The ingredients for a market crash are all in place

By Satyajit Das

Rising levels of government and corporate debt, higher costs of capital and contagion risks are all on the table

A witch's brew of rising debt levels, higher costs of capital and contagion risks is bubbling.

Like culinary dishes, market crashes require specific ingredients: overstretched valuations, high debt levels and cash shortfalls, high volatility, rising capital costs, contagion vectors and poor shock absorbers. All of those are now lined up neatly on the kitchen counter.

Since 2000, price increases have outstripped underlying cash flows. Real-estate and equity-market valuations are stretched. Global debt has reached around $348 trillion, or 308% of world output, up from around $210 trillion a decade ago. Credit intensity is rising, with growing levels of debt needed to generate the same level of activity.

As a percentage of total output, government debt in Japan, the U.S. and the U.K. has reached 252%, 127% and 106%, respectively, representing increases of 116%, 71% and 69% since 2000. The actual level of government debt may be even higher because of unfunded liabilities, such as future healthcare and eldercare costs as well as pension entitlements in the U.S. and Europe.

There are also significant levels of private borrowing, including layers of leverage, with investors, funds and underlying businesses all borrowing at the same time against the same underlying cash flows.

True indebtedness is understated by the proliferation of off-balance-sheet financing arrangements, which at Alphabet (GOOGL), Microsoft (MSFT), Amazon (AMZN), Meta Platforms (META) and Oracle (ORCL) have reached $1.65 trillion, compared with $1.35 trillion in on-balance-sheet debt.

Chip makers sell to customers, funding the buyers via "investments." Data-center operators monetize commitments by users to utilize capacity. The capacity to meet future obligations in these opaque circularities remains uncertain, requiring a massive uplift in artificial-intelligence revenues.

Around $6.7 trillion of this debt, including $1.2 trillion of non-investment-grade debt and $330 billion of private-credit loans, must be refinanced by 2028 at a higher cost than the current low rates. The U.S. government must refinance about a third of its debt every year, creating a substantial risk of a disruption.

Cash insufficiency threatens failures and credit losses. In parallel, investors, pension funds and insurers need to finance spending or meet contractual payouts. A lack of distributions and write-offs reduces available funds that underpin economic activity, creating adverse feedback loops. Simultaneously, higher volatility feeds risk models triggering margin calls and deleveraging as lenders further tighten liquidity.

A low cost of capital can cushion shortfalls. But the era of low government bond yields has ended. Higher-for-longer rates are probable due to cost pressures from wars, disruption of supply chains and reshoring driven by national security risks. Premiums for risky assets, which have fallen to historic lows, will rise to compensate for increased instability. The rising gap between required returns and cash generation will undermine asset prices.

Linkages between financial institutions, derivatives, securitization and market structures create multiple paths that will rapidly transmit shocks, making it difficult to quarantine problems.

U.S. banks have exposure to private-credit funds of between $410 billion to $540 billion, and $300 billion for the capital commitments of limited partners. U.S. and European banks have combined exposure of $4.5 trillion dollars to non-bank financial institutions, primarily through their prime brokerage operations. Private-equity-controlled life insurers have large exposures to private credit.

Derivatives and securitizations, whose volumes remain high, diffuse risk through the financial system but also link entities in daisy chains of risk. Passive investments and trading styles, particularly multi-strategy platforms, rely on momentum or similar quantitative risk models. They trade price signals, often identically reducing diversification and increasing fragility.

These vectors amplify market dislocations as multiple participants simultaneously unwind positions. Even a small liquidation in such a tightly coupled system can produce a chain reaction with major consequences.

Available shock absorbers may prove inadequate. Market-making, which in a crisis plays a critical role in warehousing risk purchased at discounted prices, is now dominated by investors and quantitative-trading firms such as Jane Street and Citadel, which are actually users, not providers, of liquidity. Rising volatility and erratic price signals frequently result in these institutions withdrawing, reducing the capacity for investors to offload positions.

Regulators are perversely reducing bank capital requirements, which act as buffers at a time when they are likely to be needed.

Assumptions of government and central-bank support will be tested. Public finances are stretched by intractable budget deficits and the highest levels of debt outside of war. Central-bank balance sheets at around $20 trillion (below the peak of over $25 trillion) are well above their $5 trillion level in 2007. Modest interest rates limit the scope for large cuts even without inflation concerns.

The final trigger is always some geopolitical event, natural disaster, default or change in financial markets, such as unexpected economic-data prints or aggressive interest-rate increases. When one happens, the ingredients will combine in a very unpleasant and bitter dish.

Satyajit Das is a former banker and author of "Traders, Guns & Money," "Extreme Money" and "The Age of Stagnation." His new book, "The Everything Bubble," will be released in 2027.

-Satyajit Das

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09-23-26 1547ET