Henry Kaufman
Henry Kaufman once said: ‘Money matters, but credit counts’ © Bloomberg

The writer is managing director at Crossborder Capital and author of ‘Capital Wars: The Rise of Global Liquidity’

After nearly two years of solid gains across stock markets, will the feared roller-coaster return? The answer is yes, due to higher debt levels, the tapering of central banks’ liquidity support for markets and the growth of indexation.

Only two things really matter in investment: how much money there is in the system and how it is deployed. Recently surging equity prices once again confirm that both are highly elastic concepts.

Some may argue this has always been the case. Fine, but we should ask whether we have reached the point where this elasticity is becoming a far bigger and more institutionalised problem. I think it has.

We calculate that global liquidity — the volume of cash and credit shifting around world financial markets — is testing $172tn. This figure is a stock of all sources of liquidity, including from central banks, traditional commercial banks and the so-called shadow banks that supply short-term debt and currency derivatives.

It echoes the words of Henry Kaufman, Salomon Brothers’ former economist: “Money matters, but credit counts.”

Since the financial crisis, the US and China have been the two dominant liquidity providers, but because China’s international financial footprint is small, America’s actions matter far more for global markets, particularly during crises.

Consider the importance of the dollar funding worldwide and the extension of lines of support between central banks to provide access to facilities backed by the US currency during the Covid-19 emergency. According to our calculations, these actions, together with a near-60 per cent jump in the size of central bank balance sheets to more than $30tn, have fuelled the 30 per cent rise in global liquidity since early 2020.

Yet these figures are still overshadowed by a huge debt pile that we now estimate exceeds $300tn — an eye-watering three times GDP — that burdens the world economy.

The problem is that debt ultimately has to be repaid or, more likely, rolled over. Taking an average debt maturity of five years implies a $60tn annual refinancing problem that requires balance sheet capacity, or, in other words, liquidity.

This means the modern financial cycle gyrates with the tempo of debt maturities. More liquidity requires more debt as collateral, and more debt needs more liquidity for refinancing.

Policymakers seem stuck in this cycle. They keep policy interest rates low and, thereby, encourage still more borrowing, but, often in the same breath, they threaten to withdraw liquidity through so-called quantitative tightening or tapering measures.

Several of the world’s key central banks, including the US Federal Reserve, the linchpin of the global monetary system, plan to reduce their quantitative easing programmes next year. Some have already started. Less liquidity makes it more difficult to roll over existing debts.

Meanwhile, capital markets have lately turned into large-scale debt refinancing mechanisms, easily eclipsing their textbook role of funding new capital projects.

The result is a dizzying spiral of debt, with central banks forced to respond by quickly restarting their quantitative easing programmes to support markets with asset buying whenever financial instability threatens. Consider the policy responses to the 2008, 2010, 2019 and 2020 market sell-offs, and the support given through the colourfully dubbed “Greenspan, Bernanke and Yellen Puts”, after successive Fed chairs.

A renewed dose of QE, or a “Powell Put”, seems the inevitable remedy for the next stock market sell-off. In short, future growth of global liquidity has seemingly become institutionalised by these debt burdens.

The irony is that when the Fed’s cash flows through the system, it often gets forced into a narrow list of often-illiquid securities and has an outsized effect on prices. It drives indices across asset classes substantially higher and compels other investors to chase prices upwards, which magnifies its impact.

Many of the largest investment managers now track these indices across both bonds and equities. About half the assets under management in US equity funds passively track indices such as the S&P 500, according to Bloomberg Intelligence. Traditional valuation metrics play no role in their decisions.

Unless the spiral is broken by higher interest rates, global liquidity will ultimately bound higher. At the same time, asset allocation has been put on a potentially self-destructive autopilot that ignores sensible investment criteria, so that money is focused on the largest stocks, driving their valuations and sometimes even their owners towards the moon.

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