Liquidity, Not Growth

Market regimes are often interpreted through changes in economic growth, with GDP treated as the primary anchor for asset prices and risk appetite. This paper argues that such a framing is structurally incomplete. Asset markets are not priced off flows of economic activity but off balance sheets. Liquidity, defined as the capacity of the financial system to fund, leverage, and absorb risk, is the dominant determinant of valuation regimes, discount rates, and market stability. A substantial body of financial cycle research shows that expansions and contractions in credit and leverage are only weakly correlated with GDP growth, yet strongly associated with asset price booms, crises, and regime shifts (Borio, 2012; Borio, Drehmann and Tsatsaronis, 2012). GDP captures real activity but provides little insight into funding conditions, leverage, or collateral dynamics, helping to explain why major regime changes often occur without corresponding shifts in growth. Asset price fluctuations are driven primarily by changes in discount rates rather than revisions to expected cash flows, and those discount rates are highly sensitive to liquidity conditions and balance sheet constraints (Campbell and Shiller, 1988; Cochrane, 2011). When liquidity is abundant, leverage expands and risk premia compress, supporting elevated valuations even in weak growth environments, while liquidity contractions force rapid deleveraging and non-linear repricing through funding and collateral channels (Adrian and Shin, 2008). Growth is therefore priced within liquidity regimes rather than determining them. Interpreting markets through a balance sheet lens provides a more coherent framework for understanding valuation dynamics, financial instability, and the persistent divergence between asset prices and economic growth, particularly in a globally integrated financial system shaped by a common financial cycle (Rey, 2015).