Financialization

Financialization is the reason why ‘everyone is a day trader now’

There was a significant increase in trading volume during the coronavirus crash. Apparently, the market got filled with amateurs who had nothing better to do during lockdown. The implied result was unusual price action of some stocks as retail traders allegedly don’t know what they are doing.

I feel slightly insulted being called an amateur who has nothing better to do. There is a deeper phenomenon which explains the elevated retail activity. It is based on rational argument and is called Financialization. No insults, no vanity, just economics.

What is Financialization

The world economy wasn’t great after the Second World War. Then John Maynard Keynes came up with macroeconomics in the form of government intervention and high employment. It worked well until the 1970s when growth stalled. Keynes’ principles stopped working so world leaders needed something different.

The new economic order was characterised by a decline of labour as a driving force of progress. This brought the demise of unions, deregulation and an ever increasing role of capital over labour.

We currently have financial capitalism, wage stagnation in the developed world and an increase in paper assets. Don’t mistake this with poorer generations as the living standards have increased significantly in comparison to past periods.

There are many definitions of Financialization. We will look through the following lens:

Financialization is the transfer of economic activity from the productive economy to the financial markets

It is becoming increasingly difficult for firms to justify real economy projects considering that the returns from financial activities are higher and require less effort.

An example of a financialized firm would be a car manufacturer involved in vehicle finance. Another one is when a company, such as Boeing, draws 100% of a multi-billion dollar credit facility to buy back its own shares.

The Productive economy

Most of us participate in the productive economy, whether through paid work or a private business. And we all know how hard it is to make money or to get rich, it’s really, really difficult. But what are we all fighting against besides random chance?

The benchmark

It is the stock market in simplistic terms. You are an employee and work for a company. You have targets and you feel that there are a lot of expectations for the amount you are paid.

The company itself, small or large, has to perform to beat its opponents. The competition consists of big firms listed on an exchange. These companies have to perform to satisfy the shareholders if they want to prosper. Otherwise the shareholders will move on to profit making firms.

When everyone starts to sell shares and no one wants to buy them the company’s assets quickly become worthless and it goes bankrupt. Therefore, the listed firm has to achieve above average return while you have to beat it.

Returns

You either get 20% return on equity or you just put it in shares unless the project is leveraged. If we borrow 80% of the money at 4% interest we only need to beat a 7.2% return to make the proposition viable.

Debt is not that bad when used in moderation, therefore, an ideal 50% allocation will require a minimum return of 12%.

Private companies

Below is some data from the Office of National Statistics. As you can see the net profit margin of all non-financial corporations has deteriorated since 1997 and is now around 10%.

This is consistent with the recent underperformance of Private Equity funds which I discussed here. The Services sector is doing a bit better maybe due to lower costs, however, it has not reached the US stock market performance.

We can invest globally without much hassle thus it seems prudent to seek the best returns either in the UK or overseas.

Note that the net profit of all companies is on par with what we’d expect from a 1:1 debt to equity ratio at 4% interest.

Labour and Capital

Financialization is a result of the notion that market forces will balance labour and capital better than state intervention. It started with Thatcher in 1979 and Reagan in 1980.

I don’t think that anyone at the time had an agenda to create the reality of today. Governments just wanted to resolve the problems they faced in the 1970s by increasing economic prosperity.

I would argue that it worked but not for everyone as is often the case.

Derivatives & Stock

The notional value of all derivatives, exchange traded and over the counter, was less than $2 trillion in 1986 considering $4 trillion worth of stock traded worldwide. Over the counter products had grown to a notional value of $559 trillion at the end of 2019.

Their exchange traded counterparts stood at $85 trillion in terms of open interest in June 2020 with a daily turnover of $5 trillion. The value of all stocks traded in the entire world was $60 trillion in 2019.

Just to put this into perspective The global debt, government and corporate, was $250 trillion at the end of 2019. The world GDP was $88 trillion in 2019.

The notional value of derivatives is irrelevant in isolation as a $3 option can easily have a notional value of $30,000. However, the important part is that more and more derivative products are available.

The total return of stocks has to go up in a financialized economy as they are part of the country’s paper assets. You may have noticed that the richest countries in the world are the ones with developed stock markets and expensive housing.

This is not by accident, how else do you prop up a private pension invested in a fund. Furthermore, steady share price growth ensures lower cost of debt for companies. This in turn secures profits for leveraged projects or firms.

The market forces

It seems clear that the market forces are pricing financial assets as more lucrative than the productive economy. Derivatives are not all bad. Without debt securities almost no one in the developed world would ever be able to buy a house.

They make it easier for banks to lend money and thus improve the accessibility of credit for projects in the productive economy. It has never been easier to borrow a million pounds on a shoestring if you can repay it.

Conclusion

Nowadays, it is hard to be part of the productive economy. The developed world never recovered from the 2008 financial crisis.

Everyone can see that, low interest rates, quantitative easing ad infinitum, piles of almost free money, yet no growth. Then Covid 19 struck and brought major world economies to a standstill.

People are not stupid, we all know that the stock market is completely detached from the reality on the streets. This is why everyone is trading. The average person may not know enough about economics to define financialization, but they sure notice it.

Why would anyone risk it all in a business which can go bankrupt overnight when they can trade stock which always goes up. We have all heard the stereotype of a random 28 year old banker who made millions.

We all want that! Few will succeed, most will fail. But you can’t win if you just watch from the sidelines.