Global equity markets have hit record highs on hopes of a strong economic recovery, particularly in the US. Yet major losses have been inflicted on several financial institutions this year. The most notable episodes were the short-squeeze on GameStop and the blow-up of Archegos Capital Management. At the same time, the VIX index of implied volatility of the S&P 500 has slid to its lowest levels since the Covid-19 crisis broke. This all seems difficult to square.
Most people think that the hits taken by certain banks and investors have been isolated incidents, and the fact that they have caused barely a ripple across the financial system as a whole reflects the robustness of the banking system today. But the odds are that we will soon see more blow-ups, potentially culminating in another global market crash.
What assessing wealth relative to GDP tells us
The factor that connects all the recent market developments is high and rising systemic leverage. Systemic leverage can be associated with debt but also with the concentration of risk. One indicator of leverage is wealth relative to GDP. In the US, during the pandemic personal wealth has soared relative to GDP, from a ratio of 5.2 in early 2020 to more than six. This follows a persistent rise since the 1990s. Between 1945 and 1994 the ratio averaged 3.6.
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Many might think that wealth is the inverse of leverage rather than being an indicator of it. Similarly, it is common to believe that there is nothing wrong with financial and property wealth rising exponentially relative to GDP; that this is merely a sign of economic progress. But in a theoretical stable-growth equilibrium GDP and wealth should grow together. Any monetary inflation should inflate both. GDP can be seen as a proxy for the return on an economy’s true wealth. If genuine wealth grows, then GDP should grow roughly equivalently.
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Measured wealth can depart from GDP because of leverage. Imagine a street of ten identical houses, each valued at £400,000. I am desperate to buy one of the houses and am willing to pay up to £500,000 for it using borrowed money. After my purchase, all the houses in the street will be revalued to £500,000, based on this most recent sale.
The total value of property in the street has then increased by £1m but the total debt by only £500,000 (my mortgage to buy the house). So total net “wealth” will have apparently increased by half a million pounds even though there is no rise in the real productive potential of the economy – just the same ten houses standing there. In the US, gross financial assets have rocketed during the pandemic while global debt statistics also suggest that systemic leverage is at record highs.
Extreme leverage requires market liquidity. Leveraged market participants need to be able to sell – because they may be forced to – which requires the presence of “market makers”: those who are prepared to buy when others are selling, including “dip buyers”, and those who sell, or short, volatility in other ways such as writing put options or shorting measures of volatility such as the VIX. The recent decline in the VIX demonstrates the presence of volatility sellers.
However, volatility sellers are also naturally leveraged: their potential downside in a crisis (when volatility spikes) can be much greater than the upside they receive from the volatility-selling premiums they earn. They have come to rely on central banks, particularly the US Federal Reserve, acting aggressively to support markets if they begin to fall sharply, as they did again in March 2020.
The Fed’s actions last year, together with the government’s fiscal measures, have resulted in a massive increase in the US money supply. The headline M2 measure of money supply is up by an unprecedented 26% over the past 12 months. This has quite reasonably led to fears that we are heading for extreme inflation. However, although inflation appears inevitable in the end, it is certainly not a foregone conclusion in the near term. It is quite likely that this magnitude of money-supply increase was necessary to “validate” the huge rise in asset prices that had already occurred – to, in a sense, monetise the pre-existing degree of leverage.
Just because the Fed and other central banks continue to buy financial assets on a large scale does not mean that asset prices are immune from declines. Each successive round of central-bank action only serves to encourage ever more leverage in the system – consequences of which we have been seeing recently. The likelihood is that the pyramid of systemic leverage will once again tip over. The fact that relative to the aftermath of previous volatility spikes the VIX has remained quite elevated, even in the face of extreme central-bank money printing, suggests that market liquidity available from volatility sellers is becoming less plentiful. This points to the risk of another deflation shock, as in February and March last year – one that will catch out most investors and speculators.
• Tim Lee is an economist and a co-author of The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (McGraw Hill, 2020)
