The Perfect Storms

Written by Scott Fulton, Co-CIO and Co-Host of Keanaissance

The PPE degree offered by Oxford University is much prized. It combines three strands of “thinking” which, according to the Dons of the 1920s who launched it, would open minds rather than harness them to a discipline. Philosophically, Confucius is the shoulder on which many subsequent giants have stood. Perhaps apocryphally, he said:

“When the wind blows the grass bends.”

Adaptability is likely at a premium right now as we are forced, once again, to consider the cost of our recent and current experiences in another of the Dreaming Spires’ strands. 

Economics is known as the “dismal science”. The turning points in its canon are reactions to crises which are retrospectively described as “revolutions”. From agriculture, through trade and industry, to communications, economics has sought to describe the mechanics of the last upheaval in the context of foretelling the next. While this has given rise to the trope “economics has predicted 7 of the last 3 recessions”, we are now again in thrall to economics. We enter this period dominated by Monetarism and the pre-eminence of monetary policy. So much so, in fact, that Monetarists sought to engineer a supply-side alternative to Keynesian demand management via quantitative easing. As the Old Lady puts it:

“Quantitative easing is when we buy bonds to lower the interest rates on savings and loans. That helps us to keep inflation low and stable.”

Bank of England, Monetary Policy, What is Quantitative Easing?

Perfect Storm #1: The supply constraints of the Pandemic, exacerbated by the Russian invasion of Ukraine, meet the robust demand created by low interest rates, Covid public largesse, and the gains in the savings ratio. Inflation rates in the G7 go through 5.0% and now rest between 7.0% and 10.0% as the received wisdom of monetary policy since 2009 is abandoned.

On 4^th May 2022, the Federal Open Market Committee (FOMC) raises its discount rate by 50 basis points to a level last seen in 2018 (1.0%) and by a quantum not seen since 2000. The FOMC also indicates that it would unwind its quantitative easing (QE) book which stands at close to $9 trillion. On the same day, the Monetary Policy Committee (MPC) of the Bank of England votes (6-3) to increase Bank Rate by 25 basis points to 1.0%. The MPC indicates that the direction of travel for rates is upward, possibly to 2.5% by 2023, and the Bank indicates that its $1.2 trillion QE program was coming to an end. While the European Central Bank (ECB) has yet to follow suit, its recent statements echo that of the FOMC and MPC on rates and indicate also that its QE program is closing.

Perfect Storm #2: Equity markets, globally, react badly to the emerging economic picture. Between 5^th May and 11^th May 2022, the average fall in equity indices around Europe and the US is close to 5.0%. Indeed, the “tech-heavy” S&P 500 and NASDAQ indices fall by 6.9% and 9.7% respectively. Although there is a subsequent rally, there is something of the “dead cat” to this particular bounce.

The reaction of equities indicates a recognition that the equity risk premium has increased and as determined by the Capital Asset Pricing Model (CAPM), the rate of return demanded by investors has risen commensurately. The risk-free rate, whether taken from the Federal Reserve, Bank of England, or ECB has increased and is likely to increase further. The market return has clearly reduced as indices, such as the S&P 500, have fallen while the risk-free rate has increased. Alongside greater inherent volatility for individual share prices (e.g. Netflix), and the case for higher betas is now well made.

Perfect Storm #3: Governments find their coffers have been depleted. It is estimated that the US Government spent $5 trillion on support during the Pandemic. In the year to April 2021, the UK Government borrowed £299 billion, the highest annual figure on record. As a result, public sector debt was 95% of GDP, the highest proportion since 1961. EU debt, issued by Governments within the Union, rose above 100% of GDP during 2021 and is expected to close 2022 at €12.6 trillion, almost three times what is was in 2000.

Unwinding QE is not going to replace all of the lost Sovereign treasure. It is quite clear that Government debt issuance is likely to increase just at the time when Central Banks, under mandate to control inflation, have to increase the cost of that debt via interest rates.

A possible route to getting the required Sovereign debt issues away is to reduce the attractiveness of the alternatives. In that the most obvious alternative to debt is equity, the emerging picture from G7 Central Banks is akin to car salespeople publicising actively the dangers of cycling and overcrowding on the buses.

What do these storms mean for companies looking to raise capital? The obvious impact will be on valuations. Stand-alone models, such as Discounted Cash Flow (DCF), rely on a discount rate which is often derived from a Central Bank (e.g. Fed, BoE, or ECB rates). We know, with some certainty, that these are up and rising from now until 2024. Comparative ratios, such as Enterprise Value (EV) to revenue or EBITDA, or Price to Earnings Ratios (PERs) are compromised by the volatility of share prices such that the variance in any sector group of numerators (EV or share price) render the comparisons unstable.

Net, net, companies are likely to face having to accept less cash for more equity while, at the same time, having to pay more for debt issuance or higher levels of gearing.

These are general observations. How companies buck these trends will be down to management teams’ ability to tell a different story. For every company suffering under the new economics, there will be another whose structure and product benefits.

Critically, in these interesting times, the ability to adapt will be the characteristic most prized by investors. This is not the ability to turn your rubber glove factory into a state-of-the-art producer of PPE. The gainsaying in this regard over the last two years is unlikely to dissipate quickly. It is the ability to manage change. It will be measured in qualitative as much as quantitative ways.

For example, if you have managed to maintain, either absolutely or relatively, production or output while allowing the workforce to WFH, you are adaptable. If you have sought out new markets as Pandemic, war, or Brexit hurdles have emerged, you are adaptable. If you have contained input price inflation while managing product or service price growth, you are adaptable.

Economics is a zero-sum game. It is not whether we win or lose, but how we play that determines our value and that of our companies. There will be many that are too afraid, or too hidebound to change their spots. The winners will be those that did adapt, re-purposed lines or teams, opened up new markets in old places, and – simply – found a way through.

Using the difficulty is a key theme at 2022’s Keanaissance. VIP and its guest speakers will present details of how the Pandemic posed difficulties which demanded, and received, responses.