15 Mar 2023
Global Macro-economic and Geo-political Update
We thought it important to provide a brief comment on the global economic situation given the panic occurring in some quarters. We believe there are reasons to be concerned about the global economy as outlined in our last newsletter; however, we do not believe the current correction driven by Silicon Valley Bank (SVB) failure will be the catalyst, rather it’s the growing head winds of the levels of global debt through loose monetary and fiscal policies that may lead to a sovereign debt crisis within the OECD family.
Silicon Valley Bank – Liquidity Crisis
You may have read that SVB (based in California south of San Francisco), Silvergate Capital (based in San Diego) and Signature Bank (based in New York) have all failed. Silvergate failed because of its exposure and activities in the crypto-currency area so there is no need for further comment.
With respect to SVB and we understand also the Signature Bank, their failure is a result of lack of “viable” liquidity. In the US, all deposits up to USD250k are insured with the Federal Depository Insurance Corporation (FDIC), so no depositor will be out of pocket, although all shareholders have lost their money.
So what do we mean by “viable” security?
Under US banking laws all deposits must be invested by the bank in safe haven assets, e.g., US treasuries and bonds. They can’t be invested in equities. SVB were complying with US regulation, however the deposits were invested in US Government bonds with maturities in 1-10 years time. When a bond matures an investor receives the face value of the bond (principal amount); however, if the bonds must be sold before-hand the bank can have either a (unrealised capital gain/loss) which will be realised. As we have reported many times over the last 2 years yield curves are inverted, (i.e., short term rates are higher than long term rates), including US treasuries which means those bonds held by SVB were underwater (i.e., sitting on unrealised losses) and when depositors wanted their money SVB had to sell these bonds and realised significant losses causing the bank to fail. It’s a story of not understanding interest rate risk and bond markets. If the depositors funds had been invested in US treasury bills, not bonds, then SVB would be operating today.
Why did depositors want their money?
SVB is a well-known bank in Silicon Valley area that catered for the technology sector. As we have been reporting technology companies in the USA (many are based in Silicon Valley) have been laying off staff as sales have been falling and some businesses were unprofitable. Many of those organisations and employees banked with SVB, and SVB found it was overrun with depositors seeking their money to live off and when rumours over the viability of SVB spread “a run on the bank” started by panicked depositors. This made everything worse and a “trickle became a stampede” and the liquidity of the bank dried up, i.e., it did not have enough money to pay all the depositors. Signature Bank we understand suffered the same fate.
What has been the impact on debt markets?
Since the failure of SVB there has been a flight to very short term US treasury bills (up to 6 months) and similar instruments issued by other countries which the market considers as good collateral. This has pushed bond prices up and yields down increasing the steepness of the inverted yield curve, i.e., the market is saying there needs to be lower interest rates while the US Federal Reserve and RBA are increasing their cash rates to compact inflation.
What has been the reaction of equity markets?
Understandably equity markets have fallen as they are worried about a contagion as we saw in 2007/08. Given the unique positioning of SVB and actions taken by the US Federal Reserve we do not see this happening.
As we have written about a lot on a macro-economic level we are much more concerned about the next global financial crisis being a sovereign debt crisis because of the high levels of debt globally. As reported in our last newsletter (no 45) we outlined issues impacting the UK Gilt (Government Bond) market in October 2022 and that the Bank of England had to bail out the bond market and let the pound devalue. We believe that Japan is the likely starting point of a global sovereign debt crisis with its Debt to GDP ratio over 250%, negative yielding bonds for many years now, using yield curve control to suppress rates rising and the Bank of Japan never ending Quantitative Easing (QE) programs all of which are aimed at driving inflation up (Japan has been suffering from deflation for 30 years). The Bank of Japan effectively owns bond and equity markets as it is a buyer of these instruments. Japan as part of its stimulus program has run large budget deficits. Japan has an aging population and is a closed society so it has major challenges that may be insurmountable in the medium to long term. The Yen continues to fall against the USD and in the longer term will eventually collapse unless the above issues are not addressed swiftly. Last year the Yen fell for the first time to 245 against the USD.
Flight to Store Value
We continue to advocate that holding store value assets, e.g., property, precious metals, commodities, energy and equities with strong cashflows as the best solution for wealth protection and creation. We also see Australia doing relatively well because of the low level of debt to GDP ratio and the need to reduce the budget deficit.
If you wish to discuss any of the above, please feel free to contact us.