When Lightening Strikes

13 October 2025

If you want to know where the future risk is; follow the leverage. As we often note, there is an intimate link between liquidity, leverage, and volatility. From our vantage point, the impulsive correction in the US markets on Friday was the start of a probable unwind in extreme leverage, crowded positions, and consensus beliefs. The announcement on tariffs was simply the lightning strike that sparked the forest fire. The fuel was the liquidity and levered positions in exchange traded funds and single stock positions on the major technology companies. The additional challenge was extremely poor risk compensation, euphoric valuations, and fraudulent companies (First Brands) ahead of the correction.

Leverage in this episode is evident in exchange traded funds on the popular themes (technology and AI) and even single stocks related to those themes. Our understanding is that selling volatility and buying accumulators for yield (income) has been a meaningful contribution to the rally in crowded positions. That is also evident in the non-linear price action itself and compression in realised volatility. It has contributed to the self-reinforcing feedback loop and price momentum. Prior to the correction on Friday, CTA and other trend following strategies were also near maximum long positions. That created a negative gamma like downside accelerator. In a Sharpe Ratio or Value-at-Risk framework investors were forced to reduce exposure.

As we have noted previously, there is often legitimate support for a speculative mania. That reinforces the trend and the misconception of reality. It also encourages speculators to buy an asset on the hope that it will be worth more in the future. The recent announcements by Open AI and related partners on vendor financing had strong parallels with the 2000 episode. Moreover, on some measures the divergence between price and fundamentals is even more extreme than in the first technology bubble. The US Information Technology Sector trades on 10 times sales today compared to 8.5 times sales in 2000.

In addition to the crowded positioning in technology and AI, another area of leverage in this cycle has been in the US Business Development Companies (BDCs) or listed private credit. The recent weakness in this sector and the underperformance of the majors like Blackstone might have been a warning signal on risk assets more broadly (chart 1). The collapse and default of auto-parts supplier First Brands (held by many of the BDCs) and potential fraud is also significant. Fraud is often uncovered at the end of a boom-bust episode.

Chart 1

Source: Bloomberg

In most of the period since 2008 the US and the global economy have been supported by a positive feedback loop of low rates, forward guidance (the promise to keep rates low) QE and large fiscal easing since 2020. In turn that contributed to a rise in credit and leverage. The contrast post 2020 was that leverage was built in the public sector. The “good outcome” for the bond market in the current episode would be a growth shock that takes out inflation pressure. In contrast, a “bad outcome” might be if inflation re-accelerates given leverage in the public sector and fiscal dominance.  

Long credit and “carry” (in all forms) are inherently short volatility. From an empirical perspective credit spreads tend to widen when cyclical conditions, profits and cash flows deteriorate. Debt is repaid out of cash flow. For the reasons we noted above, the process also tends to be non-linear due to the reflexive or self-reinforcing feedback loop and the intimate link between liquidity and leverage. The context is also the extremely narrow risk premiums in equity and credit. The two most important questions for investors are; where is leverage and am I being compensated for risk? Following the strong rally in risk assets over the past few months, challenging policy outlook and elevated valuations, the odds of a meaningful correction have increased.

20251013_When_Lightening_Strikes.pdf

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