Something is bound to break when the Federal Reserve is ratcheting up interest rates as quickly as it has been doing. Since early 2022, the US Federal Reserve has rapidly tightened monetary policy from a low of 0.25% to a smidgen below 5% today. By the end of this month, the Fed Fund rate could breach the psychologically-worrying five handle.
Interest-rate hikes at lightning speed is almost certain to send tremors through the financial system. One of the first to crack was the UK pension industry. It fissured when pension funds were forced to sell Gilts to cover margin calls. Some of us didn’t even realise that pension companies could do something as risky as that. But we learn.
The second has been the collapse of America’s 16th largest bank that primarily serviced start-ups in Silicon Valley. Its concentrated depositor base relied heavily on fresh funds being raised through IPOs, private equity, and venture capital investments. Meanwhile, these cash-hungry start-ups were munching through their deposits with untrammelled cash burn. After 2008, some of us thought that another banking crisis could never happen again. But we learn.
Whilst both the first and the second calamities have been contained in these highly febrile times of monetary tightening, more shocks to the financial system cannot be ruled out. Cash is, after all, the lifeblood of any financial system. And as much as we would like to think that we can somehow do away with cash, we simply can’t. What’s more, there could be less cash available as the US Fed continues with monetary tightening as $1 trillion is drained from the global economy this year.
For us, investors, the lesson is to focus on cash, cash generation, free cash flow and cash burn. Cash is king. Without cash, a company cannot do anything. But for those with healthy free cash flow, the impending economic downturn could be seen as an opportunity rather than a threat. We should have nothing to fear if we have invested in highly cash generative businesses. In fact, a market correction could be a chance to buy more of what we like at better prices.
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