A Founder's Perspective: The "So What" of the Global Market Conditions

At school, I found macro economics theoretical, and less applicable to the real world. Yet this past quarter, all the theories I learnt seems so much more relevant.

Economics is a series of impossible trade-offs. Governments and central banks make choices that are "less destabilizing", but there are no clear-cut answers.

Some people claim that this time the world's recession will likely be worse than we have ever seen before. But what are the factors driving this hypothesis? Should we be worried?

Below is my attempt to distill the important points. I'm sharing this in the hope that it can help other Founders frame planning for their own startups.

Backdrop of the Current Global Debt Situation.

Global debt is at record levels ($305 trillion in Q1 of 2022). What is even more alarming however, is the percentage of global debt to GDP - which has ballooned to 350% of GDP. During the last Global Financial Crisis of 2008, this ratio was at 200%.

Meanwhile, countries' need for debt continues to grow. As the diagram below shows, the budget deficits of countries worsened significantly from 2019 to today in 2022.

Why is Leverage a Problem?

As Ray Dalio described (this video of him explaining economy is a must watch), debt creates bigger economic swings or cycles, because it amplifies spending during inflationary periods, and amplifies busts during deleveraging periods. When the debt bubble bursts, the economy goes through a painful process of eliminating credit in the system, and this results in a cascading effect that ultimately ends in a financial crisis.

Below is a graph depicting the peaks and troughs of debt-to-GDP percentages throughout history in the US. Note that depressions typically occur in periods when debt-to-GDP ratios fall sharply within short periods of time.

If we assume that history will likely repeat itself, typically debt bubble bursts are followed by 5-7 years of painful deleveraging periods, characterized by high unemployment and higher poverty. Deleveraging after the global financial crisis of 2008 occurred mainly in the financial sector, and lasted for ~5 years (as shown by graph below).

However, the problem is system-wide deleveraging never happened (as seen by the debt-to-GDP ratio in the US which in fact increased during this period). This build-up worries economists, especially because countries had to take on more debt during the pandemic.

The Current Economist Dilemma: Global Debt Crisis OR High Inflation.

To understand the dilemma that economists are currently facing, it's important to understand the relationship between interest rates, inflation, growth rates and their impact on debt-to-GDP ratios.

In summary:

• Increasing interest rates increases overall debt-to-GDP ratios because the increase in cost of debt compounds the overall value of debt
• Increasing inflation decreases overall debt-to-GDP ratios because it decreases the relative value of debt
• Increasing GDP growth rates decreases overall debt-to-GDP ratios because GDP represents a country's ability to service debt

My best attempt at drawing this out:

Given this relationship, the central bank's impossible choice is to either prevent a full-blown debt crisis or actively manage inflation to prevent stagflation. It is difficult (ie. borderline impossible based on history) to achieve both simultaneously.

Currently, the US government has chosen to control inflation, knowing full well the trade-off it has to make, which is to likely push the world into a debt crisis.

While ultimately reducing inflation is the lesser of two evils, the Fed is facing other unexpected factors: the Ukraine-Russia war causing oil price shocks, and post-pandemic commodity supply shocks, which make controlling cost pressures much more difficult.

As seen in the diagram above, in the 1970s, oil price shocks contributed to sharp increases in the producer price index (PPI), resulting in a period of high inflation. This eventually tipped the economy into a period of deleveraging.

Faced with the scary possibility of a stagflationary debt crisis, the Fed is increasing interest rates in an attempt to control inflation. However, what they are doing will likely have little impact, due to another economic phenomenon...

The Collapse of the Velocity of Money.

The Velocity of Money measures the ratio of nominal GDP to money, which is basically the frequency of transactions per unit of money. It measures how much GDP expands when money supply expands, which is its sensitivity to monetary policies. Case in point: the higher the velocity of money, the more effective monetary policies are, and vice versa.

Based on the diagram above, we can see that while the money supply (M2) has increased dramatically (due to significant money printing during the pandemic), the velocity of money has dropped to levels below the 1970s.

Some initially believed that the printing of money during the pandemic caused the recent inflationary pressures. However, if we look at the data, the picture is a little different. While money supply (M2) has increased overall, velocity of money has dropped. The drop in velocity of money almost perfectly offsets the increase of money supply.

Below is a better look at Velocity of Money versus the Supply of Money (M2), with gray shades of the graph demonstrating periods of US recession:

Because supply-side shocks are the main reason behind recent inflationary pressures, the Fed's monetary policies - typically designed to control money supply and demand - will be less effective in combatting inflation.

As a result, the Fed is in a huge quandary: its interest rate hikes could have very little impact on inflation, and yet simultaneously drive the world into a full-blown debt crisis.

Popping of the Debt Bubble will Likely Be Bad.

Central bankers can now only prepare for the worst. The world will likely face a debt crisis, sparked by a series of default events that will push investors towards risk-off assets. This will drive credit spreads upwards, and result in a liquidity crunch.

Similar to what happened in 2008, the world will be pushed into a period of deleveraging, as credit in the system gets wiped out within a short period of time. Usually it starts with one large-scale default event (ie. bear Stearns) that causes contagion, and culminates into a series of other defaults.

