Craving Capital

January 24, 2022

The financial world has been overcome with a binary switch over the past forty years or so. It’s the idea of risk-on or risk-off. Many times headlines on venues such as CNBC, Marketwatch, even Bloomberg, talk about market conditions being risk-on or risk-off.

The big money, those who invest in the hundreds of millions or billions also view the world in a similar way. If you read through project reports for construction or large capital projects, they are measured using IRR or internal rate of return. A project with an IRR that exceeds some metric, will move ahead and the capital allocated, the project begun, etc.

Over the past decade and a half, indeed the last 40 years, is that the amount of available capital has been rising constantly, and over the past 13 years even accelerating. This while the cost of capital, inflation, and taxation have been declining. This is all coming to an end and rather abruptly.

Those trading stocks and perhaps even bonds will still view the day to day swings in markets with a risk-on or risk-off lens, but the macro conditions are clearly in a risk-off scenario and capital is starting to pull back rapidly from many projects just as demand soars. In the end there is a good chance that future textbooks will be written highlighting the misallocation of capital that happened during the COVID recovery, or the Great Recession and how the world really couldn’t manufacture money to resolve the basic needs of society.

These big claims are currently just that. But there is substantial evidence appearing as well.

  • Recent headlines about Evergrande (a property developer in China) highlight the ‘risk-on’ nature of their investment. They kept selling property believing there would be a never ending supply of capital, until the capital ran out. There are at least a dozen other property developers in China in a similar mess.
  • At the government level, the US government has had to alter their debt limit twice in the past year as they ran out of money. Meanwhile many agencies are running out of cash to support individuals in housing, food (SNAP benefits got a boost in December), and healthcare.
  • Riskier assets are seeing a pull-back. Stock markets have pulled back sharply so far in January, with declines of 8-10%. Riskier assets such as crypto and high flying growth companies are off as much as 50% or more.

These signs point to a need for capital. During the Great Recession in 2007-2009, the culprit was thought to be mortgage debt. Banks had to dramatically curtail lending in all areas to cover capital requirements when bad mortgages ballooned.

In the current market, the number and variety of assets that have ballooned in value means that it may be harder to spot where the pull back will start. Evergrande or Bitcoin may be the canary in the coal mine. Perhaps a decline in housing values, or a decline in the value of one or more currencies (Turkish Lira anyone?). Perhaps it will be an increase in taxes, or a run on food that causes people to adjust their risk appetite and stop spending money, stop investing in uncertain opportunities. It is always difficult to know. That need for capital, particularly on very large projects such as housing developments or rockets going to space get cut slower than the more visible items such as building a house.

What is clear is that debt levels around the world have skyrocketed. Returns on investment appear to be moderating, if not declining and it is not always clear who is in the most trouble. Companies like Peloton show this clearly. A relatively small company with a niche solution that was timely due to unusual circumstances became all too comfortable until the circumstances changed. Certainly some investors were not savvy enough, or insightful enough, or cautious enough to see much of this in advance. Last week their shares sank below their 2019 IPO price and are off about 85% from their high. Gains in other companies (such as the meme-stocks like AMC Theatres (AMC) or GameStop (GME)) have eroded sharply and investors may soon find themselves holding shares in companies that are not as robust as they imagined.

These scenarios may play out more and more in the coming weeks or years as all of that growth is overwhelmed by the lack of money available to do everything and a skewed view of risk.

Investing remains a wise approach to storing unused capital, but risk-on is probably not the right approach. A modest view of future returns would be healthy.

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