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The Big Conversation

Episode 68: Are your stocks at risk from leverage? 

This week we look at the risks that excess leverage can pose for the financial system. Was the recent demise of a family office an isolated incident or the tip of the iceberg and are there any market parallels in recent history? In this week's Chatter, Refinitiv’s Head of Banking and Capital Markets, Cornelia Andersson, reviews the surge in M&A volumes at the end of last year that has spilled over into the first quarter of 2021.

  • Last week, we touched on the issues around the leverage of the family office Archegos and how this should be viewed in the market’s wider context of cheap and easily available capital.  This story continues to reverberate around the trading desks. Archegos looks like an isolated event, just like the demise of the internal hedge funds within Bear Stearns did in June 2007, a year before the Great Financial Crisis took hold. But if we include this year’s problems at Greensill Bank and the hedge fund Melvin Capital, then there are many parallels with 2007, when issues at Bear Stearns were mirrored in other allegedly unconnected sectors. The market back then, like today, still carved out new highs, but these were the first signs of structural problems. These so-called isolated events pre the GFC turned out to be connected by the very framework of the financial system. In this week's Big Conversation, we'll look at the current spate of problems and ask whether there are signs that the financial fabric is again running dangerously high on leverage. 

    Numerous reports suggest that Archegos had fund equity of around $10 billion, but positions estimated to be in the range of $50 billion to $100 billion. This is yet another anecdote referring to the leverage and speculative excess sitting at the heart of today’s market activity, which has largely been accommodated by the unorthodox monetary policy adopted by global central banks over the last 20 years.

    Many financial actors including retail investors now employ significant leverage through “over-the-counter” derivatives positions established via multiple securities firms who have extended the cheap credit made available by central banks and the suppression of interest rates.

    [00:01:41] These derivatives have helped to supercharge an already hot market in which the rise of passive funds, another feature of central bank intervention, have also led to outsized moves per unit of capital invested today compared with the past. That's great on the way up, but as we've seen from numerous asset price air pockets, a problem on the way down that needs yet more central bank intervention. After the 2008 crash, a whole host of new regulatory initiatives were introduced all around the world to prevent the recurrence of the issues that snowballed into the end of 2008 when deleveraging caused turmoil in global markets. But where there are now new regulations, there are also new opportunities for other players to step into the breach, which has given momentum to the rise in today's shadow banking system, where hedge funds and family offices have filled the hole left by the retreat of proprietary trading desks at investment banks. In addition, regulatory oversight has encouraged a number of hedge funds to convert to family offices. In a report issued a year ago, the business school INSEAD calculated that the number of single family offices had grown by 38 percent between 2017 and 2019 to reach more than 7000. Assets under management stood at five point nine trillion dollars in 2019 and we are probably well beyond that number today. Family offices have greater freedom to take risks because they're generally closed to external investors. But it must be stressed, however, that most are extremely conservative because they are focused primarily on preserving capital. But for some, this greater freedom can potentially lead to extremely concentrated positions and a liquidity mismatch. Risk management models use volatility as an input which often allows leverage to increase when volatility falls. It should be no surprise, therefore, that very low levels of volatility are often a precursor to sudden surges in volatility, precisely because it models for excess leverage during the periods of low vol. Although the VIX today has not yet returned to the lows, the speed of the policy response last year has encouraged leverage to proliferate. But as we've seen this year, this is a system-wide issue, in which investors of all types, regulations permitting, are emboldened by the hyper loose policy and liquidity backdrop, which has facilitated a massive rally in the markets that has been increasingly detached from profits over the last five or six years. Meanwhile, financial leverage is readily accepted because it's embedded in the market's psyche that global central banks will always provide support during market extremes. 

    [00:04:17] Investors such as Warren Buffett have long termed many of these new types of derivatives as financial weapons of mass destruction. The FT's Robert Armstrong notes that global banks earned an estimated 11 billion dollars in revenue in 2019 from synthetic equity financing, including total return swaps, double the level of 2012. Regulators have struggled to rein in these profit engines, especially in an era where other revenue streams have been pinched by previous regulations. Despite the talk of increasingly monitoring risk, global regulators have not been successful in curbing the extraordinary growth in leverage that's characterized this bull run. Last year, broker dealer loans surged by a record 164 billion dollars, up 40 percent year on year. For the second half of 2020 broker dealer loans expanded by over 100 billion dollars, dwarfing changes over the previous 10 years, and despite the economy stuck in lockdown - clearly a tale of two worlds. 

