Premier Miton Macro Thematic Multi Asset Team
This month has seen another huge crypto bust, leading to massive losses for end investors. We wrote about crypto back in July and the points made back then are still relevant today, so we won’t reprise those again. However, this and other recent blow ups do evidence the stage we are at in the market and economic cycle.
This is the liquidation phase of the cycle. In this phase, the impact of rate rises, and reduced liquidity begins to feed through to the economy via company failures. It is a natural situation, during the strong growth phase of the economic cycle, excesses build up, valueless projects are funded, and excessive prices are paid for assets. This is because money is cheap and freely available, so investors take on more risk. Now that 4% or so is available in a bank account, the incentive to speculate is greatly reduced. So, we would expect an increasing number of unprofitable businesses to fail in the coming months.
At the same time these higher rates will be putting pressure on overleveraged investment and business strategies. We have already seen the damage done to UK institutional pension funds because of the excessive use of leverage. No doubt if high rates are sustained there will be more investors who find themselves forced to liquidate. The same will inevitably happen in parts of the corporate sector, with borrowing costs much higher than before.
Of course, this is in fact the plan. It is required that capital is destroyed to reduce inflationary pressures. This is the point of rate rises. They reduce inflation through the wealth effect on consumers, who, feeling poorer spend less. They also send a signal to businesses directly, through the capital markets, via lower equity prices and higher borrowing costs. This leads to bankruptcies and corporate spending cuts, creating unemployment. All this reduces final demand and brings inflation back down.
In that sense, we can see the ongoing crypto carnage as a good thing. It has a deflationary impact via consumers and businesses. The same goes with the collapse of unprofitable technology stocks. Note the recent large layoffs at Twitter and other technology companies. All these are necessary to bring forward the point where inflation is back at a more normal level, interest rates can be cut, and the economy can start to rebound. Whilst it is happening in parts of the economy to which we are unexposed to, all the better.
All this is not to say the bear market and recession are coming to an end, that we cannot know. We can say that things are progressing as you might expect. The time is coming closer where sufficient slack has been built in the world’s economy that inflation will temporarily abate. Markets at some point will want to start to discount the forthcoming rate cuts. Bond yields will then fall and eventually equity markets will recover. Indeed inflation, during the recession, will no doubt overshoot to below its long-term average.
During this process we expect the market to believe we have returned to the era of lower for longer, where equities and bonds were negatively correlated, and growth was the main style driver of equities. We think this will be a false hope, a temporary phenomenon. The structural drivers which drove lower inflation for the past two decades have reversed, we are in an era of deglobalization and resource shortages. Combine this with fiscally reckless governments and you have a recipe for inflation settling at a higher rate than is generally expected for many years.
We retain our focus on real assets, cautiously buying into areas we like for the longer term, conscious that we cannot accurately spot the market lows. This goes for both equities and corporate bonds. Within both asset classes attractive valuations are available, irrespective of the interest rate and economic outlook, for selective investors prepared to look beyond the obvious.