I’ve yet to come across anyone who has a better way of describing current monetary policy than Louis Gave from Gavekal. Paraphrasing Louis, ‘the Fed is dynamite fishing, they’ve lit the fuse, thrown the stick of TNT in the water, we’ve heard the bang and the fish are floating to the surface’.
Put simply, rate rises of the speed and scale we have seen over the last 12 months put pressure on the financial system. This pressure quickly translates into risk appetite and quickly percolates through the banking and credit system increasing the cost of capital Businesses that are heavily dependent on credit or that may be perceived to have misallocated capital come under pressure. No one quite knows what this process will reveal as no one quite knows what lies beneath the surface.
When such ‘squeezes’ occur, commentators immediately focus on banks, looking for obvious signs of fragility that might lead to reflexive systemic effects. In this case, it didn’t take long to find a few causes for concern. The problems at Credit Suisse were well documented and shouldn’t surprise anyone. The problems at SVB are surprising, but were perhaps only to be expected given their business model. Perhaps the biggest ‘surprise’ to surface is the headline data that is now appearing on US regional banks and their lending into the US real estate sector, particularly as it seems to carry distinct echoes of 2006-2008 and appears to have been catalysed by marked reduction in US regulatory oversight in 2018 and may have been turbo-charged using the capital markets.
Central banks and their finance ministries appear to have a good grasp of the risk that these events pose. They have moved immediately to ensure that there is ample liquidity on offer to those that need it and have acted quickly to stem the systemic risks associated with capital flight. This problem may have been ‘Born in the USA’ but given events in Switzerland everyone seems to have collectively recognised that viral instability cannot be allowed to spread. The PTSD from the last crisis serves a purpose.
Although the response to these events has been rapid, there has been a clear shift in economic sentiment to reflect the rising risk of a recession, particularly as monetary policy has neither paused nor pivoted. Commentators have moved on from the ‘no-landing’ macro narrative and there is a serious discussion of a global hard landing. This has caused some widening in credit spreads, but market rate expectations have adjusted down so the overall effect on the cost of credit has been modest thus far. Crisis averted?
That is difficult to say, particularly given the nature of the regional banking problems in the US, but in practice, the primary challenge for investors may not boil down to crisis risk, the absolute peak cost of credit or economists arguing about the definitions of a hard or soft landing. The primary challenge faced by investors is how best to make money by allocating capital to meet the burgeoning economic need at a reasonable price and in a timely fashion during a period of heightened uncertainty.
We know that macro uncertainty will mean that capital (specifically private capital) will not flow freely and evenly in the next 12 months. Indeed, as the value of having unallocated dry powder has just gone up, we should expect that it may be rationed carefully for some time. We also know that this will inevitably accentuate stresses and strains causing further market disruption, particularly in situations where capital was misallocated in the covid boom. As investors inevitably over-react to such stress, we should fully expect that any dislocation will present significant opportunity. This should be a great time to be a non-bank lender, particularly in less efficient markets. Similarly, there will be significant opportunities to participate in recapitalising assets with new equity across a range of markets and geographies globally.
The secondary challenge is timing. Experience suggests that trying to time a market bottom is a false economy, particularly in private markets where prices are discovered slowly and discretely behind closed doors. This implies that investors should be thinking about cost averaging into any dislocation, constantly adjusting their basis to capture the price benefit on offer and positioning themselves so that they can accelerate or decelerate as needed. But at the same time, we should also remind ourselves that this cycle will not be a rerun of the last one, the true window of opportunity is always shorter than we think. US regional banks may be in for a rough ride, but Europe’s banking system is not in the parlous state it was in 2011. The operating fundamentals are different. Consequently, the play-book from the last cycle needs updating and we should recognise that the leaders and laggards may not be the same. There is money to be made but it will be made by those who have capital and are able to distinguish the obvious similarities from the profound differences.
