Since America elected Donald Trump as president on November 5th, the value of its listed firms has increased by $3.7trn, more than the entire worth of London’s stockmarket. The S&P 500 is up by nearly 30% this year. At 23 times its forward earnings, the index has rarely been so highly rated by investors. Nor, in recent years, have its constituents been able to borrow more cheaply. The cost for risky companies of raising funds is at its lowest relative to Treasury bonds since the spring of 2007. Everywhere you look, there are signs of exuberance. This month the price of bitcoin reached $100,000. And all this is happening despite positive real interest rates.
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What is going on? A familiar part of the explanation is that American technological innovation has made investors giddy. No two businessmen exemplify the boom better than Jensen Huang, whose firm sells artificial-intelligence (AI) chips, and Elon Musk, who makes electric vehicles and rockets, and will be part of Mr Trump’s administration. Their two firms, Nvidia and Tesla, are part of the “Magnificent Seven” which now account for a third of the S&P 500’s market value and a quarter of its profits—an extraordinary degree of concentration.
Less remarked upon, however, is the wave of financial innovation that is under way, and which brings new risks. The Schumpeterian urge burns as hot among the country’s financial engineers as it does for those who build real things. Exchange-traded funds (ETFs), for instance, have accelerated their decades-long rise. Those listed in America now manage $11trn of assets, and come in increasingly speculative forms. Investors can now buy ETFs that provide leveraged exposure to Nvidia and Tesla—or even MicroStrategy, a software firm raising billions to purchase bitcoin, whose share price has shot up by around 500% this year.
The structural changes taking place in private markets are no less dramatic. On average, shares in the three biggest private-markets firms have risen by more than those of the Magnificent Seven this year. Private-credit providers are nosing into lending markets once dominated by banks, often funding investments with life-insurance policies. A Cambrian explosion of products for individual investors is under way.
Their architects are not bankers. Quant firms such as Jane Street are minting fortunes making markets in ETFs. The popularity of such low-cost investment products has squeezed active portfolio managers; survivors have migrated to huge multi-manager hedge funds such as Citadel and Millennium. BlackRock, dominant in public markets, is targeting private ones: this month it agreed to buy HPS, a lender. Apollo, a private-markets firm with a big insurance arm, is moving the other way. It plans to launch a private-credit ETF.
Investors buying the most speculative new products are likely to end up disappointed. Firms consolidating the private-credit industry today risk doing so at the top of the market.
What matters more is the risk this rapid innovation poses to the broader financial system. Regulators face at least a dozen growing non-bank institutions which on the basis of their size, novelty, opacity and interconnectedness may be deemed systemically important. Some of these companies may indeed efficiently shift risk away from the banking system, which is always vulnerable to runs by depositors. But deciding which of them strengthen the system in this way, and which pose new, unacceptable and poorly understood threats, is the most important question in financial regulation today.
That may not be a priority for Mr Trump, whose interest in regulation appears to centre on lifting rules for the crypto industry. Yet today’s sky-high asset prices lend the task urgency. Markets show signs of becoming more fragile. In August the VIX, a measure of stockmarket volatility, recorded its biggest-ever one-day spike as hedge funds unwound highly leveraged currency trades. Equity investors react more and faster to company earnings than they used to. In debt markets, reports from business-development companies, a type of investment vehicle, indicate plenty of sloppy lending in private credit.
Even if some investors admit that returns in years to come may be lower, many are too sanguine about the risk of a market crash. Although volatility has returned to normal and default expectations remain benign, minds could change quickly. Imagine that one of America’s tech champions suddenly issues a gloomy outlook and that financial innovators also turn out to have misunderstood the risk contained in their new products. Markets would be falling from a very great height.
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