You may not know the name Michael Burry off hand, but you probably should. He was one of the investors who made a fortune as part of the “big short” during the Financial Crisis. Well, he has come back into the limelight this week with an eye-opening warning. He argues that ETFs, and indexing generally, are essentially the same as CDOs were before the crisis. He explains that the massive capital inflows into ETFs have eliminated any realistic pricing mechanism for underlying stocks, just like huge demand for structured credit inflated all asset prices before 2008. Additionally, the daily liquidity underlying many of the stocks in index funds is vastly lower than the index funds themselves (again, just like CDOs). Burry uses a theater metaphor, saying that the theater has grown much more crowded, but the exits are still the same size.
FINSUM: This is a great argument, and one that seems to have fundamental truth to it. However, even Burry admits that he has no idea when this “bubble” might actually burst.
For many years after the Crisis, the main theme around consumer debt was the idea that Americans were deleveraging. However, steadily, consumer debt has risen back to alarming levels. In the first quarter of this year, consumer debt hit $14 tn, surpassing the $13 tn of leverage pre-Crisis. Student debt has been a major area of credit expansion. Even when comparing debt to the population, the debt per person is a little higher than in 2008.
FINSUM: So obviously inflation needs to be accounted for here, but the picture is still worrying. It is yet another sign that we may be nearing the end of this run.
Many advisors may respect the opinion of Bob Rodriguez. The former fund manager achieved some acclaim by accurately forecasting the Dotcom bust and Financial Crisis. The former CEO of First Pacific Advisors says that a financial crisis is now a “near certainty”. His fear is that excess leverage in the economy, coupled with a recession, will cause a big crisis. He believes “delusional” equity markets are now only starting to recognize this reality.
FINSUM: The preconditions for a crisis are there—a big buildup in corporate debt and pending recession. However, the timing and magnitude are both big question marks.
The market has been very worried about a potential bond market meltdown. Both investment grade and high yield debt have seen major losses lately as fears have mounted about high corporate debt heading into a possible recession and downturn in earnings. One of the big worries is that there will be a surge in BBB (the lowest rung of investment grade) debt that falls into junk status. However, Bank of America is more sanguine, arguing that growth is solid and companies have actually been issuing much less debt, and will continue to do so. Their view is that companies are in a much sounder financial position than before the last crisis.
FINSUM: The debt gorge that happened over the last several years is inevitably going to have consequences, and we think BAML is way too relaxed about the risks.
This story is not getting much attention in the US, but we thought it too big to ignore. S&P Global, one of the world’s leading credit raters, just announced that a “debt iceberg with titanic credit risks”. S&P says that China has seen a massive rise in borrowing by its local governments, much of it hidden from view, and the the excessive borrowing poses grave risks. The ratings agency says there is between $4.3 tn to $5.8 tn of off-balance sheet debt held by local governments following “rampant” borrowing. The debt is hidden is what are called “Local government financing vehicles” (LGFVs), which were entities used to raise debt before local governments were allowed to issue bonds in capital markets.
FINSUM: This is a pretty scary story that only the FT seems to be covering. It makes one wonder if LGFVs will be the acronym at the center of the next crisis.