Philip Saunders | Don’t ignore the good news in the bad news

The abrupt collapse of Silicon Valley Bank – America’s 16th largest bank has heightened investor fears of a re-run of the Global Financial Crisis (GFC) where weaknesses in the financial system triggered a recession and pronounced weaknesses in equities and other ‘risk assets’. The old saying is that the US Federal Reserve (Fed) tightens ‘until it breaks something’ and if we look at past tightening episodes, this has certainly been the case.

Iconic Fed chair Paul Volker’s tightening finally broke the back of inflation in the early 1980s but this led to Continental Illinois Bank’s failure in June 1984, which marked a key policy turning point. At the time, Continental was the eighth largest bank in America. In 1998, it was the turn of Long Term Capital Management, one of the largest hedge funds in the World at the time, with $127 billion of market exposure at its peak.

Time will tell whether SVB was the equivalent. The run on smaller US banks will certainly tighten credit conditions further down the track, but so far the Fed continues to see fighting inflation as opposed to maintaining financial stability as its priority, and has continued to raise rates and the reaction of equities and credit has been relatively muted.

The Fed’s challenge has been made greater because the financial – as opposed to the underlying ‘real’ – economy has become bloated, predominantly the result of sustained loose monetary policy. Signs of distress in the former are the logical consequence of the battle to keep expectations of future inflation rates at moderate levels.

Unsurprisingly, much of the clamour for the Fed to relent, to ‘pivot’ and expand liquidity once more, has been coming from the major beneficiaries of the former ‘zero rates’ regime – such as SVB’s Silicon Valley client base – the clue was in the name as it were.

The process of normalisation may be painful and the price that needs to be paid well prove to be a recession, but we would argue that that would be a price worth paying. A new ‘New Normal’, with positive as opposed to negative real interest rates, would impose the capital allocation discipline that was clearly missing in the post-GFC period in particular, and which rewarded the kind of business models that SVB and FTX exemplified. As David Scott, Chief Strategist at Cha-Am Advisors, puts it so perspicaciously, ‘Bear markets are a process of discovery.’ The excesses and the weak links tend to be ruthlessly exposed and we suspect that there is more to come than the recent batch, especially if the Fed stays the course.

True, as investors we are confronted by many challenges. The literal fog of war, the China US standoff, stubborn inflation, high government debt levels to mention a few, but we need to recognise value where it has been restored and consider what the next cycle is going to look like.

Unlike the United States and Europe, China is experiencing a strengthening recovery and that will help drive Asian growth more generally. Oil and gas prices have fallen sharply from their extreme peaks at the time of Russia’s invasion of Ukraine just over a year ago. Saudi Arabia has acted boldly to transform its economy while agreeing to a truce with their Iranian neighbours. In fact, many emerging economies are in good shape. The winners of the new cycle are unlikely to be those of the last, both regionally and sectorally.

*Philip Saunders is Investment Institute Director, Ninety One.