A global financial crisis typically resets debt-to-GDP ratios to more reasonable levels and is generally part of economic cycles. However, as global-scale deleveraging never truly happened in 2008, a lot of economists believe the current debt crisis will be much worse. We could be expecting a deleveraging cycle more similar to the post-WWII era or the 1970s.

The Inevitable Condition: Stagflation.

With inflation spiraling out of control, the world will likely go into a period of stagflation, which is the deadly combination of inflation, stagnant growth and high unemployment. The US looks like it's already there:

Meanwhile, in some developing countries like Indonesia, things are still relatively under control:

However, while this presently looks positive for developing countries like Indonesia, the "Impossible Trinity" makes it inevitable for developing countries to eventually succumb to the same economic pressures.

Which brings me to the next economic trade-off...

The Impossible Trinity.

According to this popular economic theory, it is impossible to have all three of the following at the same time: a fixed foreign exchange rate, free capital movement and an independent monetary policy.

Countries have to choose between 3 choices:

• Stable Exchange Rates & Free Flow of Capital, but no Monetary Policy Autonomy
• Monetary Policy Autonomy & Stable Exchange Rates, but No Free Flow of Capital
• Monetary Policy Autonomy & Free Flow of Capital, but Unstable Exchange Rates

Emerging markets typically choose stable exchange rates and free flow of capital, as most developing countries rely on foreign debt and direct investments. Based on the economic theory of uncovered interest rate parity, capital flows to higher yielding countries and hence most developing countries are not immune to the Fed's monetary policies.

So as the US increases interest rate over time, developing countries need to follow suit in order to stay competitive from a capital attractiveness standpoint.

A Snapshot of Indonesia: The Economic Trilemma in Action.

Let's use the example of Indonesia. With recent interest hikes in the US, Indonesia will need to increase Bank of Indonesia rates in order to:

1) Stabilize the currency to ensure ability to service foreign-denominated debt.

It is currently one of the largest external debtors amongst low-to-middle income countries, with external debt making up around 30-40% of its GDP.

While still a manageable proportion compared to other countries, any depreciation of Rupiah can make the debt more difficult to service, and hence needs to be managed well.

As the diagram below shows, Indonesia's foreign reserves are fast decreasing as a result of its attempt to stabilize the Rupiah, in the wake of the Feds increasing interest rates. This is a sign that Indonesia will need to continue increasing interest rates to stabilize its currency without depleting its foreign reserves.

2) Maintain foreign direct investment attractiveness and prevent "hot money" from flowing out and destabilizing the currency.

Foreign direct investments (FDI) tend to be a double edged sword for countries. On the one hand, it provides very much needed capital for development. On the other hand, over-reliance on foreign capital can destabilize the economy, especially if the capital is not reinvested. Lower real interest rates relative to the US will reduce the likelihood that FDI gets reinvested back into the local economy.

The likelihood that the Bank of Indonesia will need to increase rates in tandem with the Fed means that Indonesia could face recession. However, one point to note is that Indonesia's debt-to-GDP ratio is only 39%, compared to 125% in the US. So even if deleveraging will likely happen, the likelihood of a full-blown debt crisis is lower.

What does this all mean for Founders?

The current economic climate is dynamic and uncertain. The Fed's decisions will have an impact on the global economy, especially in poorer countries. Even now, the UN has already identified 54 countries at risk of default, representing 18% of the world population. Since 90% of emerging market debt is denominated in US dollars, the high interest rate environment could spark a series of defaults. The situation will be similar to the Asian Financial Crisis of 1997-98, but this time it will occur at a more global scale, as countries have become even more interconnected than in the past.

Given the current oil and commodity supply-side shocks that is beyond the control of any central banker, a global financial crisis is likely to happen. It's no longer a matter of IF, but a matter of WHEN.

Large-scale defaults will start in Europe, which will drive contagion throughout the world, causing an extreme global liquidity crunch. This could culminate into social unrest and political instability. All we can do as Founders is to prepare for the worst, and ensure our company will survive through any unexpected economic or political situations.

How long could the recession last? What should Founders plan for?

Generally recessions last for periods of 1-2 years, but it could take up to 3 years for liquidity and asset prices to return to its upward trends, and 5-7 years for valuations to reach back to its previous highs. Plan for at least 3-5 years of runway for present times or be very clear about your path to profitability. Becoming profitable is the only way you can control your own destiny.

The more important indicator to watch as Founders in my opinion, is not valuation metrics, but rather liquidity indicators. This is because as long as you raised at reasonable valuations, you shouldn't worry about valuations over the longer-term, especially because inflationary conditions typically bolster revenue growth.

Generally yield inversions are leading indicator of recessions (as shown below) as it represents investor appetite. This matters more to a startup, as it predicts availability of capital for longer-term investments, like startups. Inverted yield curves demonstrate fear in markets, and hence lower availability of long-term capital. Even if dry powder is available, LPs or investors will likely prefer shorter-term duration investments. During times of yield inversions, you do not want to be raising, unless you have no choice.

If we take a look at past liquidity measures (generally based on the gap between long-term and short-term treasury yields), the liquidity crunch during the last global financial crisis of 2008 lasted about 3 years, as demonstrated by the yield spreads of 3M and10YR Treasury Rates (ie. my red arrow drawing).

And this is in line with VC activity, as deal values in aggregate began to recover only after 2011, as shown below.