No More Easy Money: Implications of the Rising Cost of Capital

A new report by Citi Research’s Scott Chronert takes a detailed look at the rising cost of capital and its implications.

Money is getting costlier. 

After the cost of capital for the S&P 500 fell to a historic low in 2021, monetary policy normalization last year created a sharp valuation reset, and the cost of capital has risen. 

In the last year, the cost of equity and debt for the S&P 500 has quickly hit levels not seen since the 1990s, as the chart below shows. And Scott says the cost is likely to settle and endure somewhere close to those 1990s levels.

S&P Cost of Capital, 50 years

 

© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research, FactSet, Bloomberg, Haver Analytics

One important factor to consider is how higher capital costs effect the supply of equities.

Buyback volume historically has mirrored the cost of equity: when the cost of equity increases, so buyback activity picks up. Valuations are implicitly lower as the cost of equity rises. 

Another component is tied to the trade-off between reinvestment opportunities and return of capital. As the cost of capital rises, the set of profitable reinvestment options gets smaller. Management may elect to return capital to shareholders in preference to retaining earnings.

Capex and M&A

As we’ve discussed, in theory a higher cost of debt cuts the available set of profitable capex opportunities. Over a longer period, this can weigh on earnings growth.

In M&A, things are a bit blurrier, the Citi Research note said. A volatile cost of capital seemingly hampers M&A activity. But a higher cost of capital doesn’t necessarily dampen M&A activity.

   Announced M&A Volume vs Cost of Capital

© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research, Bloomberg, FactSet, Haver Analytics

As the cost of capital rises, consistent European equity outflows versus the US have contributed to a historically wide valuation gap between the two markets according to a recent report by Citi Research’s Robert Buckland Global Equity Strategy - Fund Outflows: US More Vulnerable Than Europe, first published on January 20th. The MSCI Europe index now trades at a 25% discount to the MSCI US, well above the long run average of 15%. Europe vs US valuation gaps are widest in the Energy, Food & Staples Retail and Tech Hardware sectors.

US Valuations Have Partly Responded to Improving Returns, but in Europe Valuations Have Barely Moved

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© 2023 Citigroup Inc. No redistribution without Citigroup’s written permission.

Source: Citi Research

 

Energy, with a 40% value-gap, is the sector with the biggest value-gap according to a report, first published on January 25th by Alastair Syme entitled  The Role of Trans-Atlantic M&A in Closing Oil’s Value-Gap. In both markets energy equities decoupled from rising oil prices in 2022, but the decoupling of Europe has been even more pronounced.

Part of this delta can be explained by portfolio differences, with the US pivoting to shale and Europe to low carbon-- and the latter coming under pressure from rising rates. But Citi analysts see the biggest driver coming from a widening CoE as European investors feel increasing pressure on owning energy equities.

Citi analysts see little scope for the political backdrop in Europe to change in a way that would re-align the CoE between the two markets. If anything, European energy policy’s stance against fossil fuels has become more entrenched, they say.

Global oil companies have famously consolidated before. But the drivers of the late 1990s consolidation do not look applicable today, the note said.

For more information on this subject, please see the full report on the rising cost of capital, first published on January 20th, here US Equity Strategy - New Era for the Cost of Capital: Equity Market Implications

Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research; however, it may contain thematic content previously expressed in an Independent Research report. For the full CGI disclosure, click here.

 

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