Ian Lance

Ian Lance

Portfolio manager

Market liquidity

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The market drawdown in March brought with it extreme and unprecedented moves in global stock markets. While we saw significant increases in market volumes, market liquidity deteriorated. Market depth, the market’s ability to sustain relatively large market orders without impacting the price of the security, saw a significant reduction (~90% decline relative to the past year average).

Despite all the ongoing uncertainty surrounding the pandemic and the large negative shock to the global economy, significant stimulus measures from governments and central banks helped to bring back some calm to markets, volatility declined from its high levels and equities started to recover. That does not, however, mean market liquidity recovered.

One of the reasons we have consistently suggested investors need to position themselves before any growth to value rotation is that we believe that the lack of liquidity in some FTSE 100 names is not fully appreciated. Waiting for ‘the catalyst’ that everyone else can see and then trying to re-balance at the same time as lots of other investors would likely lead to big price moves on both the buy and sell-side. This appears to have happened over the last few weeks. For example, many names within our portfolios have seen significant moves this month including Capita whose share price has increased over 100% month-to-date[1] and Marks & Spencer Group whose share price is up almost 60% month-to-date.

Figure 1. Capita Share Price

Figure 2. Marks & Spencer Share Price

Source: Bloomberg 25 November 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

Volumes

As the sell-off at the beginning of the year gathered pace, there was a dramatic increase in primary market volumes (the number of shares traded), with volumes in March around 300% higher than the January 2020 daily average. As the year has gone on, volumes have moved back towards the levels seen in January save for the occasional spike due to index rebalancing or the spike on 9th November on the Pfizer vaccine news.

Figure 3. Volume Change vs January 2020 Daily Average

Source: Bloomberg 19 November 2020.

Liquidity

While there was a large increase in volumes during the market sell-off, there was a sharp drop in market liquidity[2]. When the market is more liquid, it allows traders to buy/sell a larger quantity without substantially moving the price. Even as the market environment has calmed over the year, liquidity has not fully recovered in Europe.

Figure 4. Top of Book Liquidity (represented by the median number of shares proxied against January average)

Source: Liquidnet Investment Analytics, 10 November 2020.

Spreads

The difference between the highest bid and the lowest ask is called the bid–ask spread. During the height of the sell-off, the average bid-ask as a percentage for the FTSE 100 increased from an average of 7bps in January to as high as 32bps. It took some time for bid-ask spreads to tighten back to pre-Covid-19 times, representing the ongoing uncertainty in the market.

Figure 5. FTSE 100 – Average Bid-Ask Spread Percentage

Source: Bloomberg, 19 November 2020.

What impact does all of this have?

Despite the increasing trading volume, the reduction in market liquidity and wider spreads has resulted in a challenging trading environment and an increase in implicit trading costs. Looking at the chart below we can see that the cost of trading increased rapidly as the market sell-off picked up pace. This peaked in mid-March before reverting as markets calmed. However, the cost of trading today remains higher than January across all markets. We consider all these factors, among others, in reviewing when, where and how to trade to ensure that we achieve best execution for our clients.

Figure 6. Trading Costs

Source: Credit Suisse AES, 2nd November 2020.

While the market sell-off in March was a black swan event caused by the panic surrounding Covid-19, it highlights just how quickly the market environment can change, how quickly prices can move and highlights the importance of positioning ahead of an event. Over the last few years, valuation spreads between value and growth stocks have moved to extreme levels. This has only been exacerbated by the pandemic. This level of dislocation is unlikely to be sustainable, and while we cannot know when spreads will return to more normal levels, experience tells us that, as and when it does happen, the move is likely to be swift and poor market liquidity will only add to this.

[1] 30th October 2020 to 25th November 2020.

[2] As represented by the number of shares at the top of the book – highest bid and the lowest ask.

The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of RWC Partners Limited. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. This article does not constitute investment advice and the information shown above is for illustrative purposes only and should not be construed as a recommendation or advice to buy or sell any security. No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment

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