The Tide Is Going Out

Guest post by Ted Lamade, Managing Director at The Carnegie Institution for Science

Like many Americans, when I was a child, my family used to take a week-long vacation in July or August. Unlike many families, we weren’t the “beach-going type”. We joke that it was because my younger brother hated the feeling of hot sand on his feet, but it was largely due to my parents wanting us to experience something different each summer. This said, three decades later, the trip that ironically gets remembered and talked about the most was the one that had the most things “go wrong”. It isn’t even close.

In 1992, my family decided it would be fun to visit Nova Scotia. Since my brother and I had not been out of the country, my parents thought it would be a good opportunity to head north of the border. As a result, we piled into our car in early August and hit I-95 north. What followed was a trip filled with record setting heat, a massive backup on the George Washington Bridge, several missed exits, a work emergency that forced my father to fly back half way up the east coast, and a hotel that didn’t have air conditioning due to the fact that this part of Canada rarely saw temperatures above the low 80s, just to name a few of the “hiccups” we encountered. However, these all paled in comparison to us almost getting trapped on an island in the middle of the Bay of Fundy.

While you have likely never heard of it, the Bay of Fundy has the largest tidal range in the world with a range of 16 meters versus an average range worldwide of 3.3 meters. In a single 12-hour tidal cycle, about 100 billion tons of water flow in and out of the bay, which is twice as much as the combined total flow of all the rivers of the world over the same period. As a result, at low tide you can even drive your car across its bottom to various islands. The key, however, is that you have to carefully watch the clock because if you don’t get back in time, you will be stuck on the island for the night.

You can see where this is going.

After my father rejoined us in Nova Scotia, he was determined to drive across the Bay of Fundy, so we headed out to explore one of the islands the next day. Despite my initial skepticism, it was actually a pretty cool experience. We saw some people walking across, while others were just hanging out in it. To our surprise, we were the only cars crossing when we did, but there were plenty of cars in the parking lot once we got to the island. I didn’t think anything of it at the time, but this would make a lot more sense in a few short hours.

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After parking, we started to explore. There wasn’t a ton to see near the parking lot, so we ended up straying a bit further from the car than we had planned. Eventually, my father said it was time to head back knowing that the tide was going to come back in soon. The trouble was that there weren’t any cars left in the lot when we got back. They had all crossed back over. He hadn’t realized that you needed to head back well in advance of the tide coming in. You couldn’t just sneak back across right before the water did. Thankfully though, we made it back to our car just in time and crossed back over the Bay of Fundy.

So, why do I bring up the Bay of Fundy and our trip to Nova Scotia?

First, I have always found it interesting that the family vacation which involved the most problems is the one that comes up most often to this day. Most importantly, we do not talk about it in a negative light. In fact, when one of us mentions it, it largely elicits laughs and positive memories – how we adjusted to the heat, how we found the best bacon cheeseburger in Canada, how our drives on the golf course were much longer given it was so firm and burned out from the lack of rain, how my mom traversed the Maine National Forest at night by herself, and of course, how we almost got stuck on an island in the middle of the Bay of Fundy. Makes you wonder, today as people endlessly “pursue perfect” — the perfect family vacation, the perfect athletic experience, the perfect house, the perfect life, are we missing the point? Instead of “searching for perfect”, should we instead be searching for unique experiences and embracing whatever this pursuit brings?

Second, it feels like the economy might be experiencing the early stages of a “Bay of Fundy” moment. Much like the tidal cycle in Nova Scotia, which sees the tide go in and out every 12-hours, the economy has been in a very advantageous tidal period for more than 12-years given how long interest rates hovered near historic lows. Yet, with the Fed having hiked rates more quickly than in any period since the early 1980’s, the economic tide is clearly shifting. So far, we have just seen the earliest signs.

The most obvious?

The yield curve is the most inverted it’s been in two decades, gasoline prices above $4 are squeezing consumers, leading economic indicators have been trending lower for 17 straight months, office occupancy is cratering as leases roll, instability in the banking sector is rising as balance sheets fall under water as a result of higher rates, credit is expensive at best and unavailable at worst, housing affordability is at an all-time low, and corporate bankruptcies are rising, just to name a few.

The less obvious?

In the wake of the financial crisis fifteen years ago, congress enacted legislation to strengthen and safeguard the financial system. More specifically, in order to prevent another crisis, regulators restricted banks’ ability to overextend themselves again through the Dodd-Frank bill. Unsurprisingly, this caused many banks to curb lending, focus on fewer business channels, and take less risk more broadly. As is typically the case, in trying to solve the past crisis, the government may have sown the seeds for the next one.

Regulation simply shifted the risks to a different part of the economy. In this case, when Dodd-Frank forced most banks to pull back on lending, plenty of people and/or funds stood ready to fill the gap. Unsurprisingly, this has largely come from the less regulated part of the market, namely in the form of the private markets. With rates at historic lows, these new lenders provided capital to nearly anyone who asked for it.

The good news?

It led to an increase in sources of capital and new business formation.

The bad news?

Capital inevitability funded many more businesses and opportunities than were needed, or warranted. It also led to the creation of countless funds, many of which are led by people who have never invested through a crisis. Looking ahead, this could be a problematic combination.

So where does this leave us?

If I had to guess, we are likely in a similar situation to the one my family found ourselves in when we started making our way back to our car in the middle of the Bay of Fundy. In this case though, while a few cars have already left the island (see any private equity firms that raised large funds, funds that made large asset sales in 2021-2022, or companies that obtained long-term cheap debt), many more haven’t.

So, what is in store for those “still on the island”? More specifically, businesses that have great concepts but are fundamentally unprofitable businesses, venture funds that deployed too much capital at high valuations, and lenders that thought rates were going to remain low forever? I suspect many will find themselves stranded without access to capital and other important resources; only instead of it being for one night, it will likely be for several years. Some will survive long enough to eventually get off the island, but many more will not.

While this will likely still take time to unfold in the private markets, it appears to already be well underway in the public markets with the average small-cap stock in the Russell 2000 down more than 33% from its 52-week high.

In the meantime, for those who managed to get off the island in time or passed on visiting the island altogether (i.e., those who took less risk, did not get overextended, and/or have plenty of cash on hand), it might make sense to spend time trying to make a distinction between those that will eventually get off and those that will not, because when those that get off do, they will likely be available for very attractive prices.