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

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 October 2019)

Geographical allocation
Country Fund (%)
United Kingdom 81.95
United States 11.28
Luxembourg 3.76
Switzerland 1.50
Ireland 0.75
Norway 0.75
Sector allocation
Industry Fund (%) Benchmark (%)
Cash and near cash 100.00 0.00
Total 100.00 100.00

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: 27 Old Gloucester Street, London, WC1N 3AX.

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