Premier Miton Macro Thematic Multi Asset Team
For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Silicon Valley Bank (SVB) was a major lender to the venture capital and tech industries in the US and elsewhere. It has just failed in a classic ‘run on the bank’ way. It was weakened by unrealised losses from US treasury holdings and, like many weak banks, an overreliance on wholesale funds.
While this particular bank is not important in itself, like the LDI problems in the UK, it highlights how vulnerable the financial system is to rising rates. Ultra-low interest rates for an extended period have led to a large amount of questionable investment decisions. As government bonds consume very little capital for banks many have bought huge amounts of longer dated bonds using cheap money. Now they, just like the UK pension funds, are sitting on huge unrealised losses. While Silicon Valley Bank was an extreme example, no doubt others will have similar problems.
At the same time, this bank was a big lender to venture backed tech startups. You might ask why loss-making start-ups were borrowing money from the bank. These days this is not uncommon and is again a feature of a long period of ultra-low interest rates. Lending standards in the US have already been tightening, I am sure they will now tighten further. Clearly access to funds from banks like Silicon Valley Bank, will further dry up for companies which in many cases only really existed as a feature of cheap money.
The buyer of the assets of a failed bank has a huge incentive to quickly realise the portfolio. Having bought a loan book, at a discount of which they have no detailed knowledge of the most obvious strategy is to quickly liquidate. Given that Silicon Valley Bank had a policy of demanding proceeds from loans and equity commitments were held largely on deposit at the bank, a liquidity crisis for many weaker startups seems plausible. This will have knock on effects for the whole tech sector, this industry sells an awful lot of its products to these small start-ups.
The central problem
The central banks have a problem, they have sticky inflation as a result of a strong labour market, but the financial system continues to be under huge strain from rate rises. This is a difficult one to reconcile. Past experience would suggest that they will prioritise financial stability over the real economy. As we have suggested before, it might be possible to square this with rate rises offset through ongoing quantitative easing (QE). The QE can prop up the liquidity in the financial system, while the rising short-term rates might dampen demand and hence inflation in the real economy.
We doubt they will succeed. We will much more likely see ongoing tightening of bank lending standards, high rates impacting the housing market, and other knock-on effects that may lead to an eventual contraction in the labour market and a recession.
Alternatively, no amount of QE can offset a normalisation of the financial system which is spectacularly over leveraged and needs to deflate. At that point, the Fed may be forced to pivot, in the meantime they will carry on until something serious breaks. Whether inflation is down at acceptable levels by that point we doubt. We think that inflation will be on a rising trend for several years to come, with significant swings in the process.
We remain very cautious about financial markets; this tightening phase seems doomed to either end with a major financial crisis or a painful economic contraction and markets do not appear to be priced for either. Our higher for longer base case therefore persists, higher rates, higher inflation, and higher volatility.