Risk Ascent | Exploring the Edges of Risk

The years 2022-2023 marked a huge shift for the US economy. The long era of cheap money came to a sudden end as the U.S. central bank rapidly raised interest rates to fight soaring inflation. This was not just a typical downturn; it was a major stress test for the entire financial system. The change sent waves through the stock and bond markets, exposed critical weaknesses in the banking industry, and clearly separated the strong, quality companies from the speculative, high-hype ones.

This article breaks down the key events of that turbulent time, based on my personal observations:

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1. The Conductor (Central Bank): Interest Rates and Market Cycles:

There is a powerful inverse relationship between the direction of central bank policy and asset prices. The 2022-2023 cycle was a masterclass in this dynamic.

• Why Assets Repriced: Equities fell as higher interest rates increased the discount rate used to value future earnings, making them worth less today. Bonds sold off as investors exchanged older, low-coupon bonds for newly issued debt offering much higher yields. This price decline is what causes bond yields to rise.
• The Yield Curve’s Message: Central banks control short-term rates through fixing feds funds rate, while the market prices long-term rates based on future growth and inflation expectations. The resulting yield curve provides critical signals. The inversion seen in this period where short-term rates exceeded long-term rates is a historically reliable indicator of recessionary fears, signaling that investors expect the central bank to eventually cut rates to support a slowing economy and weaker labor market as inflation falls.
• The Forward-Looking Market: Markets do not wait for news; they anticipate it. The decline in stocks and bonds began months before the first-rate hike. The recovery also began early, rallying 6–8 months before the consensus believed the hiking cycle would end.

2. The Great Divide: Technology Sector Dynamics:

The downturn did not impact all companies equally, creating a clear split in the technology sector.

• The Hype Bubble Bursts: Profitless, high-multiple companies, whose valuations were based on distant future earnings, were decimated. They experienced 70–80% drawdowns as higher discount rates made their business models untenable.
• Quality Bends, But Doesn’t Break: High-quality, cash-rich leaders (like the “Magnificent 7”) also saw significant declines of 40–50%. However, their strong balance sheets and market positions allowed them to weather the storm and rebound first and fastest.
• The Generative AI Catalyst: The rebound for these high-quality technology companies was dramatically accelerated by the emergence of the Generative AI Supercycle. This was not just a minor tailwind; it acted as a powerful new catalyst, fundamentally rewriting their growth narratives and attracting a massive wave of new investment.
• Key Lesson: Volatility is an opportunity for the prepared mind. Using a disciplined dollar-cost averaging strategy during these drawdowns to build positions in high-quality companies is a powerful wealth-building tool.

3. The Pressure Test: Banking Sector Vulnerabilities

The rapid rise in interest rates exposed significant, and in some cases fatal, vulnerabilities in the banking sector, particularly among regional players.

• Unrealized Bond Losses: Banks holding long-duration bonds purchased in a low-rate environment (to maximize returns) faced massive paper losses (when rates rise, these bonds lose value – see point one above). This created a severe Asset-Liability Management (ALM) mismatch. The failure of Silicon Valley Bank, Signature, and First Republic occurred when deposit runs forced them to sell these bonds and realize crippling losses.
• Deposit Flight: With risk-free Treasury bills and money market funds offering attractive yields, customers pulled cash from low-yield savings and checking accounts. This disproportionately harmed smaller banks with concentrated client bases.
• Margin Compression: The cost to retain and attract deposits soared, squeezing bank profitability, even as they earned more on new loans. Large, diversified banks with vast retail deposit networks had a significant competitive advantage.

4. The Investor’s Playbook: Valuation and Selection Rules

The cycle reinforced several timeless principles of disciplined investing.

• IPO Caution: IPOs are often priced for perfection during bull markets. It is usually wiser to wait for the post-launch correction before considering an investment.
• Focus on Fundamentals: Prioritize businesses that generate high free cash flow and reinvest it at a high Return on Capital Employed (ROCE). For example, Costco uses its low-margin model to drive rapid inventory turnover, generating a high ROCE from its efficient use of capital and membership fee income. This efficiency is why it commands a premium valuation over its retail peers. This model reinforces that high-return reinvestment is key; excessive dividends can signal a lack of growth opportunities, while buybacks often offer a more tax-efficient return of capital.
• Contrarian Opportunities: Look for value in undercapitalized sectors with strong secular demand, such as industrial commodities (copper, uranium), hard infrastructure (LNG terminals, water, etc.), When panic strikes, high-quality companies get sold off with the bad (“the baby is thrown out with the bathwater”). These are prime moments to acquire quality assets at distressed prices. The 2023 regional banking crisis was a fitting example. The sector-wide fear created an opportunity to acquire fundamentally strong banks those with large, diversified deposit bases and high-margin businesses like broking at distressed prices. Resist the temptation to chase sectors at peak valuations after a massive run-up. We saw this play out with pharmaceutical stocks during the COVID pandemic and again with oil and gas stocks in 2022. While these can be profitable short-term momentum trades, they rarely make for sound long-term investments once the narrative has gone mainstream.

