LONDON – Bond guru Bill Gross has warned investors today of six scenarios that could trigger a run on so-called shadow banks – ETFs and other mutual funds – that have started to finance capital markets after the credit crunch of 2008.
He also advised investors to hold cash so as not to “panic sell.”
In his monthly investment outlook for Janus today, Gross said the “liquidity illusion” means investors believe they can all exit at the same time via a narrow door. He criticised the notion that ETFs add extra liquidity in a down market, as they, unlike banks, are lightly regulated and required to hold cash reserves.
ETFs In A Down Market
“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,” the manager of the Janus Global Unconstrained Bond Fund wrote.
Prices will go down during a market crash, he said, as liquidity becomes harder to grasp, and that is what makes the difference for any holder of an ETF. And as trading has decreased by 35 percent and 55 percent in the investment grade and high yield bond markets, respectively, since 2005, prices movements in fixed-income markets have become more magnified.
“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,” he added, referring to central banks offering their own forms of liquidity provision when the markets tank.
6 Events That Could Trigger A Sell-off
Gross outlined six events in his blog which could bring about a market sell-off:
- A central bank mistake leading to lower bond prices and a stronger dollar
- Greece, and if so, the inevitable aftermath of default/restructuring leading to additional concerns for eurozone peripherals
- China – “a riddle wrapped in a mystery, inside an enigma.” It is the “mystery meat” of economic sandwiches: You never know what’s in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.
- Emerging market crisis – dollar-denominated debt/overinvestment/commodity orientation; take your pick of potential culprits, he says
- Geopolitical risks – too numerous to mention and too sensitive to print
- A butterfly’s wing – chaos theory suggests that a small change in “nonlinear systems” could result in large changes elsewhere. While he described this as “kooky,” he went on to say that in a levered financial system, small changes can upset the status quo— keep that butterfly net handy.
Other investors have followed Gross’ line about holding cash reserves in their portfolio. Saxo Bank’s CIO Steen Jakobsen blogged this morning that it would be wise to take a six-month holiday from the markets during this period of heightened uncertainty.