Market liquidity is at times one of those little-discussed footnotes in an investment thesis that is typically understood by those with deep knowledge with broad interests. It takes a nuanced understanding to recognize that even defining liquidity is not a confirmed science. Some say volume is not entirely a true sign of liquidity, which can change rapidly, particularly during a market crisis. It is in this environment that Greenwich, CT-based Gramercy Funds Management notes a significant change in emerging market liquidity, one that presents challenges as well as opportunity as the amount of debt has grown exponentially.
Since the turn of the century, banks have played a vital role in providing often two-sided liquidity to both listed derivatives markets as well as in noncleared derivatives such as SWAPs. But this role has changed and it is concerning to Robert Koenigsberger, chief investment officer at Gramercy, particularly if markets run into a crisis.
"We’re potentially sitting on one of the most illiquid market conditions in emerging markets that I’ve ever seen," Koenigsberger told Bloomberg, noting that a portion of the $6 billion Gramercy manages could be caught in a liquidity crunch. "This market isn’t well set up for outflows. It showed its stripes in the taper tantrum, and I think this will challenge the taper tantrum, if not 2008."
Looking at current liquidity sans meaningful bank participation, Koenigsberger wonders if the debt markets in which his firm is known for investing creatively in distressed situations is on solid ground.
“Is this a market or a bazaar?" Such a rhetorical question from Koenigsberger point to the difference between a robust exchange where multiple buyers and sellers are active versus a single seller obfuscating value and price data to extract a higher price when liquidity is needed most.
Illiquidity provides cause for concern but also an opportunity to find spread opportunity
For Gramercy Funds Management, particularly noted for its deft handling of distressed Peruvian bond debt among other activist adventures that created alpha, the loss of bank liquidity is an issue that could tip market scales if a squeeze were to occur. Such a crisis event might be a troubling for those looking to exit during an emotional period without banks providing liquidity.
"In 2017, with the absence of banks providing liquidity, who will facilitate the flows for the one-day ETFs and mutual funds?" Such is a major concern in the emerging market arena that has quadrupled to about $763 billion. The dichotomy is that since 2009, dealer inventories, typically correlated to various degrees with debt levels, have decoupled and reduced to nearly a fifth of their former self. Market makers without access to deep inventory is typically a sign of friction to come if market demand tips in one direction.
It is not just market making where bank participation has been forced to the sidelines. Bank lending is a point where “a vacuum” can be filled, creating opportunity.
Gramercy Funds Management offers direct lending, with a focus in Argentina, Brazil and Colombia, a region in which nearly 2/3rds of their portfolio exposure. Such investments are known as long-lock credit vehicles and usually tie up funds for five to seven years.
The ability to find and allocate towards investments that require such illiquid conditions is a source of more profitable spreads. Unlike Asia, where crowded trades have led to diminished profit margins, Gramercy Funds Management prefers sectors with diffuse levels of complexity that it can untangle, understand and monetize.
Perhaps among the more complex problems in the region impacting a wide swath of people is in Venezuela, a nation where Goldman Sachs recently made bond purchases amid a region currently engulfed in social chaos. With all investments, however, the firm looks at the probability path for a recovery and notes a patient that is on a respirator and whose debt may become even more distressed.
"In 30 years, I can’t recall human conditions being so bad beneath a debt stock,” Koenigsberger said. “When President Nicolas Maduro is gone, some people think there might be a ‘Macri of Venezuela’ that will quickly solve the problem. That’s a bit crazy because the issues are so much more dire."
Buying emerging market debt on a drawdown and then working to ensure a recovery is a Gramercy special, but Venezuela could be a case where the crisis has further to go before an investment is warranted.