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Here We Go Again

Mar 21, 2023

• We retain our cautious view on both bonds and equities
• The booming venture capital industry where exaggerated activity reflected ultra-easy monetary conditions for too long was an accident waiting to happen
• The Fed is reversing balance sheet reduction while trying to keep its credibility to tackle inflation
• The risk is of dollar weakness and gold strength – the very direction that the markets took last week
• ECB raises policy rates by 50bps – the Fed should follow with a 25bps increase
• Some asset bubbles are already a good way through their deflationary stage

Let there be no doubt about the fact that the Federal Reserve has created this mess and it will now scramble to get us out of it. The consequences of the Fed’s crazily loose monetary conditions, even in the face of building inflation pressures, are coming home to roost.

The current epicentre of the unravelling of the Fed’s past mistakes is the venture capital ecosystem. The growth of the US venture capital industry in recent years has been vibrant but unnatural. Deal volume in 2021, for instance, was up 40% in a year! For an industry where lengthy due diligence should take precedence over anything else, such a phenomenal growth within the span of a year was unnatural even though the industry might have tried to present it as vibrant

Chart 1: US Venture Capital Inflows


The free money from the Federal Reserve through quantitative easing measures, and the central bank’s relaxed stance on the ballooning inflation problem, which it continued to sidestep, encouraged a greater pool of investor capital to flow into venture capital – one of the riskiest assets to allocate capital to. Although deal volume dropped in 2022 (Chart 2), it was still well above the 2020 levels.

Chart 2: Global Venture Capital Deals Dropped in 2022 But Were Still Vibrant


Last week saw the Fed scramble to get a grip as the financial markets tumbled. Unfortunately, in doing so, the Fed is going back to drawing on the policies of the past that, in part, drove us to this situation. The Fed is back to expanding its balance sheet (Chart 3), a step that may be a tiny tick-up on a chart, but has been massive news for the markets. The need for the Federal Reserve to expand its balance sheet yet again may be heartening for the institutions that were bailed out, but it is not good news for the markets over the longer term.

It is evident now that in recent years there has been profound misallocation of capital and mispricing of risk. To go back to the venture capital industry, as the rounds of funding progressed, the valuations went to unprecedented levels in 2021 (Chart 3). It is not that these valuations were warranted by solid fundamentals. Instead, they reflected the huge inflows of easy money into the financial markets.

Chart 3: Venture Capital – Pre-money Valuations by Stage


The Central Bank-Sponsored Bailouts Begin
US and Swiss central bankers rushed to secure their respective financial sectors with action through the past week. The recent upheaval that began in the financial markets was led by Silicon Valley Bank. It is interesting to note here that by late last week SVB was signing up new customers as the bank’s support for the VC industry combined with explicit government intervention made it a competitive proposition again!

Table 1: Bailouts of the week

Source: The Global CIO Office

We could sense the bulls in the market salivating at another liquidity boost to financial markets. In such conditions, both bonds and equities do well. On the week, both the asset classes were highly volatile but as rescue measures were announced they ultimately recovered sharply. However as the markets opened today the rally looked much less well based.

Chart 1: Fed Balance Sheet Expands Again

Source: Bloomberg

At this stage we do not see the current challenges taking the shape of a financial crisis, let alone a global financial crisis. The shape of our current economic difficulties differs significantly from those that prevailed during early 2007. For one, only a handful of market experts suggest that we face a systematic, concentrated misallocation of capital by the global financial sector on the scale of what we saw in the real estate sector in 2005-07.

However, it is worth keeping in mind the news cycle and the subsequent market performance of 2007-09. We are only in the early stages of discovering the fault lines in the financial sector. Given the lingering inflation challenges, central banks will likely have to keep the aggregate monetary policy tight for longer. Despite the current turmoil in the global markets, the European Central Bank still went ahead with its 50bps rate hike last week. The Fed is still likely to raise interest rates by 25bps at its next meeting, even if it has loosened policy somewhat courtesy last week’s balance sheet expansion.

Gold Shines Again! Concerns about the credibility of central bank policy will have played a part in pushing the gold price towards the $2000 level this week. A solid showing on Friday left the spot gold price at $1993.7 an ounce, breaking through the COVID high of $1973. Technical analysts are generally optimistic about the yellow metal. Some recent large volumes of buying may help price momentum. It was the most significant volume this year and the second biggest of the past 15 months. Nevertheless, we prefer to not take aggressive tactical bets on gold, instead keeping it in our portfolios as a strategic asset.

Remember the hard facts of economic cycles. If central banks want to achieve their aim of bringing inflation down to their targets, they must impose some suffering on the economy – which, unfortunately, implies businesses close and people lose jobs. The Fed is in a demand destruction mode currently. If a central bank loses face in its battle with inflation, it risks putting its currency into a downward momentum.

The impact of the reset of interest rate expectations has already been felt. The market will continue to search for the fault lines in companies, asset classes, and governments that overextended themselves during the binge of easy money conditions. We have already had some unwinding of the bubble. Table 2 outlines a few examples of significant double-digit negative returns in previously thought sure winners. Bitcoin led the way peaking in December 2021, bottoming in November last year, and then showing a useful recovery. Proterra, the previous darling of the E.V. sector, collapsed last week and is struggling to survive despite its successful $1.6bn valuation initial public offering in 2021.

The one market bubble still in play is Singapore, where drivers are still paying higher and higher prices to put their expensive cars on the road. The capital flows from China that benefit the Singaporean economy are much less interest rate sensitive.

Table 2: The Unwinding of Asset Bubbles

Source: Bloomberg

*Invesco Global PE ETF tracks the red rocks global listed private equity index of listed PE funds
*Refinitive VC index is designed to measure the value of the US-based venture capital private company universe in which venture capital funds invest.

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