This month’s Macro Print is characterized by a great focus on inflation and deflation. We thought to address this in our first edition as both inflation and deflation have a very direct impact on how many things we’re able to buy and when it’s best to buy them. Inflation is also one of the key economic indicators economists track to monitor the health of an economy, similarly to cholesterol levels in human beings.
When economists or financial media mentions inflation, they generally refer to price inflation, which is an economic indicator that is used to track the sustained increase in the average price of products and services across different periods of time. In simpler terms, inflation helps us get a sense of how much prices have increased between periods of time.
Economists believe that a low and stable level of price inflation (usually around 2%) is healthy. Broadly, we can assume that there are two main drivers of inflation:
Demand-Pull: The level of consumer demand in an economy, and
Cost-Push: What we refer to in the Macro Print as inflationary bottlenecks
To calculate inflation, institutions like the Bureau of Labor Statistics (BLS) first need to track the average price changes of goods and services (called a market basket) that are likely to best represent the overall goods and services consumed by the average consumer. According to the BLS:
“The CPI [Consumer Price Index] market basket is developed from detailed expenditure information provided by families and individuals on what they actually bought. There is a time lag between the expenditure survey and its use in the CPI. For example, CPI data in 2016 and 2017 was based on data collected from the Consumer Expenditure Surveys for 2013 and 2014. In each of those years, about 24,000 consumers from around the country provided information each quarter on their spending habits in the interview survey. To collect information on frequently purchased items, such as food and personal care products, another 12,000 consumers in each of these years kept diaries listing everything they bought during a 2-week period.”
The type of goods and services that are considered in the calculation is adjusted for seasons (we use more gas in winter times given colder temperatures) or for geographies, although the general calculation is quite similar across the globe. The overall composition of the basket, meaning the goods and services that institutions keep track of to monitor inflation, changes across time as the preferences and necessities of consumers changes.
What does this mean from a practical sense? By tracking inflation, we know that a market basket of goods that once cost $100 in 1913, now costs $2,605.
It is through the tracking of the changes in the price of this market basket that we derive inflation numbers. Mathematically:
The rate of price inflation is obviously affected by a myriad of factors, but let’s keep things simple for now: the general rationale behind the idea of a low and stable rate of inflation being good is that, if consumers become wealthier across time (wealth creation is at the core of a capitalist society) and are prone to spend their wealth, then we can expect that the general quantity of products and services demanded by consumers will increase until it exceeds the overall quantity of products and services provided by producers. This will lead producers to increase their prices and generate inflation.
How, then, can consumers become wealthier over time in order to generate inflation? Well, they certainly become wealthier as they earn more money, either through higher wages (employees) or profits (employers). But consumers can also “nominally” feel wealthier in two other ways. Firstly, through a phenomenon that behavioral economics defines as Wealth Effect: as the value of their assets increases (house prices, for example), people tend to spend more despite their income (wages or profits) and costs remaining the same. Secondly, through borrowing money, which increases the amount of money we can spend today, despite the implied need to repay our debts on a future date. Both are “nominal” increases in consumers’ wealth because, on the Wealth Effect side, consumers will only have more disposable income if they actually liquidate their assets (you would have to actually sell your house to make that “nominal” increase in wealth a “real” one), whilst borrowing only means that we’re pulling future income forward, and what we spend today we’ll have to repay tomorrow (i.e. our overall wealth doesn’t change).
As the Federal Bank of St. Louis explains:
“When consumers are feeling pretty good about the economy, for instance they have jobs and expect to keep them, they expect they will get annual raises in their wages, or they see their investments going up, they become confident that they can borrow money and have the ability to pay it back. So, they borrow money and spend it on goods and services. However, if people demand more goods and services than producers can produce, the store shelves will empty quickly, and there won’t be enough of the goods and services consumers want. There is a solution to this problem. If producers were to raise the price of those goods and services, some consumers would buy less, and products would remain on the shelves for the people who were willing to pay the higher prices. If this were to happen on a broad scale we would label the result inflation.”
This demand-pull, driven by higher wealth, will force prices to increase, so that demand and supply find a new level of equilibrium, leading to inflation. Adding to the previous chart:
Before we jump into cost-push inflation, it is important to contextualize how central banks have tried to boost inflation through demand-pull focused initiatives.
