The economist Benjamin Graham once said: “In a speculative market, what counts is imagination and not analysts.”
As the world economy enters a new phase of uncertainty, financial leaders of great imagination, insight and savvy will need to play key roles in steering investors through the speculative thicket that has led to soaring inflation, shaky financial institutions and collapsing asset valuations.
Although the bulls have consistently triumphed on Wall Street over the past decade, many financial commentators have warned that we’ve been living in a speculative bubble. Taking their cue from cosmology, some analysts believe there are a multitude of bubbles, realms of irrationality where the normal rules of economics and psychology don’t seem to apply.
Analysts have also warned that creating speculative bubbles is the easy part; finding a way out is the real trick. Of course, without dramatic intervention from fiscal and monetary policymakers, and perhaps even a change in the mindset of the market, speculative bubbles will inevitably pop, erasing wealth and disrupting the overall financial system.
Investor Seth Klarman has noted, “At the root of all financial bubbles is a good idea carried to excess.”
The optimists who laid the foundation for the dramatic rise in the valuation of financial assets since the trough of the Great Financial Crisis certainly saw many good ideas at work in the economy, or believed that they did. Expanding access to home ownership, for instance, has always been a wonderful idea, from an altruistic perspective. Keeping interest rates at zero for an unprecedented length of time also seemed pretty smart. So-called free money padded profits, stimulated consumer spending and kept interest on government debt low, which seemed to make it safe to spend even more on worthy programs.
But now almost every economic observer, from the consumer at the supermarket to the heads of the largest banks, are keenly aware of the excesses that have become very real dangers to growth, standards of living and the financial system itself.
Knowing that, and knowing how important it will be for financial leaders of great imagination, insight and savvy to take the reins, the question becomes: Where do investors find such leaders? Are they already on the scene, and is anyone listening to what they have to say?
One Canadian leader to key an “eye” on is Arif Bhalwani who runs Third Eye Capital, Canada’s leading alternative capital provider to businesses undergoing change. Bhalwani’s quarterly market commentary is an eagerly anticipated, must-read for his firm’s investors seeking insights into private credit markets. We were fortunate to get a copy of Bhalwani’s most recent letter for Q4-2022.
Bhalwani writes: “2022 was the first time in 150 years that public equity and long-term bonds both fell more than 10%. The era of ultra-low interest rates is over.”
He sees the Canadian housing market as the first domino to the risk of a recession: “Increased leverage has proven to be an unsustainable financial accelerator causing asset price bubbles particularly in housing. … The Canadian housing market is undergoing a major adjustment process and with loose financial conditions and large net capital inflows no longer inflating home prices, there will be harmful spillover effects.”
Among these secondary effects will be the collapse of some alternative mortgage lenders. Bhalwani notes: “Historically, it has been difficult to increase prudential supervision in bubble episodes because inflated asset prices allow financial actors to argue that their balance sheets are strong. The ongoing correction in home prices will make tighter residential mortgage sector regulation inevitable.”
In March, the world got a glimpse of how one wobbly domino can create a panic that collapses a whole array. It happened with a run on the Silicon Valley Bank that spread to a few regional banks and across the ocean to Credit Suisse. Many analysts suggest the panic was started by something as minor as chatter on Twitter, a reality which tends to highlight the fragility of the system.
Is the destruction inherent in the bursting of speculative bubbles inevitable? Here, once again, the optimists and pessimists part company.
Optimists hope for a smooth landing that will preserve wealth and prove the integrity of the system. Pessimists expect the worst, but hope that this classic quote from John Stuart Mill has no relevance to the present situation: “As a rule, panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.”
