The Great American Bubble and other bursting questions
Thoughts on the global financial system's unipolar moment, why is Trump so worried about the dollar, two glimmers of hope for Europe, Britain's local government scandal and what's left of Northvolt
In this newsletter:
The Great American Bubble: Global finance’s unipolar moment
Dedollarisation: what is Trump so worried about?
Continental Drift: Two glimmers of hope for Europe
Called to Account: Britain’s local government auditing scandal
Electric Shock: What’s left of Northvolt?
1. The Great American Bubble
There has been plenty of debate this year, including here at Wealth of Nations, about whether we are in the midst of an AI bubble or a Bitcoin bubble. But could it be that America itself has become a giant bubble? This came up in in every meeting that I had last week and it is not hard to see why. This column by Ruchir Sharma in the FT set out the case very clearly. He noted that global investors are committing more capital to a single country than ever before in modern history:
The US stock market now floats above the rest. Relative prices are the highest since data began over a century ago and relative valuations are at a peak since data began half a century ago. As a result, the US accounts for nearly 70 per cent of the leading global stock index, up from 30 per cent in the 1980s. And the dollar, by some measures, trades at a higher value than at any time since the developed world abandoned fixed exchange rates 50 years ago.
Nor is this just AI mania by a new name. On indices that weight stocks equally regardless of size and correct for the domination of Big Tech, the US has outperformed the rest of the world by more than four to one since 2009. Some of the premium is rational. Compared to Europe and Japan, the US economy is growing faster. Compared to many other developing nations, however, it is slower. Yet it commands a premium not seen since the depths of the financial crisis that gripped emerging markets in 1998.
America’s drawing power in the global debt and private markets is also stronger than ever. So far in 2024, foreigners have poured capital into US debt at an annualised rate of $1tn, nearly double the flows into the Eurozone. The US now attracts more than 70 per cent of the flows into the $13tn global market for private investments, which include equity and credit.
Someone else who is concerned at the extreme valuations in the US is Davide Serra, the founder and chief executive of global asset manager Algebris. As he pointed out to me last week, Warren Buffet is currently sitting on a $355 billion cash position because he thinks that the US stock market is overvalued at two times America’s GDP. Yet the situation becomes even more extreme when you consider the debt market. The US stock market is valued at $70 trillion and the US bonds and credit markets are worth another $70 trillion.
In other words, the market value of the US is four times the country’s GDP of $35 trillion. Meanwhile the rest of the world has a combined GDP of around $65 trillion while its equity and liquid bond and credit markets are both valued at $35 trillion each, valuing the other 70 percent of the global economy at just one times GDP. As Davide says, “the most critical decision investors need to ask themselves is what will this dynamic look like in three, five of ten years?”
As America sucks in the world’s capital, this is having real consequences everywhere else. As Sharma notes:
In Mumbai, financial advisers are pressing their clients to diversify outside of India by buying the one market that’s even more expensive — America. In Singapore, the host of a lunch with wealth managers asked them: “Anyone here who does not own Nvidia?” Not a single hand went up.
The consequences are clear in Europe too. I’ve written extensively on the travails of the London stock market, which has traded since Brexit at a steep discount to the rest of the world. And as I reported a couple of weeks ago, the valuation gap between European and US shares is widening too. That is hastening the exodus of European firms to the US, with long-term consequences for European tax bases, jobs and skills. Last week the London market is shrinking at its fastest pace in over a decade. I was shocked to hear last week that liquidity is so bad that firms with a market value of under £1 billion now have to pay analysts to research them.
Yet there is no sign of this bubble, if that is what it is, bursting any time soon. Instead, global investors are ending the year more bullish on American stocks than ever. In their newly released outlook for 2025, Bank of America economists and strategists said that they expect US economic and earnings growth to outpace that of other developed economies and that the Standard & Poors 500 should end at 6666, which would be a 11 percent return on current levels.
Meanwhile the proportion of US households that expects share prices to rise over the next 12 months has just hit its highest level in the 37 years of the Conference Board monthly survey. Mutual fund cash levels are at record lows and passive equity inflows are on track for a record year. All this at a time when the price earnings ratio on the S&P500 is around the level at the height of the dotcom bubble in the late 1990s and the price to book ratio is even higher.
The big question raised is whether a US market crash might finally allow capital to start to flow back to other regions. Sadly, it is unlikely to be as simple as that. A word of caution comes from Joachim Klement, chief strategist at Panmure Liberum and author of the brilliant Klement on Investing newsletter on Substack: he notes the likely fallout from a US market crash is likely to be bad for everyone:
For one, even more than in the early 2000s US households will be hit hard in their savings and investments, creating a negative wealth effect and an even stronger reduction in consumption growth than what we saw in 2000 and 2001. Could this trigger a recession in the US? I don’t know.
But what seems likely to happen is the same as happens during every major market downturn in the US: US investors will likely sell not only their US holdings but also their foreign holdings to cover for their losses in the US. And this creates a spillover of a US market downturn to Europe and the UK that we cannot ignore.
