RETURNS REINVENTED 2021 GLOBAL INVESTOR CONFERENCE ...
Transcript of RETURNS REINVENTED 2021 GLOBAL INVESTOR CONFERENCE ...
1
R E T U R N S R E I N V E N T E D202 1 G LO BA L I N V E STO R CO N FE R E N C E
Ascending with Waxed Wings: Inflation & the Tech ‘Bubble’
2
• Inflation dominates the macro discourse, but markets seem almost exclusively focused on tech-enabled productivity growth and the digital businesses that facilitate it. This disconnect makes sense if inflation is “transitory,” as seems likely, but it also creates danger, especially for portfolios aggressively adding exposure to those assets that surreptitiously embed the most inflation risk.
• Inflation risk is not restricted to fixed income markets, nor is it an industrial or “old economy” problem. The valuations most exposed to higher interest rates are those of tech-enabled digital assets whose free cash flow arrives furthest into the future and is therefore most heavily discounted.
• It is neither the time to fly too low and bet against tech-enabled productivity growth, nor the time to fly too high, hubristically putting all of one’s eggs into that basket. Diversified portfolios that treat “technology” as a value-added input rather than an asset class are likely to exhibit the most impressive risk-adjusted performance.
3
Of the many twists and turns in the
macroeconomic data since the start of
the pandemic, two stand out: the surge
in productivity and spike in inflation. Both
phenomena have been especially evident in the
United States, and both appear to be the product
of a “high-pressure” economy characterized
by increasingly digitized processes, speedier
execution, and a sense of pervasive shortages
(materials, semiconductors, labor, etc.). While the
former drives near-term market movements, the
latter dominates market conversations.
Since March 2020, labor productivity in the U.S. has
grown at a 3.7% annual rate (Figure 1), nearly 4x the
annual average of the past decade, and almost
3x the 1.3% annual growth observed between 2014
and 2019.1 When translated into company financial
ratios, these gains are even more impressive:
economy-wide revenue-per-worker has increased
by more than 12% (Figure 2) and operating margins
are up 24% (Figure 3) relative to pre-pandemic
levels. These efficiency gains have helped to
validate much of the run-up in asset prices in 2020
and fueled added gains this year.
1 U.S. Bureau of Labor Statistics, August 2021. Figure 1. Source: Carlyle Analysis; Bureau of Economic Analysis of Portfolio Data; Bureau of Labor Statistics.
August 2021. There can be no assurance these market conditions will continue to be achieved.
Figure 1. U.S. GDP-Per-Worker Up 6% Since 2019
Disconnect Between Market Discourse & Market Prices
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 1: U.S. GDP-Per-Worker Up 6% Since 2019
Source: Carlyle Analysis; Bureau of Economic Analysis of Portfolio Data; Bureau of Labor Statistics. August 2021. There can be no assurance these market conditions will continue to be achieved.
-16.0%
-14.0%
-12.0%
-10.0%
-8.0%
-6.0%
-4.0%
-2.0%
0.0%
2.0%
4.0%
Dec-
19
Jan-
20
Feb-
20
Mar
-20
Apr
-20
May
-20
Jun-
20
Jul-2
0
Aug
-20
Sep-
20
Oct
-20
Nov
-20
Dec-
20
Jan-
21
Feb-
21
Mar
-21
Apr
-21
May
-21
Jun-
21
Jul-2
1
Cumulative Change in GDP Cumulative Change in Employment
PRODUCTIVITY GROWTH
4Figure 2. Source: Carlyle Analysis; Bureau of Economic Analysis of Portfolio Data; Bureau of Labor Statistics. August 2021.
There can be no assurance these market conditions will continue to be achieved.Figure 3. Source: Carlyle Analysis; Bureau of Economic Analysis of Portfolio Data; Bureau of Labor Statistics. August 2021.
There can be no assurance these market conditions will continue to be achieved.
