The Economist - USA (2022-02-12)

62 Finance&economics TheEconomistFebruary12th 2022

cape, ratio,a levelsohighit isonlytopped

bytheperiodwhichprecededthestock­

marketcrashof 2000 (seechart2).

Frothyvaluationsattracteda torrentof

capital­raising.Arecord­breaking$600bn

wasraised in initialpublic offeringsin

2021.Private­equityfirmssawthepotsof

capitalthey oversee overflow. Norwere

stockstheonlyfinancial assetssoaring.

Cryptocurrencies leapt by even more.

HousepricesinAmericahaveclimbedby

29%sincethestartof2020.

“Allassetpricesarewheretheyareto­

daybecauseofliquidityandinterestrates,”

says Greg Jensen of Bridgewater Asso­

ciates,a hedgefund.Asdemandforgoods

andserviceshasjumpedinthefaceofsup­

ply­chainconstraints, theconsequences

havecroppedupasinflationandshort­

ages. This has forced policymakers to

changecourseandstartremovingliquid­

ity.Asrecently asOctoberinvestorsex­

pectedjusta single0.25percentage­point

raterisefromtheFedin2022.Theynowex­

pectfive,andthereistalkoftheFedbegin­

ning“quantitativetightening”,sellingoff

itsbondholdings,laterthisyear.Thisreal­

ityisnow“catchingup”withvaluations,

saysMrJensen.

A correction—quite possibly a big

one—appearstobeunfolding,then.The

mostimportantquestioniswhetherthefi­

nancialsystemisequippedtohandlethe

ride.“Marketsneedtobeabletocorrect,

andsomepeoplewilllosemoney.Thatisa

necessarypartoftheprocess,”saysSirJon

Cunliffe,a deputygovernoroftheBankof

England.“Whatmattersisdoesthatknock

ontosomethingelseoristhatcorrection

absorbed?Youwanta financialsystemthat

canabsorbcorrections.”

Thelastbigcorrection,inMarch2020,

wasa weirdone.Causedbyanexogenous

shock—the pandemic—it was easy for

policymakerstojustifyintervention.The

lastcrashcausedbyendogenousfinancial

riskswasthatoftheglobalfinancialcrisis.

Sincethenthefinancialsystemhasunder­

gonea periodofunusuallyrapidtechno­

logicalandregulatorychangewhichhas

fundamentallyaltereditsstructure. Itis

hardtoknowhowa correctionwouldrattle

throughthisnewsystem.

The financiallandscape hasbeen al­

teredinthreemainareas:whoownsfinan­

cialassets;whichfirmsintermediatemar­

kets;andhowtransactionsaresettled.

Startwiththeownersofassets.A small­

ershareoftheseisnowheldonbankbal­

ance­sheets.In2010,justafterthecrisis,

banksheld$115trn­worthofglobalfinan­

cialassets.Otherkindsoffinancialinstitu­

tions,suchaspensionfunds,insurersand

alternativeassetmanagers,heldroughly

thesameamount.Butnon­banks’slicehas

swollenfarmorequicklysince.Bytheend

of 2020 theyheld$227trn,26%morethan

the banks did. The share of American

mortgagesthatoriginatedinbanks(many

ofwhichtheyheldonto)wasaround80%

beforethefinancialcrisis.Todayaround

halforiginateoutsidethebankingsystem

andmostofthesearesoldontoinvestors.

A post-bankingworld

The composition ofnon­bankshas also

changed.Inthepastmostindividualin­

vestorsheldtheirfinancialassetsindirect­

ly, through pension funds. In the early

1990saroundaquarterofthewealthof

American householdscamefromclaims

ondefined­benefitpensionsandjust10%

wasinequitiesdirectly.Today,households

hold27%oftheirwealthdirectlyinstocks,

the highest­ever share. Just 15% comes

frompensionclaims.

