As we approach the end of 2023, investors are again feeling anxious about what the future looks like for markets. Historically speaking, September is the worst month for the S&P 500 index. Stock markets tend to see low liquidity in the summer months, and September marks the return to work, prompting investors to re-evaluate their asset allocation decisions for the remainder of the year.
What has investors concerned this time around, and how will this impact the cost of capital that firms are facing? Before we answer these questions and share what it means to M&A market and IPO activity, we believe that a recap of current global economic and financial market conditions will provide a useful context.
Looking Backward: The Fight Against COVID-19 and Inflationary Pressures
After COVID-19 was declared a pandemic, central banks and governments around the globe implemented massive monetary and fiscal policies to support their domestic economies. Some of these stimulus packages were similar in magnitude to fighting a world war.
Consumers were flush with cash, creating pent-up demand for goods. However, pandemic lockdowns led to significant global supply chain disruptions and labor shortages, exacerbated by China’s zero-COVID policies. This created a disconnect between supply and demand, the perfect environment for inflation to surge.
As economies began reopening in 2021, inflationary pressures spilled over to services like restaurants, travel and entertainment. Rent and energy prices also surged. Russia’s war on Ukraine in February 2022 triggered dramatic rises in energy and agricultural commodity prices, placing renewed pressure on still- recovering global supply chains.
The Surge of Inflation in 2022 and Monetary Policy Tightening
Complacent by years of low inflation, central banks were initially slow in responding to upward pressures in prices, attributing the trends to “transitory” effects of the pandemic. After months of accelerating inflation, Jerome Powell, Chair of the Federal Reserve, finally capitulated in late 2021, acknowledging that inflation was more persistent than anticipated.
Even so, it took time for central banks to react in a decisive manner. The Bank of England was the first of the major banks to start raising rates, back in December 2021. The Fed still waited until March 2022 for its first rate hike since the onset of the pandemic. Meanwhile, the European Central Bank (ECB) waited until July 2022 for its first rate hike in 11 years. Since then, major central banks around the world embarked on an aggressive interest rate hiking cycle to fight inflation.
U.S. inflation hit 9.1% in June of 2022, a 41-year high, while the less volatile core inflation (i.e., excluding energy and food prices) reached a 40-year high of 6.6% in September 2023.1 In the eurozone and UK, it’s an even worse story. The eurozone saw inflation surge to 10.6% in October 2022, the highest level on record since the creation of the euro in 1999.2 And in that same month, the UK also reached an inflation high of 11.1%, a 41-year record.3
The uncertainty on whether central banks would be able to control inflation caused major havoc in global financial markets. Higher interest rates, combined with slashed expectations for economic growth, contributed to lower valuations. Many companies saw their market value collapse by half or more during the year. In fact, 2022 was the worst performance for the S&P 500 since 2008, at the height of the global financial crisis.4
Fast Forward to the Present
Inflation has been progressively decelerating across major economies in 2023 and economic growth has been more resilient than previously expected at the beginning of the year. The U.S. has seen strong consumer spending, which accounts for about two-thirds of the overall economy (as measured by GDP). The labor market is cooling off, although the unemployment rate remains low by historical standards. This created optimism among investors that a “soft landing” was the most likely scenario for the U.S. economy, with a recession perhaps being avoided and inflation getting under control. It also created the expectation that the Fed would start cutting interest rates toward the end of this year. The combination of these factors buoyed stock markets, with the S&P 500 climbing by almost 20% (in price terms) from the beginning of 2023 through the end of July. Although still below the record level reached in January 2022, it was an impressive performance.
Recently, that recovery has lost some ground. At the time of writing, the S&P 500 has risen by 11% year-to-date.5 In September alone, the S&P 500 has lost 5% in value. This comes at the heels of the latest Fed decision on September 20. While this was the second time the Fed paused interest rate hikes since March 2022, the Federal Open Market Committee (the committee setting U.S. interest rates) hinted that one more increase is still possible in 2023. Moreover, the FOMC indicated that it intends to keep rates higher for a longer period, with fewer cuts in 2024 than previously projected.
Getting inflation back to the Fed’s 2.0% target may be a more difficult task than originally anticipated. While consumer price inflation had been coming down progressively, it saw an acceleration to 3.7% in August from 3.2% in July 2023, due to a jump in energy costs. Earlier in the year, Saudi Arabia and Russia agreed to voluntary oil supply cuts, which have been recently extended through the end of the year. Oil prices could approach $100/barrel, making the Fed’s job of controlling inflation more difficult.
Moreover, the Fed’s preferred gauge for inflation, the Personal Consumer Expenditures (PCE) Price Index, actually accelerated in July to 3.3%. Likewise, the core PCE index (i.e., excluding food and energy) saw an uptick to 4.2% in July, demonstrating the challenge the Fed is facing in bringing down inflation. And while the Fed does not believe the U.S. will see a deep recession in 2024, a shallow economic contraction is still in the cards.
Elsewhere, both the eurozone and UK are flirting with recessions. Despite inflation being higher in both geographies than in the U.S., the ECB and Bank of England are trying to balance the need to control inflation without sinking their respective economies into a deep recession. While the Bank of England decided to pause interest rate hikes in September and the ECB may decide to do the same at the next meeting, one thing is clear: policy interest rates will stay higher for longer.6
What Does this Mean for Cost of Capital?
These trends have direct implications for both the cost of debt and cost of equity used by companies to finance their operations. When dealing with valuing investments or pricing deals, investors and corporations care about long-term cost of capital estimates. In this context, risk-free rates (the building block of any cost of capital estimate) are not based on the policy rates set by central banks (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. Risk-free rates are their highest level since the global financial crisis. For example, the U.S. Treasury 10-year yield has not been this high since 2007.