Figure 2. Revenue-Per-Worker Up 12% Since 2019
Figure 3. Profit Per Unit of Value-Added up 24%
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 2: Revenue-Per-Worker Up 12% Since 2019
80.00
85.00
90.00
95.00
100.00
105.00
110.00
Feb-
20
Mar
-20
Apr
-20
May
-20
Jun-
20
Jul-2
0
Aug
-20
Sep-
20
Oct
-20
Nov
-20
Dec-
20
Jan-
21
Feb-
21
Mar
-21
Apr
-21
May
-21
Jun-
21
Jul-2
1
Headcount Gross Revenue
Source: Carlyle Analysis; Bureau of Economic Analysis of Portfolio Data; Bureau of Labor Statistics. August 2021. There can be no assurance these market conditions will continue to be achieved.
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 3: Profit Per Unit of Value-Added up 24%
Source: Carlyle Analysis; Bureau of Economic Analysis of Portfolio Data; Bureau of Labor Statistics. August 2021. There can be no assurance these market conditions will continue to be achieved.
10.0%
11.0%
12.0%
13.0%
14.0%
15.0%
16.0%
Dec-
11
Apr
-12
Aug
-12
Dec-
12
Apr
-13
Aug
-13
Dec-
13
Apr
-14
Aug
-14
Dec-
14
Apr
-15
Aug
-15
Dec-
15
Apr
-16
Aug
-16
Dec-
16
Apr
-17
Aug
-17
Dec-
17
Apr
-18
Aug
-18
Dec-
18
Apr
-19
Aug
-19
Dec-
19
Apr
-20
Aug
-20
Dec-
20
Apr
-21
PRO
FIT
PER
UN
IT O
F V
ALU
E A
DDED
5
Figure 4. Inflation Dominates Public Discourse
Figure 5. Inflation Risk Premia Near All-Time Lows
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L 4
TTM MENTIONS OF “INFLATION” & “PRODUCTIVITY” SCALED FREQUENCY OF ARTICLES ON INFLATION PRODUCTIVITY
Source: Carlyle Analysis of News Website Text; Google News. August 2021. There can be no assurance these market conditions will continue to be achieved.
Figure 4: Inflation Dominates Public Discourse
-
10,000
20,000
30,000
40,000
50,000
60,000
70,000
80,000
90,000
Inflation Productivity
NYT WSJ FT Bloomberg Reuters CNBC
75
85
95
105
115
125
135
145
155
165
175
Jan-
18
Apr
-18
Jul-1
8
Oct
-18
Jan-
19
Apr
-19
Jul-1
9
Oct
-19
Jan-
20
Apr
-20
Jul-2
0
Oct
-20
Jan-
21
Apr
-21
Jul-2
1
JAN
UA
RY 2
018
= 10
0
Inflation Productivity
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 5: Inflation Risk Premia Near All-Time Lows
Source: Carlyle Analysis, FRED Data. August 2021. There can be no assurance these market conditions will continue to be achieved.
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
Jan-
03
Aug
-03
Mar
-04
Oct
-04
May
-05
Dec-
05
Jul-0
6
Feb-
07
Sep-
07
Apr
-08
Nov
-08
Jun-
09
Jan-
10
Aug
-10
Mar
-11
Oct
-11
May
-12
Dec-
12
Jul-1
3
Feb-
14
Sep-
14
Apr
-15
Nov
-15
Jun-
16
Jan-
17
Aug
-17
Mar
-18
Oct
-18
May
-19
Dec
-19
Jul-2
0
Feb-
21
PERC
ENT
5Yr Forward Real Inflation Risk Compensation 10Yr Term Premium
Yet, it seems that all anyone wants to talk about is
inflation. Over the past year, inflation has garnered
nearly 12x more mentions than productivity in major
financial news outlets (left panel of Figure 4). Across
all news sources, stories on inflation have grown
70% more numerous while productivity articles
run only when quarterly data are released (right
panel of Figure 4). Markets have been surprisingly
unperturbed by the suffocating attention the
topic receives; measures of inflation risk premia2
extracted from Treasury yields remain near all-time
lows (Figure 5).