5. The Macro Backdrop: Inflation and Global Forces

• Pricing Power is King: Contrary to common belief, inflation does not uniformly hurt equities. The most resilient stocks belong to companies with significant pricing power – the ability to raise prices without losing customers. This allows them to protect their margins and grow nominal earnings, effectively acting as an inflationary hedge for investors.
• Labor Market Resilience: A strong labor market can significantly delay or even prevent a deep recession, even in the face of aggressive rate hikes, as consumer spending remains supported.
• Geopolitics vs. Economics: Geopolitical events (e.g., Regional Wars) tend to cause short-term market shocks. Their impact fades unless they lead to a sustained disruption of global energy or supply chains.
• The U.S. Oil Factor: The emergence of the U.S. as a major oil producer has acted as a crucial stabilizing force, capping price spikes from OPEC+ cuts and providing a tailwind for the global economy.
• The Strong Dollar Magnet: The Fed’s aggressive rate hikes created a powerful interest rate differential between the U.S. and other major economies. This attracted a massive inflow of global capital from investors seeking higher, safer yields in U.S. Treasury bonds. This flood of demand to buy dollars not only caused the currency to surge impacting foreign economies and U.S. corporate earnings but also created a steady, stabilizing source of demand for U.S. assets during a period of high volatility.

6. The Hidden Engine: Liquidity, Policy, and Psychology

• Liquidity Drives Everything: Central bank liquidity operations are a primary driver of asset prices. Quantitative Easing (QE) – central banks buy assets, increase money supply, boost inflation, and fuels rallies to lift asset prices, while Quantitative Tightening (QT) – central banks sell or let assets mature, reduce liquidity, and tighten access to capital – acts as a headwind and lowers asset prices.
• Fiscal Policy as a Catalyst: Government spending, like the U.S. Inflation Reduction Act (IRA) and CHIPS Acts, can create powerful, targeted tailwinds for specific industries. The contrast between massive U.S. pandemic stimulus (which fueled inflation) and more restrained approach by certain countries (e.g., India) is a key reason for their divergent inflation and interest rate paths.
• Market Psychology and Seasonality: Markets are prone to short-term irrationality but are generally efficient over the long run perfectly illustrating Benjamin Graham’s analogy of a “voting machine vs. a weighing machine.” In the short term, the market acts as a voting machine, driven by sentiment and popularity, which can lead even sophisticated investors to panic-sell to protect immediate performance. This dynamic also creates predictable seasonal flows, like tax-loss selling in October and December. However, savvy investors understand that eventually the weighing machine takes over, where fundamentals dictate value. They can therefore anticipate these short-term, non-fundamental “votes” to acquire quality assets at prices below their true long-term “weight.”

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Conclusion:

Nearly every historical model predicted that raising interest rates that far, that fast, would trigger a significant recession and a spike in unemployment. Yet, the labor market remained historically tight, and consumer spending, while strained, did not collapse. This resilience was the bedrock that allowed the “soft landing” narrative to take hold, prevented a deeper market crisis, and provided the foundation for the subsequent market recovery. It was a powerful reminder that while liquidity and valuations drive markets in the short term, the real economy’s underlying strength is the ultimate anchor.

As Mark Twain’s wisdom suggests, the history of the 2022-2023 cycle is destined to rhyme in the future. The next market storm will undoubtedly have its own unique catalyst, but the core challenges will look familiar: a shift in liquidity, a test of corporate fundamentals, and a battle against investor psychology. Understanding the lessons from this recent stress test provides a durable framework for navigating that future uncertainty. It reinforces that the best preparation is a steadfast focus on quality and a rational mind that can see opportunity when others only see panic. What was your single biggest takeaway from that period?