(GuruFocus) - I've been doing an AMA on social media and getting a lot of great questions I've been sharing here. Here are some thoughts I had in response to a question about Silicon Valley Bank (SIVB, Financial).
I think that it is a very classic event in the very classic bubble-bursting part of the short-term debt cycle (which lasts about seven years, give or take about three) in which the tight money to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process that continues until central banks create easy money that negates the debt-credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem until these short-term cycles build up the debt assets and liabilities to the point that they are unsustainable and the whole thing collapses in a debt restructuring and debt monetization (which typically happens about once every 75 years, give or take about 25 years).
While in different cycles the sectors that are in bubbles are different (i.e., in 2008 it was heavily in residential real estate and now it’s in negative-cash-flow venture and private equity companies as well as commercial real estate companies that can’t take the hit of higher interest rates and tighter money), the self-reinforcing contraction dynamic is the same. Based on my understanding of this dynamic and what is now happening (which line up), this bank failure is a “canary in the coal mine” early-sign dynamic that will have knock-on effects in the venture world and well beyond it.
To put this in context and think about how this will likely play out, I find it useful to go to my archetypical debt cycles dynamic that I cover more comprehensively in my book Principles for Navigating Big Debt Crises than I can cover here. I am linking to the PDF version available for free here and will summarize in this Observations.
How the Machine Works
Because one man’s debts are another man’s assets and most people are levered long (i.e., they are holding assets financed by debt), when interest rates rise and money becomes tight, assets fall in value, which hurts debtors, creditors, asset holders, and financial intermediaries, which causes a self-reinforcing contraction and contagion because when money is needed, other assets are sold and when creditors are hurt, they curtail lending. Those financial intermediaries (most importantly banks) that are most leveraged long to the asset bubble that is bursting are particularly affected. It is classic that coming out of an extended period of very low real interest rates and abundant credit, there is an enormous amount of leveraged long holding of assets that are going down due to higher interest rates and tighter money, which is producing this classic dynamic of dominos falling.
Because a) we are in the early stage of the contraction phase of this cycle and b) the amount of leveraged long holding of assets is large, it is likely that this bank failure will be followed by many more problems before the contraction phase of the cycle runs its course. Before the contraction phase of the cycle ends, history and logic have shown that there will be 1) forced sales of assets at very low prices that require big losses to be reported and cause further contractions in lending, 2) equity dilution, i.e., selling at prices that are at significant discounts to conservative estimates of the present values of their future cash flows, 3) attractive acquisition prices for strong synergistic companies to buy distressed ones, 4) credit problems being a negative for markets and the economy, and eventually 5) the Fed easing and bank regulators providing money, credit, and guarantees because the problem becomes system-threatening. At this turning point into the contraction, it is too early for the Fed to ease, but I will be watching closely what it does as the trade-offs become tough. Looking backward rather than ahead, tightening rather than easing seems appropriate. Looking ahead, it’s likely that it won’t be long before the problems pick up, which will eventually lead the Fed and bank regulators to act in a protective way. So I think we are approaching the turning point from the strong tightening phase into the contraction phase of the short-term credit/debt cycle.
Now that we’ve looked at the archetypical cycle and what will likely happen, let’s look beyond the immediate problem to what I believe will eventually be the much bigger longer-term problem.
How do these cycles go? When debts are in a country’s own currency, debt crises and the debt contagions that result from them can and will eventually be contained by central banks creating enough money and credit to fill in the funding gaps. For example, in this case, with the Fed guaranteeing all depositors against loss and indicating that it will go beyond that to protect others, not only did it come up with more credit, but it also signaled that it would probably act similarly in other cases.
That begs the question: at what cost is money and credit being created?
That brings us to the much bigger longer-term problem, which is that the US central government has large outstanding debts and is selling more debt than there is demand for, and central banks are monetizing the debt. Controlling the problems is financed by the central bank printing money and buying the debt. With debt assets and debt liabilities so large, it is very difficult to keep real interest rates high enough for the lender-creditors without making them too high for the borrower-debtors.
The really big problem will come when there is too much of this money printing to provide creditors with adequate real returns, which will lead them to start selling their debt assets, which will substantially worsen the supply/demand balance. With the enormous size of US debt assets and liabilities outstanding, plus lots more to come, there is a high risk that the supply of government debt will be much larger than the demand for it, which will cause too-high real interest rates for the markets and the economy, leading to debt and economic pain that will eventually lead the Federal Reserve to switch from raising interest rates and selling debt (QT) to lowering interest rates and buying debt (QE). This will lead real rates to fall, which will lead to a high risk that there will be more selling of debt assets because of the bad real returns that these debt assets are providing. While people are now not thinking about the next interest rate cut and QE of the Fed, we should because the timing of these is probably less than about a year away and that will have big effects. I think that there is a good chance that it will produce a big decline in the value of money. So, it looks likely to me that the financial/economic picture over the next year or two will be tough.