2 As opposed to inflation breakevens, the term premia measure the compensation for unexpected inflation over the next 10 years.Figure 4. Source: Carlyle Analysis of News Website Text; Google News. August 2021. There can be no assurance these market conditions will continue to be achieved.Figure 5. Source: Carlyle Analysis, FRED Data. August 2021. There can be no assurance these market conditions will continue to be achieved.
6
Markets embrace the Fed’s mantra that inflation
is likely to prove “transitory.” Indeed, markets
may be more convinced of this than the Fed itself.
“Hawkish” June rhetoric from the Fed, motivated by
concerns that inflation may prove more persistent
than expected, was met with a sharp drop in long-
term bond yields and an upward adjustment in the
foreign exchange value of the dollar (Figure 6). If
anything, these price movements are suggestive of a
central bank potentially overreacting to
inflation risk.
There is good reason to suspect that the market has
this priced correctly. Today’s elevated inflation has
its origin in temporary, pandemic-induced supply-
Inflation’s Origin: ‘If You Don’t Make Stuff, There is No Stuff’3
demand imbalances that nearly every household
has experienced in some form or another over the
past 18 months.
Starting in the middle of 2020, cash-rich but locked-
down households channeled the savings from
sharply reduced spending on travel, leisure, and
live events towards durable goods. Sales of new
and used cars, boats, pools, pianos, motorcycles,
personal water craft, hot tubs, and construction
materials all boomed at never-before-seen rates.4
Overall consumption soon recovered to pre-
pandemic levels, but its composition had shifted
massively, with durable goods spending running
about 30% above prior trends (Figure 7).
Figure 6. Inflation Risk Perceptions Fall in Response to Fed
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 6: Inflation Risk Perceptions Fall in Response to Fed
Source: Carlyle Analysis, FRED Data. August 2021. There can be no assurance these market conditions will continue to be achieved.
110.5
111.0
111.5
112.0
112.5
113.0
113.5
114.0
114.5
1.8
1.9
2.0
2.1
2.2
2.3
2.4
2.5
7-M
ay
14-M
ay
21-M
ay
28-M
ay
4-Ju
n
11-Ju
n
18-J
un
25-J
un
2-Ju
l
9-Ju
l
16-J
ul
23-J
ul
30-J
ul
6-A
ug
13-A
ug
20-A
ug
USD
INDE
X (T
RADE
WEI
GH
TED)
YIEL
D IN
PER
CEN
T
30Yr Treasury Yield USD Index
Fed April Minutes Released
June FOMC Meeting
3 Elon Musk on Joe Rogan Experience, May 2020.4 Carlyle Analysis of Bureau of Economic Analysis Data, August 2021.Figure 6. Source: Carlyle Analysis, FRED Data. August 2021. There can be no assurance these market conditions will continue to be achieved.
7
Figure 7. Durable Goods Spending Rises 30% Above Prior Forecasts
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 7: Durable Goods Spending Rises 30% Above Prior Forecasts
Source: Carlyle Analysis; St. Louis Federal Reserve, July 2021. There can be no assurance these market conditions will continue to be achieved.
$1,000
$1,200
$1,400
$1,600
$1,800
$2,000
May
-11
Sep-
11
Jan-
12
May
-12
Sep-
12
Jan-
13
May
-13
Sep-
13
Jan-
14
May
-14
Sep-
14
Jan-
15
May
-15
Sep-
15
Jan-
16
May
-16
Sep-
16
Jan-
17
May
-17
Sep-
17
Jan-
18
May
-18
Sep-
18
Jan-
19
May
-19
Sep-
19
Jan-
20
May
-20
Sep-
20
Jan-
21
May
-21
BILL
ION
S
Pre-Pandemic Trend
7
Unfortunately, capacity in most of these product
markets only exists to meet unit sales growth of 1% to
3% per year. In other words, there are no factories
sitting idle, waiting to be turned on to accommodate
a sudden surge in orders. And due to the lockdowns
and management conservatism, manufacturing
output actually dropped by -6.5% through Q1-2021,
leading to a massive supply-demand gap (Figure 8)
that not only led to shortages of finished goods, but
also the components, parts, semiconductors and
other intermediate goods that go into them.
