Recent stock market volatility, and the damage that volatility has caused, raises a key question: Is financial liquidity always a good thing? In highly interconnected financial markets where events and even inaccurate perceptions of risk can destroy real economic value, liquidity should best be viewed by policymakers and investors as having both negative as well as positive elements. Both the potential upsides as well as downsides of liquidity should be considered when developing a financial plan or designing an investment strategy.
Economic Benefits of Liquidity
The standard view of financial liquidity in macroeconomics is that it is, by definition, a good thing. From a practical perspective, it is not hard to see why. In economic systems that are highly dependent on the use of capital, the ability to convert assets into ready cash plays a vital mechanical as well as psychological role.
First, an economy in its simplest terms is a system of interrelated payments and liquidity is necessary to meet short-term cash payment obligations. Meeting these obligations in a timely manner is required for the continued production and purchase of goods and services. Without a sustained ability to make these payments and realize these transactions, an economy will quickly grind to a halt.
Second, liquidity in some form is necessary to support the timely allocation and reallocation of assets and resources. Given the inherent volatility of supply and demand and other market factors, without cash or a cash equivalent it is difficult to move an asset for which there is little demand but great supply in one market to another market where there is little supply but high demand. The ability to use capital to support asset allocation decisions is important, not only to maximize an asset’s economic value, but also because the inefficient use of assets sets in motion a chain of consequences that can have a major negative economic impact. This can create negative economic momentum that is very difficult to reverse.
Third, liquidity is necessary to suppport investment in fixed assets and human capital which is required to preserve economic value and sustain future economic growth. Without the ability to quickly make expenditures when circumstances warrant it, companies often must pay an additional financial and opportunity cost. This creates a risk of a reduced overall return on a company’s use of capital which in turn reduces the likelihood that capital can be recycled into other value-creating uses.
Positive Liquidity in Investments
In the investment context, liquidity has also been historically viewed as highly positive. When analyzing investment opportunities, investors are often willing to pay a premium for investments that can be quickly converted into cash.
First, investors often take the view that there is an intrinsic value to the ability to immediately convert an investment that provides one risk-adjusted rate of return for another one that is better. Liquidity, in this sense, is a form of call option on a potentially more valuable investment opportunity.
Second, investors often want the ability to convert an investment position into capital that can be used for a purpose that, while not necessarily paying a higher rate of return or representing a better overall economic use of capital, simply represents a preferred use of cash. This is sensible given that the need for cash in the future and the timing of that need cannot be predicted with certainty.
Third, there is the captain of a sinking ship concern. Even in the absence of a desire to spend money elsewhere, an investor generally wants the ability to immediately exit an investment that takes a turn the worse or for one reason or another becomes inconsistent with the investor’s investment objectives or values.
The Downside of Liquidity
As global markets have become more interconnected, however, the classic view that liquidity is always a good thing should come under increased scrutiny. This is because, first of all, the interconnectedness of commercial markets means that an event in a faraway part of the globe and even in an unrelated sector can cause the value of an asset in another part of the world to significantly fall regardless of the asset’s intrisic value. There is often a direct relationship between the liquidity of an investment and its exposure to this type of risk.
More significantly, perceptions of risk can increasingly be immediately transmitted throughout financial markets which can destroy economic value even if the perception of risk has little to do with underlying asset strength. In other words, the price of liquidity is an asset position the value of which often rests on perceptions that can be erroneous and highly volatile. It is arguable that the larger the market, the greater the risk that factors unrelated to an asset will bring the value of that asset down.
Another component of liquidity risk is the incredible speed at which assets in public markets can lose value. Due to the impact of coronavirus, the Dow Jones Industrial Average lost nearly a third of its value in less than a month. While the advantages of liquidity are premised on the ability to immediately convert an asset into cash, there can be market as well as practical restrictions on how quickly an asset can be made liquid. A great deal of value can be lost in the asset-to-cash conversion process. Additionally, converting an asset into cash raises the question of what is to be done with the cash once it is in hand, a situation requiring choices that can lead to positive as well as unforeseen negative outcomes.
Given the downside of liquidity, it is not surprising that after the global financial crisis, many large asset managers sought to rebalance their portfolios and include additional amounts of real assets, such as real estate or agriculture, as a hedge against market volatility. It would not be surprising if this tendency gained strength in the aftermath of the impact of coronavirus.
Financial Planning and Portfolio Construction
When developing any type of financial plan, it is important to balance positive and negative sides of liquidity. Doing so requires an analysis of how exposed a particular financial strategy is to market volatility, which is a function of the nature of the strategy and the time over which it will be executed.
From a macroeconomic perspective, when building an economic plan it is necessary to think through the impact of downside liquidity scenarios and how those scenarios will in turn affect financial assets and in turn other elements of the economy. This requires having the short-term ability to not only respond to the impact of negative liquidity events but also to ensure incentives of balanced economic growth with real assets that can withstand liquidity shocks.
For investors who are analyzing the value of assets, it is important to consider an asset from multiple liquidity perspectives. In addition to considering how quickly an asset can be converted into cash, it is useful to consider how protected the asset is from the key liquidity risks, value interconnectedness, exposure to a loss of value due to perception of risk and the inability to convert a asset into a less risky position. In practical terms, this means that investors should be careful not to pay excessive liquidity premiums when in reality they are buying significant downside exposure.
Conclusion
While liquidity has many economic and investment advantages, the increasing interconnectedness of global markets requires a reexamination of the benefits and drawbacks of liquidity and a more balanced incorporation of liquidity perspectives into financial and investment planning and valuation. This is especially true given the exposure of liquid investment positions to not only direct financial and economic factors and risk perceptions but also other phenomenon such as the rapid proliferation of political risk and the spread of contagious diseases.