While in this Observations I have been focusing on the money/credit/debt/market/economic dynamic, let’s remember that it is being accompanied by the internal conflict dynamic (most importantly the 2024 US elections that are coming up) and the external conflict dynamic (most importantly the US-China conflict and the US-NATO-Russia conflict, though others like that with Iran are notable). All of these conflicts affect each other. This setup implies to me that there is a significant risk that there will be 1) bad financial and economic conditions at a time of 2) bad internal conflict and 3) bad international conflicts—with the world being leveraged long. In a nutshell, it looks to me like the next two years will be a very risky time.
Please understand that I’m not sure of anything. That’s why I believe that the key to good investing lies in achieving balance of uncorrelated good return streams so that one’s portfolio has little or no bias to go up and down as conditions get better and worse. As I have stated repeatedly, this risk reduction can be done without reducing expected returns. So that’s what I think and what I recommend doing.
Bridgewater Daily Observations is prepared by and is the property of Bridgewater Associates, LP and is circulated for informational and educational purposes only. There is no consideration given to the specific investment needs, objectives, or tolerances of any of the recipients. Additionally, Bridgewater's actual investment positions may, and often will, vary from its conclusions discussed herein based on any number of factors, such as client investment restrictions, portfolio rebalancing and transactions costs, among others. Recipients should consult their own advisors, including tax advisors, before making any investment decision. This material is for informational and educational purposes only and is not an offer to sell or the solicitation of an offer to buy the securities or other instruments mentioned. Any such offering will be made pursuant to a definitive offering memorandum. This material does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors which are necessary considerations before making any investment decision. Investors should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, where appropriate, seek professional advice, including legal, tax, accounting, investment, or other advice.
The information provided herein is not intended to provide a sufficient basis on which to make an investment decision and investment decisions should not be based on simulated, hypothetical, or illustrative information that have inherent limitations. Unlike an actual performance record simulated or hypothetical results do not represent actual trading or the actual costs of management and may have under or over compensated for the impact of certain market risk factors. Bridgewater makes no representation that any account will or is likely to achieve returns similar to those shown. The price and value of the investments referred to in this research and the income therefrom may fluctuate. Every investment involves risk and in volatile or uncertain market conditions, significant variations in the value or return on that investment may occur. Investments in hedge funds are complex, speculative and carry a high degree of risk, including the risk of a complete loss of an investor’s entire investment. Past performance is not a guide to future performance, future returns are not guaranteed, and a complete loss of original capital may occur. Certain transactions, including those involving leverage, futures, options, and other derivatives, give rise to substantial risk and are not suitable for all investors. Fluctuations in exchange rates could have material adverse effects on the value or price of, or income derived from, certain investments.
Bridgewater research utilizes data and information from public, private, and internal sources, including data from actual Bridgewater trades. Sources include BCA, Bloomberg Finance L.P., Bond Radar, Candeal, Calderwood, CBRE, Inc., CEIC Data Company Ltd., Clarus Financial Technology, Conference Board of Canada, Consensus Economics Inc., Corelogic, Inc., Cornerstone Macro, Dealogic, DTCC Data Repository, Ecoanalitica, Empirical Research Partners, Entis (Axioma Qontigo), EPFR Global, ESG Book, Eurasia Group, Evercore ISI, FactSet Research Systems, The Financial Times Limited, FINRA, GaveKal Research Ltd., Global Financial Data, Inc., Harvard Business Review, Haver Analytics, Inc., Institutional Shareholder Services (ISS), The Investment Funds Institute of Canada, ICE Data, ICE Derived Data (UK), Investment Company Institute, International Institute of Finance, JP Morgan, JSTA Advisors, MarketAxess, Medley Global Advisors, Metals Focus Ltd, Moody’s ESG Solutions, MSCI, Inc., National Bureau of Economic Research, Organisation for Economic Cooperation and Development, Pensions & Investments Research Center, Refinitiv, Rhodium Group, RP Data, Rubinson Research, Rystad Energy, S&P Global Market Intelligence, Sentix Gmbh, Shanghai Wind Information, Sustainalytics, Swaps Monitor, Totem Macro, Tradeweb, United Nations, US Department of Commerce, Verisk Maplecroft, Visible Alpha, Wells Bay, Wind Financial Information LLC, Wood Mackenzie Limited, World Bureau of Metal Statistics, World Economic Forum, YieldBook. While we consider information from external sources to be reliable, we do not assume responsibility for its accuracy.
This information is not directed at or intended for distribution to or use by any person or entity located in any jurisdiction where such distribution, publication, availability, or use would be contrary to applicable law or regulation, or which would subject Bridgewater to any registration or licensing requirements within such jurisdiction. No part of this material may be (i) copied, photocopied, or duplicated in any form by any means or (ii) redistributed without the prior written consent of Bridgewater® Associates, LP.
The views expressed herein are solely those of Bridgewater as of the date of this report and are subject to change without notice. Bridgewater may have a significant financial interest in one or more of the positions and/or securities or derivatives discussed. Those responsible for preparing this report receive compensation based upon various factors, including, among other things, the quality of their work and firm revenues.
By Sydnee Gatewood
March