    [00:05:15] Successive Fed chairman have repeatedly said that monetary policy was not an appropriate tool to counter asset inflation and bubbles, especially when excessive levels of debt could come under pressure if rates were to rise. That's one of the reasons why the world's central banks have not used interest rates to deal with asset inflation or stock market bubbles. But the counterargument proposed by the monetary authorities was that there would be macro prudential policies that will safeguard financial stability, and yet we continue to see a recurrence of the issues that have significant repercussions for the wider market. From an investor's perspective, the key question is whether these problems at Archegos or Greensill are truly individual issues that happen together by chance, or whether like Bear Stearns funds before the GFC, they're part of a bigger trend. In many ways, it appears to be the latter, a long term trend that has achieved powerful momentum. The heads of the US Treasury, the Fed, the SEC and other major financial regulators met last week to discuss the Archegos issues. They're also trying to ascertain the losses of other institutions and whether these have systemic implications. We pointed out the comparisons to Long Term Capital Management's 1998 blowup and in particular the events of the preceding year, which led to the intervention of the Fed. Archegos is  smaller and its derivatives exposure, only a fraction of the LTCM positions. 

    [00:06:34] It did not borrow in the money markets and was not levered to the credit instruments of others, which generally means less systemic impact. But it was a bet on the perpetual bull market facilitated by an ultra accommodative monetary backdrop. And the key risk is that after this type of shock, we should expect securities firms to be far more cautious in extending credit and leverage. That will certainly mean tighter credit conditions going forward because high leverage charges will push up the cost of capital, which will have an impact on liquidity. Therein lies another issue. Regulators will want to be careful that they don't create a disorderly unwind of leverage by an aggressive response because this will accentuate existing liquidity issues. Likewise, they won't want the build up of leverage to continue unchecked. Trillions of dollars of speculative leverage have already accumulated over this protracted bubble period. Assets among shadow banks have increased following the GFC, totaling more than 200 trillion in 2019, now making up about 50 percent of the global financial system, according to the Financial Stability Board. And you can see what happens when the music stops, even in very liquid securities. Viacom, for example, traded 38 million shares on March 23rd 2021, trading at ninety six dollars late that Tuesday afternoon. By Friday, some twenty trading hours later, the stock had been cut more than in half. Certainly the large margin call block trades to unwind Archegos' positions were a major factor, but how much selling came out of the woodwork in an attempt to avoid the worst of this forced liquidation? Some smell blood and others panicked. And the market in Viacom's stock turned illiquid liquid and then quickly dislocated. Market participants often point out the curse of liquidity that appears to be there, but not when you need it, meaning that when things are going fine, liquidity looks to be abundant, but then things take a turn for the worse. Liquidity evaporates, as happened with oil futures in April 2020, the bond market in March 2020 and the Swiss franc in 2015. In many ways, the price action of Viacom is a mini version of the price action in GameStop driven by the sudden ebb and flow of liquidity and not by underlying fundamentals. After beginning the year at thirty seven dollars, Viacom was trading at one hundred dollars only nine sessions ago. Importantly, it was the speculative melt up that set the stage for the inevitable reversal, dislocation and deleveraging. Perhaps this is now the new normal, and we just need to adapt to a market framework in which backward looking fundamentals based on historical profitability have been replaced by expectations of future growth regardless of earnings. Liquidity and momentum, not earnings per share, have become dominant forces in which, as mentioned earlier, many stocks rallied by far more per unit of capital invested than they did 20 years ago. But this increases the risk of air pockets to the downside as well. However, should longer term investors care if policymakers are going to juice stocks back through their all time highs, regardless of the quality of a company and its management? Unfortunately crash protection has become harder and harder to monetize given the shorter and shorter windows for recovery. But with the VIX now back below 20, though still considerably higher than the base levels of the last five years, index protection is becoming increasingly attractive, especially if the Fed is happy to let yields run higher. Conversely, maybe it's those bonds that once again offer decent hedge to equities. Yields are approaching the top of the long term trend channel, where they could act as a catalyst for lower equities as they did prior to 2008 and in late 2018. Yields on the 10 year now have much more room to fall again if markets start to struggle, potentially offering a valid hedge to equities. Now, these trends in monetary and fiscal policy have also been instrumental in a huge recovery in global M&A volumes. In the next section, I talked to Refinitiv's Cornelia Andersson about those trends. 

    [00:10:29] The last few months have been exceptional for M&A activity, which has rebounded to record levels. 

    [00:10:34] Q1 of 2021 and has been another record breaking period. So M&A activity is continuing to smash records and worldwide activity totaled about one point three trillion euros dollars, which is an increase of 94 percent compared to year ago levels. And it's the strongest opening period for M&A since the records began in 1980. It really has been an astounding start to the year. And we, of course, saw a strong recovery in the second half of last year and assumes that this is set to continue and even to accelerate. So let's talk about what kind of deals we're seeing. So there's a couple of key themes here. Private equity continues to be very active, hitting an all time high recently. Private equity buyouts accounted for about 20 percent of M&A activity in Q1, which is double from a year ago and continues to the strong finish we saw late last year. SPACs, another headline-grabbing sector, accounted for about 17 percent of Q1 activity, and by all accounts will continue to drive volumes this year. Now, if we look at this globally, the U.S. markets dominate M&A activity, accounting for about half of all global deals in Q1. And this is noteworthy, because as we discussed in previous sessions, the U.S. was behind the other regions late last year, largely due to uncertainty around the presidential elections and the covid response. But that lost ground is not more than made up with very healthy figures. Asia saw a good increase in activity, and while Europe was also up, it was slower growth than the U.S. and Asia. In Asia specifically, Q1 levels are at a six year highs, so it's really healthy market activity, but interestingly, Japan is at a two year low, which clearly signals more growth opportunities elsewhere in the region. Now, in terms of sectors and industries, technology continues to go from strength to strength, and we saw an all-time record for tech M&A where those numbers tripled. Alongside technology, other sectors that have been very healthy are financials and industrials, they really close out the Q1 activity. 

