Inflation forecasting for VCs & corporates

Let’s say you want to have a Whopper, but there’s a shortage of some of the ingredients, let’s say tomatoes. To increase your chance of getting a full burger without any missing tomatoes, you could try going to multiple Burger King restaurants. However, this is probably going to be a futile exercise if there’s a nationwide shortage. You would need a different strategy for this. You would need to visit Burger King restaurants in multiple countries (ok, that Whopper might end up being very expensive). The point is that different types of risks require a different way to mitigate them, and tracking them.


In finance, we have a similar issue with managing risk, that there are different buckets of risk. Finance itself isn’t homogenous, with different participants, with different time horizons. The recent failure of SVB has shone a light on the whole area of VC within finance, given that SVB customer base was heavily made up of VCs.


We can characterise the investing model of VCs as long vol in long dated instruments. This is somewhat different to what many traders do, who tend to employ strategies, which are basically short vol. A strategy for a VC is akin to buying lots of out-of-the-money calls. Most options will expire worthless, but if just a few expire in the money (eg. a company they invest in, becomes a unicorn), it will more than make up for all their investments which have expired out of the money many times over. Their portfolio is diversified, but only to some extent. If for example they purely invest in tech companies, they have sector risks.


More broadly they also have macro level risks. By attempting to diversify at a micro level, we don’t necessarily eliminate the macro risks. We need to have an understanding of macro level risks, and what is happening to the broader economy.


There are for example risks around funding costs, which can impact not just VCs, but also for investors more broadly and corporates. Inflation is a key input into understanding funding costs. At Turnleaf Analytics, which I cofounded with Alexander Denev, we forecast inflation across 29 countries both in DM and EM. As well as providing the forecasts themselves, we also provide confidence bands to indicate risks to the forecasts themselves. Forecasts can help to flag risks ahead of time.


Inflation forecasting and economic forecasting more broadly shouldn’t be seen as something purely for those speculating in markets, but is important for anyone involved in funding businesses and for forward planning for firms. If we are not aware of the types of risks, we could be facing then we also will not be able to take action to mitigate them (such as through hedges).


In the case of SVB, they had faced losses due to the rise in rates, as the Fed hiked to stem inflation, a risk they could have hedged. They also had their risk concentrated by serving a particular industry. No one can see with certainty. However, having an idea of what could happen in markets in the future, can at least allow you to prepare beforehand.