In his latest Investment Outlook, Bill Gross describes what events might trigger a retail exodus (thus tipping the first domino), and says investors should hold enough cash to ride out the storm without participating in a firesale caused by rising rates or some manner of exogenous shock.
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From “It Never Rains In California”:
Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash.Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.
While Dodd Frank legislation has made actual banks less risky, their risks have really just been transferred to somewhere else in the system. With trading turnover having declined by 35% in the investment grade bond market as shown in Exhibit 1, and 55% in the High Yield market since 2005, financial regulators have ample cause to wonder if the phrase “run on the bank” could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks. Thus, current discussions involving “SIFI” designation – “Strategically Important Financial Institutions” are being hotly contested by those that may be just that. Not “too big to fail” but “too important to neglect” could be the market’s future mantra.
Aside from the obvious drop in trading volumes shown above, the obvious risk – perhaps better labeled the “liquidity illusion” – is that all investors cannot fit through a narrow exit at the same time. But shadow banking structures – unlike cash securities – require counterparty relationships that require more and more margin if prices should decline. That is why PIMCO’s safe haven claim of their use of derivatives is so counterintuitive. While private equity and hedge funds have built-in “gates” to prevent an overnight exit, mutual funds and ETFs do not. That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances. But even in milder “left tail scenarios” it is price that makes the difference to mutual fund and ETF holders alike, and when liquidity is scarce, prices usually go downnot up, given a Minsky moment. Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested.
And what might precipitate such a “run on the shadow banks”?