The topic of inflation is receiving no shortage of headlines in the financial press. The change is all the more striking because, as average inflation has been in the 1 percent to 3 percent band over the last several economic cycles, it had fallen off of many market participants’ radar. In fact, the last time inflation was deemed “high” (ie, greater than Fed targets of around 2-3 percent) was back in the early-90s, and before that, in the early-80s.
Inflation: What has changed?
Most of the current inflation drivers have been a result of covid-19: the rapid economic shutdown in early 2020 and the restart after the vaccine rollout in late 2020 and into 2021. Simply, demand is outstripping supply, thus driving up prices for most goods and services. May average 12-month CPI had escalated to 5 percent, with some categories such as transportation, used vehicles and fuel at much higher levels (up around 11 percent, 30 percent and 50 percent, respectively).
The index has increased every month since January and is up the most in a 12-month period since June 1992. Several other categories had material increases in May alone: home furnishings (up 1.6 percent), apparel (1.2 percent), airline fares (7 percent, after rising 10 percent in April) and new vehicles (1.6 percent). The most pronounced increases have been recent, in April and May, so clearly there is a current material uptrend.
How will higher inflation impact the private equity and credit markets and their underlying investments?
The obvious answer is negatively, but how will companies, the capital markets and governments react? Higher inflation is typically negative for company valuations in the nearer term because it increases input costs (materials and labor) and borrowing costs, and it reduces standards of living via lower purchasing power when wage inflation fails to keep up with goods-and-services inflation). More importantly, in the longer term, it reduces expectations of growth, thus putting additional downward pressure on equity values. That pressure is further compounded in the private equity space due to the high leverage (and thus, high fixed interest costs impacting cashflows) used to capitalize companies.
In the world of valuation, lower cashflows (current and expected) and higher capital costs mean lower valuations. On a fundamental basis, discounted cashflow valuations are negatively impacted as modeled cashflows decline with lower margins and lower expected growth, as well as from higher discount rates used to discount projected cashflows. Market approach valuations are negatively impacted as well by (i) lower valuation drivers because of lower earnings estimates, and (ii) lower valuation multiples due to lower public comparable levels as valuations decline.
What is really happening in the corporate world?
So far, in our current valuation analyses, we are seeing most companies report some form of input cost inflation, both goods and services as well as wages, and thus lower margins. Many are trying to pass those higher costs along by increasing sales prices. For now, most companies are expecting to meet upcoming credit financial covenants and are maintaining year-end 2021 budgets.
When will the rate of inflation slow?
It’s also too early to tell if inflation will continue to escalate. The Fed is currently taking the position that this inflation is temporary and supply will catch up with the demand as more businesses come fully back online. Per a recent New York Times article, some commodities like lumber have had a material recent price reversion as supply has come back online and production ramped up. Lumber prices have come down materially from a May 2020 peak at $1,600/board feet to just under $900/board feet. Many are expecting lumber prices to fall back down to historical levels at $400 to $500/board feet.
Hence, policymakers have conveyed that supply will catch up with demand and they will likely maintain the current low-interest-rate environment until 2023. This is further supported with forward LIBOR spot and swap curves, which are upward sloping but still depict relatively low historical base rates. However, as the curves have shifted up since last quarter (see below graph), investors are still factoring in some expectations of higher base rates, notably in 2023 as guided by the Fed.
Irrational consumer behavior?
The other inflation factor is consumer psychology. In the early 70s and 80s, many consumers feared that runaway inflation was sustaining so it led to continued panicked buying that seemed to perpetuate additional consumer inflation (“I’d better buy this car or this house today at today’s dollars because in a month, it’s going to be 5 percent more”). So far, irrational consumer behavior does not seem to be taking hold. Maybe the Feds’ actions and the capital markets’ reactions are calming consumer fears.
And the capital markets?
On the back of Fed and company guidance, the financial markets have not skipped a beat. Public equity and bond prices continue to climb and the private market participants continue to report record volumes and valuations. So clearly, the markets are not pricing in runaway inflation (via expected profit compression) or near-term higher interest rates (via higher expected equity risk premiums). Credit markets are robust as well. Investors are not expecting slower growth and higher default risk.
What if the Fed and the markets are wrong?
What if inflation proves not to be temporary? The Fed will likely act sooner than 2023 to raise short-term rates to slow demand and growth and thus slow inflation. Company profits will eventually become impacted as sales price increases will become less effective. In the US, GDP is about 70 percent based on consumer spending. If wages growth does not keep up with product and services inflation, then consumers will cut back spending, which, in turn, will slow company and overall economic growth.
As noted above, higher interest rates will also increase equity risk premiums and thus required rates of return on equity which will negatively impact company and equity valuations. This, along with slower earnings growth, will be a double whammy on company and equity valuations.
For the private credit markets, as most instruments are floating rate, higher rates would initially result in higher coupons payments for borrowers and greater income for lenders. Accordingly, we are seeing increased demand from investors for floating rate loans at the expense fixed rate bond products. However, if the private loan markets remain competitive, history tells us that credit spreads will tighten to lower all-in yields. Middle-market first-lien loans have generally hovered in the 6 percent to 8 percent range since the early 2000s, depending on competitive conditions, according to data from Refinitiv.
Hence, if base rates rise due to inflation risk, borrower costs and lender income will likely come back down. But clearly, lower growth and lower cashflows from inflation will affect borrowers’ financial performance, whereby credit ratios will worsen and thus erode credit quality. This will negatively affect lender credit valuations.
For now, higher inflation appears innocuous and near-term higher interest rates appear unlikely, and the economic expansion will continue. But time will tell if the Fed’s – and the capital markets’ – rosy prognosis proves correct.
John Czapla is chairman of VRC, an independent, global valuation firm, and head of its portfolio securities valuation practice