by Robert M. Almeida – Global Investment Strategist / PM
A great deal has been written in recent years about the uniqueness of Modern Monetary Theory and quantitative easing. The reality is that they are neither unique nor modern. They are centuries old. As Ed Chancellor points out in The Price of Time, facing a banking crisis in AD 33, Julius Caesar lent out the government’s treasure without interest, creating liquidity which pushed interest rates lower. And history points to each episode of their use ending with unintended and unwelcome consequences.
Why?
For capitalism to function, investors must be compensated for putting their money to work. At a minimum, interest rates need to be above 0% since without compensation for foregoing immediate gratification there would be no savings or investment.
Further, history shows that when policymakers suppress the cost of capital to levels below the natural or market equilibrium rate resources are often misallocated. When private market signals become distorted, malinvestments accrue and inefficiencies build. In other words, in such an environment, people are more likely to make bad financial decisions. While it can take years, the consequences of those decisions usually result in financial or economic turmoil.
We’ve seen multiple episodes of financial stress over the past year in cryptocurrencies, special purpose acquisition companies (SPACs), the UK pension crisis and, most recently, the failure of several regional banks in the United States.
Not a repeat of 2008
For the sake of brevity, I won’t detail the many reasons why the current US banking crisis is dissimilar to the 2008 global financial crisis but in short, in 2008 banks were liquid but insolvent due to years of bad consumer loan making and excessive leverage. Today, they are solvent but illiquid due to deposit outflows.
Today’s crisis is a result of artificially suppressed interest rates, another of those unintended and unwelcome consequence for policymakers. Years of subdued savings rates and anemic demand for consumer loans pushed banks into investing deposits into bonds, allowing them to earn a hefty spread. But as savers shifted out of deposits into materially higher yielding money market funds, T-bills and the like, asset liability mismatches occurred, resulting in the stresses seen in recent weeks.
In speaking with clients, I’m repeatedly asked “Is the crisis over, and which bank is next?”
But what may matter more than if another regional bank will fail — as there is likely to be more given how portable deposits are due to digital banking — is the feedback loop to the economy.
Small banks are significant providers of capital to individuals, small businesses and other borrowers that drive the bulk of economic activity. While some of that lending slack will be absorbed by larger banks (which don’t face the same risks to deposits), the current climate makes deposit-funded banks less willing to lend. This is a disinflationary force that accelerates the pathway to a recession. Recent and not-so-recent moves in the bond market point in that direction as well.
The bigger picture
For many years, particularly since 2008, much of the wealth that was created did not result from economic growth. Instead, it was a by-product of declining capital costs which fueled the gearing of existing income streams. This is readily observed in the all-time high global corporate profit margins that were achieved in the late-2010s amid the weakest business cycle in over a century was. While profit levels have been high, their quality has been poor. The graph below, for instance, charts the difference between what companies tell investors they’ve earned versus what they earned per standardized bookkeeping, also known as Generally Accepted Accounting Principles or GAAP.
There are many good reasons for small differences between the two profit measures, such as non-cash charges that are one-time events and not reflective of long-term or enterprise health. However, as business cycles age, what we find is that companies increasingly ask investors to “ignore” an increasing number of impairments due to bad investments. While levels are nowhere near those observed in the 2008 financial crisis, they are at cycle highs and well above any other period this century, suggesting to me that the quality of today’s profits is very poor and are consistent with the bad decisions spurred by capital cost suppression.
Opportunity amid the great unwind
The surge in inflation over the last 18 months has forced global central banks to unwind many years of policies that suppressed interest rates. While the normalization of interest rates has exposed small pockets of stress, in our view there are more unintended and unwelcome consequences to come. We think this new environment should set the stage for a multi-year transition in leadership from non-discretionary portfolios to fundamentally oriented active strategies and create significant opportunities for alpha generation.
