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.
This is believed to be a truism, as in every tightening cycle there is generally a major breakage in the financial system. However, this doesn’t mean the truism has any predictive power.
Central banks are tightening policy with a view to bringing inflation under control, however, economies throughout the developed world have become absurdly overleveraged following decades of easy money. Cheap money is hugely distorting to the incentives in any economy, leading to an imbalance of risk and reward. Risk taking is inadequately rewarded, pushing investors to take excessive risk. However, the downsides to excessive risk taking are not felt as ever more debt can be piled into poor projects at minimal cost. The recent failure of Silicon Valley Bank (SVB) highlights many of the features of excessively low interest rate environments.
SVB was heavily involved in the financing of venture capital businesses. These days venture capital (VC) is very different from its early days. Early on, investors would provide equity capital to fund the growth of early-stage businesses. These days VC funds provide both debt and equity capital and are in some cases themselves partially debt financed. Funds with no natural source of income are borrowing money to lend to businesses with no means of paying the interest, other than the next funding round.
This model has led to the creation of a number of business models which basically dash for growth in revenues in order to justify a higher share price at the next funding round. All very well, but often the product on sale is only attractive because it is being sold at a loss. In other cases, businesses are dashing for market share to create a monopoly where no barriers to entry exist.
The problem with thinking the recent failures such as SVB and now Credit Suisse mark the end of the tightening cycle, and the bottom of the equity market is that this can only be evident after the event. The GFC (Global Financial Crisis) is a relatively recent tightening cycle and a good example. Northern Rock failed in September 2007, Bear Sterns in March amongst other failures in the lead up to the failures of AIG and Lehman Brothers in the Autumn of 2008. Interest rates were being cut throughout this period and bottomed in December 2008. Quantitative easing (QE) was introduced at the beginning of 2009 and markets bottomed in March 2009.
We doubt what we are seeing now is sufficient cause for concern for policy makers to reverse course. UK CPI is still printing in double digits and US inflation and employment both remain strong.
We think the current policy of tightening via interest rates, combined with various forms of quasi-QE through financial assistance to favoured institutions will continue for the time being. This is storing up huge problems going forward and ultimately is unlikely to bring inflation down to levels the market predicts.
There have already been several examples of this, starting with the UK’s Liability-Driven Investment (LDI) crisis last autumn, where investment banks were taking huge losses on collateral that they were selling, as pension funds lost money on their LDI positions. The Bank of England stepped in and bought these positions at rising prices enabling the investment banks and pension funds to close their positions at less cost.
In the SVB failure, the deposit guarantee upper limit was waived, enabling the venture capitalists and their ventures to avoid material losses, but also some Chinese state-owned enterprises. Janet Yellen was explicit in saying this support would not be available for just any old bank.
In the case of Credit Suisse, shareholders, including Saudi National Commercial Bank and the Qatar Investment Authority received a modest return on their stakes while AT1 bondholders were zeroed.
The problem with all these cases is they involve changing the rules as you go along, seemingly to favour certain parties at the expense of others. In each case you can see the political expediency near term. Avoiding a widespread rapid collapse of the California venture capital industry, given its huge donations to the party in power in the US, might seem right at the time. The consequence is a flight of deposits from smaller banks into larger banks, thought to be subject to similar favouritism. Ultimately this will lead to the demise of the majority of small regional banks in the US, something the Fed and its owners might favour.
The favouring of equity over supposedly higher ranking AT1 again might seem prudent at the time, given that middle investors are some of the most important customers of Swiss banks. It has sadly led to a dramatic knock on effect across this part of the bond market, with repricing to reflect these bonds apparent change of status. This makes the cost of capital for all banks higher and calls into question the purpose of this instrument, if it no longer has rights above that of common equity.
In both cases regulators are claiming special circumstances and backpedaling rapidly, but they have clearly caused as many problems as they have solved so far. The can is being kicked down the road, the show is kept on the road and the fight against inflation can continue for now. The problem with the strategy is that it is implausible that you can have both, you can’t resolve the inflation problem without some pain in the real economy; the deleveraging process is essential and losses must happen. Some of those losses must be borne by those with money and hence, political influence.
We retain a cautious stance and our long term outlook remains higher for longer, but we are conscious that the near term is becoming ever more unpredictable as policy is being made on the fly. We think it more likely that tightening continues, and that we haven’t yet seen a breakage of sufficient magnitude to change policy or bring inflation down sufficiently.