Itwasa lotharderforthoseindividuals

tomoveinandoutofinvestmentsbefore

thefinancialcrisisthanitistoday.Thanks

totheriseoflow­costretailbrokerages,it

isnowtriviallyeasyforpeopletobuyor

sellstocksorbondfundsona smartphone.

Theeasewithwhichthelittleguycantrade

hasmadeitfareasierfortheretobea run

ontheinvestmentindustry. Andthein­

vestmentindustrydoesnothavethesame

backstopthatbanksenjoythroughdeposit

insuranceandcentral­banksupport.

Nextconsidertheintermediaries.Bank

tradingdeskshavelongbeenoutcompeted

byspecialisthigh­frequencytradingfirms

likeCitadelSecurities,withwhizzyalgo­

rithms which automatically match buy

andsellorders.Butincreasingly,overthe

pastdecade,therehasalsobeena retreat

frombankintermediationofTreasuryand

corporate bonds,owing to bothtechno­

logicalandregulatorychanges,including

newrulesthatdeterbanksfromholding

tradingassets.

Broker­dealers’ gross inventory posi­

tionsofTreasurysecuritiesfellfrom10%of

outstandingbondsin 2008 tojust3%in

2019.Theshareofcorporatebondsheldby

dealershasfallenevenfurther,tolessthan

1%,downfrom8%in2007.Thishampers

theirabilitytoactasmiddlemeninmar­

ketsintimesoftrouble.Itcanalsoamplify

theimpactofthefailureofa fund.“Twen­

ty­fiveyearsago,ifa bankhada clientthat

could notmake amargincall thebank

couldbid[buy]thatpositionitselfandab­

sorbit onitsbalance­sheet.Butnowbanks

don’thavethatbalance­sheet.Sotheyjust

hangouta ForSalesignandeverybodysees

itanditjustdrivesthemarketdownfur­

ther,”says Robert KoenigsbergerofGra­

mercyFundsManagement.

Atthesametimeascapacitytointerme­

diatehasdroppedthesupplyofbondshas

grown,inpartdrivenbya delugeofgov­

ernmentsupplyandinpartbecausecor­

porateborrowersrelymoreondebtissu­

ancethanbankloans.Andthedemandto

tradebondshasbeenfuelledbythegrowth

inexchange­tradedfunds(etfs)builtby

thelikesofBlackRock,theworld’slargest

assetmanager.

Itusedtobehardtobuybondsinsmall

increments. Now, thanks to etfs, it is

much easier. Some ofthe fixed­income

etfs offeredtoindividualsbyBlackRock

mighthave8,000ormoredifferentbonds

inthem.Ifdemandforunitsofthefund

risesorfallsitbeginstotradeaboveorbe­

lowthefairvalueofitscomponentbonds.

Thatincentivisesmarket­makerstointer­

vene,eithercreatingunitsbybuyingupa

portfolioofsimilarbonds ordestroying

thembysellinga portfolio.Muchofthis

activityisautomated.

Problemscanariseintimesofstress.

etfs tradefarmorefrequentlythantheir

componentbonds.InMarch2020,asvola­

tilityshookmarkets,BlackRock’sbiggest

investment­grade corporate­bond etf

traded90,000timesa day,whilethetop

five holdingsofthefundtraded just 37

times.Somearguethatthismakesbond

pricesmoreaccurate.Butitcanalsoreveal

just how volatile pricesare in times of

stressandcouldencouragea run.

Theproblemscanbemostacutewith

investments like emerging­market bond

funds.Intimesofstress,liquiditydriesup.

Iffundsneedcash tomeetredemptions

theyhavetoselltheirmostliquidassets,

likeTreasuries,insteadoftheiremerging­

Cheap at half the price

S&P 500, cyclically adjusted

price-earnings ratio*, %

Source: Robert Shiller,

Yale University

*Based on average inflation-adjusted

earnings from the previous ten years

2

50

40

30

20

10

0

222000806040201900

The jitters index

United States, share who think stockmarket

valuations are “too high”, %

Source: Robert Shiller, Yale University

1

75

50

25

0

052001 10 15 21

Institutional

Individual