Central banks are institutions that control the money supply, interest rates and the currency of one country. Central banks are incredibly important institutions, and the most important ones to pay attention to are the Federal Reserve (U.S.), European Central Bank (self-explanatory), Bank of England and Bank of Japan.
Usually, central banks have a mandate of sustained price stability (read it as ensuring that inflation is around 2%) and sustainable growth. To satisfy this mandate, they can usually pull two different levers: change the interest rates at which commercial banks (where you have your deposit) can borrow, or print more money. Fundamentally, the important thing to understand is that central banks have a direct impact on the money supply (usually called M1 or M2), and that money supply impacts the (“real” or “nominal”) wealth of consumers, which directly influences their level of demand, and hence, inflation. Yes, we know it’s a long chain, so here’s a visual representation of it:
A core idea that we’ll explore in the Macro Print is how Central Banks, since the 80s, have focused on measures that aimed to increase the money supply in the hopes it would increase inflation. Those measures were firstly the lowering of interest rates (considered conventional monetary stimulus), which were followed by programs such as Quantitative Easing (unconventional monetary stimulus), both of which have been widely discussed in the last decade. The focus on increasing inflation comes from economists’ worry of having economic deflation, and you’ll see later on why that concern is justified.
Central Banks define the interest rates at which commercial banks can borrow money. That borrowed money is, in part, what allows banks to then lend money to consumers (the alternative is equity financing). When interest rates are low, consumers tend to save less and borrow more from banks. As consumers borrow, their “nominal wealth” increases, they spend more (low interest rates disincentivize savings) and drive inflation upwards. This exercise simplifies the sequence of events, but it does highlight how interest rates and inflation are inversely correlated.
Additionally, central banks have begun printing money (in the most literal way possible given that they are the institutions with the ability to do that) and are using that money to buy government bonds, in the hopes that governments will then use that money to promote liquidity in the market and finance initiatives that will lead to higher wealth for consumers, and hence, promote demand which would be expected to drive inflation up.
Inflation, as we often discuss in the Macro Print, is not only a phenomenon that happens through changes in the money supply or the wealth of consumers, both of which affect the level of demand. Inflation also happens when there are shortages on the supply side (bottlenecks), which force producers to raise prices, leading to price inflation.
Although less common and more specific, bottlenecks are a very intuitive concept. Scarcity leads to higher prices, and when events such as natural disasters, regulation or other supply-chain disruptions lead to a shortage of a certain kind of good or service, then producers increase prices in order to force some of the demand out of the equation. A natural disaster that destroys oil refineries will likely lead to a temporary increase in the oil price. The price of cigarettes increases as governments expand the regulatory burden on the industry. And so on.
Inflationary bottlenecks can also happen when a country devalues its currency, making its imports more expensive (a weaker currency means that the local economy must pay more to import). As that happens, producers are likely to translate that higher input cost (their import) into a higher price for the good or service they produce, passing on the price inflation to consumers in order to protect their margins.
Within the topic of inflation, you’ll likely also hear about disinflation, which occurs when the rate of price inflation is decreasing but is still positive (meaning prices are still increasing, but at a slower pace). Much more important than that, though, is the need to understand deflation.
Simply, deflation is a negative inflation rate. This means that prices are actually decreasing on a period by period basis. Deflation is the economists’ bogeyman given the consequences that it can have in the trajectory of an economy.
Optically you might think that deflation is a good thing for the general economy because it will incentivize spending, given the lower prices. Realistically, what you’ll want to focus on understanding is the impact of a deflationary spiral.
If prices are lower tomorrow than today (implied in deflation), then consumers will be incentivized to hold off on purchases today and wait for tomorrow. But what if prices on the next day are even lower? Then consumers will, once again, be incentivized to hold off on purchases and wait for the following day. This reinforcing cycle will lead to lower overall demand (as consumers recurrently postpone demand to the following day given lower prices), which leads to lower corporate profits. Companies will then be forced to lower their cost base in an effort to maintain profitability, which usually leads to lower employees’ wages or flat out layoffs. Lower wages or higher unemployment leads to lowers consumer income, which subsequently reduces their disposable income and ability to consume goods and services, leading to lower corporate profits. You can see, now, how deflation is every economists bogeyman.
