After suffering the painful losses of 2022, the US stocks have largely recovered and are now back in sight of their all-time highs. It’s as if the memory of a year, of what many have touted as a downright annus horribilis, when momentum in the global economy was lost amid a very sharp rise in inflation in the advanced economies, is now a mere nightmare. The situation has stabilized, inflation is falling and stock markets pulled up by cyclicals are rejoicing. What a Wonderful World!
This may seem strange in an environment of battling inflation and still a somewhat bad mood in the real economy, but the stock market just seems to be responding to its fundamental link with inflation. To wonder at the irrationality of a significant rise in equities in the face of a significant decline in inflation dynamics would not be very rational. At the same time, the turning point in the US stock market also broadly coincides with a turning point in the global liquidity cycle, the slope of which makes the wind at the stock market’s back.
It is therefore worth remembering in retrospect that the turning point in the US stock market also coincided with the collapse of a seemingly innocent pension product that threatened the British financial system and, by extension, the entire British economy at the end of September last year. It may sound catastrophic, but the ‘time bomb’ investment strategy, which, incidentally, the responsible authorities had warned about, exploded, and – it was a wake-up call. What would have happened if the calamity of the selling wave and tectonic movement in the UK Gilts markets had taken place in the US government debt market, already brutally devastated by losses in its value, in a market on whose shoulders rests the stability of the entire global financial system? The aforementioned market incident induced by the materialization of liquidity risk in the United Kingdom has become a signal for a turnaround. Concerns about the impact of the previous squeeze on funding sources, representing gross flows of funds, credit and international capital through the world’s banking systems and wholesale money markets based on the ever-increasing use of collateral, have proved to be valid. In this system, U.S. government debt securities play anything but an essential role.
The US Treasury bond market and the debt markets in general, are truly gigantic in size and compared to them most stock markets look like mere midgets. Surely, no one will dare to dispute what has always been true, and what is still true today, that the US sovereign debt it is a very large market. Much depends on it in the global financial system. Its size has continued to increase significantly over the last fifteen years, at a time when low rates have encouraged increased spending and indebtedness. Moreover, the US budgetary outlook does not seem to look particularly rosy either. According to the most recent Congressional Budget Office projections, the primary deficit will persist at or above 3% of GDP and the unified deficit will exceed 7% of GDP at the end of decade. The debt will keep rising from one high to yet another higher high. So one might acknowledge the importance of what should and will happen in the world’s most sophisticated debt market. It can also be expected that a lot of effort will be put into ensuring its smooth functioning and to keep it as liquid as possible in order to be able to absorb shocks coming from the global financial system. In a collateral-reliant world, the important thing will be to curb its volatility so as not to complicate the process of setting haircuts on the valuation of the relevant maturities as collateral.
The financial crisis at the end of the first decade of this century was a debt crisis. Today, fifteen years on, many major countries have more debt in absolute and relative terms. In this respect, we are dealing with a system that is more fragile and people should therefore be cautious. It may be desirable to go into debt, reasonably and temporarily. Those who need a tractor should buy a tractor so that they do not have to dig with a hoe and spade. However, when the debt gets beyond reasonable limits, when it is a case of robbing Peter to pay Paul, when the debt becomes unbearable, then the goat milks the blood and the good servant becomes the bad master. I am far from giving apocalyptic visions. However, let us be clear about this, it is high time for a somewhat more reasonable and responsible approach. When things ever get back to normal, what a wonderful world it will be again. In the meantime, people, especially retail and non-professional investors, should be cautious and avoid going into the shark-infested waters.
Capital Wars: The Rise of Global Liquidity 1st ed. 2020 Edition, by Michael J. Howell