Inflation rates have largely tracked the size of the
gap, peaking at a 0.9% monthly rate in Q2-2021 and
declining to 0.3% in July as manufacturing output
rebounded and consumption rotated back towards
services like travel and live events.5 In total, durable
goods prices rose at a 16.8% annual rate in Q2-2021,
accounting for virtually all of the excess inflation
observed this year (Figure 9).6
5 BLS, August 2021. Inflation refers to the monthly percentage change in the core CPI index.6 Carlyle Analysis; BEA, Q2-2021 GDP Report.Figure 7. Source: Carlyle Analysis; St. Louis Federal Reserve, July 2021. There can be no assurance these market conditions will continue to be achieved.
8
Figure 9. Durable Goods Prices Drive Overall Inflation
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 9: Durable Goods Prices Drive Overall Inflation
Source: Carlyle Analysis of BEA Data, August 2021. There can be no assurance these market conditions will continue to be achieved.
9
-2.0%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
Jan-
20
Feb-
20
Mar
-20
Apr
-20
May
-20
Jun-
20
Jul-2
0
Aug
-20
Sep-
20
Oct
-20
Nov
-20
Dec-
20
Jan-
21
Feb-
21
Mar
-21
Apr
-21
May
-21
Jun-
21
Jul-2
1
EXC
ESS
CU
MU
LATI
VE
INFL
ATI
ON
CUMULATIVE EXCESS INFLATION VS PRE-PANDEMIC
Services Durable Goods
Figure 8. Source: Carlyle Analysis, FRED Data. August 2021. There can be no assurance these market conditions will continue to be achieved.Figure 9. Source: Carlyle Analysis of BEA Data, August 2021. There can be no assurance these market conditions will continue to be achieved.
Figure 8. Durable Goods Supply-Demand Imbalance
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 8: Durable Goods Supply-Demand Imbalance
Source: Carlyle Analysis, FRED Data. August 2021. There can be no assurance these market conditions will continue to be achieved.
95.00
97.00
99.00
101.00
103.00
105.00
107.00
109.00Ja
n-16
Mar
-16
May
-16
Jul-1
6
Sep-
16
Nov
-16
Jan-
17
Mar
-17
May
-17
Jul-1
7
Sep-
17
Nov
-17
Jan-
18
Mar
-18
May
-18
Jul-1
8
Sep-
18
Nov
-18
Jan-
19
Mar
-19
May
-19
Jul-1
9
Sep-
19
Nov
-19
Jan-
20
Mar
-20
May
-20
Jul-2
0
Sep-
20
Nov
-20
Jan-
21
Mar
-21
May
-21
Jul-2
1
JAN
20
12=
100
TTM Manufacturing Output TTM Durable Goods Demand
9
Inflation Atmospherics & Confirmation BiasIf pinpointing inflation’s origin is so straightforward,
easy to document, and consistent with virtually
everyone’s lived experience, both in terms of changed
consumption patterns and extended delivery times
and backorders, why has the topic commanded
so much attention? The inflation debate seems far
livelier than merited by the facts surrounding it.
The answer lies in the atmospherics surrounding
the issue. To many observers, the pandemic seems
to have unlocked changes in attitudes, behaviors,
and expectations that all point in the direction of
higher prices. Elevated inflation provides empirical
validation for this supposition, irrespective of its
actual origin.
For example, consider the scale of the attitudinal shift
among policymakers. As laid out explicitly in the new
policy strategies of the Fed7 and European Central
Bank (ECB),8 and implicitly through enacted and
proposed deficit spending (especially in the U.S.),
imprudence seems to have become the default
fiscal and monetary policy setting. If you worried
that $6 trillion in new federal spending funded
by printed money would inevitably lead to higher
inflation, a 5.4% annual increase in the consumer
price index would provide powerful confirmation
of those fears.