Lower prices followed by postponed demand leads to…
Velocity of Money
According to the Federal Reserve of St. Louis:
“The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.”
Velocity of money measures how quickly money is moving from one hand to another, which is a proxy indicator of the level of demand of a general population. As we’ve seen previously, increased demand drives inflation, whilst lower demand can cause disinflation or even deflation.
“There are several components of the money supply,: M1, M2, and MZM; these components are arranged on a spectrum of narrowest to broadest.
Consider M1, the narrowest component. M1 is the money supply of currency in circulation (notes and coins, traveler’s checks [non-bank issuers], demand deposits, and checkable deposits). A decreasing velocity of M1 might indicate fewer short- term consumption transactions are taking place. We can think of shorter-term transactions as consumption we might make on an everyday basis.
The broader M2 component includes M1 in addition to saving deposits, certificates of deposit (less than $100,000), and money market deposits for individuals. Comparing the velocities of M1 and M2 provides some insight into how quickly the economy is spending and how quickly it is saving.
MZM (money with zero maturity) is the broadest component and consists of the supply of financial assets redeemable at par on demand: notes and coins in circulation, traveler’s checks (non-bank issuers), demand deposits, other checkable deposits, savings deposits, and all money market funds. The velocity of MZM helps determine how often financial assets are switching hands within the economy.”
Whilst this is intuitive, an easier way to look at velocity is by looking at it as a rate of return. Velocity of money is usually calculated by:
We divide the Gross Domestic Product (GDP) by Money Supply (M1, M2 or MZM) because we’re trying to assess how many units of GDP does one unit of money generates. Logically, when velocity is high, it means that we’re able to generate more units of GDP with one unit of money. When velocity is low, the inverse happens. With that, we can now see how velocity of money typically moves with the business cycle: higher velocity typically leads to higher GDP and higher inflation, and lower velocity typically leads to lower GDP and lower inflation.
The velocity of M2 in Q1 2020 in the United States was 1.374. The way to read the number is: “with one unit of money, in Q1 2020 we generated 1.374 units of GDP”.
With all of this in mind, you’ll now be able to understand why Roger, in the Macro Print, talks about how the velocity of money will continue to come down as the money supply (the denominator) explodes, which will likely drive deflationary pressures in the economy in the short to medium term.
Moving on from Macro to the Editorial Print, we’ll get a heavy dose of valuation theory, so that is where the focus of the Primer for this section will be. These are some of the basic theoretical concepts that will help contextualize the why and the implications of the financing decisions the airlines (and the broader market) have been making.
Cost of Capital and the Weighted Average Cost of Capital
The Cost of Capital, in a very literal sense, is the cost to a company to finance its operations.
It can, and should, be viewed through two lenses:
1) that of the company to finance its operations, and
2) that of the investor and the expected return on their capital invested in the company.
From the company’s perspective, they need to raise funds to operate their business (buy machines, pay people, etc.). Raising these funds comes in the form of one of two options, but realistically it’s a combination of both; 1) selling debt to raise cash (bonds), and 2) selling equity to raise cash (stock). Investors provide cash in exchange for one of these two, or both.
Each method of raising cash carries with it its own unique set of circumstances.
Raising cash through debt means that the company receives cash, and in return, promises to pay interest to the investor, as well as return their principal when the maturity of the bond is up. The investor of the bond owns a promise from the company to pay interest and return of principal. They are not owners of the company, simply lenders. Bond holders typically have first claim to assets in a bankruptcy situation, meaning if the company runs into trouble and goes under, bond holders are typically the first to get paid, then equity holders. Because of this, we can say that bond holders take on less risk than equity holders. Therefore, the return that they require back from the company is typically lower than equity holders. Bond holders receive guaranteed interest and principal paid to them and have first claim to assets. This means investors have a safer position than equity holders.
