This week is a test for the huge liquidity question building in financial markets this year

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ANZ’s chief economist Warren Hogan pointed today to something that will be a concern for many in markets worldwide this week.

Liquidity, the saying goes, is always there – until it’s not. At its simplest liquidity is the ability to buy and sell assets quickly. Large numbers of buyers and sellers in the market tend to keep price moves smaller because it’s easier to find someone who will meet your price. When it reduces – because people with money get collectively cautious about buying or selling anything – prices get volatile and the market whips around.

Now look what happened to the Australian dollar today:

It moved a lot at the start of trade in line with the Euro sell-off. But then it quickly bounced and has ended up above where it started trading for the week. This came after the Chinese stock markets opened. Now it can be difficult to divine what exactly moved a currency price but what we do know is there hasn’t been any of the economic data that you’d typically associate with moves of this size. The action today has been in the equity markets.

The same applies to stocks and liquidity has been a mounting concern for investors worldwide. Last month the WSJ ran a long feature on the issue. It started, ominously:

Talk to almost any banker, investor or hedge-fund manager today and one topic is likely to dominate the conversation. It isn’t Greece, or the U.S. economy, or China, let alone the U.K.’s referendum on European Union membership. It is the lack of liquidity in the markets and what this might mean for the world economy—and their businesses.

Market veterans say they have never experienced conditions like it. Banks have become so reluctant to make markets that it has become hard to execute large trades even in the vast foreign-exchange and government-bond markets without moving prices, raising fears investors will take unexpectedly large losses when they try to sell.

Privately, some money managers have been expressing similar concerns in Australia. Some of it has been playing out in the decisions of fund managers – such as Hyperion and Paradice Investments – to shut their doors to new inflows of funds. Paradice Investments even returned $800 million from its small cap fund to investors – reducing the size of the fund back to $1 billion.

The rationale for this has been it has been getting increasingly difficult to find quality assets which investors think will deliver returns above the performance of the broader market. Stock pickers have been getting pickier and pickier. As a result they have been accumulating more and more cash in their funds – some higher than 20%.

Pengana Capital told investors in its May update on its Australian Equities fund:

As at 31st May 2015, cash represented 24% of the Fund. Whilst this is a high cash level it does not represent an attempt to predict a market correction. It is an indication of the paucity of attractively priced investment opportunities currently available. Cash is a valuable, low risk, income producing option to take advantage of future opportunities.

(The emphasis there is Pengana’s.)

As Hogan points out, the sudden escalation in concern over a now-likely default by Greece, combined with the rapid losses in Chinese stocks lately, will feed some price volatility. The lack of liquidity could really compound the price moves.

When there’s no liquidity and you want to sell, you have to keep dropping your price until finally someone decides there’s value in the price amid the chaos. With investors already reluctant to buy, this creates a worrying scenario for many in the markets.

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