By J. Keith Buchanan, CFA, Portfolio Manager
Increasing money supply seems to have a way of making new investment ideas and inventions appear worthy of lofty valuations and waves of capital. However, the risk is not appreciated until excess liquidity begins to recede and the most egregious assets or asset classes appear so. Warren Buffett has intimated the concept many times in newsletters to shareholders that only when the tide goes out do you see who is swimming naked.
We subscribe to this logic. As central banks open the money spigot to speed the healing of scars from the previous economic cycle, the new money supply flows into each nook and cranny of the economy just like any Newtonian fluid would. This marginal liquidity initially finds its way to sectors, assets, and ideas which, we believe, attract that capital for good reason. Either those destinations are new promising concepts or proven, but undervalued ideas and assets, or some blend of the two. However, with nowhere left to go, liquidity spills into the less traditional and questionably valued edges of the market. For example, how do you value a picture of a rock sold as a non-fungible token (NFT)? These investments are less easily accepted, seedy, or just outright suspicious. Nevertheless, money will find a home.
At the same time, this increase in supply places downward pressure on the price of money, also referred to as interest rates. Interest rates have been on a secular downward trajectory for over a generation as money supply has increased with months and quarters of temporary moves higher.
However, there have been moments in which rates move marginally higher, pressuring the economy. That pressure has a way of testing the weaker hands of the bull market. The more obscure corners of the market feel the pressure of even a minor reduction of liquidity first and most dramatically. These are also moments when over-levered and even fraudulent investments become exposed.
The chart shows the US 10-year Treasury rate over time. Even though rates have generally moved lower since the early 1980s, cyclical shifts higher in rates have coincided with collapses in areas of the market which became highly valued or perhaps fraudulent. Temporarily higher rates occurred with the market crash of 1987, the savings and loan crisis in 1990, the Asian and Russian financial crises and the downfall of Long-Term Capital Management in the late 1990s, and the Great Financial Crisis of 2008.
We have maintained that the increase in rates over the past year would place strains on economic demand and something may break. The investing world heard cracking noises in the cryptocurrency world earlier in 2022, but the dramatic collapse of FTX last month is the latest in this string of complicatedly leveraged and/or potentially fraudulent entities that unravel when rates move higher.
Or, to put a twist on Buffet’s often quoted phrase, only when the liquidity tide goes out do you see who is swimming naked.
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