State Street's Cunningham Sees a Liquidity Crisis as Fundamentals Improve

William Cunningham, head of credit strategies and fixed-income research at State Street Corp.’s investment unit in Boston, which oversees almost $2 trillion, comments on the volatility in financial markets.

He spoke in a telephone interview today about the environment filled with investors’ “concerns around the constant attacks from policy makers” and speculation that Europe’s sovereign-debt crisis may derail the world’s economies.

On the current crisis:

“Our view right now is that this is a quintessential liquidity crisis, and we’d differentiate that from 2007 and 2008 in that the fundamentals are clearly improving across corporate America and they’re clearly improving, albeit from obviously distressed levels, in the consumer space.”

In 2007 and 2008, “you were really quite vulnerable fundamentally, and that took the markets down, and then you got into the spiraling-out-of-control process,” where weakening markets hurt consumers and companies, which, in turn, disrupted markets further.

“There really isn’t any precedent that we can point to in history where the markets actually turned around improving fundamentals.”

Still,“it’s not inconceivable to imagine a situation where the markets behave so poorly, the liquidity behaves so badly, and risk-tolerance just evaporates that -- particularly in Europe -- consumers contract, businesses stop hiring and stop investing, and economic activity halts, and that feeds on itself in a negative downward spiral.

“While it’s never happened like that before coming from positive fundamentals, the fact that we’re just recently coming out of this global credit crisis, the fact that we still have some structural vulnerabilities, it makes us more nervous.”

On financial regulation in the U.S. and Germany:

“The broad-side assault on anything to do with capital markets by politicians across the globe is something that is a real threat to the stability of markets.

“No matter what you think may need to happen, in terms of reform, you really do need to leave these markets alone and let them heal for a period before you start to change everything and cause doubts.

“Investors just don’t know where they can tread in these markets and be safe.”

On the resiliency of the economy:

“Say the economy starts to turn down again, would these companies be as vulnerable as they were in 2007 and 2008? The answer would be, ‘no’ ” because they have reduced borrowing, boosted cash and cut costs.

“The difference is in 2008, the fundamentals were falling out of bed, you could easily be in companies that were going to default: 2008 was different, you really needed to panic.

“We don’t see the vulnerability fundamentally: It’s all in the market space, which makes it a classic liquidity crisis. In that type of environment we don’t really want to be in the position of selling into illiquidity. We want to be in the position of being patient and waiting.

“But we do have to be mindful that, like the last crisis, things can happen that we’ve never seen before. But right now, we’re trying not to do too much, to not be a panic seller. If you didn’t anticipate this, you basically should be riding it out.”

On investing today:

“Basically, we’re trying to avoid doing too much.

“Have we taken some risk off the table? Yes of course we have. But are we thinking we need to panic? No, because it’s not the same environment” as in 2007 and 2008. He declined to talk about specific changes in the company’s portfolios.

“Right now, there’s not that much liquidity in the market. If you were going to take risk off you had to have it off in the last couple of weeks. This week it would be almost untenable.

“From my standpoint, it’s prudent to just hold our positions here. We do expect in the next few weeks for this crisis to calm down and burn itself out.

“Right now we’re in a quintessential liquidity crises, and I’m going to watch it closely to make sure it doesn’t turn into a fundamental crisis.”

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net

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