Concerns over trade war conflicts are troubling investors, resulting in a drastic drop in liquidity in the US stock market. With the relationship between the US and China being volatile and apprehensive, increasing tariffs, along with militaristic friction, are making the participants in these markets more and more take a backseat. This unwillingness to participate is resulting in lower trading activity and increase in bid-ask spreads. Analysts predict that lower liquidity in the market can lead to it being even more volatile, making it exceptionally harder for investors to sell or buy shares due to the rising economic fears.
What Is Causing the Liquidity Crunch?
There is a myriad of reasons that are associated with the weakening of liquidity within the US stock market:
1. Trade war uncertainty
Changes in the trade done between the US and China has undeniably broken investor trust. Exposed tariffs, as well as future trade deals being exceedingly vague and uncertain is driving a lot of investors to leave the market which is resulting in low trading volume. New potential tariffs that could be implemented are hindering institutional investors from executing big trades due to fears of them disrupting the global supply chain.
2. Volatility Ratio and The Degree of Market Risk Aversion
Participants in the concerned economy seem increasingly withdrawn from risk. A large rational fraction of business process participants refrain from making the big moves as they await the resolution of trade talks and the Federal Reserve policy moves. This has caused a fall in daily volume trading and has also caused the liquidity of the market to deteriorate.
3. Automated Trading Systems and Rapid Price Crashes
The more pronounced the existence of High Frequency Trading (HFT) firms, the more the concern deepens about liquidity. These firms make liquidity-creating trades under normal circumstances, but they tend to retrench during volatility periods and exacerbate liquidity drought when it is in short supply the most. Retail and institutional investors find it exceedingly difficult to trade as a result of rapid price changes, also known as flash crashes, which make having a reliable price very difficult.
Consequences for Investors and Markets
The erosion of liquidity affects investors and the economy in myriad ways from unsurprising to bizarre.
Greater Bid And Offer Spread: Investors and traders have to incur additional expenses because the prices at which they can buy and sell greatly differ, due to the lack of liquidity.
Worsened Markets And Economic Data: Increased price variability due to lower liquidity can result in drastic changes within the economy and the market in reaction to certain news stories or data.
Hedge funds and pension funds are likely to sit on the sides for a while as they await more favorable market conditions before making any substantial investments.
What Do Analysts Say About the Market?
Market analysts believe that volatility and low liquidity conditions could persist in the medium term, particularly if trade confrontations worsen. However, additional factors could boost confidence:
Status of Trade Deal Negotiations: Any signs of progress towards the resolution of the US-China trade dispute or softened tariffs would improve investor morale and alleviate trading inactivity.
Intervention by the Federal Reserve: The signaling of monetary policy support by the Fed would help Ms stabilize some of the liquidity and time relations.
Earnings Recessions Resolving: Stronger than expected corporate earnings accompanied by positive economic data would offset some concerns and entice traders back into the market.
Conclusion
In the wake of trade war uncertainty and economic risks, the US stock market is undergoing a liquidity crunch. The heightened geopolitical tensions have resulted in the exacerbation of lower trading activity, wider bid-ask spreads, and higher volatility, making it challenging for traders and investors to navigate. While there are hints of resolution to the trade war or actions from the Federal Reserve to boost liquidity, positive conditions are not expected in the near-term. Investors will have to move with caution as there is a growing squeeze on the economy due to global conflicts.