Time to Pay the Piper? A Look at the Prospective Cost of Capital
In the first installment of this series, we made the point that the corporate cost of capital has nowhere to go but up. But what does this imply in the real world? We believe the implications are significant.
Increased Capital Costs Cause Projects To Become Uneconomic
“Iron laws” of economics dictate that firms should pursue initiatives that result in returns in excess of their cost of capital. When the cost of capital increases, the list of viable projects dwindles – which would ordinarily be of great concern to proponents of increased economic investment.
In a world where government subsidies and incentives may already be critical in pursuing “green” objectives, a rising cost of capital could impose additional hurdles. It would be easy to envision that the government would either have to layer on additional incentives, or to accept a meaningfully slower rollout of green technology.
Real World Impacts
When capital’s price increases, less of it is used in the investing process. The result may be a diminution of societal wealth.
Existing projects with poor prospects can become even more uneconomic. For example, many oil and gas plays have significant end-of-life cleanup obligations (known as Asset Retirement Obligations, or AROs). Rising costs of capital could give even more encouragement to the producers to defer that day of reckoning for as long as possible. The societal fallout from this dynamic could be very unfortunate to the extent that the economically-responsible parties go broke before they perform on their AROs.
Taking this beyond oil & gas, a rising cost of capital environment could cause an industrial manufacturer to shutter operations or cancel planned capital investments, resulting in a loss of employment.
The overall takeaway is unsurprising – when you increase the price of something, you use less of it. When capital’s price increases, less of it is used in the investing process. And the result may be a diminution of societal wealth.
Financial Asset Prices Will Face Headwinds
Financial asset prices are essentially determined by prospective cash flows (sometimes approximated by net income) and discount rates. In an environment of rising costs of capital, we would expect discount rates to increase, depressing financial asset prices. And the problem may very well snowball. With a shrinking pool of viable investment prospects, we would not expect cash flows across the economy to boom and strengthen corporate credits.
If the foregoing is true, then why are CCC credit spreads shrinking and terrible credits getting financed? CCC bonds (half of which will default in five years – and 25% within 12 months) currently yield a paltry 7%.
This is because we are in the midst of one of the most aggressive fiscal stimulus programs in history.
But when the stimulus ends (and we believe it will taper off as our leadership’s misplaced obsession with Modern Monetary Theory comes to an end), credit spreads will widen and government bonds may even once again reflect rational pricing. At such a juncture, we would anticipate that high yield corporate bonds will likely enter an extremely rocky period.
The equity markets overall may not fare much better. The performance of HY bonds are highly correlated with equity performance (Figure 2).
Stock prices are also heavily influenced by the growth of prospective cash flows, but (like bonds) would also be adversely affected by rising discount rates.
We think it instructive to look at the 1962 – 1980 period, the last decades-long interval characterized by rising costs of capital.
In Figure 3, we present the S&P 500 index from 1962 to 1980 against the earnings growth of the index. During this time period, earnings of the S&P 500 increased four-fold, but the index itself barely doubled (representing a tepid 3.5% CAGR before dividends, 7% including them).
This dichotomy of earnings vs index performance is due to the rise in the cost of capital over that period, which went from 7% to almost 20%, per NYU professor Aswath Damodoran.
The increase in capital costs chewed up half of the earnings growth performance of the index.
Another way of illustrating this impact is by looking at the cost of capital over this period compared to the price-to-earnings ratio (Figure 3). As the cost of capital increased meaningfully in the 1970s, the P/E ratio of the S&P declined from 15x to under 10x. In the charts to the left, we have boxed the period beginning in 1972 and ending in 1980 when right as earnings performance accelerates, the cost of capital began to increase.
We find no big surprises here, as the pricing of financial assets is largely driven by fundamental math. Some companies (high-growth winners) will continue to enjoy stock price appreciation. However, the great majority of companies probably won’t.
Among those companies that fail to achieve membership in the top tier of stock market performers, we would also expect a greater than normal percent of them to eventually experience financial distress. Lack of viable investment prospects and painful costs of refinancing debt (if refinancing are even available) will cripple many firms, unless they are in the favored sectors targeted for government largesse.
Stay tuned for more of our views on these topics. As Margo Channing (Bette Davis) said in All About Eve, “Fasten your seatbelts, it’s going to be a bumpy night.” And this particular night may last many years.
Fig. 1: ICE Data Indices via Federal Reserve Bank of St Louis FRED (BofA CCC & Lower US High Yield Index Effective Yield)
Fig. 2: Relevant ERP and S&P 500 return/yield data sourced from Aswath Damodaran (pages.stern.nyu.edu/~adamodar/New_Home_Page/data), HY returns represented by the Salomon Smith Barney High Yield Composite Index from 1980 through 2002, the Credit Suisse High Yield Index (DHY) from 2003.
Fig. 3: Damodaran (pages.stern.nyu.edu/~adamodar/New_Home_Page/data)
Fig. 4: Damodaran (pages.stern.nyu.edu/~adamodar/New_Home_Page/data)
Want to Discuss This Further?
This post and the accompanying exhibits were produced in-house by members of the Gordian team. Clients, potential clients and members of the media can book a call or meeting to learn more by contacting Leslie Glassman directly.