Arguably, the next economic downturn will find the main world economies in close-to-zero or even negative interest rates territory. With two of the three currency reserves (euro and yen) already around 0%, the Fed would likely pin interest rates near 0% too as soon as the next downturn becomes apparent.
Moreover, quantitative easing has become less and less effective due to a number of reasons, but to name the ones that we consider most relevant:
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- Limited additional margin, if at all, for quantitative easing programs. This is highlighted in our view by the inability of Central Banks to significantly shrink their balance sheets, limiting the potential effect of additional asset purchase programs in case of need.
Figure 1 – Bank of International Settlements 2019
- QE has seriously distorted yields, spreads and risk perception. Bond yields have been falling for over a decade now and are currently trading at a highly unusual low level, with less direct relationship to the creditworthiness of companies and countries. The yield of the Bloomberg Barclays US Corporate High Yield Total Return Index has gone down from 9.06% in December 2009 to 5.19% in December 2019, which should be, under more typical circumstances, the yield of creditworthy companies. The longer this trend and situation goes on, the stronger the distortion of asset prices, making investors move towards riskier assets in the quest for returns, and thus making assets riskier – ceteris paribus – as their prices keep going up.
- Rates near or below zero in the case of Japan and Europe have destroyed the net interest margins of banks (the EURO STOXX Banks Price Index has been continuing falling since the financial crisis, from 219.96 in 2009 to the current levels of 96.67, far away from its highest level of 463.97 achieved in 2007) as intermediaries between savers and investors. This has introduced a serious divergence between the increasing asset values of the financial asset holders and the relatively decreasing value of the savings of those who do not own financial assets.
This byproduct of QE, detrimental for those who do not own financial assets, therefore increasing the wealth gap, has contributed to rising populism in Europe and America, destabilizing economies and increasing political uncertainty.
Moving forward, we see QE as a politically increasingly hard to justify tool, which in effect is contributing to widen the wealth gap between social classes, fueling concerns at all levels – political, economic, and social – about its sustainability.
- As inflation rates are not responding to current monetary policy, despite the sustained low interest rates and asset purchase programs, and with the markets in record highs, a new wave of quantitative easing (similarly to what happened in the markets at the end of 2018 when the Fed announced a minimal rate hike) could send a message of uncertainty and upcoming downturn in the economy to markets, accelerating, in fact, its arrival.
The recent increase in open market Repo operations of the Fed has proven that the actual liquidity of the markets is lower than what was estimated, and that the debt levels of the different agents is probably larger than anticipated.
For the Central Banks and Governments to reach their target inflation levels, or to react to the next economic downturn, they would have to switch its policy towards a more direct lending/spending that would presumably have positive effects in the short run but whose benefits are questionable in the mid-long run as the cycle finally turns. In this context, we think that the economy will move into uncharted territories (at least uncharted in the context of the economic history witnessed over most of our lifespan) as we approach the next economic downturn.
This may result into a next wave of Central Banks and Governments action plans coordinating monetary and fiscal policies. As the Bridgewater paper “It´s time to look more carefully at monetary policy 3 and modern monetary policy” describes, the two aspects that will define the new set of policies are who is stimulated to spend (public vs. private sector), and how directly do thy receive stimulus (Central Banks providing helicopter money directly to consumers vs. indirect but strong measures that will allow for higher spending).
Figure 2 – Bridgewater Associates 2019
Although some of these initiatives may look exotic at least, it is helpful to remind ourselves that there are historical examples of most of them, including Central Banks giving newly printed money to Governments to spend without issuing new debt (UK during World War I, US during the Civil War, or in the Imperial China), or even printing money and transferring it directly to households, such as during the Ming Dinasty in Imperial China in 1390, that led to a dramatic currency depreciation due to the overprinting, and subsequently resulted in the return of metallic money (silver and copper). We strongly recommend reading the aforementioned Bridgewater paper for a more in-depth description of these and other examples of less traditional monetary policy.
