Don’t swim naked with the seagulls

Legendary investor Warren Buffett famously observed “when the tide goes out, you see who is swimming naked.”

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Eric Cantona’s infamous scissor kick

As a pithy analysis of human nature it’s up there with Eric Cantona’s “when the seagulls follow the trawler, it's because they think sardines will be thrown into the sea."

”There is a good case against tech stocks. Rising rates depress the net present value of sometimes distant positive cash flows via higher risk-free discount rates.” – Lex, Financial Times

Well, the last few months have seen the supply of sardines dry up and the tide’s going out pretty rapidly.

Cantona, the mercurial French Manchester United star, was pointedly referring to the media flock who squawked around sporting celebrities hoping for a good gotcha. It could equally refer to the millions of investors who have piled into new wave financial assets like crypto or fintech hoping to be dished up a million or two or more.

Buffett’s line more specifically referred to those business models which were predicated on extraordinarily generous conditions, such as near free liquidity – as we have had now for more than a decade with money printing by central banks and zero interest rates.

Well, that tide of liquidity is what’s going out – inflation has arrived, quantitative easing is being withdrawn and interest rates are rising. And, geopolitically, environmentally, economically, the world is suddenly much more risk averse.

Case against tech stocks

As I wrote in my last column, those circumstances inevitably make more secure assets look cheaper and riskier ones more expensive.

The Financial Times’ (FT) eminent investment column Lex explained this succinctly when assessing the sell-off of tech stocks generally: “There is a good case against tech stocks. Rising rates depress the net present value of sometimes distant positive cash flows via higher risk-free discount rates.”

That is, investors buy an asset not just for its face value today but for the anticipated total return – including interest payments, dividends, capital growth – over a period of time. That anticipated cash flow is discounted to take into account how at risk that future stream of returns is.

Conversely, if lower risk assets like government bonds start paying a higher yield, they look relatively better value.

This tidal shift has been most evident in crypto assets, particularly poorly understood and high volatility cryptocurrencies which lack any underlying value or utility.

But it will play out across the financial universe. Anything impacted by a higher cost of capital and lower risk appetite will be hit – and that includes fintechs and newer lending models like buy now, pay later (BNPL).

Financial technology commentator Chris Skinner makes the point tech – and fintech – investors are prepared to forgive a lack of immediate returns if the future looks promising. But investors in TradFi – traditional finance – demand returns up front because the investment in growth has already been made and the future potential is much more restrained.

“The net:net of this is that fintech stocks are valued as tech stocks at the start but, if they stumble, they start being valued more like bank stocks,” he said and quoted DA Davidson analyst Chris Brendler: “These hybrid financial technology stocks trade like tech stocks, when they’re growing really fast and the financial side of their business doesn’t cause any problems but, if you start having higher losses or funding problems, that’s when they start to perform like financials.”

Shadow banking

That’s what we’ve been seeing this year with BNPL stocks cratering – in part because growth rates are slowing as economies slow, in part because credit losses are climbing, in part because regulators are looking more closely.

Meanwhile, the largely unregulated financial sector known as “shadow banking” also historically suffers when economies become more fragile and/or interest rates rise.

Writing in the FT, Rockefeller International Chair Ruchir Sharma noted as interest rates have risen in the past, driven by the world’s central bank, the US Federal Reserve, this has “always led to financial crises somewhere — including every major global crisis in recent decades.”

“Shadow banks include creditors of many kinds, from pension funds to private equity firms and other asset managers,” he explains. “Together they manage $US63 trillion in financial assets — up from $US30 trillion a decade ago. What started in the US has spread worldwide, and lately shadow banks have been growing fastest in parts of Europe and Asia.

“This realm beyond regulators is where the next crisis will arise.”

Sharma argues so-called private lending markets, rather than say the non-bank mortgage companies decimated in the last crisis, are the weakest link in the shadows because they have chased the most – largely lightly regulated – risk.

“After 2008, as regulators tightened the screws on public debt markets, many investors turned to these private channels, which have since quadrupled in size to nearly $US1.2 trillion”.

While the main front of a financial crisis constantly shifts, the conditions which signal a Code Black are always the same: a change in sentiment to risk, economic uncertainty, and less – and more expensive – funding (higher interest rates).

More than one would-be start-up would have flinched at this widely circulated cold bath from investment firm Andreessen Horowitz in a blog post “Navigating Down Markets”. In short, given this new market, the firm found a typical start-up would have to grow revenue more than five times to justify the valuation it raised in its previous funding round.

As CB Insights sardonically observed “going from $US20 million to $US133 million annual recurring revenue just to get back to and justify your last financing valuation doesn't sound like fun and is NO JOKE to accomplish”.

Again, context is important and just because we’re about to see the ranks of fintech and DeFi very heavily thinned out we will not see a return to the “golden years of banking” when both economic drivers and industry structures favoured traditional institutions.

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Consulting firm Oliver Wyman’s 2022 State of Financial Services report found while the top incumbent firms in the industry have increased their market value by 70 per cent over the past decade, delivering $US1.3 trillion in new value, a combination of large financial infrastructure, data and fintech firms have delivered 400 per cent value growth and nearly $US2.3 trillion of value.

“Essentially, more total value is being created outside the incumbent industry, from firms that purport to be in similar ecosystems with the incumbents,” the firm reported.

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Apples, oranges, bananas

It’s good to remember too when the tide goes out, not everyone has been swimming naked.

International Monetary Fund (IMF) Managing Director Kristalina Georgieva advised against dismissing cryptocurrency technology outright after the sudden collapse of some coins – like stablecoin TerraUSD (UST).

She reminded everyone there were many types of assets with varying levels of associated risk and, in particular, there were many different versions of cryptocurrencies and even stablecoins – notably the significant difference between stablecoins backed by cash and other assets and those that rely on algorithms to maintain their value, such as UST.

“I would beg you not to pull out of the importance of this world. It offers us all faster service, much lower costs, and more inclusion, but only if we separate apples from oranges and bananas,” she told the recent Woodstock for Capitalists (World Economic Forum) festival in Davos.

Financial innovation won’t disappear but those who make it through this cycle will either have a superior business case, deep enough pockets or substantial support from the much-derided TradFi universe. Including banks.

Andrew Cornell is Managing Editor of bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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