I consult, write, and speak on running better technology businesses (tech firms and IT captives) and the things that make it possible: good governance behaviors (activist investing in IT), what matters most (results, not effort), how we organize (restructure from the technologically abstract to the business concrete), how we execute and manage (replacing industrial with professional), how we plan (debunking the myth of control), and how we pay the bills (capital-intensive financing and budgeting in an agile world). I am increasingly interested in robustness over optimization.

Tuesday, May 31, 2022

The Credit Cycle Strikes Back

A few months ago, I wrote that the capital cycle has become less important than the tech cycle. I’d first come across this argument in a WSJ article in 2014, and, having lived through too many credit cycles, it took me some time to warm up to it. The COVID-19 pandemic laid this out pretty bare: all the cheap capital in the world provided by the Fed would have done nothing if there wasn’t a means of conducting trade. Long before the pandemic, tech had already made it possible to conduct trade.

Capital has flexed its muscles in recent months, and the results aren’t pretty. The Fed has raised interest rates and made clear its intention to continue to increase them to rein in inflation. The results are what you’d expect: risk capital has retreated and asset values have fallen. Tech, in particular, has taken a beating. Rising inflation was limiting household spending on things like streaming services, abruptly ending their growth stories. Tech-fueled assets like crypto have cratered. Many tech firms are being advised to do an immediate volte-face from “spend in pursuit of growth” to “conserve cash.”

But this doesn’t necessarily mean the credit cycle has re-established superiority over the tech cycle.

Capital is still cheap by historical standards. In real terms, interest rates are still negative for 5 and 10 year horizons. Rates are less negative than they were a year ago, but they’re still negative. Compare that to the relatively robust period of 2005, when real interest rate curves were positive. Less cheap isn’t the same as expensive. Plus, it’s worth pointing out that corporate balance sheets remain flush with cash.

Any credit contraction puts the most fringe (== high risk) of investments at greater risk, e.g., a business that subsidizes every consumption of its product or service is by definition operationally cash flow negative. Cheap capital made it economically viable for a company to try to create or buy a market until such time as they could find new sources of subsidy (i.e., advertisers) or exercise pricing power (start charging for use). If that moment didn’t arrive before credit tightening began, well, time’s up. Same thing applies to asset classes like crypto: when credit tightens, it’s risk off as investors seek safer havens.

The risk to the tech cycle is, how far will the Fed push up interest rates to combat inflation?

Supply chains are still constrained and labor markets are still tight. Demand is outstripping supply, and that’s driving up the prices of what is available. Raising rates is a tool for reducing demand, specifically reducing credit-based purchases. Higher interest rates won’t put more products on the shelves or more candidates in the labor pool. If demand doesn’t abate - mind you, this is still an economy coming out of its pandemic-level limitations - inflationary pressures will continue, and the Fed has made clear they’ll keep increasing rates until inflation cools off. With other shocks lurking - a war in Europe, the threat of food shortages, the threat of rolling electricity blackouts - inflation could remain at elevated levels while capital becomes increasingly expensive. Of course, sustained elevated interest rates would have negative consequences for bond markets, real estate, durable goods, and so on. The higher the rates and the longer they last, the harder the economic landing.

That said, tech is the driver of labor productivity, product reach and distribution, and a key source of corporate innovation. The credit cycle would have to reach Greenspan-era interest rates before there would be a material impact on the tech cycle. And even then, it’s worth remembering that the personal computer revolution took root during a period of high interest rates. Labor productivity improvement was so great compared to the hardware and software costs, interest rates had no discernible effect.

The credit cycle is certainly making itself felt in a big way. But it’s more accurate to say for now that capital sneezed and tech caught a cold.