Time to Pay the Piper? A Look at the Prospective Cost of Capital
In the first in a series about the cost of capital, Gordian employees discuss the impact US monetary and fiscal policy has had on interest rates and asset prices and lay the ground work for how those actions may affect future government policies, valuations and investment decisions.
Falling Rates Driving Asset Price Inflation
For over four decades, the cost of corporate capital has been plummeting.
- In September 1981, the 10-year Treasury yielded 15.8%. By the end of 2020, it was 0.6%. Virtually every other fixed income statistic tells a similar story.
- Junk bond yields dipped below 4% and CCC-rated bonds (among the riskiest of them all) were yielding a paltry 7%.
- Because equity valuations are driven in part by bond yields, stock market P/Es have now risen to soaring heights of 40x on a LTM basis and 25x on a projected next-year basis.
How did we get here?
Under Paul Volcker, inflation was tamed and 10-year Treasury rates fell below 10% by 1985. Then Bob Rubin’s bond-friendly policies during the Clinton Administration pushed rates down towards 5% by 2000. The LTM S&P 500 P/E was at 27x. Looking back, we might begin to view this Reagan/Clinton period as a golden age.
Then chaos hit, repeatedly. 9/11. The Tech Bubble. Wars in Iraq and Afghanistan. The Financial Crisis. Quantitative Easing. 2020, particularly COVID.
There were multiple government policy responses to all this, with the cumulative effect being a huge increase in the money supply. And this ocean of money sloshing around drove up prices of financial assets (stocks, bonds) by lowering the required returns, as well as prices of hard assets (real estate, art, other collectibles) and of private education
Government & Central Bank Policies Promote Inequality
In turn, these dynamics have created more acute societal rifts. For the 1%, things were good as the rich got richer. The wealthiest 1% now hold 31.4% of all net worth in the U.S., up 800bp from thirty years ago. But for the Upper Middle Class, it was problematic. The cost of schooling in a competitive education environment was being driven much higher by the Upper Class’ ability to pay virtually any tuition, and the financial returns the Upper Middle Class could logically expect from their investments were decreasing as market rates fell. Ever-rising healthcare costs also ate into the take home pay of the middle class.
We believe that much of the taxation talk coming out of Washington today is borne of that conflict. Those tax proposals (increases to capital gains and corporate taxes, and the implementation of a wealth tax) will have meaningful implications on capital allocation and asset values.
Dollars to Shareholders Outpace Capital Spending, Furthering the Divide
There have been disturbing dislocations in the corporate sector as well. Economic theory says that a well-run company should invest in projects that have a return more than the firm’s cost of capital. With security prices rising (and capital costs plunging), you might expect that companies would have found more investment opportunities. On the contrary, the corporate sector has embarked on a massive share buyback effort (sort of a dividend), which has had the effect of increasing EPS through higher leverage. Up until 2000, capex spending by companies in the S&P 1500 was effectively equal to spending on stock buybacks, dividends and acquisitions. By 2018, these three items exceeded capital spending by $1 trillion, representing a more than two-to-one ratio. This is despite a continued decline in interest rates that would theoretically promote capital investment.
All of this feeds back into higher share prices . . . But this dynamic does not produce more investments and more jobs – which adversely affects the “working” population. In fact, many of these new darlings of Wall Street – Uber, Lyft, Door Dash, Etsy, Wag – benefit from the “gig economy,” utilizing a labor force without the attendant costs and benefits normally afforded to full time employees. And so, the government is now contemplating its own investment program in infrastructure.
Bond Markets Suggest Inflation May Be On the Horizon
While it may be tempting to point fingers at the government for the last 20-plus years, it is undoubtedly quixotic. Hubristic governments do what they do, including our current one.
But each turn of the wheel may be different. Bond markets appear to be well-aware of the macroeconomic reality of current fiscal and monetary policy: Never-ending money supply growth, $4 trillion budget deficits, and expectations for further government spending all point to increasing inflation and, therefore, higher interest rates. We believe it is no coincidence that the 10-Year treasury yield has increased from 0.5% to 1.75% in just 6 months.
Implications of an Increased Cost of Capital
Our sense is that we are at a big inflection point in the financial markets, if not more broadly. The last time we saw a large increase in the US cost of capital occurred during the 1960s and 70s, when the stock market fluctuated, but basically went nowhere for a decade. This was also the period of Vietnam and great societal unrest. Future installments in this series will examine clues as to where all of this may be going in the years ahead.
Want to Discuss This Further?
This post and the accompanying exhibits were produced in-house and 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.