High Interest Rates Sometimes Lead To A Liquidity Squeeze

Everyone worries about the stock market, but what if it is a distraction?

The world financial market includes much more than equity investments.

The world stock market value at 2021 year-end was about $125 trillion. It is less now, but that really doesn’t matter. 125 trillion is a number too large to have meaning. Put another way, it is 125,000 billion. That’s about 550 of Elon Musk, or a thousand Bill Gates, and none of us can comprehend their net worth either.

But there’s more. The total value of all business equity in the world is unknown, probably unknowable, because small businesses dominate and don’t report their value. In Ontario, there are about 1,200 businesses that employ more than 1,000 people. That is 0.3% of all the businesses there are in Ontario. What’s the value of the others?

The global publicly traded bond market is about the same size as the global stock market, but the global credit market is much larger. The credit market includes those bonds plus other credit instruments like home mortgages, bank loans to businesses and people, credit cards, student loans, car leases, and other forms of financial obligation.

The problem

The credit markets are in turmoil because central banks have, together, decided to raise interest rates in the hope of controlling inflation. Interest rate policy is a massive scam. Waiting to raise them until the obvious problem appears, then cooling the economy by driving up the cost of acquiring assets. That hurts people and results in businesses shrinking or failing. Employees pay with their jobs. Even less demand then, and that’s the plan. They should have acted years ago.

The second problem is the US federal government owes $31 trillion and growing. Who will buy the new bonds needed to allow the growth, and will every current debt owner roll it over when it matures? Maybe we can find those lenders at some rate of interest, and maybe not. Strangely, as rates rise, lenders become more nervous. Intuitively they believe that at a higher rate, not everyone can repay. They lend less.

The need for more lenders and their reluctance to lend is a dangerous combination.

Liquidity is harmed.

People and businesses of all kinds rely on credit markets for liquidity. That’s the availability of cash to operate as they wish. Some of it is borrowed because their business cycle is not smooth. I had a toy manufacturer client who built for inventory 9 months a year and sold it during the pre-Christmas season. Borrowing from their bank against the inventory, together with the likelihood of selling it, smoothed the cash flow.

As interest rates increase, liquidity shrinks because lenders see less likelihood to liquidate inventories when expected. It only takes one bad Christmas season to destroy a small toy maker. Even for the ones who make it, the cost of the debt can wipe out profits and the ability to grow.

If liquidity tightens, other rules apply.

It doesn’t matter if you are profitable if you cannot get the cash you need to operate. Old statistics show that roughly half of all businesses that went out of business were profitable when they did so.

An example. I had a client with 11 employees who manufactured outdoor advertising signs. The normal sale was 20% down and finance the rest over a five-year lease. The company then sold the leases to a financial institution and so enjoyed easy cash flow. In 1974, in the first half of their year, they had a net income of $129,000 and planned to expand. That’s roughly $800,000 of today’s money. In the second half of the year, the credit market stalled, and their cash flow became very negative because they could not sell the leases.

They did not get to make a comeback in 1975. They merely disappeared as a business.

The bit to take away

Businesses can cope with higher interest rates; they just change their prices a little.

Businesses cannot cope with a liquidity squeeze. When you cannot meet payroll or pay rent, you are in trouble, no matter that you are profitable.

No one likes an unpredictable future and if the current credit market malaise creates a liquidity shortage, the stock market will fall. Worse yet, many smaller businesses will disappear entirely.

Be very aware of, and protect your own liquidity. Cash doesn’t pay you much, but it reduces the need for sleep medication.

Be very aware of the possibility of a liquidity squeeze in the economy and act as soon as it becomes even slightly visible.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software startup, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning and business matters. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Federal Business Development Bank.

Be in touch at 705-927-4770 or by email at don.shaughnessy@gmail.com.

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