Other factors may place additional upward pressure in long-term interest rates. In the U.S., the significant increase in government debt in the aftermath of COVID-19 has major credit rating agencies worried. The significant increase in federal debt was used to finance both COVID-relief packages and other ongoing fiscal programs that intend to boost long-term growth (e.g., CHIPS Act, Infrastructure Act, Inflation Reduction Act). The political division in the U.S. was seen at its worst during the debt ceiling debate earlier in the year. An agreement to raise the ceiling was reached back in June, but this did not prevent Fitch Ratings from lowering the U.S. sovereign debt rating to “AA+” from its coveted “AAA” rating in August. More recently, as negotiations in U.S. Congress threatened a government shutdown, Moody’s has threatened to also lower its ‘AAA’ rating for the U.S. While a shutdown was temporarily avoided, Moody’s—the last major agency still assigning the top rating to the U.S. debt—could still follow suit and downgrade the U.S. rating. The stopgap bill to avoid a shutdown only provides government funding through November 17, 2023. With the ousting of representative Kevin McCarthy as the Speaker of the House, the discussions needed to avoid the next government shutdown just became more complicated. This could erode investors’ confidence in the U.S. and its government system, putting additional pressure on the interest rates it must pay to finance its obligations. Businesses would not be immune to such negative developments.
All 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. While investors are generally more optimistic in 2023, in recessionary environments the earnings volatility of businesses rises, which increases the risk of investing in the equity of those companies. Businesses may have to deal with an environment of higher cost of capital for the foreseeable future.
What Does This Mean to the M&A and IPO Markets?
The current deal market faces headwinds given the rise in interest rates over the past two years. Whilst the cost of borrowing has nearly doubled for many financially leveraged buyouts, lenders are also imposing more restrictive covenants on credit facilities, shorter maturities of loans, higher principal amortization requirements and an overall lower level of debt capitalization in a capital structure. A few other factors that have come into play include quality of earnings, as lenders are more skeptical of EBITDA add-backs and pro forma earnings adjustments today than in 2021-2022. In addition to the rapid and material increase in the cost of debt capital for our firm’s clients, we also observed that the overall availability of capital has diminished in many industry sectors including technology, office real estate properties and consumer discretionary businesses. The current market environment is risk-off for more speculative industries and high growth companies with no proven earnings.
The Modigliani-Miller Theorem taught us that capital structure composition does not impact firm value, if 1) there are no taxes, 2) there are no transaction costs, 3) there are no bankruptcy costs and 4) individual investors and corporations can borrow at the same rate. Of course, these are unrealistic assumptions outside academia. In the private equity buyout world particularly, and to a large extent in the homeowner marketplace with mortgage rates, interest expense deductions create valuable tax shields and super charge the expected returns of levered equity. Similar to what happens in the residential housing market when mortgage rates increase, many homeowners adjust their purchase price based on what they can afford to pay on a monthly basis. The same thing happens in the private equity and commercial credit market. For example, if a borrower could borrow up to five times debt-to-EBITDA in 2021, and now can only borrow 3.5x debt-to-EBITDA in 2023, then the projected IRRs and ROIs accruing to the equity holders decline significantly, even with the same firm value. Hence, the buyers have adjusted their purchase prices downward to reflect the more expensive cost of debt, the more restrictive debt covenants and economic uncertainty facing the global economy in Q4 2023 and 2024.
As of this moment, it appears that inflation may be under control in the U.S. But any quick cut in interest rates would be a sign that there is a material economic slowdown and earnings and cash flows would soon be under pressure for private equity borrowers. At Kroll Corporate Finance, we think deal activity will continue to be consistent with what we observed over a 10- to 20-year historical period. But it is unlikely to reach the volumes experienced from Q4 2020 through Q3 2022 for a while. Hence, financial buyers will have to create firm value by generating synergies with merger partners, improving operational efficiencies and generating organic revenue growth to offset the returns that were greatly realized by cheap and borrower-friendly debt covenants.
One trend that we predict may come to fruition in 2024 is an increase in IPOs and equity offerings as firms look to raise equity capital to strengthen their balance sheets and reduce interest expense burdens. This will likely happen in the private equity community with continuation funds and secondary sales from new PE capital, as new money comes into a capital structure through an equity co-investor in the form of convertible debt or preferred stock to fund growth, working capital and press-the-reset-button on a borrower’s credit ratios.
1 Monthly inflation readings are calculated on a year-on-year basis. Source of underlying data: U.S. Bureau of Labor Statistics (BLS), “All items in U.S. city average, all urban consumers, not seasonally adjusted” series, 12-Month Percent Change” and “All items less food and energy in U.S. city average, all urban consumers, not seasonally adjusted, 12-Month Percent Change”.
2 Source of underlying data: Eurostat database, series “HICP - monthly data (annual rate of change)”, available here: https://ec.europa.eu/eurostat/databrowser/view/prc_hicp_manr/default/table?lang=en. Accessed on September 26, 2023.
3 Source of underlying data: UK Office for National Statistics, Inflation and price indices.
4 Source of all stock market index data: Capital IQ. Calculations by Kroll.
5 This discussion was prepared on September 26, 2023.
6 Updated real GDP growth projections for the global economy, as well as U.S., Eurozone and UK can be found in Kroll’s Cost of Capital Infographics landing page: https://www.kroll.com/en/cost-of-capital/cost-of-capital-infographics. Projected growth for other major economies is also available.