2012 Review and Outlook: Plus ça change... BY JASON M. THOMAS

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1 Economic Outlook 2012 Review and Outlook: Plus ça change... September 10, 2012 BY JASON M. THOMAS Over the past several years, central banks have taken unprecedented actions to suppress both short-andlong-term interest rates in an effort to spur spending. The announcement, or anticipation, of these policies has generally led to sizeable increases in stock indexes, which has caused some to fear that monetary easing is artificially propping up asset prices at unsustainable levels. In fact, what central banks have done is suppress the risk-free portion of discount rates; the incremental returns investors earn from bearing macroeconomic, market, and credit risk are quite high by historical standards. The gap between the expected return on corporate assets and the cost of fixed-rate, external finance makes today an especially favorable time to make long-term investments in cash-generative businesses. Monetary Policy and Discount Rates The key question facing investors a year ago at our investor conference was whether the United States economy was likely to fall into a double dip recession. At the time, we characterized the U.S. economy as being in the midst of a long hard slog that would involve slow, unsatisfying growth but not outright contraction. 1 While our basic outlook remains largely unchanged, the context has shifted markedly. Rather than assessing the economic meaning of a sharp sell-off in equity markets, as was the case in September 2011, the curiosity of the moment is that asset prices have risen for several months even as the economic outlook has darkened. The simplest explanation for the anomaly is that market participants have bid up asset prices in the anticipation that central banks will provide further monetary policy accommodation. Asset pricing theory is based on a simple identity: the price of an asset equals the discounted present value of its expected future cash flows. Since 2010, central bankers have frequently responded to news that future cash flows would fall short of previously formed expectations by announcing policies to reduce the discount rates applied to those cash flows. Negative macroeconomic news that would have previously been injurious to asset prices could now be positive, on net, if it could reasonably be expected to result in aggressive central bank action to suppress discount rates. Discount rates include a risk-free component that measures the present value of a future payoff delivered with absolute certainty. Since the term structure of interest rates is determined by arbitrage relationships between the current overnight interest rate, the yields on high grade sovereign bonds, and interest rate swaps and forwards, central banks can reduce longer-term yields by committing to keep short-term interest 1 The Long Hard Slog, August 26, Available at:

2 rates lower for a longer period of time. Alternatively, the central bank can reduce the yields on longer-term notes by simply purchasing them at higher prices than those that currently prevail in the market. The Federal Reserve has pursued both strategies with a great deal of success. Before the money market crisis hit in the summer of 2007, the present value of $1 to be delivered in ten years was $0.60. Today, it is $ Discount rates also include a premium to account for the risk that the future payoff may be lower than expected due to macroeconomic stress or problems specific to the business. Although an explicit goal of the Federal Reserve s asset purchase programs has been to reduce these risk premia, 3 both theory and evidence suggest that monetary policy has had very little impact on the premium investors earn from bearing credit or market risk. 4 Credit Spreads and the Credit Risk Premium Measured relative to the equivalent duration swap rate, the average credit spread on high yield bonds has averaged 5.62% since Of this total, expected default losses have accounted for about 3 percentage points (54% of the spread), on average, while the credit risk premium the expected excess return an investor earns for bearing default risk has accounted for an average of 2.6 percentage points (46%). 6 However, as shown in Figure 1, the size of the credit risk premium and its relative contribution to credit spreads has varied considerably through time. Figure 1: Decomposition of High Yield Credit Spreads 20.0% 15.0% 10.0% 5.0% Average spread, % Jan-90 Feb-91 Mar-92 Apr-93 May-94 Jun-95 Jul-96 Aug-97 Sep-98 Oct-99 Nov-00 Dec-01 Jan-03 Feb-04 Mar-05 Apr-06 May-07 Jun-08 Jul-09 Aug-10 Sep-11 Credit Risk Premium Expected Losses Error Term Author s Calculations; Bank of America Merrill Lynch 2 U.S. Treasury, Constant Maturity 10-year Yields. 3 Bernanke, B. (2012), Monetary Policy since the Onset of the Crisis, Federal Reserve Bank of Kansas City Annual Symposium. 4 Woodford, M. (2012), Methods of Policy Accommodation at the Interest-Rate Lower Bound, Federal Reserve Bank of Kansas City Annual Symposium. 5 The credit spread is the difference between the yield on a credit risky instrument and the risk-free rate after accounting for taxes, liquidity, and other factors. The U.S. Treasury rate is not a pure default-free interest rate because Treasury securities have greater collateral value, tax advantages, and more liquidity than corporate bonds. As a result, pure compensation for credit risk is best measured by the interest rate spread relative to the swap curve. 6 Thomas (2011), The Credit Risk Premium and Return Predictability in High Yield Bonds, George Washington Univ. 2

