Sixteenth largest bank in the United States of America, Silicon Valley Bank, collapsed last week. It catered to technology startups and venture capital community.
The primary reason for the failure can be attributed to the poor risk management policies of the company. The bank suffered a loss of $15billion by holding a portfolio of bonds yielding 1.6% (current yield 5%).
We are living in times when the global economies are doing well but the central banks around the world are raising interest rates at a record pace to control the inflation.
Why is inflation so important for central banks that they are willing to trade off the growth? Before proceeding further, two universally important relationship needs to be recalled:
Demand/supply and inflation
As evident from the graph above, prices of any product increases when the demand increases or/and the supply falls (& vice versa).
Interest rates and bond value
Market price of a bond reduces when there is an increase in the interest yields by the government (& vice versa). However, face value and interest payout of the bond remain the same throughout the tenure of the bond.
2001-2008: How it all started
Post dot com burst, interest rates (federal rates) in the United States went down from 6% to 1%. Everyone started borrowing heavily and a large chunk of low interest loans went towards sub prime mortgages (home loans to low credit score borrowers).
As inflation started to move upward, Central Bank of the United States raised interest rates, which went as high as 5% in 2008. Many borrowers could not afford to repay home loan EMIs and therefore, defaulted. As a result of a high number of defaults, 465 banks, including Lehman Brothers and Merrill Lynch failed, starting the Global Financial Crisis.
To save the economy, the Central Bank acted swiftly and reduced interest rates to a record low of <1% within a few months.
2009-2020: Cheap $
Interest rates in United States were kept below 1% for the next 12 years. As a result, the national debt in US increased from $10trillion in 2008 to $31trillion in 2020 (68% of GDP in 2008 to 123% of GDP in 2022). This low cost money was invested across the world, in real estate, startups, shares, bonds etc. Low interest rates have following effects:
Businesses are willing to take more risks triggering expansion. Profitability increases because of low cost of loans;
Accelerates growth of the economy – Government prints money at low interest;
Consumers prefer to buy on credit;
Increases asset values (discounting future cash flows at lower rates)
2021-Present: The new normal?
During COVID, the United States provided $1.9trillion in financial aid to Americans. This accelerated the demand for products when the global supply chain was disrupted resulting in record high inflation (prices of goods rise when demand increases or/and supply falls).
However, in late 2021, the US government was of the view that inflation is transitory (Inflation that moves above a steady rate for a short period and then reverts back to normal).
Russia-Ukraine war reduced the supply of oil, grain and gas to developed nations- further accelerating the prices. As a result, Inflation in US touched a 40 year high of >9%. The stance of the government changed suddenly and it carried out steepest rate hikes in the history of America. [Interest rate hikes curb the demand for goods/loans which in turn controls the prices (inflation)].
However, labour market in US is very strong as extremely aggressive subsidy regime has made America attractive again for manufacturing. Unemployment rate is at 50 year low and only 3.5% of Americans, willing to work, are unemployed. This makes situation even more difficult for the central bank as demand for goods does not fall as per expectation.
Indian markets:
As interest rates are hiked in United States, the dollar appreciates with respect to other currencies (INR fell from 74 to 84 in last one year).
To protect INR from sliding further, the Reserve Bank of India also hiked the interest rates in India (Interest rate parity theory);
Foreign investors withdrew money from emerging markets as investing became costly because of higher interest rates & falling currencies (However, there was no major impact on Indian equities as huge inflows from mutual funds, LIC and Employees provident fund provided cushion).
As I write this memo, foreign investors are sitting on $400B of cash, which will be eventually invested across geographies (Just to give you an idea – foreign investors just withdrew $5B from Indian equities – a lot of money will be moving back once the global situation stabilises).
Way ahead: No one knows with certainty
Scenario 1: Fed hikes interest rates by another 1-1.5% -> inflation cools down -> fed starts rate cuts later this year/early next year
Everyone is expecting as well as wanting this as no one wants to bear the consequences of high interest rates. Even if Fed gives an idea about rate cuts, a bull rally in equities may not be ruled out.
Scenario 2: Fed aggresively hikes interest rates going forward:
Recession can not be avoided. Money will move from equities to short term bonds. However, Fed will step in (like they did in 2008) and cut interest rates to normalise the situation. But this will take some more time.
Either ways, rate cuts are bound to happen.
Portfolio strategy:
Debt, as an asset class, has become attractive again. Indian 10 year bond is yielding around 7.4%. It is prudent to lockin the interest rates before they slide.
Equity: As valuations moderate, we continue to remain bullish on the Indian equities, considering the fact that India is the fastest growing major economy in the world. Historically, equities have always rewarded the patient.
Gold: Allocation should be increased considering the recent price correction.
Real estate: as an investment should be avoided considering the fact that interest rates are high. There will be slowdown in demand.
However, your personal portfolio should be aligned as per your goals and risk appetite. Please get in touch with your wealth manager in case of any query.
