Last week Andrew visited the InvestSense offices and shared his observations and findings from his visit to the United States, specifically New York.
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The Recent Surge in Leverage and its Implications

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Andrew's visit to the United States confirmed his suspicions regarding the surge in leverage within the financial system. He noted that this surge was even more significant than he initially anticipated. The primary driving force behind this surge was the credit crunch in March/April, which led banks to seek alternative avenues for generating earnings growth. As a result, banks lent to other financial institutions, who in turn invested in equity markets. The substantial increase in leverage created a favourable environment for risk assets. This trend has been reminiscent of previous instances such as the tech bubble and the bullish sentiment towards Chinese investments around 2015. Hunt highlighted that a positive (but difficult to quantify) theme, availability of leverage combined with funds flow created a powerful rally in the markets.

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Impact of Foreign Entities Accessing Dollars

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During his visit, Andrew was also surprised at the extent to which foreign entities (ex-US) had had a significant impact on the reflation trade in emerging markets. These entities were able to access dollars at a level that far exceeded his expectations and it has clearly resulted in a surge in market activity in emerging markets. Andrew also emphasized the unintended consequence of the credit crunch, where banks were reluctant to lend to the real economy and instead focused on generating earnings growth. This surge in leverage, coupled with foreign entities' access to dollars, created a powerful catalyst for market growth.

"The surge in leverage within the financial system is like lighting the blue touch paper and watching the markets rally." - Andrew Hunt

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Potential Risks Associated with Excessive Leverage

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While Hunt acknowledged the positive impact of leverage on risk assets, he also cautioned about the potential risks associated with excessive leverage. During his discussions with bankers in New York, he discovered that non-bank (private debt) lenders were using up to four times leverage in some cases. This level of leverage, when combined with illiquid markets, could lead to significant damage if these lenders become forced sellers. The interconnectedness of private equity funds and the potential for a domino-effect scenario also raised concerns about the stability of the financial system. Additionally, Hunt highlighted the emergence of subprime-like behaviour in lending, particularly in terms of lower quality borrowers and loan terms. This behaviour, primarily driven by non-bank originators and financed by Ginnie Mae, could lead to financial difficulties if the labor market weakens, resulting in defaults and increased liability for originators.

"We've seen a surge in leverage, but we must also consider the potential risks associated with excessive leverage and subprime-like behaviour." - Andrew Hunt

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The Role of the Federal Reserve

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Andrew has previously opined that the Fed has become distanced from the banking system and demonstrated a lack of understanding of the intricate inner workings of the financial plumbing in the ‘money centre of the world’. However, this time he expressed optimism about recent changes in personnel at the New York Fed. He highlighted the hiring of individuals with significant expertise and described them as a positive development for the central bank's engagement with the banking sector, mentioning one senior, high profile appointment in particular. Hunt speculated that the Fed might adopt a more accommodative stance in the future, potentially through a form of quantitative easing (QE) combined with quantitative tightening (QT). He suggested that the Fed might implement a program to assist regional banks and potentially steer treasury yields down to address funding problems caused by the budget deficit.

"The Federal Reserve's engagement with the banking sector is crucial for the stability of the financial system. Recent personnel changes at the New York Fed indicate a positive shift in their understanding of the banking system." - Andrew Hunt

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Implications for the Bond Market

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Hunt's analysis extended to the bond market, where he highlighted the potential impact of fiscal deficits on government debt. He noted that the shift from quantitative easing (QE) to quantitative tightening (QT) had changed the dynamics of the bond market. Previously, the supply of treasuries to the market had decreased due to the Fed's bond purchases, resulting in minimal reaction to inflation. However, with the resumption of treasury issuance and the reduction in bond purchases, the market would need to absorb a significant supply of treasuries. This increased supply, combined with potential Chinese selling, could lead to higher yields. Hunt cautioned that if governments continued to run significant budget deficits and inflation picked up, the bond market could face renewed volatility and potential risks.

"The shift from QE to QT has changed the dynamics of the bond market. Governments now need to consider the longer-term fiscal position and the potential impact on bond yields." - Andrew Hunt

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The Outlook for Australia and New Zealand

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Andrew also discussed the implications for Australia and New Zealand. He highlighted the decline in permanent income expectations in Australia due to the slowdown in China and the subsequent impact on terms of trade. This decline in income expectations could lead to reduced borrowing and spending, resulting in a weaker economy. However, Hunt noted that Australia had been relatively insulated from the risks associated with excessive leverage and subprime-like behavior. The housing market and banks had not experienced significant stress, and the Reserve Bank of Australia had taken a more cautious approach compared to its New Zealand counterpart. In contrast, New Zealand had seen aggressive tightening, leading to a potential recession and financial strain. Hunt expressed concerns about New Zealand's current account deficit and the potential for a significant economic downturn.

"Australia and New Zealand face different challenges. While Australia is experiencing a slowdown, it has managed to avoid the risks associated with excessive leverage. New Zealand, on the other hand, may face a significant recession and financial difficulties." - Andrew Hunt

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Conclusion

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In the middle of what we at InvestSense perceive to be a regime change in central bank/government policy we think it is especially important to understand the dynamics of the financial system and dig beneath the headlines into these more subtle issues. There is a good chance that we wake up one day and these are the headlines.