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Hey friends 👋 ,

Happy Monday and welcome to the eighth issue of Through the Noise!

What a crazy week of growth– 447 of you have joined the party since last week.

Today we're looking at the chaos that is ensuing in the markets.

We'll start with a big picture primer before we dive into the VC and startup climate next week.

It's time to strap in and enjoy.

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Where are we?

We’re in bear market territory. From all time highs in Q4 2021, the S&P 500 is down 18% and the NASDAQ is down 29% respectively.

Contributing factors include surging inflation, rising interest rates, the war in Ukraine, supply chain bottlenecks as well as the persistent effects of COVID-19. To get a stronger grasp of how we ended up here, it's important we take a step back.

Rewind the Tape

In March 2020, the Fed began injecting massive amounts of stimulus into the economy to avoid economic collapse. This involved:

• Paying $900B per quarter to households

• Cutting interest rates from 1.5% to 0%

• Doubling the balance sheet to nearly $9T

As a result, there was a complete dislocation of asset prices– the Fed had distorted capital markets.

Supply/Demand Shocks

The Fed’s massive stimulus package, cheap money from low interest rates combined with a super fast recovery in economic activity led to a positive demand shock for goods. Toilet paper, hand sanitiser, baby formula, wheat, diapers and wipes, you name it! Services on the other hand lagged from the requirement for in-person business, constrained by lockdowns and work-from-home mandates.

On the other side of the table, global supply chains were constrained. Lockdowns in China now coupled with Russia’s invasion of Ukraine have squeezed commodity markets from oil to wheat creating a negative supply shock.

Positive demand shock + negative supply shock = 🚀 prices

Over the past six months, the US Consumer Price Index (CPI) rose at an annualised pace of 8.9%, the highest it has been in 40 years. This is significantly higher than the Fed’s targeted 2.0% inflation rate. How do you overcome this problem? The primary lever is to raise interest rates.

When a country’s economy gets overheated with prices getting out of hand, the central bank can use a contractionary monetary policy by increasing interest rates. This hike increases the price of money and encourages saving to reduce spending. In turn, lending activities are reduced and business activity can fall.

For the first time in 10 years, the Fed has raised rates at both March and April meetings. In total, interest rates have risen by 0.75%. The market expects an additional 2.0% by the end of the year according to the fed fund futures prices. As a result the fed funds rate would rise to 3.0%– the highest level before the global financial crisis of 2008.

As seen in the image above, there is a dislocation between inflation rate and fed funds rate. The fed waited too long to react to rampant inflation, causing interest rate expectations to sky rocket, creating a collapse in asset prices.

Asset Repricing

The primary catalyst for the market sell off is a sharp increase in the market’s expectations for rising future interest rates. As a result, we’ve seen a serious repricing of asset valuations. Higher interest rates lead to higher borrowing costs which lead to higher discount rates, depressing valuations further. A discount rate is simply the interest rate used to find the present value of future cash flows. Startups command a higher discount rate as future cash flows are realised many years in the future; as a result they are more sensitive to discount rate changes.

Digging a little deeper, leverage has fallen off a cliff in the public markets. Now, to be clear, total stock market leverage is unknown as it takes many forms. Even investment banks and brokerage firms don’t know how much leverage is sloshing around, especially when it comes to individual clients. A prime example of this information asymmetry is the implosion of Archegos back in March 2021, wiping out billions of dollars of capital.

Margin is one type of leverage which involves borrowing capital from a broker to invest in a position that is greater than what you can afford on your own. For example if I’m investing $100 with 2x leverage, my total position will be $200. Think of it as a $100 loan from the broker. To have the ability to lever tf up, you need a margin account (separate from a cash account) and deposit a minimum– this is different from broker to broker.

Margin debt is just the tip of the iceberg when it comes to total stock market leverage. Margin debt has fallen from $936B to $773B (17%). But the unwinding has just begun.

Selloffs trigger more selloffs for investors who are highly leveraged on certain stocks. Here are the percentage changes of well known stocks from their high to May 13th 2022 (it’s a bloodbath):

• Carvana: -90%

• Vroom: -98%

• Rivian: -85%

• Snap: -70%

• Pinterest: -76%

• Netflix: -73%

• Wayfair: -84%

• Chewy: -78%

• Shopify: -77%

• Teladoc: -89%

• Lyft: -77%

• Zoom: -79%

• Palantir: -81%

• GameStop: -80%

• AMC: -84%

• Coinbase: -83%

• Zillow: -81%

• Redfin: -88%

• Compass: -75%

• Opendoor: -82%

• MicroStrategy: -85%

• Robinhood: -87%

• Moderna: -72%

• Beyond Meat: -87%

• Peloton: -90%

• DoorDash: -72%

This is analogous to the Dotcom bust– only bigger.

An investor with heavy concentrations in these stocks using margin would be forced to sell to pay down the margin debt they borrowed from their broker. The requirement to close positions / add $$$ to meet your maintenance collateral is called a margin call. When this happens at scale, you are chucking fuel on the fire, adding to the selling pressure.

This gives rise to an important relationship: stock prices and margin balances are linked. An increase in leverage is a leading indicator for an increase in stock prices. A collapse in leverage is a leading indicator for… well, a collapse in stock prices. Absolute dollar amounts don’t matter as much. The real catalyst is the steep percentage changes in margin debt. The Fed’s $4.7 trillion money-printing mania and repressed interest rates created the “vertical wall” of margin debt from March 2020 to October 2021. It’s now unwinding.

If inflation remains rampant, the Fed will be forced to increase interest rates therefore unable to support markets. When this happens, it only affects the demand side of the equation. The supply side will be heavily determined by the outcome of the war in Ukraine.

Perhaps the worst outcome would be stagflation. Let’s break this down:

This is when a recession is inflationary. Supply chains would worsen and commodity prices would rocket. Inflation would remain at 8%+. GDP would plummet and we’d be on the ropes. The complete supply/demand imbalance would result in a strong jab and a devastating right hook:

Discount rates and risk premiums increase sharply (present value of future growth is small) all while economic growth plummets– it wouldn’t be pretty!

Next week we'll explore the private markets and how things are shaping up in VC/startups.

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Through the Noise Podcast

Last week we recorded the eighth episode of the Through the Noise podcast.

Our guest was Felix Sim, Co-Founder and Project Lead of Salad Ventures. Salad is a blockchain and play-to-earn think tank that develops and backs projects that shape the future of work 3.0 ecosystem.

This was the first time diving into web3 on the pod:

• Why is play-to-earn gaming important?

• Where is the future of work heading?

• Games as a source of income vs source of entertainment?

Catch the episode on Spotify, Apple and Callin.

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That's all for today friends!

As always feel free to reply to this email or reach out @thealexbanks as I'd love to hear your feedback.

Thanks for reading and I'll catch you next Monday.

Alex