3 As of August 31, the average yield-to-maturity on high-yield bonds was 7.3%; near a record low. 7 However, this yield represents a 6.6% spread relative to the equivalent duration swap rate of 0.7%, which is 100 basis points greater than the average spread since Based on Q trailing twelve-month default loss estimates provided by Bank of America Merrill Lynch, the credit risk premium accounts for an estimated 3.6 percentage points of the average credit spread. 8 This means that the risk premium for bearing default risk is currently 100 basis points greater than its long-run average of 2.6% per year. This is significant because variation in the credit risk premium explains nearly 40% of the variation in realized trailing twelve-month (TTM) excess returns, with average excess returns 6.9% when the credit risk premium is above its average of 2.6% and -1.0% when it is below average. 9 The Fed Model and the Equity Risk Premium The premium investors earn from bearing stock market risk is measured through ratios that relate the market price of corporate assets to fundamentals such as cash flow, earnings, or the replacement cost of capital. The Fed model, for example, posits a long-run relationship between the earnings yield on the S&P 500 (the reciprocal of the price-to-earnings (P/E) ratio) and the 10-year Treasury yield. The yield gap the difference between the earnings yield on the S&P 500 and the yield on the 10-year Treasury note represents the risk premium, or spread, investors demand to hold risky stocks instead of government bonds. When the yield gap is positive, excess stock market returns tend to be positive, both at short and long forecasting horizons. 10 In the 11 quarters when the gap was negative since 2000 (the yield on the 10-year Treasury exceeded the earnings yield), the average TTM return was -7.0%. In the 39 quarters where the gap was positive, the average TTM return was 8.8%. At the end of Q2-2012, the earnings yield on the S&P 500 was 6.83%, which was more than 5 percentage points greater than the 10-year yield of 1.6%. The 10-year yield has not only fallen below the earnings yield, it is also 70 basis points below the dividend yield on the U.S. stock market. 11 This is the first time since 1953 that the current income provided by the stock market has persistently exceeded that of Treasury bonds. Tobin s q and the Fair Value of Corporate Assets The equity risk premium can also be measured using Tobin s q, which measures the ratio between the stock market-implied value of corporate assets and their replacement cost. When the ratio is greater than one, the discount rate applied to corporate earnings is lower than the expected return on capital. 12 Conversely, when the ratio is less than one, the stock market sells at a discount to fair value and investors are paid a premium to bear stock market risk. As a result, one would anticipate a strong, negative relationship between q and subsequent stock market returns. That is precisely the relationship observed in the data. Since 1951, a 10% increase in q (i.e. 1.1 relative to 1) is associated with a 1.7% decrease in TTM stock market returns, on average. 13 When q has been less than one, the TTM return has averaged 12.4%, or 3.7% more than the 8.7% return when q has been greater than one. When excluding the high returns of the stock market bubble period ( ), the relationship is 7 Bank of America Merrill Lynch, H0A0 Index. 8 Melentyev (2012), Bank of America Merrill Lynch High Yield Chartbook, Q Thomas (2011). 10 Maio (2012), The Fed Model and the Predictability of Stock Returns, Review of Finance. 11 CRSP Value-weighted U.S. stock market. 12 Tobin J. and Brainard, W.C. (1977), Asset Markets and the Cost of Capital, Cowles Foundation Paper No CRSP and Federal Reserve Board of Governors. This coefficient is statistically significant at the 0.1% confidence level. 3

