Insurance companies and pension funds increased their liquid assets – currency, bank deposits and short-term money market paper – by £28 billion, or 18%, in the year to September. With the value of their portfolios falling by 10% over the same period, the ratio of liquid to total assets rose to 9.1% – the highest since September 1990.
Even assuming no further addition to liquid assets in the fourth quarter, weakness in markets should have ensured a continued rise in the ratio. In other words, the liquidity ratio has probably now surpassed the 1990 peak and is at its highest level since 1974 – see first chart.
Institutions generally target a stable proportion of liquid assets in portfolios over the medium term. For insurance companies and pension funds in aggregate, the ratio has averaged 5.5% since 1964 and the chart shows evidence of mean reversion.
Suppose insurers and pension funds attempted to reduce the liquidity ratio to its long-run average of 5.5%. Based on the position in September, this would involve a first-round injection of £70 billion into markets. Institutions might take the opportunity to "rebalance" their portfolios towards assets that have underperformed recently, including UK equities and corporate bonds. (Overseas investments have benefited from the fall in sterling.)
The £70 billion of buying, however, would represent only the first stage of a multiplier process. An individual institution can reduce its liquidity ratio by buying assets but if the seller is also an insurer or pension fund the aggregate position is unchanged. Rather than being extinguished, "excess" liquidity is simply transferred to another institution, leading to a further round of buying.
Consider the extreme case of a fixed supply of assets entirely owned by insurance companies and pension funds. Liquidity would circulate between institutions, stimulating further buying, until asset prices rose sufficiently to bring the aggregate liquidity ratio down to its target value. In other words, asset prices would bear the entire burden of adjustment back to equilibrium.
In practice, the supply of assets available to insurers and pension funds is not fixed – higher asset prices will induce other holders (e.g. overseas investors) to sell and originators to issue more. However, the essential point remains – the attempt to restore liquidity equilibrium is likely to involve multiple rounds of buying and a significant impact on asset prices.
Consistent with this explanation, there is historical evidence of a positive relationship between the level of insurance companies and pension funds' aggregate liquidity ratio and future UK inflation-adjusted equity returns – second chart. The line of best fit suggests each 1 percentage point rise in the ratio is associated with a 10% increase in the cumulative real return on equities over the subsequent five years.
One caveat to the above analysis is that institutions may wish to hold a higher proportion of short-term assets in their portfolios than in the past because they have entered into interest rate swap agreements involving payment of a floating rate in exchange for a fixed nominal or real income stream, intended to match future liabilities. This may have raised the "equilibrium" level of the liquidity ratio, although any increase is likely to have been much smaller than the recent actual rise, implying the latter still has positive implications for asset prices.
