A Perfect Storm for Leverage?
In the first four installments of this series, we looked at the effects of US economic and monetary policy on the historical cost of corporate capital and how it may be affected in the future. We believe the implications are significant. In this fifth installment, we take a closer look at the dichotomy between inflation and interest rates and that impact on asset prices.
Cost of Capital
Both debt and equity capital costs for businesses consist of the risk-free rate (i.e., Treasuries) plus an appropriate risk spread (stocks also price in growth expectations). I think we have reached the turning point in Treasury rates and risk spreads, if not growth as well.
I can reach that belief by only making two assumptions, which are not necessarily currently shared by the capital markets:
- The Fed will follow through on its current inclination to eventually (if not sooner) taper out of the Quantitative Easing of the last decade.
- Inflation will not be as benign as the Fed’s forecast, nor will it be a return to the Ford/Carter era. I am assuming a range of 3-5%.
Treasuries should be adversely affected by both these assumptions. Looking at the following chart, it seems intuitive (to me, at least) that the reversal of at least some of the interest-rate depressing Fed liquidity injections will return Treasury rates to a higher plateau. And historically, real Treasury rates have averaged about 1 – 2%. Meaning that if inflation rises, so should interest rates.
I look at this data and wonder why these interest rates don’t equal or exceed the 4% level of the early 1960s. After all, 4% would be only a 1% real rate based on my low-end inflation assumption of 3%. However, rates in excess of 3% would exceed the forward interest rates implied by today’s forward Treasury curve. In other words, mainstream bond markets don’t seem to be buying higher inflation (10-year TIPS trade at a level implying inflation of 2.50%). I think the upshot is that when and if inflation does prove to be entrenched, we will see an interest rate spike.
For leveraged companies, I think a good benchmark for most of the cost of their debt capital is the St. Louis Fed’s CCC spread.
Today’s high yield spread over Treasuries for the least creditworthy high yield tier is 6.58%, a historically low number. It has been that low for less than two out of the last 25 years, but the sector has been the beneficiary of investor search for yield. The tapering of Quantitative Easing may start to change all that: the average CCC spread has been 11.33% over the 25-year period, raising questions about the likelihood and effect of a reversion to the mean. And a higher spread, together with a higher Treasury rate would imply a much higher junk bond yield.
Were the future to unfold in this general direction, bondholders would suffer losses on the non-defaulted portion of their portfolio simply due to higher underlying interest rates. Any increased defaults – perhaps due in part to years of too-cheap capital skewing investment decisions – would be another headache. While companies may have a mirror-image value pickup due to a decline in debt prices, they would also have to pay a lot more interest for additional or replacement capital. If capital could be obtained at all.
One way to look at the equity portion of Enterprise Value is to multiply the relevant P/E ratio by after-tax leveraged earnings or cash flow. P/Es (and equity values) will decrease when either the cost of capital goes up or expected growth goes down.
Given my Quantitative Easing and inflation assumptions, Treasury rates should increase. That would send P/Es downward. I also think it is fair to say that equity prices reflect a risk premium that may be as compressed as the high yield spread. Any such equity risk premium increases would also depress P/Es.
P/Es and equity values are also heavily influenced by growth rates. Mild inflation might help (or at least not hurt) corporate earnings. Significant inflation – such as that which produced the stagflation of the 1970s – could impair the economy. Hard to say which way the spin of the wheel will end up. But it is difficult to see how there could be robust, sustained gains in the stock market these days.
There is also a vicious cycle here for highly leveraged companies. To the extent that Treasury rates and risk spreads do increase, their equity values – and perceived creditworthiness – decline. In turn, financing costs increase, and various woes invariably arise.
Will There Be a Storm?
I think the answer is yes, subject to when and how large. We have been binging on “helicopter money” for over a decade now. The Fed’s policies have worked to kick the can down the road, but the prospect of inflation has thrown a monkey wrench into the gears. I suspect that the moment the market believes that real interest rates are meaningfully negative, there will be a bond selloff that triggers a series of corrections in financial markets. And given current market pricing, I think the downside to investors is a lot greater than the upside. Importantly, many companies with marginal creditworthiness will likely find themselves more and more shut out of financing alternatives. More later.
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.
Commentary by Gordian Group CEO Henry Owsley