The economic data out of Europe, the US and Japan have been very good in the last few months. And I believe this will continue. But equity valuations have become stretched and bond market spreads are razor thin. With the US treasury yield curve flattening to almost 60 basis points between 2 and 10-year maturities and the Fed proposing 4 rate hikes in the next 13 months, we need to ask where the vulnerabilities in the market are, because this spate of good news could end. I believe we should look at high yield, leveraged loans and commercial real estate because this is not just where balance sheet risk lies, but also where there are problems with ‘fake’ liquidity as well.

Now, it should go without saying: complexity and leverage are the handmaidens of financial distress. Financial crises are all about forced selling by leveraged investors creating such a violent repricing of a specific asset class or market that investors end up selling what they can in unrelated markets, rather than the repriced assets they want to sell. It’s all about complex financial relationships that are difficult to untangle creating contagion as motivated sellers liquidate positions in any and all assets. These things move so fast that regulators simply don’t have the time to ring fence the risks.

The last financial crisis was no different. In the real economy, we saw a violent repricing of residential property – an inherently leveraged market due to mortgage lending. And this led to a similar repricing of mortgage-backed securities that metastasized – through fear generated by complex financial instruments and opaque financial relationships – into a general global asset repricing, financial sector distress and eventually crisis.

While the present cycle doesn’t have to end in crisis, market excess has become acute enough to ask where the fingers of instability lie. One place to look is in markets where ‘fake’ liquidity is being generated by exchange-traded funds of inherently illiquid markets like high yield bonds and leveraged loans. These markets are ones dominated by institutional investors like pension funds and insurance companies who often buy and hold to maturity, such that underlying assets do not trade as readily or frequently as they do in equity markets.