Tarek Sakr is a former investment banker and CEO of Kuwait’s largest classifieds company – 4Sale
Market participants are now watching the United States anxiously as the Federal Reserve has committed to a roadmap of raising interest rates after its more relaxed policy of the last two years. The debate about pitfalls of loose monetary policy, sparked by unprecedented monetary easing on a global scale during and since the 2008 Great Recession, has found its way from the pages of the business press into the public consciousness.
A fast-rising rate of inflation has woken everyone up.
Well, not quite everyone. The continued Middle East tech boom is riding a wave of digitisation catalysed by a pandemic that forced life and business online. Paradoxically, as inflation manifests itself in rising equity valuations, unsustainable business models are given flawed vindication rather than being deterred by the high-risk environment.
After more than forty years with a relatively tame rate of inflation, pandemic pressures on supply chains, labour shortages due to illness and restrictive policies, and trillions of dollars of fiscal and monetary stimulus in the world’s leading economies have hiked inflation in many countries.
For consumers, the perilous chain reaction of rising prices is a reasonably well understood phenomenon. Simply put, flexible prices of everyday goods climb faster than ‘sticky’ wages, and this strain on household budgets contributes to a general economic contraction which, depending on the sensibility of policy, might spiral into recession.
The stance of business vis-à-vis inflated prices is, however, more complicated. While the economy has suffered under pandemic conditions, an unexpected global trend has been the almost continuously strong run of stock markets around the world. Growth stocks, traditionally associated with technology companies, especially realised outsized returns during one of the worst global crises in modern history.
The main reason for the stock market’s unhampered charging ahead is an unprecedented flow of money into equities. While there are arguments about the sources of these inflows, and their respective shares in this development, ‘cheap’ money lent out under historically low interest rates in combination with gigantic pandemic stimulus packages is a top contender. What is more, the tendency predates the immediate pandemic situation, having been building up for about a decade.
High and increasing equity prices, being partly a function of stimulus, have the merit of encouraging economic activity. They are attractive to investors and entrepreneurs alike, contributing to a climate of economic risk-taking beneficial to growth. At least for a time.
While economic common sense might suggest inflationary movements at some point necessarily entail a deflationary countereffect, this does not always have to be the case. The whole principle of stimulating lending to consumers and businesses by easing access for banks to central bank money is justified by the idea of creating growth that outpaces collateral inflation.
To understand the downside to inflation in the equity market, a comparison with the problems of businesses which are part of funding frenzies, or speculative bubbles, is instructive.
Business profitability is key to generating wealth and adding value to the economic system. Profitable businesses put out goods with a value higher than the cost needed to produce them, or they go out of business. In a speculative bubble, this mechanism ceases to work – because profitability stands back behind growth.
Subsequently, when profitability is replaced by valuation as the litmus test of successful businesses, entrepreneurs have an incentive to embrace ultimately unsustainable but fast-growing business models. The almost certain prospect of a well-paid exit funded with abundant resources of (equally inflated) venture funds disbalances the risk-reward relationship.
While public and private markets have different fundamentals and drivers, the perils of the growth over profitability model can be manifested in some Mena startups too, especially if the default read across is to Silicon Valley valuations. The US is a unified market of 331 million people with a common language and a single currency – while Mena is a highly fragmented market of around twenty nations with many languages and multiple currencies – accounting for 400 million people. The best Mena startups, who are clearly profitable, will deserve Silicon Valley-style premium valuations. But there is a tail of regional startups who don’t.
Indeed, the risk for the booming technology sector, especially in the Middle East, is a direct consequence of these factors. Inflated equity valuations at the stock exchange are the macroeconomic expression of the same rigged scale of prices present in individual businesses valued at millions of dollars – but without any positive future cash flows to be expected any time soon.
We have reached a point where artificially high valuations in equity markets have become detrimental for sustainable economic activity. With consumer price inflation for the first time in years alerting politicians and central bankers to reverse their monetary and fiscal policy stances, all ingredients for a comprehensive meltdown are present.
Under such circumstances, the first businesses to go bust are cash-burning, non-profitable tech companies. Business leaders are well advised to brace for strong headwinds, and vet their business models.
Venture capitalists and investors should ask themselves whether their stakes in technology businesses are worth what an overheated market has made them believe – and what their strategy will be for the perhaps less euphoric, but also more healthy, economic environment after equity markets return to valuations borne out by market fundamentals.