By Hal Callais
Every day, I read some new prediction on what the post-COVID world will look like. People are focusing on micro predictions of the “accelerated adoption of remote working,” that “COVID’19 accelerated rise of telemedicine,” or any enormous volume of other things.
I don’t know about you, but I think that a lot of this is just noise. There has been no other crisis in the US, which has resulted in a near-complete shutdown of the economy since the Embargo Act of 1807. But even this comparison is extremely thin and 214 years out of date.
What is keeping me up at night, are the following questions I have about the next 1-2 years:
How much debt can the US take before it absolutely cripples the dollar?
Some quick monetary history: 1. The US dollar has been the reserve currency of the world since 1944, 2. FDR unpegged the US Dollar from gold in 1933 to help end the Great Depression, 3. Nixon disallowed foreign governments from converting dollars to gold in 1971, 4. US Debt hit $1 trillion dollars in 1981, 5. US Debt has not decreased since 1960, the and 6. US Debt has increased by 2.7 trillion from 9/30/19 to 5/20/2020.
It is not possible to issue debt in near unlimited quantities and have no blowback. This was done during the Great Recession through the COVID-19 crisis, and there seems to be no end in sight. The Fed’s purchase of this debt during these periods has added cash to the money supply, which in turn, requires real economic growth to ensure inflation remains in check.
Inflation is here. CPI hit 5.4% in July, and consumers everywhere are seeing the impacts of it in their daily lives in places like the grocery store and other everyday products.
Besides making life more expensive for all of us, isolated inflation in the US would make foreign goods more expensive. As a net consuming economy, our goods imported here would become more expensive against the trade partner’s comparatively strengthened currency.
But what does this mean for short-term and long-term asset pricing?
A key part of most modern approaches to valuing stock and other equity instruments, is the risk-free rate. Simply put, the risk-free rate is the rate of interest paid on the 10-year US Treasury Bond, which is considered by the markets and modern financial theory to have basically no risk of default. Herein lies the concern: If the US continues to issue debt (thereby creating money), then the debt load will eventually become too much to ever pay back and/or service.
All else being equal, the usual reason to borrow money is to take the proceeds and reinvest it into the organization, with the expectation that the investment will increase cash flows allowing the organization to repay the debt.
So to keep it as simple as possible, the levels of debt in the US imply that the US will be able to achieve breakaway growth, to support the increased debt burdens. OR, the US will need to increase taxes, which stands to decrease the after-tax earnings of companies and could impact their ability to reinvest. Without reinvestment, US domestic growth will slow, perpetuating the debt problem anyway.
What about all of the cash?
There is a tremendous amount of cash in private equity right now (dry powder). Coupled with low interest rates, this makes it buyout dealmaking very aggressive. Company owners are in a strong position and with upcoming tax hikes, they are more interested than ever to sell their business.
This has led to a fervor of deal activity across the risk spectrum as funds holding lots of cash are taking greater than expected risk and paying more than they otherwise would from competition. Not to mention that there has been an explosion in the number of SPAC’s in the market seeking targets, often competitive with the buyout funds. What we are seeing, is a rush of too much capital chasing after too few deals.
In venture capital, we are seeing many funds reaching beyond what they would have otherwise done and closing deals in days instead of months. This speed should be a big concern for their investors as speed to win deals, based on FOMO, can increase a funds loss rates. This is especially true when it comes to younger funds with 2018 and 2019 vintages.
However this activity seems to be occurring, there is opportunity for startups to raise PE growth capital, or be bought due to these conditions. Unless very careful, this could end up being simply a transfer of risk from VC to PE when the shoe drops.
Summary
But in all, I am anxious to see how the confluence of this activity with inflation, asset pricing, and PE/VC dealmaking will permeate through the system. These are the key risks I am thinking about.