Half of US investors fear rate rises will trigger liquidity crisis

Half of institutional investors fear rate rises will trigger a liquidity crisis, while nearly three in 10 think equity markets could fall up to 20% this year, new research shows.

A CoreData Research study of 120 U.S. institutional investors found 50% are worried that higher interest rates could spark a liquidity crisis. A similar proportion (49%) are concerned that higher rates will expose hidden fault lines in U.S. financial markets. And more than four in 10 (43%) think the Federal Reserve will be unable to raise rates much above 5% due to the resulting economic damage and financial turmoil.

The CoreData study, conducted in January, also shows that some investors think equity markets could fall up to 20% this year as a deep recession takes hold. Nearly three in 10 (27%) expect a "bear" case scenario characterized by stagflation, deep recession and a 10-20% fall in equity markets to play out in 2023. A higher proportion of public defined benefit pension funds (34%) fall into this "bear" camp.

Just one in seven (14%) investors are "bulls." expecting 2023 to bring a mild recession followed by a strong recovery, falling inflation and rising equity markets. However, smaller institutional investors with less than $1bn AUM are much more likely to have a bullish outlook (30%).

Despite high levels of concern about the potential damage inflicted by rate hikes, investors are also eyeing fixed income opportunities from higher interest rates. More than half (55%) plan to increase allocations to fixed income if the Federal Reserve raises rates to 5%. Investment grade corporate bonds (36%) and government bonds (33%) are set to see the largest increases in allocations under such a scenario. But emerging market debt is not favored — far more plan to cut (23%) rather than increase (8%) allocations in response to a rate rise.

“On the one hand, institutional investors harbor deep concerns about higher interest rates triggering an economic tsunami whose waves will reverberate through the US financial system,” said Andrew Inwood, founder and principal of CoreData, “But on the other hand, higher interest rates now offer better income opportunities after a prolonged and frustrating search for yield in the post-financial crisis low-rate environment. The income has finally returned to fixed income.”

Elsewhere, about a third (32%) of institutional investors will up allocations to cash if rates move to 5%, while nearly three in 10 (28%) will raise exposure to commodities and natural resources. And a quarter (25%) plan to hike allocations to private equity, with this figure increasing to 35% of smaller investors with less than $1bn AUM. But institutional investors are shunning digital currencies – just 3% will raise allocations to cryptocurrencies if rates hit 5%, while six in 10 (61%) do not invest.