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Economic Cycles: A Quantum Shift is Coming

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Quantum shift (idiom): a complete transformation, a radical change of direction in thoughts, goals . . . (Dictionary)

In the history of the global economy, there have been 2-3 major instances of quantum shifts(from bubbles to crashes) which have resulted in hard economic realignment and fundamental changes in investment philosophy for the next few decades.

It seems we are in the midst of one such shift in the global economy and markets. All sectors, from large corporations to startups are being impacted by this.

Let's take a brief look at the history of such shifts from the past.

History of quantum shifts in global markets

1930-1970

The period between 1929 and 1941 was the era of Great Depression which was the longest economic recession in modern history. Before the Great Depression, there was a free flow of money in the market and interest rates were very low. Due to surplus cash, there was an increase in speculative trading and companies became highly leveraged. The US federal reserve tried to control this by increasing interest rates, which caused a global market crash in 1929. This was followed by policies of monetary tightening that led to failure of many small banks, underconsumption of goods due to low availability of cash and an increase in unemployment resulting in widespread poverty and economic hardship.

This brought about the first quantum shift in investments too. Investors became risk-averse and avoided speculative investments. The top index stocks like today's so called ‘Nifty Fifty’ stocks were considered the best after the crash. Also, the  investors avoided non-investment grade bonds. Any double B and below became off limits to fiduciaries due to avoidance of risk. It went until the mid-1970s.

1970-2008

In the mid-1970s, a new generation of investment managers started to invest in high-yield bonds with enough interest rate to compensate for the risk of default, which led to a major change in investment strategy. This meant smaller firms could acquire larger ones by heavily leveraging their balance sheets.

Moreover, during 1973-74, OPEC's (Organization of the Petroleum Exporting Countries) oil production cut increased oil prices, leading to rapid inflationFinally, to control inflation, then Fed chairman Paul Volcker raised the fed rate to 20%, bringing down inflation to 3.2% by 1983 from 14%. The Federal Reserve's ability to curb inflation paved the way for the reduction of the fed funds rate to high single digits in the 1980s, which remained steady for the rest of the decade and eventually fell to mid-single digits in the 1990s.

Volcker's policies helped to establish a trend of declining interest rates that persisted for four decades, promoting economic expansion by lowering the cost of credit for consumers and enabling businesses to invest in capital assets and inventory at lower costs.

This was the second quantum shift.

2008-2022

The mid-2000s saw banks and financial institutions take on risky assets such as subprime mortgages  and CDSs(Credit Default Swaps), leading to a crisis of confidence in financial institutions and liquidity when people started defaulting on their mortgage payments. It turned into the Global Financial Crisis of 2008 (GFC) which resulted in:

  • Millions of jobs loss and an increase in unemployment rates
  • A sharp decline in stock markets and property values
  • Bankruptcies and bailouts of major financial institutions
  • Reduction in global trade and economic growth

Central banks around the world lowered their interest rates to pull the economy out of the Global Financial Crisis (GFC). Due to this crisis/recession, there was  a shift in investment strategy towards a more conservative and risk-averse approach. Fixed-income investments become popular due to their safety and fixed return. Then Fed's intervention in late 2008 resulted in record-low interest rates as the fed funds rate was cut to zero, providing free liquidity. This move bolstered market strength and prompted investors to return to risk-taking earlier than anticipated, fueling the prevalent emotion of FOMO. As a result, buyers were eager to enter the market while holders were not incentivised to sell. Relaxed monetary policies of this phase ensured a bull run in the markets from 2009 till the pandemic's bear run.

This was the third quantum shift.

So what is happening now, post-pandemic ?

Inflation is rising globally - The current inflationary pressures are being driven by a combination of supply chain disruptions, increased demand, fiscal and monetary policy, rising energy prices(Ukraine war) and labor market challenges. Governments and central banks are grappling with the challenge of managing inflation.

The interest rates are rising globally too - The central banks across the world are busy controlling inflation using one tool: increasing interest rates. Recently, The Reserve Bank of India raised its key repo rate by the expected 25 bps to 6.5% during its February 2023 meeting. Similarly, the US Fed raised the fed interest rate by 0.25% points. Hence, becoming a big hindrance for businesses looking for raising funds, with startups being the most impacted.

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What does this mean ?

  • A recession in the next 12-18 months appears to be a foregone conclusion among many economists and investors .The famous Yield based indicators are pointing towards recession for some time now
  • Even if high rates may mean slowing inflation, today at 6.5% its still far from federal reserves target of 2%. Along with strong growth this may mean that rates can remain higher for longer rather than short interest peak and troughs
  • The base interest rate over the next several years is more likely to average 2-4% in the US
  • The Indian startup ecosystem is already  facing a funding winter, with VC investment dropping by almost 50% in CY2022
  • What worked during the 2008 crisis may not work now. The 2008 crisis was induced because of the fall of financial systems whereas the current scenario is triggered by the pandemic, disruption of the global supply chain, increased savings, and rising energy prices
  • It's crucial to acknowledge that the current and future economic landscape may differ significantly from the past 13 or even 40 years. As a result, investment strategies that proved effective during those periods may not be the most successful moving forward

That’s the QUANTUM SHIFT we are talking about.

Zerodha’s Nithin Kamath also shared his key takeaways on changing market cycle

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Parting wisdom for businesses and startups

  • The world of investments is undergoing a quantum shift, and everyone involved needs to adapt to the changing circumstances to survive and thrive. Act with discipline in balancing risk and growth regardless of market cycle
  • Shift focus towards generating revenue and profitability instead of relying on funding and user growth. When you readjust the plan communicate it with transparency and context
  • Be proactive and creative by taking an agile approach to identify and leverage opportunities, and explore alternative funding sources. Never be at the whims of market
  • If the business model allows, try to shift focus toward product-led growth instead of sales-led to succeed. Use this period to build sustainability and endurance in your company

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Economic Cycles: A Quantum Shift is Coming

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  • January 23, 2024
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