Raising cash through equity means the company receives cash, and in return, the equity investor owns a piece of the company. The investor gets to participate in the upside of that company in the event the stock price goes up (and subsequently participate in the downside if the stock goes down). There are no guarantees for the equity holder; no interest, no return of principal (only if the equity holder decides to sell), and they are last in the pecking order if the company goes bankrupt. Therefore, equity holders take on more risk, and therefore, they require a larger return from the company to compensate them for that risk.
So the Cost of Capital is simply,
To the company: the cost of financing to operate the company and
To the investor: the expected return from the company
So, Weighted Average Cost of Capital (WACC) is simply the capital structure of the company, weighted for its debt cost and equity cost (the debt and equity costs are the required returns from investors).
The Editorial Print will discuss at length capital structure financing decisions, and why, as a capital allocator, you may choose to finance your firm with one over the other. If the goal of a company is to maximize its value (and that usually is the goal), then understanding the interplay between debt and equity can help you solve for maximum value.
It’s about time we get to an equation:
Now let’s look at an example:
Let’s assume that a company has financed itself with 60% Equity and 40% Debt. Let’s also assume that the required return from equity holders is 12% and the required return from debt holders is 4%. Said differently, the cost of equity capital to the firm is 12% and the cost of debt capital to the firm is 4%. Lastly, let’s say that the tax rate of the company is 30%.
What is that tax bit doing in there? Because the interest payments that companies pay on their debt are tax deductible, we need to take this into account when we are valuing a company. It’s called a ‘tax shield’.
(Calculating required return from equity and debt investors (the 12% and 4% above) is probably a bit too deep for this Primer, but if you’re really interested then let us know and we’ll cover it when we send the Follow-Up in a couple weeks)
So now we know the current capital structure of the firm has an 8.3% WACC. How should we interpret this?
If you look at the entire weighted investor base of this company, they require the company to create at least an 8.3% annual return on their investment. If the company doesn’t return that amount on an ongoing basis, then, as a prudent investor, they should allocate their investment to a different company that they believe can return more value.
There is a practical piece to this as well as a theoretical piece. 8.3% is theoretically the hurdle rate that the company needs to beat; however, an equity investor who requires a 12% return is going to evaluate company performance based on that 12%, whilst the debt investor, who requires a 4% return, is going to evaluate the company performance based on that 4%. So, ultimately, WACC, more than a practical benchmark for investors, is a theoretical hurdle rate used for valuing a company using a Discounted Cash Flow model.
Discounted Cash Flow for Stock Valuation
Valuing a company is the only reason we care about WACC. We need to be able to use WACC to value the airline companies to understand why they were aggressively pursuing share buybacks to adjust their capital structure (creating a higher weighting of debt to equity, or more specifically, issuing debt to buy back their equity).
On to the Discounted Cash Flow. Let’s look at it conceptually, then at the basic equation, then apply it to the newsletter.
Conceptually, if you break down ‘Discounted Cash Flow (DCF)’ into its piece parts, it’s once again very literal. What we are doing is summing up all the forecasted cash flows that a company will earn into perpetuity, and then discounting those cash flows back to today to determine what the total value of the firm currently is. The discount rate that we use is the WACC.
Here is the basic DCF equation:
Looking at this equation, we can see that if a company lowers its WACC, then it can increase its value, simply by math. Lower denominator equals higher value of firm, assuming that the Sum of Future Cash Flows stays the same.
If we go back up to the WACC equation, we can see that if a company adds debt to the capital structure, which again typically carries with it a lower cost of capital (remember, debt holders require a lower return on their investment), then they can, usually, lower their WACC. And viola, more value has been created.
We say usually very tongue in cheek, because there is one large caveat here. As a company takes on more and more debt, the likelihood of them not being able to pay back that debt goes up, and at some point, they can go bankrupt if their operations are not able to support their debt load. If the company takes on too much debt, then new investors (both debt and equity) will require a higher return to be compensated for the additional risk. If investors continually require a higher rate of return to be compensated for the additional risk, then at some point, the firm can no longer lower their WACC, because the cost of issuing more debt (and equity) becomes more expensive.
This is what we are talking about in the Editorial print when we introduce the idea of Static-Trade-Off Theory. It simply states that there is an optimal capital structure that optimizes all factors that decide the cost of capital. With that, simply by optimizing the capital structure, firms are able to lower the WACC, which maximizes the value of a company.