Cost of Capital. The Past, Present and Future? | Part 8

Three Potential Economic Outcomes

It’s been quite a roller coaster ride for the last several months, and it has been a nightmare for many investors.  The silver lining is that the range of potential outcomes has become clearer.

In our prior posts, we focused on the likelihood of inflation and higher interest rates.  Those demons have now materialized, but observers have mixed expectations as to the magnitude and duration of their movements.  Nevertheless, for discussion purposes, I think we can box the outcomes into three groups:

  1. Fed Hikes Cool Off Inflation Without Major Economic Damage. The Fed Funds rate has been increased from zero to 1.6%, and the market expects the increases to continue into the 3% to 4% area.  If the Fed achieves a soft landing, then a recession is averted.
  2. Fed Hikes Lead to Recession. Technically, we may be in a recession already and many are beginning to predict that it may get a lot deeper.  According to the Fed, this scenario would also tame inflation.
  3. Stagflation. If inflation is not tamed and if we continue marching towards a restrained economic environment, things may look a lot like they did 50 years ago.  Even if the economy avoids a major recession, higher input costs may well create an “earnings recession” in which corporate profits and credit metrics become dismal.

For the first outcome above – the “just right” one – to come to pass, we believe that many favorable events will have to take place.  Because the Fed has said it will continue hiking rates until inflation is abated, risk-free interest rates will likely continue to go up for some time unless the price rises stop immediately.  We think that an immediate cessation of inflationary pressures is highly improbable, given increasing labor wage demands, built-in upcoming rental housing cost increases, and the lingering Ukraine conflict, among other factors.

We have learned to “never say never”, but it is difficult to envision the Fed achieving the Goldilocks case above.

RELATED: PART 7 – COST OF CAPITAL | 2022 Financial Predictions

Instead, we find the latter two cases to be increasingly probable.  And both of them share some unpleasant characteristics:

  1. Multiple Compression. Equity values are typically translated into a multiple of earnings or cash flow.  The multiple is a function of risk-free interest rates, additional required equity returns and the expected growth rate.

A higher interest rate environment will depress earnings multiples.  And if investors’ uncertainties about stocks get worse, required equity spreads will increase, further depressing multiples.  Unless the expected earnings growth rate balloons to offset these adverse effects, the overall multiples will indeed go down.  And although corporate revenues may increase with inflation, history suggests that input cost increases will offset much of the gain in revenues.  In other words, multiples will continue to go down in all likelihood.

2. Lower Earnings. In the recession scenario, we would expect corporate earnings and cash flow to hit an air pocket, dropping a meaningful percent.  In stagflation, perhaps income statements will not take such a large immediate hit, but will erode over time as increased input costs continue to eat into earnings.  In either case, projected earnings would be weaker than they are today.  And a lower multiple applied to lower earnings would generate much lower equity values.  In other words, stocks would still have a ways further to fall.

3. Deteriorating Credit. For as long as a recession or stagflation lasts, companies probably will be exposed to credit challenges.  High yield credit spreads could even increase a lot further from here, and weaker credits may not be able to refinance at all.  No more kicking the can down the road.

The main takeaway is that the stimulus provided over the last 15 years is being yanked away.  The Fed’s tools are never precise and may now be working at cross-purposes with the Biden Administration’s agenda.  These currents may push the economic outcome from a hard recession into stagflation.  [We will cover this more in the next blog.]

RELATED: PART 2 – COST OF CAPITAL | IMPLICATIONS FOR THE FUTURE

RELATED: PART 3 – COST OF CAPITAL | INTEREST RATE DILEMMA

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