What a difference a year makes. In 2021, the S&P 500 index increased by 27%, while the NASDAQ gained 21% in price terms. In Europe, the STOXX Europe 600 index ended the year 22% higher. At the beginning of 2022, new record highs were reached by the S&P 500 and the STOXX Europe 600, as optimism about the recovery from the COVID-19 pandemic continued to fuel stock prices, despite some uncertainty on inflationary expectations.
A year on, and the picture has changed dramatically. The S&P 500 dropped by as much as 25% for the year entering “bear market” territory, although it has recovered somewhat since then. The NASDAQ plunged before settling at a loss of 30% in early December, and many companies saw their market value collapse by half or more. This year will likely be the worst performance for the S&P 500 since 2008, at the height of the global financial crisis.
This bleak performance for 2022 reflects volatile economic and geopolitical conditions. Since mid-January, inflation has continued to rise, reaching levels not seen in decades in some countries. To make matters worse, since Russia’s war on Ukraine began in late February 2022, there’s been a spike in energy and other commodity prices. This has added uncertainty to what was an already complex environment. For businesses operating in and across these economies, cost of capital and valuation assumptions have been impacted, creating challenges for firms in terms of forecasting cash flows and assessing future risks.
How did we get here?
Inflation across the eurozone is surging and has hit a record 25-year high, reaching 10.6% this October. In the U.S. and UK, it’s a similar story. But how did we get here?
It all stems from the impact of COVID-19. Around the world, governments implemented stimulus packages to support their economies, which amounted to a magnitude similar to fighting a world war. At the same time, central banks brought their policy interest rates to zero and launched unprecedented quantitative easing (QE) measures, creating an environment of easy and cheap access to credit.
That left consumers flush with cash, creating pent-up demand for goods. However, lockdowns left manufacturers and businesses struggling with global supply chain disruptions and labour shortages. China’s zero-COVID policies have exacerbated supply chain problems. This led to a disconnect between supply and demand and the perfect storm for inflation to surge.
At first, lockdowns left businesses unable to keep up with consumer demand for goods. As the economy reopened, inflation expanded to services, as people were able to travel or go to restaurants, for example. But industries like hospitality and health care continued to struggle with staff shortages. This all contributed to inflation within “services,” which is a much harder problem to tackle.
More recently, the cost of other services, such as rent and energy, have skyrocketed, with the price of energy in particular deepening the so-called “cost of living crisis”. Dramatic rises in energy and agricultural commodity prices triggered by Russia’s war on Ukraine have placed renewed pressure on recovering global supply chains, contributing to the knock-on effect of significant inflation spikes in food and certain services across the world.
Inflationary pressures are no longer limited to the volatile energy and food prices, which is creating the perfect breeding ground for “stagflation”.
The spectre of stagflation
From the onset of the pandemic, monetary policies and fiscal spending played a role in surging inflation across the globe. In contrast, today, major central banks have embarked on an interest rate hiking cycle, to tame stubbornly high inflation, which has reached levels not seen in 30 to 40 years in some countries; Germany has even hit a 70-year record high of 10.4%.
Amidst this perfect storm of inflationary pressures, major central banks, including the U.S. Federal Reserve (“Fed”), have been forced to increase policy interest rates at a much quicker pace than anticipated by investors. This has the potential to lead to a fall in the value of companies due to an increase in their cost of capital assumptions. In addition, it raises the risk of recession, a double whammy for the business outlook.
In fact, economists have severely downgraded real growth expectations for 2022 and 2023, with several countries expected to experience a recession in 2023. The Fed has placed the odds of a 2023 recession in the U.S. at 50-50. The Bank of England expects the UK to already be in recession. A period of “stagflation” where the economy experiences sluggish or no growth, accompanied by high inflation is a realistic scenario for the UK and for some economies within the eurozone.
But what does this mean for businesses?
Companies across the globe are now battling with higher cost of capital estimates, as they struggle to gauge how much money new investments need to generate to offset upfront costs and achieve profit, while also reflecting their potential risks.
In this highly volatile market, quantifying risk becomes increasing difficult. For example, if a company’s earnings are volatile or cost of capital is higher, share prices may plummet. For investors and business leaders alike, dealing with this uncertainty is increasingly important.
Despite labour shortages (e.g., the U.S. unemployment rate was recently at 3.5%, matching a 50-year low, and has only increased slightly thus far), we have already begun to see layoffs. And while the employment dynamics in continental Europe may be different, we still might see a rise in unemployment rates, as pressure on earnings may force companies to cut costs. This could start with employee reductions and then lead to cuts in spending on big ticket items like advertising and IT.
