Lending 101 - What Economic Data Tells Us
In The Most Important Thing, Howard Marks writes: "It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself."
He also notes: "It’s my strong view that, while they may not know what lies ahead, investors can enhance their likelihood of success if they base their actions on a sense for where the market stands in its cycle."
Economic data provides valuable insights into where we are in the market cycle, guiding lending decisions. For example, in a phase of economic growth, lender appetite is strong, and liquidity is ample—resulting in more attractive loan pricing and higher lending capacity. Conversely, during economic uncertainty or downturns, liquidity tightens, and lender appetite diminishes, leading to higher borrowing costs and challenges in securing desired loan amounts. These shifts can happen within months, making the finance world both dynamic and fascinating.
At its core, economic cycles impact two key factors that lenders care about:
Pricing of Debt
Economic data helps gauge central bank monetary policy—interest rate decisions and quantitative easing/tightening—key tools for maintaining economic stability. Central banks consider numerous indicators when making these decisions, including but not limited to:
In an economic expansion (e.g., low unemployment, strong GDP growth), central banks often raise interest rates to curb inflation. Conversely, during periods of slow growth and low consumption, they lower rates to stimulate economic activity.
The result is straightforward: higher interest rates and tighter liquidity increase borrowing costs, while lower rates ease them. For example, during the pandemic, mortgage rates were historically low due to government stimulus. However, as the Bank of Canada raised rates throughout 2022-2023, borrowing costs surged. Now, with expected rate reductions in late 2024, we see a direct correlation between monetary policy and economic activity—either stimulating or restraining market participation.
From a lender’s perspective, monetary policy directly affects the liquidity premium and cost of doing business.
Asset Valuation
Monetary policy also significantly impacts asset valuation. As tech lenders, we closely track valuation trends and transaction activities because technology evolves rapidly, and market conditions shift constantly. A valuation multiple that made sense last year may not be acceptable today.
The rising interest rate environment of 2022-2023 dampened tech company valuations. However, 2024 has been a recovery year for the Canadian tech sector, partly benefiting from anticipated rate cuts that reduce borrowing costs. From a lending perspective, asset valuation directly affects asset coverage ratios—higher valuations make assets more attractive, offering companies greater access to capital and reducing potential loss given default (LGD).
Final Thoughts
No one has a crystal ball—it’s impossible to predict credit cycles or monetary policy with absolute certainty. However, understanding economic data allows us to recognize early warning signs and make informed, strategic lending decisions.