And it’s not as though policy has played no role
stoking inflation. While shortages and concomitant
inflationary pressures were likely to manifest
themselves given the scale of the shift in spending
from “experiences” to “stuff,” fiscal transfers boosted
purchasing power at precisely the time output
was still constrained by the virus and supply-chain
disruptions. U.S. inflation is higher largely because
its fiscal transfers were larger (Figure 10).
Figure 10. Fiscal Deficits & Inflation Rates
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L 10
Source: IMF WEO Database as of April 2021 and The Federal Reserve St. Louis. There can be no assurance these market conditions will continue to be achieved.
Figure 10: Fiscal Deficits & Inflation Rates
15.0
10.7 11.8
9.6
7.2
9.4
5.4
3.1 2.4
1.7 1.5
0.2 -
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
U.S. Canada U.K. China France Japan
Deficit % of GDP 2021E YoY CPI % June 2021
7 FOMC Statement on Longer-Run Goals and Monetary Policy Strategy, August 27, 2020:8 The ECB’s monetary policy strategy statement, July 8, 2021:Figure 10. Source: IMF WEO Database as of April 2021 and The Federal Reserve St. Louis. There can be no assurance these market conditions will continue to be achieved.
10
Likewise, elevated inflation is exactly what one
would expect if pervasive “worker shortages”
were forcing businesses to “pay up” massively to
fill positions. Never mind that real wages have
actually declined this year, or that labor shortages
don’t look as acute as they’re portrayed – job
vacancies remain 14% below pre-pandemic levels
when measured relative to the pool of people
seeking work (Figure 11).9 Something has changed in
worker attitudes, likely due to some combination
of health risk perceptions, self-discovery, and
fiscal transfers, and it has not only left jobs
unfilled but also created new vacancies as people
leave existing jobs at elevated rates (Figure
12). Academics have dubbed it the “Great Post-
Pandemic Resignation Boom,” and believe it
reflects many workers’ unwillingness to return to
work-life as it existed in January 2020.10
Figure 11. Worker Shortages in Context
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L 11
TOTAL JOBS (FILLED + UNFILLED) DOWN 2.5% FROM PRE-PANDEMIC LEVELS
JOB VACANCIES-TO-UNEMPLOYED PEOPLE
Source: Carlyle Analysis, FRED Data. July 2021. There can be no assurance these market conditions will continue to be achieved.
Figure 11: Worker Shortages in Context
100,000
110,000
120,000
130,000
140,000
150,000
160,000
170,000
Jan-
16
May
-16
Sep-
16
Jan-
17
May
-17
Sep-
17
Jan-
18
May
-18
Sep-
18
Jan-
19
May
-19
Sep-
19
Jan-
20
May
-20
Sep-
20
Jan-
21
May
-21
THO
USA
NDS
OF
JOBS
Filled Positions Open Positions
0.00x
0.20x
0.40x
0.60x
0.80x
1.00x
1.20x
1.40xA
pr-0
2
Apr
-03
Apr
-04
Apr
-05
Apr
-06
Apr
-07
Apr
-08
Apr
-09
Apr
-10
Apr
-11
Apr
-12
Apr
-13
Apr
-14
Apr
-15
Apr
-16
Apr
-17
Apr
-18
Apr
-19
Apr
-20
Apr
-21
9 BLS, August 2021. U.S. jobs (workers on payrolls plus unfilled positions) sits 2.5% below pre-pandemic levels even as the prime working-age population (25-45) has grown by 175,000 since then. The total work-eligible population is up over 1.8 million since February 2020.
10 “How to Quit Your Job in the Great Post-Pandemic Resignation Boom,” Bloomberg.Figure 11. Source: Carlyle Analysis, FRED Data. July 2021. There can be no assurance these market conditions will continue to be achieved.
11
Finally, those who expect that inflation will prove
transitory anticipate a return to the status quo
ante, as global value chains scale up production
and household spending rotates back from durable
goods towards experiences. But what if that doesn’t
happen, either because new variants of COVID
depress services consumption and labor supply for
much longer than supposed, or because governments
and multinational corporations decide to scale back
cross-border production processes in light of the
vulnerabilities exposed by the pandemic?
