Every market cycle is both similar and different, characterised by a period of easy money and excessive speculation, followed by liquidations and collapses.
The QE of the past decade, combined with low interest rates, drove the excesses which are now unwinding.
As central banks have bought large proportions of the available ‘low risk’ assets, investors have been driven into progressively higher risk assets in the search for positive returns.
Stoked by unprecedented amounts of money creation in recent years, this has fuelled a huge bubble in many areas.
The lockdown disruption and aggressive fiscal policies finally caused inflation to shift from financial assets into the real economy.
Central banks, particularly in the US, are responding with rate rises and more importantly the ending of QE.
While they are not yet selling assets, they have stopped expanding their balance sheets, allowing existing assets to run off. This liquidity contraction is driving the current bear market.
As in every cycle, there will be some spectacular blow ups and some of the candidates are becoming evident.
Crypto and private equity
Asset classes that collapse are generally the ones which are subject to the most leverage as this leads to forced selling once the direction turns down.
Two obvious candidates are the crypto-sphere and the private equity arena. Originally billed as a non-government-controlled means of exchange, the antidote to QE if you like, crypto eventually became the opposite.
Its success has attracted the creation of large numbers of alternatives (to Bitcoin), including some ‘pegged’ to the US dollar, known as stable coins, which have become a key component of the whole crypto sphere.
Crypto now has also become largely an exchange-traded market with assets held in custody; this and the existence of stable coins has made crypto essentially ‘fiat’ (trust based).
If, as seems probable, several crypto exchanges and many stable coins turn out to be no more than Ponzi schemes, a huge amount of the wealth will evaporate overnight.
Just like when the housing market blew up in the US, this will have knock on effects not just on other asset classes but also the real economy. The apparent value in crypto has been leveraged to invest in other areas and the wealth effect from this bubble will have partly driven consumption.
Another area of obvious malinvestment, which is also now beginning to unravel, is the private equity and public growth stock arena where huge valuations have been placed on businesses with little revenue, let alone profit.
This is a feature of most recent market cycles but has been at least as extreme in the current one as the tech bubble in 2000.
The problem here is the age old one of funds marking their own homework – funds have been valuing their own private equity assets.
This becomes a problem when losses in the public equity portion of open-ended funds cause investors to want to get their money out leading to the necessity that the private holdings must be sold.
This is what happened on a small scale to Neil Woodford, but it is now happening on a wider scale in the US market. Again, the knock-on effect on the wider market is the same, driving down the prices of what can be sold as well as what should be sold.
‘Overexuberance’
There is a counterpoint to the malinvestment caused by the overexuberance of recent years. This is the underinvestment in the core building blocks of the real economy.
This includes areas such as energy, mining, and basic infrastructure, which explains why productivity growth has been so poor. These have been starved of capital as money crowded into the more fashionable arenas.
Indeed, ESG concerns often led to the active discouragement of the necessary investment. Demand for such products may fall if the economy falls into recession, although to a much lower degree than more discretionary items.
However, returns in these areas will likely remain high over the coming years, until supply catches up with demand.
We remain highly cautious at the present time, as financial conditions are evidently tightening, and leading indicators suggest economic conditions are worsening.
There appears to be no obvious sign that inflation is abating, hence central banks are set on the path of further aggressive tightening over the coming months.
While our preferred areas of energy, consumer staples and materials continue to do relatively well, we maintain a conservative overall equity position and a very defensive bond positioning.
David Jane is a multi-asset manager at Premier Miton Investors.