What would happen if financial markets crashed? | The Economist

“For historians, each event is unique,” wrote charles kindleberger in his study of financial crises. but considering that “history is particular; the economy is general”, implies looking for patterns that indicate if a cycle is changing. The American financial system today is nothing like it was before the crashes of 2001 and 2008, but lately there have been some familiar signs of froth and fear on Wall Street: wild trading days with no real news, sudden changes in prices and a feeling of nausea among many investors who have taken an overdose of techno-optimism. Having soared in 2021, Wall Street stocks had their worst January since 2009, falling 5.3%. the prices of assets favored by retail investors, such as tech stocks, cryptocurrencies and shares of electric carmakers, have plummeted. the once giddy mood at r/wallstreetbets, a forum for digital day traders, is now gloomy.

It’s tempting to think that the January sell-off was exactly what was needed, purging the stock market of its speculative excesses. But America’s new financial system is still fraught with risk. Asset prices are high: The last time stocks were this expensive relative to long-term earnings was before the crashes of 1929 and 2001, and the additional return from owning risk bonds is near its lowest level. down in a quarter of a century. Many portfolios have been loaded with “long-lived” assets that generate returns only in the distant future. and central banks are raising interest rates to control inflation. The US Federal Reserve is expected to make five-quarter point hikes this year. German two-year bond yields rose 0.33 points last week, their biggest jump since 2008.

Reading: What would happen if the stock market crashed

The combination of sky-high valuations and rising interest rates could easily lead to big losses, as it increases the rate used to discount future income. If large losses materialize, the important question for investors, central bankers and the world economy is whether the financial system will safely absorb or amplify them. The answer is not obvious, as that system has been transformed in the last 15 years by the twin forces of regulation and technological innovation.

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The new capital rules have pushed banks to take a lot of risks. Digitization has given computers more decision-making power, created new platforms for holding assets, and reduced the cost of trading to almost zero. the result is a high-frequency market system with a new cast of players. Stock trading is no longer dominated by pension funds, but by automated exchange-traded funds (ETFs) and swarms of retail investors using nifty new apps. Borrowers can avail debt funds as well as banks. Credit flows across borders thanks to asset managers like BlackRock, which buy foreign bonds, not just global lenders like Citigroup. markets operate at breakneck speed: the volume of shares traded in the united states is 3.8 times greater than a decade ago.

many of these changes have been for the better. they have made it cheaper and easier for all types of investors to trade a wider range of assets. the 2008-09 crisis showed how dangerous it was to have banks taking deposits from the public exposed to catastrophic losses, forcing governments to bail them out. today banks are less central to the financial system, are better capitalized and have fewer high-risk assets. more risk is taken with funds backed by shareholders or long-term savers who, in theory, are better equipped to absorb losses.

However, the reinvention of finance has not eliminated hubris. Two dangers stand out. First of all, some of the leverage is hidden in shadow banks and mutual funds. For example, total loans and deposit-like liabilities of hedge funds, real estate trusts, and money market funds have risen to 43% of GDP, from 32% a decade ago. companies can rack up huge debts without anyone noticing. archegos, an obscure family investment office, defaulted last year, imposing $10 billion of losses on its lenders. if asset prices fall, further blowouts could follow, accelerating the correction.

The second danger is that although the new system is more decentralized, it still relies on transactions being funneled through a few nodes that could be overwhelmed by volatility. ETFs, with $10 trillion in assets, rely on a few small market-making firms to ensure that the price of the funds accurately follows the underlying assets they own. trillions of dollars of derivative contracts are routed through five US clearinghouses. Many transactions are executed by a new generation of intermediaries, such as Citadel Securities. the treasury market now relies on automated high-frequency trading firms to function.

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All of these companies or institutions have security reserves and most may require more collateral or “margin” to protect themselves from losses to their users. however, recent experience suggests cause for concern. In January 2021, frenetic single-stock trading Gamestop led to chaos, prompting large margin calls from the settlement system, which a new generation of app-based brokerage firms, including Robinhood, struggled to pay. meanwhile, the treasury and money markets came to a standstill in 2014, 2019, and 2020. the market-based financial system is hyperactive most of the time; in times of stress, entire areas of business activity can dry up. which can fuel panic.

Ordinary citizens may not think it matters much if a bunch of day traders and money managers go bust. but such a fire could damage the rest of the economy. 53% of American households own stocks (up from 37% in 1992), and there are more than 100 million online brokerage accounts. If credit markets stagnate, households and businesses will find it difficult to obtain loans. That’s why, at the start of the pandemic, the Fed acted as a “market maker of last resort,” pledging up to $3 trillion to support a variety of debt markets and to support traders and some mutual funds. /p>

thin margins

Was that rescue an exceptional event caused by an exceptional event or a sign of things to come? Since 2008-09, central banks and regulators have had two unspoken goals: normalize interest rates and stop using public money to support private risk-taking. those goals seem to be in tension: the fed should raise rates, but that could trigger instability. The financial system is in better shape than it was in 2008, when reckless gamblers from Bear Stearns and Lehman Brothers brought the world to a standstill. however, make no mistake: you are facing a severe test. ■

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Source: https://amajon.asia
Category: Stocks