4 even stronger: since 2000, the average TTM return when q is greater than one has been -17.7% compared to an average return of 9.1% when q is less than one. 14 Today, q stands at approximately Figure 2: q Ratio and Trailing Twelve-Month Stock Market Returns, q Ratio % -30.0% -10.0% 10.0% 30.0% 50.0% TTM Stock Market Return Source: Federal Reserve Board of Governors and CRSP Putting it All Together: Ebitda Multiples and Cash Flow Yields Corporate asset prices can also be measured on the basis of total operating cash flows (Ebitda) relative to the market value of all claims on the business (enterprise value). This measure provides greater insight into the effect of monetary policy on asset pricing because it allows for direct comparison between the yields on the assets of the business (the left hand side of the balance sheet) and the yields on the constituent pieces of the businesses capital structure (the right hand side of the balance sheet). As of September 1, the multiple on the S&P 500 was 8.31x average Ebitda, which is about 10% less than its average since The reciprocal of this multiple the Ebitda yield or average annual operating cash flow per dollar of capital was 12.0%, which is extremely high in the context of today s effective interest rates. After accounting for call options and other features of the indentures, the average effective interest rate on high yield bonds is currently 6.82%. 16 The 5.2% gap between the Ebitda yield and effective average high yield interest rate is larger than any gap previously recorded and nearly 3x greater than the 10-year average of 1.77%. 17 If interest rates persist at today s levels, multiples would have to increase to 11.6x Ebitda, an increase of 40% from current prices, for the spread to return to its ten-year average of 1.77%. We restrict the sample to post because older data suggest even larger price increases. Between January 1992 and June 2012, the 14 CRSP and Federal Reserve Board of Governors. This coefficient is statistically significant at the 0.1% confidence level. 15 Federal Reserve Board of Governors data updated using the S&P 500 since the June 2012 data release. 16 Bank of America Merrill Lynch, Global Index System, H0A0 Index. 17 The data series goes back to the mid-1980s. Before this time, the high-yield market consisted mostly of fallen angels rather than original issue, speculative grade borrowers. See Altman (2007), Global Debt Markets in 2007: New Paradigm or the Great Credit Bubble? Journal of Applied Corporate Finance. 4

5 average Ebitda yield on the S&P 500 was essentially equal to the average yield-to-maturity on high yield bonds. To achieve parity at a yield-to-maturity of 7.3%, the average enterprise value on the S&P 500 would have to increase to 13.7x Ebitda, an appreciation of 65% from today s level. 18 Figure 3: Ebitda Yield Relative to Effective Average High Yield Interest Rate 25.00% 20.00% 15.00% 10.00% 5.00% average spread : 1.77% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% 0.00% Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr Oct Apr % Yield Gap (right axis) Ebitda/EV Average High Yield Interest Rate Source: S&P Capital IQ and Bank of America Merrill Lynch Implications for Capital Structure Equilibrium While price increases of this magnitude may not seem particularly likely, the apparent mispricing has important implications for capital structure decisions. Ordinarily, one would expect that the interest rate would naturally adjust upward to close the yield gap. 19 Instead, the current stance of monetary policy ensures that the marginal cost of external finance remains considerably lower than the expected return on corporate assets. This creates an obvious incentive to pledge (more valuable) future income through fixed obligations and use the proceeds to acquire corporate assets today. In simple terms, $100 payable in seven years discounted at a 7% annual rate generates $61 of proceeds that can be invested at 12% Ebitda yields to generate $135 in seven years (abstracting from depreciation and taxes). Figure 4 plots the trailing twelve-month correlation between the yield on the 10-year Treasury and corporate profits as a percentage of the market value of corporate equity. 20 Prior to 2000, earnings yields and interest rates were positively correlated, as expected. Aside from diverging at the peaks of the business cycle in 1970, 1980, and 2000, interest rates generally moved procyclically to close any yield gaps that opened up. This seems to have changed since 2000, as interest rates and earnings yields have diverged for longer periods 18 If one goes back to the mid-1980s, the average spread was persistently negative. 19 The natural rate of interest should be higher when income growth is high because of the decline in the discounted present value of the marginal utility of future income. Increases in corporate earnings yields are associated with growth in income and inflation, which create expectations of higher future short-term rates; declines in income growth and inflation have the opposite effect. Woodford, M. (2003), Interest and Prices. Princeton University Press. 20 Market value of equity data from the Federal Reserve Board of Governors, Z.1, Table B Profits data from the Bureau of Economic Analysis. 5