    [00:12:29] Part of the volume story is the resurgence off the pandemic lows, but the response from policymakers and the resilience of capital markets has provided very fertile grounds for dealmaking. 

    [00:12:39] The big question is what is it that's really driving all of these record volumes of M&A activity that we're seeing? And there are a couple of clear factors here. So the pandemic crisis last year meant that we saw a rapid shift, large corporates spent time in recovery in damage control mode, they shored up the balance sheets and operations, and then they started looking very actively at how to grow and secure the businesses. And this resulted in a strong focus on M&A. So for large corporates with solid balance sheets, this is a good time for M&A activity. Equity markets are high, investors are willing to pay for growth and interest rates are low. So this also means that assets that may not have been for sale otherwise have come onto the market, and generally there's a greater willingness amongst the corporate c-suite to engage in deals. It's a very much a case of what was initially seen as a massive challenge last year has now become the new normal, and companies are ready to move forward. So it's a good time to reshape a business and focus on growth. And I think that we will see some strategic divestitures as a result as well. Another factor here is, of course, private equity. So private equity is a big driver of M&A activity, accounting for about 20 percent of Q1 activity so far this year. And when it comes to private equity, market turmoil really creates the perfect conditions for well-funded and well experienced dealmakers that can move quickly. And that is P, they are perfectly placed to take advantage of new opportunities in the current market conditions. Now add also the fact that there is significant dry powder in play, so i.e. capital ready to be deployed by the private equity firms and we're likely to continue to see P push deal activity. And lastly, let's not forget about the capital markets, as you alluded to. So we'll do well to remember that all M&A activity requires funding. And typically this comes from the capital markets where conditions have been very favorable and record breaking amounts of capital have been raised, both through the equity and the debt market. So 2020 was very much the year of the capital markets to the rescue, with strong growth meaning that corporates are now unusually well placed to execute deals. We should probably also at this point talk about SPACs, right. So SPACs is obviously it's a headline grabbing sector of the market. And 2020 was the year of the SPAC race, it was the return of the SPAC with these special purpose acquisition companies really coming to the forefront as a driver of corporate takeover activity. Somewhat to some observers, surprise, I think. And based on the first quarter of Q1, we're looking at an even higher level of SPAC activity. So far SPACs have broken all records in 2021. In the first ten weeks of this year, more SPACs listed than in all of last year, and prospects were almost at a par to roughly 80 billion dollars. So I think that is a clear indicator of things to come. 

    [00:15:24] This rebound doesn't just feel like a one-off recovery. Dealmakers themselves are expecting the momentum to be maintained. 

    [00:15:30] Every year, Refinitiv speaks to about 500 deal makers across the M&A and capital markets to gauge their confidence and outlook for deal making. Now, the outcome of this year's survey is really fascinating, and global deal makers are overwhelmingly positive. There's a strong bullish sentiment and most expect 2021 exceeding the dramatic recovery in record breaking volumes that we've already seen. And of course, you know people are still worried about external risks. There's the pandemic, slow economic and corporate growth, fear of trade war, fear of recession really topped the list of those external risks. But none of these are enough to really hit the brakes and slow down the M&A train, it's is full steam ahead. Interestingly, previously big themes such as U.S. politics and Brexit have dropped off the agenda and seem to be much less of a concern these days. Now in terms of predictions, deal makers expect an uptick in M&A activity of about six percent, and capital markets at a similar level. U.S. deal makers are more bullish than are European and Asian counterparts where we expect to see lowest growth in Asia. Top sectors are slated as technology, not surprising, and also health care. And these are predictions I very much agree with. I do also wonder if part of the reason for the bullishness of our American dealmakers is due to SPACs and the very, very healthy activity there. Sustainability is becoming an increasing driver of deal activity. Refinitiv publishes a quarterly sustainable finance review, including league tables, and a key theme is that corporates as well as banks now have sustainability targets and goals, such as putting a specified specific amount of capital to work in sustainable areas. And this really means the existence of sustainability targets means that we're very likely to see a shift of M&A as well as capital raising activity towards sustainable assets. 

    [00:17:27] M&A volumes have benefited from the environment of cheap and easy funding and the deployment of war chests that have been built up prior to the pandemic. SPACs are providing venture capital style risk rewards, while sustainability is again building momentum as a key driver of capital flows that look like they're going to continue through the rest of 2021.