Here’s what I think is happening in our economy and keep in mind this isn’t investment advice so do your own homework. Inflation is obviously riding high and stocks are taking a dirt nap. The worst stocks are the ones that were overvalued the longest: cash-consuming, unprofitable tech stocks. It started in public markets but that dirt nap just came for venture capital and crypto and it is coming soon for private equity, private real estate, the housing market, and any other highly leveraged asset you can name.
As the movie says, there will be blood. I believe we are in for a long period of tough times that plays out in one of two ways. Option One is the Fed keeps hiking rates and selling bonds even as the economy goes into recession. Interest rates will spike and lots of tenuous businesses will go bust. Stocks and other assets will nosedive and unemployment will skyrocket but if the Fed hangs tough, within a year or so, the economy will recover.
Option 2 is for the Fed to stop tightening at the first sign that inflation is going down. That will send markets and inflation back up eventually and then the Fed will have to hike again but it’ll never hike enough to fully contain inflation. Interest rates will always be chasing inflation rates. The result won’t be a nosedive but a slow grinding sideways and down move until the Fed inflates our debt back to a normal percentage of GDP.
In either scenario there is no bounce back in six months but it’s hard for me to see the Fed having the stomach to weather a sharp downturn so my guess (and it’s just a guess) is that Option Two is what’s in store. People who tell you that they saw this before in 2000 or 2008 are betting on Option One. But I think this is going to be more like the 1940s aka financial repression1 where savings gets inflated away and assets deflate in grind sideways.
Venture Capital: I was recently told by a VC investor that these are the best times to invest. Multiples will come down and these vintages are the ones that will produce the new Googles, Facebooks, and Ubers. I don’t think so. Venture has only been around in this form since the mid 1990s. No one in venture has experience with a set of market conditions like this. VC can’t survive high inflation environments. As Marcellus Wallace famously said in Pulp Fiction, “I’m going to get medieval on their ass.” This economy is about to get 1940s on all of us and medieval on venture. My guess is it will be the hardest hit asset class. It has never survived anything like the 40s much less the 1970s so when they tell you this is the time. Call BS.
Private Equity. PE has spent a decade just trying to keep pace with the S&P 500. People love it because the men and women who sell it are good looking, played lacrosse in college, and have a last name for a first name. The other reason they love it is that there is no way to check how much it is worth every day. We are emotional and volatile creatures. When stock prices gyrate, we react.
PE smooths it all. But an asset class that is paying over 12 times EBITDA for acquisitions and then levering that EBITDA 6 times is like a Hello Kitty doll stuffed with a bomb2. Thatcher can’t save you now. There will be a long term deflation of this asset class. Good news is you won’t even know it! Unfortunately they’ve got enough money (estimated at over $3 trillion globally) for now but new raises are going to be tough and with rises debt costs that money won’t stretch as far. Eventually this money will drain out of the system but it’s going to take a while.
Commercial Real Estate. The picture here is more complicated. Some real estate like multi family should be able to raise rents with inflation but lots of real estate was underwritten at extremely low cap rates. Some of it has floating debt. How are you going to underwrite 4 cap deals with 5-6% or higher debt costs? Sam Zell (who we will hear more from later) knows more about real estate than most REIT managers have forgotten and he’s not buying. I also see a big problem for even multi family if we have a recession and people just can’t pay the higher rents. Again, this asset class will take years to deflate but it will depend more on how the asset was underwritten and specific market conditions. Good operates with low and fixed debt should be fine though.
Housing. Yuck. This one is going to be bad. I just see the market seizing up. There are lots of owners with low mortgage rates in existing homes. Why would they move? People will sit on what they have and only the desperate will sell. I don’t see any crash in prices. They will stay flat but lose to inflation for several years until they are cheap again relative to income.
Cash. Sucks. You are guaranteed a 5-8% lose every year. It’s fine if high inflation is stable. You could get some relief from high yield savings and Treasuries but if inflation is unstable as I believe it will be you are always in danger of taking a loss.
Crypto. Wow, wouldn’t touch this with a 10 foot poll for a long time.
Commodities. These will be great but really volatile. Every time there’s a rumor of peace in Ukraine or OPEC says, “lets’ pump.” You’ll get a downturn in price. In the end supply constraints will take years to unravel so the direction should be up but the gyrations are going to be stomach emptying.
Liquidity is Value. Ok, so I just crapped on everything. So what is an investor/business owner to do? If Option One happens, get ready to pounce. If you have low or long term cheap debt and lots of cash you can buy almost anything on sale. I thought this was going to happen in 2020 but the government backed up a dump truck full of cash and kept everything afloat. That won’t happen this time.
In Option Two I think you have to be more measured and really look at your cost of capital. You need to stalk rather than pounce. Assets will be slowly losing ground to inflation in this environment so you need to pick and choose. Eventually there will be value all around you but when we go from slow deflation in real value to growth is going to vary by industry and depends on thousands of variables we can’t know.
But if the Fed is hiking and then cutting rates multiple times, this provides an opportunity for business owners to take on debt during cuts (or frankly pauses in hiking) and buy assets during hikes. So as Sam Zell recently said on CNBC: liquidity is value3. People with lots of floating rate debt will blow up and over time fewer and fewer potential buyers will have the capital to compete for those assets.
I don’t usually do macro so let me give a very specific example of how this could play out in something we all deal with: housing. There will always be forced sellers. Some people have to move because of a job, a layoff, death, etc. Buyers will be facing down 6% mortgages with high down payments. As of now affordability is at its lowest point since the early 1980s. That just kills demand but what about that person who piled up cash or got a cheap fixed loan in their business before the downturn. That person can come in and scoop up a bargain. They don’t need the 6% mortgage. Their cost of capital was 2.5%. Liquidity is value. Just remember that value eventually needs to be used. Cash will take a guaranteed loss every year so be careful but not too careful.
That’s it for this week,
Alan
PS Remember I am not an economist or financial advisor. These are just my guesses.
https://en.wikipedia.org/wiki/Financial_repression
https://www.bain.com/insights/private-equity-market-in-2021-global-private-equity-report-2022/
https://www.cnbc.com/video/2022/04/06/more-than-ever-before-liquidity-will-be-relevant-going-forward-says-sam-zell-billionaire-real-estate-mogul.html