Tuesday, July 1, 2014

Risk & Valuations, Part 4: Valuations and leverage through the business cycle.

In boom times, interest rates tend to rise and risk premiums tend to fall.  In recessions, interest rates tend to fall and risk premiums tend to rise.  But, during recessions, an unexpected decrease in earnings might put firms in a position where they would want to decrease debt to re-establish an optimal capital base.  But, the problem is that in this context, firms frequently do not have wherewithal to pay down debt.

So, in economic downturns, leverage may increase coincidentally with declining interest rates.  This may appear like a confirmation of firms leveraging up when interest rates are low.  But, it is probably more a product of disequilibrium in capital markets, and more a product of decreasing equity market values than of increasing demand for debt.

We imagine Fed policy temporarily lowering short term interest rates, and we see rising PE ratios and profit margins.  We intuit that firms are leveraging up on cheap Fed-fueled capital, in a feeding frenzy of easy money.

But, firms in a downturn will be looking to deleverage, regardless of Fed policy.  If aggressive policy is appropriate, it would lead to more confidence and to a lower Equity Risk Premium, which also would increase the equity valuation and lead to deleveraging (or, after a sharp downturn, allow firms to re-establish a more deleveraged equilibrium).  As I outlined in the previous post, higher PE ratios and higher profit margins would go hand-in-hand with this deleveraging.  As the recovery matures and interest rates increase, we might then see more leverage and lower profit margins and PE ratios.

So, loose cyclical Fed policy, more properly understood, is not adding fuel of unsustainable investment demand to the economy as much as it is helping equity markets to re-establish an equilibrium level where savings demand is moving back out of debt and into equity.

When the Fed expanded its balance sheet, rates increased.
The liquidity effect in this cycle appears to have been very weak, so that interest rates on debt increased with accommodation.  So, in this cycle, while long term trends in risk free rates were low, episodes of Fed easing were actually associated with rising interest rates on debt.  In the recent recession, accommodative monetary policy was associated with higher long term bond rates, so corporate recovery would have come from increased nominal demand and decreased equity premiums.

In contrast, in the 1970's, when the Fed was too loose, aggressive Fed policies would not have lowered the Equity Risk Premium.  In that case, equity values would not recover as sharply and leverage might increase earlier in the cycle.  In fact, that is what I see in the data.  In the 1970's, because inflation was so high, demand shocks were not as sharp and subsequent Fed reactions of accommodation were not as effective.  The result was that there were less extreme fluctuations in Enterprise Value through business cycles.

Here is a picture of relative equity and debt values to help imagine the effects of economic developments and monetary policy through a cycle.

RFR = 10 year Treasury Rate, ERP = unlevered Equity Risk Premium
Each Line represents the Equity & Debt levels for a Firm with different debt levels,
from 10% debt at the left end to 90% debt at the right end

At point 1, firms have a nearly optimized debt level, with market RFR = 4% and ERP = 2%.  But, the 25% shock to Enterprise Value reduces the equity value substantially, leaving the firm more highly leveraged.  Note that a combination of operating and financial leverage mean that Enterprise Values (EV) will be much more affected by the shock than NGDP is, and Equity Value, being the residual form of ownership, will be more affected than Enterprise Value.  This hypothetical would be representative of a downturn similar to the recent recession, with a decline in NGDP expectations of just a few percentage points, leading to a 25% decline in EV, and a nearly 50% decline equity values.

At point 2, market premiums have adjusted so that RFR = 2% and ERP = 3%.  Especially in the earlier parts of a down cycle, most of these premium adjustments reflect changing market sentiment as opposed to Fed management.  Note that the maroon line to the left of point 2 represents Enterprise Value at the new lower demand level if premiums had remained at RFR=4% & ERP=2%.  In this case, with no decline in RFR, firms would have been incapable of carrying the original debt levels.

So, to recover, firms need to either see a recovery in expected demand, or a decline in RFR or ERP.  I think a visual perusal of the graph will suggest that the order of effectiveness of these changes, from most to least, is (1) demand recovery, (2) ERP decline, and (3) interest rate decline.  For instance, the 1%RFR/3%ERP context achieves higher EV and lower leverage than the 3%RFR/1%ERP context.  I believe that, generally, this supports NGDP targeting as a Fed paradigm, as the recovery in demand (whether inflationary or real) should be the primary focus.  Furthermore, the relative indifference corporations would have between reduced ERP and reduced RFR, with some preference for reduced ERP, the relative lack of direct control of the Fed over longer term rates, and the general relationship these premiums have to expectations, would suggest favoring expectations management over rate targeting.

I will also note that, from the Federal Reserve z.1 data, interest paid on corporate debt appears to roughly follow trends in long term rates, possibly with some lag.  Short term rate reductions might allow firms to reduce some interest expenses, on the margin, but they would not lead to a cumulative reduction in debt expense of the scale necessary to make a difference in corporate balance sheet recoveries.  Empirically, it's not clear that there is any coherent pattern in actual corporate debt expense due to the effect of monetary policy on short term rates.  The same might be said of ERP, simply because it is more difficult to measure.

Profit Margins and PE Ratios

Here is a graph of expected profit margins at different leverage levels, and different interest rate and risk premium contexts.

As interest rates (RFR) go up, leverage goes up, Enterprise Value goes down, and Profit Margins go down.

As risk premiums (ERP) go up, leverage goes down, Enterprise Value goes down, and Profit Margins go up.

We are now in a low RFR, high ERP context.  Profit margins will be exceptionally high for reasons simply related to risk premiums and firm leverage.  Leverage is currently low, as this model would predict.

Before we even account for changing levels of capacity utilization, demand, and relative costs, etc. we should expect to see a cyclical pattern in profit margins, presenting some difficulty in interpretation.  During the expansion, Enterprise Value and profits will be healthy, but with high RFR and low ERP, profit margins may be declining during the expansion.  They will decline even more as the initial operational dislocations of a recession take hold.  But, then, as RFR declines and ERP increases, as firms are able to deleverage back to comfortable balance sheet levels, margins should recover, hitting their highest levels early in the recovery, before RFR and ERP revert back to expansionary levels.

PE Ratios differ, in that both rising RFR and ERP make PE ratios decline.  As a result, cyclical changes in PE ratios tend to relate to changes in expected growth from the current profit levels.  But, longer term comparisons would lead us to expect PE ratios to be higher than normal now, since real interest rates are low in comparison to real growth expectations.  Below are the PE Ratios of our hypothetical firm, as leverage, RFR, and ERP change.

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