agent is Neue Helvetische Bank AG. All fund documentation including, Prospectus, Key Investor Information Documents, Instrument of Incorporation and financial reports may be obtained free of charge from the Swiss Representative in Lausanne. The place of performance and jurisdiction for all shares distributed in or from Switzerland is at the registered office of the Swiss Representative. Fund prices can be found at www.fundinfo.com.

 

Woodford Investment Management Ltd is authorised and regulated by the Financial Conduct Authority (firm reference number 745433). Incorporated in England and Wales, company number 10118169. Registered address 9400 Garsington Road, Oxford OX4 2HN.

Woodford Patient Capital Trust plc is incorporated in England and Wales, company number 09405653. Registered as an investment company under section 833 of the Companies Act 2006. Registered address Beaufort House, 51 New North Road, Exeter, EX4 4EP.

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