Wednesday, August 27, 2014

Squaring the Circular Logic of the Interest Rate-Leverage Connection (Updated)

I have outlined theoretically and empirically how the equilibrium level of corporate leverage, counter-intuitively, could rise when interest rates rise.  Here is a graph of corporate debt and equity values over the past half century (adjusted for inflation), with interest rates and equity premiums.

The next graph compares corporate equity and debt levels as a proportion of operating profits to nominal 10 year interest rates.

Now, regardless of any problems with this theory, it is clear that there is very little connection between relative debt growth rates and interest rates, and there is no evidence of firms significantly leveraging up on debt when rates are low (either real or nominal rates, short or long rates).  Except for recent periods of cyclical disequilibrium, debt levels have remained at a relatively stable proportion of operating profits over a long period of time.

In fact, due to the relative stability of debt levels, I have pointed out that the changing leverage comes about mostly through changing equity values.  So, generally when stock market levels are high and PE ratios are high, this is not a product of frothy markets fed by debt-accumulating corporations.

I recently was looking at Robert Shiller's CAPE ratio, and noted that its fluctuations follow a very similar pattern to the inverse level of interest rates and the inverse level of leverage.  In other words, when CAPE is high, leverage (Debt to Enterprise Value) tends to be low and interest rates tend to be low.  But, you might notice some circular logic here.  Enterprise value is a product of price.  Since debt levels are fairly stable, the change in leverage comes mostly from a change in enterprise value, which is mostly going to come from a change in share price.

So, how do we know that this isn't just an accounting identity?  To start, as I mentioned above, debt doesn't have to be stable.  In fact, I think it probably bucks conventional intuition that debt levels don't rise relatively when interest rates decline.

There is a kind of a paradox here.  Because, when corporations manage their capital, which partly entails minimizing their weighted average cost of capital (WACC), they use the market value of their equity to estimate costs.  In other words, they are looking at the cost of debt and the cost of equity with the same Debt to Enterprise Value model that I am using here.  They should be targeting their debt levels based on relative market values and costs of their debt and equity.  And, empirically, the pattern of D/EV matches what we would expect to see from that model of capital management.  If so, how are all of the adjustments to aggregate capital structures being carried by changes in equity, which is mostly a product of changes in equity share price?

I think we have to think about corporate capital as having many competing constraints, and the level of debt as a multiple of NOPAT probably hints at a lot of those constraints.  Here is the standard cost of capital formula:

If we assume away some market frictions, the cost (K) of each form of capital should reflect the same set of risks, so that, theoretically, except for the tax consequence, a firm should be indifferent about the capital mix.  This is the Modigliani-Miller theorem.  But, I think what we see in the graph above is that, in actual capital markets, in the aggregate, the cost of debt starts to accelerate when debt gets above 5 or 6 times net operating profits after tax (NOPAT).  If these constraints are in play, then, even if a firm is managing capital with the WACC model in the current tax context, with dynamic capital costs, then the absolute level of debt compared to output will tend to settle in a tight range regardless of more general risk premiums.  These other constraints, which affect K(d) as leverage increases compared to NOPAT, will make EV/D ~ PE look like an accounting identity.

In fact, it appears that there was a slight shift upward in the mid-1980's, to a slightly higher debt/NOPAT ratio.  And, using the implied corporate interest rate from the Federal Reserve Z.1 nonfinancial corporation financial tables (interest paid / Credit Market Instruments), there appears to have been a corresponding increase in credit spreads (the black line).  This could reflect any number of changes, including what appears to be an increase in average debt maturities.  This also happens to coincide with the development of the high yield bond market.  So, there may have been a one-time shift from financial innovations that allowed firms, in the aggregate, to increase debt/NOPAT levels.  But, it appears to be associated with a steep rise in K(d).

When low rates lead to a tendency for deleveraging, firms may engage in some pure capital management - buying down bonds, issuing new shares, changing dividend or buyback policies, etc.  But, these moves have expenses that may not be justified over the long term.  When equity becomes such a large portion of enterprise value, incremental increases in operations can have a large effect on share value.  So, even though debt will tend to remain at the maximum optimum level relative to NOPAT, firms will have incentives to increase NOPAT through operations management - more efficient use of working capital, etc.  In this way, NOPAT and debt levels can grow, and the high relative equity value will mean that this operational growth will be especially multiplied in the total value of the firm.  The original NOPAT expansion will create value, and then the expansion of debt made possible by the NOPAT expansion will create additional value.

So, we should expect to see NOPAT growth during times of low interest rates and low corporate leverage.  This is what we find.  NOPAT grows when leverage is low.  (Keep in mind that leverage was especially low in the late 1990's because of excessive growth expectations, and the high points after that were times of disequilibrium during demand crises - notice that leverage peaks when NOPAT crashes.  Firms quickly deleveraged as demand recovered.  So, cyclical fluctuations have been especially high during this period, but cyclically adjusted leverage has been close to 30% throughout this time.)

I am sure there are other narratives that can be built around other hypotheses, so this information doesn't create any exclusivity for my hypothesis.  But, the data can support my hypothesis.

Interestingly, GDP hasn't followed the trend of NOPAT.  Before the 1970's, real GDP was growing quickly.  And, real GDP growth leveled off during the high rate period, though not as sharply as NOPAT, understandably.  But, instead of reaccelerating, GDP growth has continued at that lower real growth rate as interest rates have declined.  I suspect there is a combination of innumerable explanations for this, including corporate foreign profits, demographic consumption and saving patterns, and maybe even issues with the difficulty of measuring consumption value in the age of the internet.

