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In an environment full of risk and uncertainty, there are a lot of events that investors may be worried about; Grexit, low growth regime in advanced economies, the Fed raising interest rates, China’s explosive debt. Experience shows how difficult it is to predict the implications of a negative shock.
 
Even though we don’t know where the next shock will come from, we have recently witnessed periods of volatility in the markets in which liquidity can evaporate in a matter of minutes creating “flash crash” in fixed-income, forex and equities markets. The decline in financial market liquidity is especially worrisome in fixed-income assets, traded over the counter, creating a potential disruption on the markets.
 
As Nouriel Roubini noticed, a paradox has emerged in financial markets since 2008; unconventional monetary policies have created a massive overhang of liquidity and that macro liquidity has become associated with severe market illiquidity.
 
After the financial crisis, prudential regulation (from Basel III to Dodd Franck) de-risked the banking sector. But this prudential regulatory framework has led to unintended consequences for liquidity which could fuel the next financial crisis. Investment banks have dramatically reduced their capital-intensive market making activities that used to ensure liquidity.
 
We believe systemic risk has been shifted from the banking system to shadow banking. Risk has been relocated, not eliminated. Asset Managers are the focus of policy makers regarding maturity mismatch in bond funds. Regulatory focus is likely to increase as regulators and central banks are increasingly voicing concerns about liquidity issues.
 
Asset Managers need to change their operating models to adjust to the new liquidity environment. Easy redemption options can create the risks due to a first-mover advantage. Open-end funds are exposed to redemption risk and asset managers should develop tools to minimize these risks by implementing for example minimum redemption fees, installing gates and swing pricing policies.
 
Declining market liquidity comes at a time when the Fed is about to start raising interest rates. Therefore falling liquidity of global bond markets could fuel systemic risk, making monetary policy normalization more disorderly.
 
Even though the Fed is preparing everyone for a change in its monetary policy regime, it will take time before investors will adapt to this new regime. We have all been living in an environment of financial repression, low interest rates and low volatility for years now. The last time the Fed started to raise interest rates was in 2004; we are talking about an event that many fund managers out there have not experienced in their professional life.
 
As these two events play out in the future, investors should pay attention to adapting the fund selection approach to this new market environment and favoring those fund managers with previous experience of monetary normalization who can manage liquidity risk during stressful periods.
 
In a context of rising interest rates and returning volatility, bonds may not be the safest asset class anymore. So, equities remain the best game in town because in previous tightening cycles, stocks have outperformed bonds and commodities, although volatility has increased.

Silvia Bocchiotti

Silvia joined LCL in September 2007 as Chief Investment Officer (CIO). As a member of the Board of Private Banking Unit, she is responsible for asset allocation of  LCL discretionary mandates and advisory portfolios.
Previously, Silvia was Senior Fund of Funds Portfolio Manager at Credit Agricole AM (Amundi) and the Head of LCL Advisory for third party funds.
Silvia was in charge of Funds selection at the French arm of Credit Agricole Indosuez Private Banking where she managed discretionary portfolios and Multi-Manager Mandates.
She has a Master’s in law from the University"Católica Andrés Bello"(Caracas) and graduated in political science from "Institut d'Etudes Politiques de Paris"- IEP.
She has mastered several European languages.

Website: banque-privee.lcl.fr

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