Or as the old adage says, when Uncle Sam sneezes, we all catch cold.
2. Dedollarisation
What could burst the American bubble? I put this to several of Bank of America’s top economists and strategists at lunch last week. Their answer was that the biggest risk, other than “black swan” geopolitical risks that are impossible to predict, is that US political developments undermines investor confidence in the management of the US economy. In particular, would the Trump administration try to “fight the Fed” if the central bank decided it needed to raise interest rates to counter the inflationary effects of expansionary budgetary policies?
Donald Trump has already made clear that he would like to remove Jay Powell, the Fed chairman he appointed, before his term ends in 2026 and has talked of setting up a shadow Fed, steps which the markets are assuming he will not follow through on. But any perception that the dollar system was not being managed in the interests of maintaining monetary stability would introduce uncertainty into the market and could lead investors to demand a risk premium on US Treasuries, rather than valuing them solely on the basis of inflation expectations.
Meanwhile it is clear what Trump himself sees as the greatest risk to America’s financial supremacy. In a post on X (formerly Twiter) last week, he promised to slap 100 per cent tariffs on the BRICS countries - Brazil, Russia, India, China and South Africa - if they were to take any steps towards move away from “the mighty dollar” or replace it with their own BRICS currency.
Given that no one expects the BRICS country to create their own currency, this may seem like an idle threat. But the trend towards dedollarisation by emerging central banks as they look to diversify their reserves is real and it is clear that it is rattling many in Washington. I first became aware of this nearly a decade ago when Jack Lew, President Obama’s Treasury secretary, publicly warned about the risk that over-use of the sanctions weapon might have on dollar supremacy. Steven Mnuchin, Trump’s former Treasury secretary, voiced similar concerns.
Perhaps the only interesting thing that Liz Truss has ever said was in response to a question last year about what kept her up at night: her immediate answer was the dollar losing its reserve currency status. The former prime minister does not strike me as someone who is likely to have arrived at such an unexpected but intriguing answer through her own careful reading of the Financial Times, so I assume that as a former Treasury minister and foreign secretary who moves in right-wing Republican circles, she was simply channeling what she understood to be a serious preoccupation among her contacts in Washington.
Yet it is striking that whenever economists are asked about dedollarisation, they dismiss these risks out of hand, insisting that there is no alternative to the dollar. I put this discrepancy to a very senior former European policymaker with considerable transatlantic experience last week. His response was that the politicians are anxious because they understand that the equilibrium can flip, whereas very few private financiers understand the system’s properties.
What is certain is that the trend towards dedollarisation is gathering pace, even as Trump threatens to flood the world with dollar securities to fund his deficit and pursue policies likely to send the value of the dollar higher. The central banks of the BRICS members and others in the global south are continuing to diversify their reserves, not least by buying gold. Indeed, China pointedly resumed gold purchases in November after a six month hiatus. Bank of America notes that the price of gold has now become completely decoupled from global rates, rising even when interest rates are high. It forecasts gold to hit $3,000 an ounce in 2025, up from $2,633 today, having risen more than 800 percent in two decades.
Meanwhile one sign of how seriously Trump takes the dedollarisation risk is his appointment of Scott Bessent as Treasury Secretary. Not only did the star hedge fund manager make his name with two massive currency bets, against sterling in 1992 and the Yen in 2012, but dedollarisation is one of the key macro themes being pursued by his Key Square fund, as he discussed in this fascinating interview with the Money Maze podcast a year ago.
There is probably no one in global finance who better understands what is at stake and what needs to be done to preserve dollar supremacy, which is one of the main reasons to believe that a second Trump presidency may not be nearly as economically reckless as Trump’s own overblown rhetoric suggests.
3. Continental Drift
If America is set to carry on booming, what of Europe? Sadly the outlook is not so rosy. Bank of America forecasts that European GDP will grow by just 0.9 percent next year, held back by high energy costs, the collapse of Germany’s economic model, confidence-sapping uncertainty arising from the political crisis in France, global trade tensions and slower global growth, particularly in China.
Nonetheless, the investment bank also pointed to two potential upside surprises that could lead to a brighter outlook for the European economy. The first was a move by Germany to reform or remove its debt brake, which since 2009 has limited budget deficits to just 0.35 percent of GDP. A big increase in German borrowing, which with debt to GDP at close to 60 percent it can easily afford, would not only lift the German economy but would, given how closely supply chains are integrated, lift the wider European Union economy.
The second upside surprise would be if the European Union acted on the recommendations of Mario Draghi’s report which set out over 400 pages policies to improve Europe’s competitiveness. That reform effort would pack an even greater punch if it was accompanied by a new round of common eurozone bonding to fund investments in defence, infrastructure and the energy transition, as the former Italian prime minister implicitly recommends.
What are the chances of either of these happening? Higher than the conventional wisdom currently suggests, I believe. A former close colleague of Friedrich Merz, the Christian Democratic Union leader who looks almost certain to be the next chancellor after elections in February, tells me that while he won’t remove the debt brake, he will reform it to allow more borrowing. Meanwhile even Joachim Nagel, the president of the Bundesbank, traditionally the custodian of German fiscal rectitude, has called publicly for debt brake reform.
