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In the new liquidity factories, buyers must still beware
By Mohamed El-Erian
Published: March 22 2007 02:00 | Last updated: March 22 2007 02:00
Market drivers of liquidity currently exceed influences coming from traditional monetary policy
instruments. But this is not to say that these instruments are no longer effective. They still are,
but at wider levels of economic fluctuations and with less precision - thus raising interesting
issues for policymakers and investors.
Over the past two years, markets have developed powerful liquidity factories as more investors
have embraced debt in an attempt to increase the impact of their investments. The process has
been facilitated by stable global economic conditions, widespread use of derivatives and low
borrowing costs. As overall market leverage has increased, the impact on markets has more
than offset the US Federal Reserve's 2004-2006 campaign of 17 successive interest rate
increases.
A way of illustrating the forces at work is to follow the journey of a dollar as it is reallocated by
investors away from a traditional public equity investment and towards private equity. To make
the illustration particularly vivid, let us focus on a "public-to-private" deal led by a leveraged
buy-out fund in the context of an unchanged monetary policy stance.
The journey starts with the liquidation into cash of a dollar's worth of public equity holdings,
which is then allocated to the LBO fund. By -accessing the debt markets, the fund enhances the
purchasing power of the dollar (typically 3-4 times) as it ventures into the public markets looking
for a company to "take private". On the closure of the deal, the augmented amount ends up as
cash in the hands of the seller(s) of the targeted company.
This journey results in higher leverage driven by a multiplier that is internal to the markets. This
"endogenous" process expands the economy's balance sheet and boosts asset prices. The
boost to asset prices is enhanced by the adaptive nature of investor expectations. Having
observed the beneficial impact of an LBO bid on a targeted company's share price, investors
adjust. Rather than just being reactive, they actively seek and reprice companies and sectors
that may end up on the target list of LBO funds - thus generalising the positive catalyst on share
prices.
Higher policy interest rates disrupt this process only if they undermine economic growth, curtail
the flow of investor funds to "alternatives" and widen risk spreads in debt markets. Otherwise,
successive rate increases coincide with (rather than arrest) the increase in endogenous
liquidity, as was the case in 2004-2006.
Monetary policy's recent failure to mop up liquidity does not mean it has become ineffective.
Rather, this episode illustrates the unusual potency of the current private equity phenomenon.
But, to be sustained over time, the phenomenon needs to develop sources of permanent
capital. While recent initiatives by Blackstone and Fortress suggest that private equity firms are
pursuing such sources, they are the exception rather than the rule.
The time will come when endogenous liquidity shifts from being accommodating to being
restrictive. This occurs naturally over a number of years as a critical mass of companies held in
private hands seeks to "exit" back into the public markets.
Timing could be accelerated by a disruption in underlying economic conditions and a sustained
spike in risk aversion. As the debacle in the sub-prime mortgage sector illustrates, the resulting
credit withdrawal could be quite dramatic.
Given these considerations, it is not surprising that successive increases in US policy rates
have not had the impact predicted by traditional models. It is also understandable that,
notwithstanding inflation indicators, policymakers have been cautious about raising rates too far
lest they trigger a sharp reversal in endogenous liquidity. Looking forward, it would seem
reasonable to expect them to require unambiguous evidence of a significant slowdown in
economic activity before embarking on a sustained loosening of monetary policy.
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What about investors? So far, the increase in endogenous liquidity has rewarded risk-taking
beyond what would be warranted by fundamentals. It is prudent to remember that leverage can
work against investors on the way down as much as it has worked for them on the way up.
When this occurs, the best-positioned investors will be those that have mitigated risk through
appropriate asset diversification and the purchase of insurance.
The writer is president and chief executive of the Harvard Management Company, faculty
member at the Harvard Business School and deputy Treasurer of the university
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