The year is 2020. The month is March. You are at home, scrolling through social media, and you see headlines saying: “Coronavirus”.
The year is 2022. The month is February. You are at work, scrolling through social media, and you see headlines saying: “Russia invades Ukraine”
The year is 2023. The month is March. You are sitting in your car, contemplating life, scrolling through social media, and you see the headline, “SVB fails. Contagion?”
These events happened almost around the same time in their respective years: the first quarter. But did you know that the happenings of 2023 can be traced back to the happenings of 2020?
Let’s get to it.
(TL;DR: COVID caused a low-interest rate environment; Russia exacerbated inflation and central banks had to increase interest rates and this reduced asset prices; companies, particularly growth companies, suffered, and needed money to stay afloat; SVB held government bonds, and the reduction in bond prices made them owe more than they owned, causing their collapse.)
When the pandemic happened, lockdowns ensued. Economies slowed down. Energy prices fell. People lost jobs. People lost money. People lost people (RIP).
Because of the slowdown in economic activity, the central banks worried that a recession might ensue. To spur productivity and get some life back in their economies, central banks worldwide decreased interest rates.
Interest rates are returns. If you lend someone money, you charge them interest on that loan. So to spur economic activity, central banks reduced interest rates so that people and businesses can borrow and spend. When you save, the bank gives you interest on your deposits. When the interest rate is low, you figure, “What’s the point of saving?” So you go and spend. Spending helps the economy.
The government also issues stimulus checks so that you can survive. The economy has a lot of cash swimming in it.
When everyone is spending, inflation goes up. Why? Because you have a lot of people with cash chasing a limited amount of goods. Lockdowns come to an end; fuel prices are now rising since the demand for it is back up. Economies open up. Things are relatively good.
Stock markets are benefitting from all this productivity. Companies can borrow cheaply and use the money to grow and hire more people. Their stock prices are increasing. Yay! Growth companies in particular, which are companies that are focused on increasing their revenue, market share, and customer base at a faster rate than the overall market, are doing really well!
Growth companies tend to be in industries that are growing quickly, such as tech (eg, Facebook), healthcare (eg, UnitedHealth), or e-commerce (eg, Amazon). They thrive on innovation and have products or services that are in high demand.
You, who invested in the stock market for your child’s education or retirement, are happy because things are looking up.
What could go wrong? Hehe.
Russia invades Ukraine.
Russia is one of the largest producers and exporters of oil. Wheat, too. Ukraine is also one of the largest exporters of agricultural products.
Imagine this: all the chocolate in the world is produced by 5 producers, equally (20% each). Let’s also assume that these 5 producers can satisfy the 7 billion people demanding chocolate. So everything matches. If one supplier decides to take a holiday because their spouse tells them they never spend quality time with them anymore, and they stop producing chocolate, the supply is now reduced, but the demand remains the same.
The other producers are now strained because they have to fill the demand of the missing producer. The effect of this is that there is a high demand relative to the supply. The price goes up.
This is what happened. With sanctions on Russia, the price of oil went up. With Ukraine being invaded, the price of food went up.
Companies use fuel to transport goods to their stores so you can buy them. Since the price of oil went up, companies passed this cost to customers. They did this by increasing the prices of their goods.
You can guess what happens next: inflation starts rising rapidly. Remember that after COVID, inflation was already going up. This invasion exacerbated the rise in inflation.
Everything is now expensive. The global economy is overheating. People prefer cash now to other asset classes.
“Cash is king”.
To cool down the economy, central banks do the opposite of what they did in 2020: they start increasing interest rates.
Increasing interest rates makes borrowing expensive. It also entices people to save. This is meant to reduce inflation because it slows down spending in the economy.
Since inflation was like that ex that didn’t know when to stop, central banks were aggressive in their interest rate hikes to combat it. This only made things worse. A number of people who enjoyed the low-interest rate environment were now defaulting on their loans because servicing it got expensive. Stock prices were falling. Everything was a mess.
Growth companies that enjoyed a low-interest rate environment were particularly hit hard. You could say they are allergic to high-interest rate environments. Tech companies that hired a lot of people during the COVID era, started laying off people. Things were too expensive for them. Bond prices are plummeting because their prices are inversely related to interest rates (when interest rates go up, bond prices fall).
Oh. Also, Argentina won the World Cup.
Contagion through the failure of the banking industry? Yes? No?
SVB Collapses. Signature Bank falls. Credit Suisse follows suit.
Silicon Valley Bank (SVB) is a bank that housed the deposits of many Venture Capitalists and growth companies.
Banks hold monies for people. This money is a liability to the bank because they owe people that money. Banks turn these deposits into assets by lending them out. They also use these deposits to invest.
One of the investments that SVB was in was long-term government bonds. Remember that inverse relationship? Yeah. When bond prices fell, the value of SVB’s assets reduced significantly, making them insolvent. They had more debt than assets.
Since growth companies were failing and needed money to stay afloat, they went to SVB to access their deposits. With a lot of their customers doing this, SVB needed money quickly to cover these withdrawals. They tried to raise capital, and they failed. People panicked and rushed to get their money out (a bank run). SVB collapsed, but the government assured depositors that they would get their money back. Shareholders and some debt holders of SVB saw a wipeout in their investments.
Signature Bank also followed suit after SVB failed as people panicked. Credit Suisse is the latest bank to fall.
If the banking crisis indeed happens, it would be devastating for the global economy (remember 2008?).
- People will want to withdraw their money, crippling banks;
- Banks will stop giving credit, economic growth is stifled;
- Stock markets fall;
If interest rates continue to rise, companies will be affected, which may affect banks, and ultimately, everyone and everything else.
But, analysts and investors think these bank collapses won’t spread as there are measures put in place to avoid a financial contagion…
…well, we’ll see.
Contact your financial advisor today to learn how you can build your portfolio to be resilient through these tumultuous times.