6 following recessions than had been the case previously. Today, the correlation remains negative fully three years after the start of the recovery. Figure 4: Trailing Twelve-Month Correlation, 10 Year Yield and Corporate Profitability Rate 100.0% 80.0% 60.0% 40.0% 20.0% 0.0% -20.0% -40.0% -60.0% -80.0% % Mar-70 May-72 Jul-74 Sep-76 Nov-78 Jan-81 Mar-83 May-85 Jul-87 Source: Federal Reserve Board of Governors; BEA Sep-89 Nov-91 Jan-94 Mar-96 May-98 Jul-00 Sep-02 Nov-04 Jan-07 Mar-09 May-11 The divergence from previous relationships is likely due to changes in the conduct of monetary policy since the collapse of the stock market bubble in In August 2003, the Federal Open Market Committee (FOMC) statement contained the phrase considerable period to describe the likely duration of its monetary accommodation. This lowered long-term rates by creating expectations that overnight rates would remain at 1% for a longer period than previously supposed. Following the recession, the Fed has provided more explicit forward guidance for the likely path of future short-term interest rates and also used its balance sheet to reduce longer-term rates and rate expectations. 21 The effect has been to suppress interest rates below levels that would prevail if they were allowed to equilibrate to the expected return on assets. Conclusion Expectations of accommodative monetary policy tend to increase asset prices by reducing the risk-free portion of the rates used to discount future payments to present value. These operations have done little to reduce the incremental returns investors earn for bearing risk. Rather than sustaining risk asset prices at unsustainable levels, these operations create unique investment opportunities for investors and businesses able to capitalize the value of differentials in the yields on assets relative to the yields on liabilities. This makes the slowing economy an attractive place to put money to work. 21 In 2009, the FOMC suggested that overnight interest rates would remain near zero for an extended period. In 2010, the FOMC began outright purchases of longer-dated Treasury notes. In 2011, the FOMC explicitly attached a date to the extended period suggesting that rates would likely remain low through the end of Later in 2011, the FOMC launched the Maturity Extension Program (aka operation twist ) whereby the FOMC sold its holdings of Treasury bills and used the proceeds to buy Treasury notes. In 2012, the Fed extended the guidance for low rates to the end of

7 Economic and market views and forecasts reflect our judgment as of the date of this presentation and are subject to change without notice. In particular, forecasts are estimated based on assumptions, and may change materially as economic and market conditions change. The Carlyle Group has no obligation to provide updates or changes to these forecasts. Certain information contained herein has been obtained from sources prepared by other parties, which in certain cases have not been updated through the date hereof. While such information is believed to be reliable for the purpose used herein, The Carlyle Group and its affiliates assume no responsibility for the accuracy, completeness or fairness of such information. This material should not be construed as an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. We are not soliciting any action based on this material. It is for the general information of clients of The Carlyle Group. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual investors. Contact Information: Jason Thomas Director of Research Jason.Thomas@carlyle.com (202)