Meanwhile resistance to a new round of common debt issuance may be crumbling. The Financial Times reported last week that EU countries are discussing a possible €500 billion common defence fund backed by guarantees from participating countries. The problem facing perennial opponents of common borrowing such as the Netherlands and Germany is how else is Europe going to fund its defence, given high debt levels in many EU members and so many other spending pressures? Indeed, a substantial defence fund alongside a commitment to buy US weapons may be one of the most effective bargaining chips when it comes to negotiating with Trump over his threatened tariffs.
That does not make Europe’s outlook rosy, just slightly less bleak.
4. Called to Account
At the risk of sounding monomaniacal, the one thing that all European governments could to do improve their financial performance is to better manage their balance sheets. All governments own vast portfolios of public assets that are often poorly managed, not least because they are not properly measured. The answer, as Wealth of Nations has consistently argued, is the adoption of accrual-based accounting to provide clarity on what the assets are worth and the revenues and costs associated with them allied to a public net worth target.
For clear evidence of what can happen in the absence of robust accounting, look no further than UK local government. I recently published a post highlighting the extraordinary decision by Britain’s auditor general to refuse to sign off on the government’s latest whole of government accounts, primarily because of the failure by 90 percent of local authorities to submit audited accounts. This terrific piece by David Hencke in Byline Times explains the background to this scandal.
As Hencke says, the origins of the local authority funding crisis stemmed from nearly a decade of Conservative government cuts and rising costs for education and social services. In response, some councils started investing in increasingly risky developments to create new income streams. The financial mismanagment of these schemes in turn led to a wave bankruptcies from 2020, starting with Labour controlled London borough of Croydon and quickly followed by Conservative-controlled Thurrock council and Labour controlled Slough Council
But the scale of the problem was masked from central government by two decisions taken by leading Conservative figures. Eric (now Lord) Pickles took the decision as Local Government Secretary to abolish the Audit Commission in 2015 as part of the Government’s agenda of scrapping “red tape”. Now this body checked and monitored local government finances every year, produced value for money reports and made sure there was no backsliding even in the smallest parish council.
Instead, the auditing of local councils was seen as a private sector activity and left to the market. Unfortunately the big audit firms were not keen on bidding for the work when they could work for big private corporations instead, and councils had difficulties getting anyone to audit them, which then caused a backlog.
Michael Gove when appraised of this problem, as Levelling Up Secretary, was incredibly slow in taking action. He thought about introducing a new slimmed down version of the Audit Commission in 2023 to retake control of the situation but never introduced any legislation to create the new body.
Rishi Sunak did no better as PM – using the bankruptcies of Birmingham and Nottingham councils as a political football by claiming it was because of “Labour mismanagement”. This ignored evidence from the Local Government Association that it was affecting councils of all political colours.
The result of this colossal failure of financial management is that some councils have had to make dramatic cuts to public services and huge costs have inevitably fallen on central government to bail them out. One of those local bodies whose accounts were disclaimed by its auditors was the South Teeside Development Corporation, the flagship Tory regeneration project led by Tees Valley mayor Ben Houchen which has faced allegations of corruption.
The good news is that Labour is taking action to fix the local government audit crisis. But there is no evidence of any political appetite for robust accounting to play a bigger role in public administration in Britain. Instead, Rachel Reeves in her recent reform of the fiscal rules opted a half-baked new target based on Public Sector Net Financial Liabilities which the market does not understand and which she does not even know how to measure. Indeed, she has asked the National Audit Office to come up with a method.
One might think that in a world in which Sir Keir Starmer has just appointed a new cabinet secretary with a brief to change the way the British state operates, when the French government has just collapsed because the political class is incapable of delivering a fiscal consolidation of a mere 1% of GDP, and when Donald Trump has appointed Elon Musk to head up a Department for Government Efficiency tasked with finding savings to fund tax cuts, net worth would be an idea whose time had well and truly come. Instead, institutional inertia, or even outright resistance, remains as strong as ever.
5. Electric Shock
I’ve written quite a bit in these newsletters about the travails and ultimate demise of Northvolt, the Swedish battery maker. Not only is it one of the most spectacular stories of corporate collapse by a European company that I can remember, the consequences of its failure are certain to be far-ranging. Northvolt was central to European aspirations of some degree of autonomy in battery-making, leaving its struggling automotive sector even more reliant in its transition to electric vehicles on Chinese and Asian companies.
For a fascinating account of what went wrong at Northvolt, I highly recommend this short podcast by Redefining Energy, hosted by two investment bankers with close contacts to the company, its funders and suppliers. In short, it was the wrong technology, in the wrong place, with the wrong plan and the wrong management. It seems it never stood a chance. It managed to burn through €15 billion of equity and €5 billion of debt before falling into administration. Yet its creditors will be lucky to get anything back at all. Astonishing.
Fascinating analysis Simon.
Suggest you check spelling of Buffet!
Really interesting and timely piece, thanks ...