This episode is a follow-up discussion to a previous podcast from December 2022, titled Tickling the Dragon’s Tail. Trevor Lavin, Institutional Client Group Regional head, and Kevin Kneafsey, senior investment strategist with the Multi-Asset Solutions team, refresh the audience about the Dragon research, illustrate how some recent real-life events are closely aligned with what they predicted could occur in their research, and provide investors with some actionable ideas as a result of these circumstances.


Kevin Kneafsey: Clients, to the extent they’re really pressed for liquidity, we’re doing solvency work with them. The earlier you know you’ve got a solvency issue, the more opportunity you have to make decisions.

Trevor Lavin: That’s Kevin Kneafsey. I’m Trevor Lavin, head of Allspring’s Institutional Client Group in the Western Region, and you’re listening to On the Trading Desk®. Today, we’re going to pick up where we left off on an earlier podcast from late last year when we reviewed our then recently published research paper, entitled Tickling the Dragon’s Tail, a sleeping dragon that once awakened could create havoc in portfolios, both liquid and illiquid, with knock-on impacts on solvency conditions for investors. Since then, we’ve observed events, canaries perhaps, which make us very concerned that the dragon may very well have been awoken. Today, we will discuss liquidity, illiquidity, and perhaps most importantly, talk about some of those canaries we are watching, which are showing us how liquidity stress is playing out in the markets. And this is important because as you will hear, liquidity stress can have profound impacts on all of your investments. Joining me once again is Kevin Kneafsey, senior investment strategist with the Multi-Asset Solutions Group, who will be providing us with his insights on this topic. Thanks for being here, Kevin.

Kevin: It’s great to be here. Thanks.

Trevor: Tell us why this concept of liquidity and liquidity stress is important and why our audience should care.

Kevin: Liquidity is super important because it can drive prices way past fundamentals. So, in this case, it’s going to be driving them down. So, this is going to cause great pain for a lot of investors, so they need to think about that. The other side of that coin is it will create some incredible opportunities for some investors. The analogy I like to use is liquidity is like air. So, how much do you pay for each breath of air that you take? You pay nothing. And so, the reason you don’t pay anything is because it’s abundant. When it’s abundant, nobody’s paying you to take on illiquidity risk. But when it gets scarce, people will pay almost anything for that next gulp of liquidity. And then when liquidity becomes abundant again, that premium drops back down to zero. So, it’s that pushing prices way past fundamentals is what we’re worried about.

Trevor: Just take a moment here to remind our listeners what insights we have to support these outcomes, Kevin.

Kevin: The consequences, market-wide, really are three. So, the first is that we call it secondhand smoke because it’s the liquid investors that are going to get hit first and potentially the worst by any sort of market shock. Because those are the assets that are going to get sold first to raise liquidity to fund cash flow needs. The second conclusion is the first conclusion is true until it’s not. And at that point, people have to start selling illiquid assets. So, we call that the tipping point. And the third conclusion deals with sort of what causes you to cross that tipping point. And there’s two big drivers. One is the market shock, both how big it is and how long it lasts. And then the second is how fragile the market is that absorbs that shock. So, a more fragile market has client cashflow needs that are larger and it has larger illiquid balances, i.e. smaller liquid balances, from which to fund those cash flows.

Trevor: There’s been some really interesting developments, as you know, in the market since we last spoke, and they’ve got eerie similarities to events we predicted and discussed in that research paper, Kevin. Tell us about those and why investors really need to pay attention to them.

Kevin: You’ve got two, we call them, canaries that we’re watching. One is regional banks and the second are private REITs (real estate investment trusts). So, let’s do each of those very quickly. So, let’s talk about Silicon Valley Bank as a simple example of regional banks. They had 50% in liquid assets, treasuries. 50% in illiquid assets, loans to venture capitalists (VC) and loans to startups. Then, 2022 happens. Interest rates go up dramatically, stocks and bonds fall by 15% to 20%, and the funding for startups and VCs dry up. So, Silicon Valley Bank’s not getting much in the way of deposits, but they’re losing a lot of money in the way of withdrawal, so this huge cash flow imbalance. That continues to the point where depositors start to get concerned that they aren’t going to have enough of these treasuries to meet those withdrawals. They’re going have to turn to those less liquid assets, i.e. that tipping point and have to sell illiquid assets to fund withdrawals. And that’s when you get a bank run. The private REITs, think of Blackstone’s BREIT as a classic example of that. So, most of the assets, as you’d expect in these kinds of investments, are in illiquid assets. They’re in property. So, very little in liquid assets. Now in normal times, they typically have more cash coming in than they have cash coming out. But in 2022, the rise in interest rates, property values fell, public REITs fell by 25%, private REITs didn’t necessarily mark down where they should have. And you get a fall in asset values with little money coming in and investors started to withdrawal their investments. These private REITs have had to gate redemptions. So, with BREIT, for example, they allow 5% of the money to exit per quarter. Well, that’s 20% per year. So, if you’ve got 13% in liquid assets and 20% can walk in a year, it doesn’t take very long before you’re selling property to meet redemptions, i.e. you’ve crossed that tipping point and you’re actually selling illiquid assets. Now BREIT got ahead of this, Blackstone cut a deal with UC Regents where Regents put in $4.5 billion dollars for a guaranteed 11.25% return with a $1 billion backstopped by Blackstone. So, this is the idea of when liquidity gets scarce, deals get made and some of those deals can be really attractive.

Trevor: You’ve highlighted those two canaries and we may even see more so, provide some tangible, actionable steps from here.

Kevin: The one thing all investors should think about is how can they protect the liquid assets that they have. So, this could be explicit downside protection on your equity investment, for example. So, let’s break it down into which investors this matters for and why. So, if you have a big liquid investment, so you don’t have much in illiquid assets at all, this liquidity driven market driving prices to very, very low levels presents you with huge opportunity to take advantage of buying at really depressed levels, but only if you’re protecting the liquid assets that you’ve got. On the other side of the coin, you’ve got investors with very, very large, illiquid balances. For them, preserving what liquidity they have becomes crucial. They potentially run the risk of becoming insolvent. And so, every bit of liquidity they can preserve becomes really, really valuable to them. And then the third group are those that are in between those two, so they’re in this bit of gray space. They may be able to capture some opportunity, but again, only if they preserve their liquidity. And their best chance of avoiding becoming insolvent is preserving that liquidity to keep themselves on the other side of that solvency cliff.

Trevor: With the time we have left here, just share with our audience a little bit about how you and the Multi-Asset Team around you are working with our clients to take advantage of this.

Kevin: The biggest things that we’re doing with clients to the extent they’re really pressed for liquidity. We’re doing solvency work with them. The earlier you know you’ve got a solvency issue, the more opportunity you have to make decisions. And so that work is critical to open up that window and sort of step inside. The second place we’re working with clients is how do you improve the liquidity in your current portfolio. And that can be downside protection that we talked about before. It can be shifting from less liquid, either alternatives or stepping away from beta and both places stepping into liquid alternatives. The third thing for clients is just the heightened awareness. So, where in their portfolio do they have stresses? Where do they have really big cash flow needs? And where do they see the imbalance? And then working with a particular client on how to solve that problem.

Trevor: Thanks, Kevin. And thank you for being with us and sharing those very valuable insights today.

Kevin: It’s always fun, Trevor. Thank you.

Trevor: And thank you, listener, for spending some time with us today to listen to On the Trading Desk®.

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Disclosure: Beta measures fund volatility relative to general market movements. It is a standardized measure of systematic risk in comparison with a specified index. The benchmark beta is 1.00 by definition. Beta is based on historical performance and does not represent future results.

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