A number of recent examples of creative fiscal measures exist, with good potential return on investment in fiscal spending, such as China´s push for infrastructure investments via incentivized lending to the private sector, US subsidies in 2009 to renew old cars, or the European commission investment plan targeting public and private infrastructure investments, announced in 2014.
This environment of low interest rates, and strong quantitative easing has led to increased liquidity and cheaper cost of borrowing, resulting into a significant decline in the weighted-average cost of capital of companies. For instance, the WACC of the S&P500 has steadily declined over the past years more than 20% (Bain & Company – Rethinking M&A Valuation Assumptions).
Generally speaking, this environment translates into higher asset prices, and lower expected returns associated. Spurred by a strong economic environment, M&A activity has been strong over the past years, interestingly enough though, most firms have not adjusted their internal hurdle rates accordingly to their lower cost of capital, in a belief that interest rates should rise sooner rather than later (J.P. Morgan – Bridging the gap between interest rates, 2014).
Despite the strong M&A activity over the past decade – both corporate M&A and private-equity backed transactions – the link between record-low cost of debt and corporate investment has been lackluster, partially because of the previously mentioned internal hurdle rates that most firms have kept intact. This lack of stronger connection between lower cost of debt and more investment has been also caused, ironically, by the strong market appreciation of assets, with the equity market run-up (also heavily influenced by stock buybacks) over the past decade, market leverage has declined (debt to market capitalization), offsetting the effect of lower cost of debt.
Figure 3 – Bloomberg, Bain & Company
So how may a new environment combining still record-low interest rates, similarly strong asset purchases programs from Central Banks, with a new range of monetary policies more directed at spenders than at investors impact the corporate investment and M&A world? In our view, a new wave of monetary/fiscal policy justified by the next economic downturn will induce over the recovery phase stronger inflation, which, in turn, should make interest rates go up, subsequently increasing cost of capital, and moderating asset prices.
Because the recent era of ultra-low rates, declining cost of capital, has shown a weak link with corporate investment due to the counterweight of equity market appreciation, and the resulting lower market leverage and milder positive impact of low cost of debt on WACCs, we believe the opposite is likely to happen as well. In other words, that the effect of higher cost of borrowing potentially induced by inflationary fiscal stimulus will be offset by the subsequent market correction in the equity markets, thus making WACCs more sensitive to cost of debt, that even if higher, should still result in WACCs similar to current levels, provided interest rates do not go up substantially to much higher levels than present ones.
Provided that the next wave of monetary/fiscal policy potentially introduced at the next economic downturn succeeds in reactivating spending, inflation, and growth, while focusing on high-return mid/long-term investments (productivity-enabling infrastructure – digital or physical – or strategic technologies/sectors support for instance) rather than plain spending (renovating existing infrastructure for the sake of keeping people busy, that would simply create larger budget deficits), then, in our view, M&A activity should simply follow its traditional fluctuations linked to the short-term business cycle, with little or no influence of a potentially higher cost of debt and/or cost of capital.
Obviously, the current economic and market conditions, and the potentially new monetary policies that might be introduced in the coming downturn, coupled with the existing and growing political and trade tensions introduce many unknowns whose impact is everything but clear. However, we believe that unless abrupt changes and disruptions in markets and the global economy take place, investment activity and M&A should not be subject to a strong influence from the incremental cost of capital that we expect to see with the next more aggressive wave of monetary policy, which we believe should push inflation levels towards Central Banks´ targets, if not higher in the case those less traditional fiscal stimulus are poorly managed
Sources
Bloomberg. (n.d.). FDTR Index.
Bridgewater Associates, L. (2019). It´s Time to Look More Carefully at “Monetary Poilicy 3 (MP3)” and “Modern Monetary Theory (MMT)”.
Company, B. &. (2019). M&A in Disruption: 2018 in Review.
Marc Zenner, E. J.-J. (2014). Bridging the gap between interest rates. J.P. Morgan.
Michael Robbins and Hubert Shen – Bain & Company. (n.d.). Rethinking M&A Valuation Assumptions. Bain &
Company.
Settlements, B. f. (2019). BFIS – Large central bank balance sheets and market functioning.More information:
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