It's a shame that this sort of subject tends to be reined in by us vs. them thinking regarding corporate profits versus other household income, because there are probably many interesting things going on here - many of them reasonable and helpful for general prosperity - that would only be visible to the curious and non-judgmental observer.

My Attempt at a Curious & Non-Judgmental Interpretation:

For the investor, the real NOPAT chart shows how there is plenty of room for more growth in corporate valuations, simply coming from recovery in NOPAT.  At this point in the cycle, equities probably still offer a decent expected return without depending on expansion of valuation multiples.  (If the expansion continues, allowing for a recovery in interest rates, equities will also benefit from corporate re-leveraging as rates increase and enterprise value expands.  This would allow more NOPAT expansion and equity growth even as some valuation multiples retract.)

Regarding GDP, I suggest that the housing "bubble" was a reasonable and predictable result of the baby boomer phenomenon.  Boomers are utilizing real estate as a chimera of consumption and savings.  Homes are storing value for future consumption.  From 1997 to the peak in 2006, $8.3 trillion was accumulated in real estate equity.  The rise of home values tends to be blamed for creating unsustainable spending.  I believe this has it backwards.  Mortgages rose less than equity did.  Homes, on net, were replacing spending, not funding it.

While this seems like a reasonable phenomenon to me, it isn't particularly efficient.  The homes are storing value for future consumption, but this is only partly through home production.  Much of the savings simply creates a temporary nominal increase, just as if a rush of savers bids up the price of bonds.  While the homes are a store of value, they don't serve as a basis for economic growth and productivity.  Saving through the foreign operations of US corporations seems like a more efficient means of consumption smoothing.  But, both are inevitable.

I don't think either of these savings vehicles are picked up particularly well as either consumption or savings, so since the mid-1990s, when the baby boomers started entering this phase, GDP has been understated.  And, there has been a real loss in potential GDP growth, due to the allocation of capital to real estate in lieu of more dynamic productive assets.  (On the other hand, there is no unironic way to complain about stagnation and low productivity on a blog.)  In effect, we have all been waiting for the productivity slowdown coming from the aging boomers.  But markets are forward looking, and to the extent that trades through time are available (as they are through real estate), economic trends will be traded and shared through time.  Markets are simply allowing for an exchange with the future, which is manifest as a seemingly premature slowdown in GDP.

(Some people argue that home prices should be factored into inflation measures.  They are dangerously wrong.  But, I will note that if we did count home appreciation as inflationary GDP growth, nominal GDP growth would have been much higher in the 2000's, with most of the increased nominal income going to middle class households.  But, such is the mania behind our current malaise, that broad nominal appreciation of the most widely held durable asset in the economy is vaguely accounted for only as a cost.  So, the colloquial story of the 2000's goes something like:  high home prices led to unsustainable consumption that created a false level of nominal GDP.  And real GDP was much lower than reported, because inflation would have been much higher if home prices were accounted for in inflation measures
.......this is mistakes on top of mistakes on top of mistakes, believed with religious fervor.  I am also frequently told, with the same conviction, that the falling labor force participation of 25-54 year olds is a sign of economic desperation.  I am also frequently told, with the same conviction, that the rising labor force participation of 55+ year olds is a sign of economic desperation.  Religious fervor is helpful to believe such things.  Likewise, as we all know, US corporations are unpatriotically moving out of the US to avoid taxes.  And, we all know, actual US corporate taxes aren't high at all.  They have so many tax breaks that their effective tax rates are much lower than the headline rate.  Both things, believed with fervor.)

Since 2006, the Fed has devastated the real estate savings that the baby boomers had accumulated.  With another 5-10% price accumulation, homes will probably be back near a healthy equity/mortgage balance, at which time, after an 8 year (wow) pause, boomers can accumulate marginal new real estate equity.

Of course, wide swaths of the American public, from all sides of the political spectrum, are explicitly calling for the disruption of both of these vehicles for deferred consumption - calling corporations with operations abroad unpatriotic and warning of the developing new housing "bubble".  Many of these outspoken critics of this phenomenon are boomers themselves, who, no doubt, in their personal financial dealings are holding large positions in real estate and multi-national corporations, specifically to prepare for their future retirements.

I've said it before.  H.L. Mencken was a Pollyanna.

PS.  It also happens that the one-time increase in female labor force participation coincided with the high leverage period.  Female LFP peaked and began to trend down along with male LFP coincidentally when leverage declined in the 1990's.  So, part of the dilemma may arise from this.  This may have caused the 1960s-1980s GDP to be unusually high, while this + the age-demographic decline in LFP caused the 1990s+ GDP to be unusually low.

Added:  I should have done this before I posted.  Here is the GDP graph, adjusted for the size of the labor force.  This has a shape much like the graph of NOPAT, except, instead of rising and falling inversely with leverage, GDP/LF rises and falls with Enterprise Value.  This is affected by the Equity Risk Premium (ERP), in addition to risk free interest rates, so GDP growth stalls and returns a little earlier in the 1960s-1980s period, because ERP declined before interest rates did.  (Note: the trend lines on the NOPAT graph were mathematically derived, but I just eyeballed these.)

1 comment:

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