The outlook for risk-free rates
When dealing with valuing investments or pricing deals, financial institutions and corporations care about long-term cost of capital estimates. When considering risk-free rates (the building block of any cost of capital estimate), they don’t rely on the policy rates that central banks set (which are short-term in nature), but rather on what would be the cost of financing debt and equity over the life of the investment. This means that 10- or 20-year government bond yields are more relevant as a proxy for the risk-free rate.
At the height of COVID-19, those yields were under pressure for safe-haven countries, due to a combination of investor flights to quality and central bank QE policies.
Investors were trying to preserve capital and turned to the government bonds of countries that are considered relatively safe, including the U.S., Germany and the UK. Additionally, unprecedented QE policies placed downward pressure on long-term interest rates.
Now, we face a situation in reverse. We are not only seeing the size of their balance sheets decrease (quantitative tightening) but also central banks are raising their policy rates much quicker than before. Long-term interest rates for major economies are back to the levels observed in the aftermath of the 2008-2009 global financial crisis. That’s unlikely to change substantially over the next year because central banks will continue to raise their policy interest rates through early 2023 and then keep them at those levels through much of the year.
Winners and losers
While economic recession is a real risk, central banks may need to hold interest rates at a much higher level than pre-pandemic until inflation is brought under control. Some financial institutions may actually benefit of higher rates, if their earnings stem primarily from earning a spread between the interest rates they charge on loans, versus what they pay on deposits. However, there are negative headwinds to deal with. Recessions are typically accompanied by a rise in bad debts, which hurts banks’ bottom lines. We could see consumers defaulting on their car loans or their home mortgages, for example, or businesses being forced to restructure their debt or file for bankruptcy protection.
For non-financial institutions, higher borrowing costs make financing the purchase of another company more expensive. We have already seen a significant drop in reported M&A activity and financing day-to-day operations has also become more expensive. Consequently, businesses may decrease (or delay) planned M&A investments or capital expenditures, like building new plants or opening new stores. High risk-free rates will have a significant impact on those decisions. The higher interest rate environment will continue to weigh negatively on economic activity.
All of this uncertainty also contributes to a higher equity (or market) risk premium—the additional return that investors require to induce them to invest in equities rather than government securities considered free of default risk. In recessionary environments, the earnings volatility of businesses rises, which increases the risk of investing in the equity of those companies.
Long-term inflation expectations
Global financial markets are trying to ascertain if central banks will manage a soft landing while attempting to get inflation under control. Amidst this highly uncertain environment, cost of capital inputs have risen substantially relative to the beginning of 2022 and are again approaching the levels observed just after the 2008-2009 global financial crisis.
The challenge will be whether central banks are able to get inflation back to their target level (typically around 2.0% for major developed economies) in a speedy fashion. If history is of any guidance, the 1970s and 1980s were periods of central bank policy mistakes and many countries had to deal with painful double-digit interest rates, as the process of bringing down inflation turned into a protracted affair.
The danger right now is that market participants start incorporating higher inflation expectations into long-term decisions. Economists call this a de-anchoring of inflation expectations. Certainly, we have seen long-term inflation expectations for the U.S. and Germany rise significantly since the height of the pandemic. Back in June 2020, our analysis of consensus expectations for long-term inflation (5 to 10 years out) in Germany and the U.S. stood at 1.6% and 2.0%, respectively. Fast forward to October 2022, those expectations have risen to respectively 2.8% and 2.9%.
While this may not seem like a big swing, in economic terms, the rise is actually quite dramatic. Both Germany and the U.S. struggled with subdued inflation for much of the period following the global financial crisis, all the way through the height of the pandemic. Back then, the fear was that the developed world would enter a deflationary spiral, much akin to what Japan struggled with for two decades. During this period, the Fed and the European Central Bank tried to bring inflation up to their 2.0% target with little success.
A major objective of these central banks is to ensure price stability, which has now been compromised. We are now seeing a pendulum swing, as central banks attempt to recover some of their reputation and achieve their main mission. To lose the fight against inflation has negative reverberations on the stability and functioning of global financial markets.
In that context, the aggressive monetary policy stand is totally understandable. However, this has a direct bearing on long-term risk-free rates and cost of capital estimates. Businesses may have to deal with an environment of higher cost of capital for the foreseeable future.