The longer elevated inflation persists, the more
it shapes our expectations. Today, confirmation
bias leads analysts to overlook elevated inflation’s
concrete origins in favor of their preferred abstract
narrative. But should inflation persist, initial
conditions will matter much less as convictions harden
over time and perceptions become reality.
Figure 12. Resignations Rise 34%; Interest in Quitting Doubles
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 12: Resignations Rise 34%; Interest in Quitting Doubles
Source: Carlyle Analysis of News Website Text; Google News. August 2021. There can be no assurance these market conditions will continue to be achieved.
1.5
1.7
1.9
2.1
2.3
2.5
2.7
2.9
3.1
60
80
100
120
140
160
180
200
220
240
Jan-
20
Jan-
20
Feb-
20
Mar
-20
Mar
-20
Apr
-20
May
-20
May
-20
Jun-
20
Jul-2
0
Aug
-20
Aug
-20
Sep-
20
Oct
-20
Oct
-20
Nov
-20
Dec-
20
Dec-
20
Jan-
21
Feb-
21
Feb-
21
Mar
-21
Apr
-21
May
-21
May
-21
Jun-
21
Jul-2
1
Jul-2
1
Aug
-21
QU
ITS
AS
SHA
RE O
F PA
YRO
LL
EMPL
OYM
ENT
DEC
EMBE
R 20
19 =
100
Google Search Intensity (Left Axis) Quits Rate
Figure 12. Source: Carlyle Analysis of News Website Text; Google News. August 2021. There can be no assurance these market conditions will continue to be achieved.
12
So while inflation has begun to abate, it seems hardly
the time to be cavalier about this risk, especially
considering the extent to which asset prices embed
expectations of low inflation. And that extends well
beyond fixed income or industrial businesses exposed
to rising input prices. Indeed, more dangerous
than the risk of inflation itself may be the failure to
perceive where that risk manifests itself. For many
portfolios, elevated inflation may prove to be less of
a surprise than the specific categories of assets that
get clobbered by it.
If high inflation persists, nominal and real interest
rates will have to increase, especially at longer
maturities where the risk of real capital losses is
greatest.11 Since Treasury yields constitute the
base rate used to discount all future cash flows,
economy-wide valuation ratios fall as interest rates
rise (Figure 13). While asset prices depend on a host
of other factors, including growth expectations,
time-varying risk premia, and liquidity flows,
yields on corporate bonds, equity, and real estate
all tend to correspond, over time, to long-term
interest rates (Figure 14).
Looking for Inflation Risk in the Right Places
Figure 13. Valuation Ratios Move Inversely with Interest Rates
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 13: Valuation Ratios Move Inversely with Interest Rates
Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
0
2
4
6
8
10
12
14
160x
5x
10x
15x
20x
25x
1962
1964
1966
1968
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
200
0
200
2
200
4
200
6
200
8
2010
2012
2014
2016
2018
2020
TREA
SURY
YIE
LD (I
NV
ERTE
D)
PRIC
E-TO
-EA
RNIN
GS
RATI
O
Average P/E Ratio Median P/E 10Yr Treasury 30Yr Treasury
11 Nominal rates will rise with inflation expectations and real rates will have to increase to bring inflation back down towards target. Longer-term rates will also likely rise further as interest rate risk premia increase to account for the uncertain size of the adjustment in policy.
Figure 13. Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
13
Figure 14. Corporate Earnings Yields & Bond Yields
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 14: Corporate Earnings Yields & Bond Yields
Source: Carlyle Analysis; S&P Capital IQ; Federal Reserve Board of Governors. July 2021. There can be no assurance these market conditions will continue to be achieved.
1976
19771978
1979
1980
1981
1982
1983
1984
1985
19861987
1988
19891990
19911992
1993
19941995 1996
19971998 19992000
2001
200220032004
2005
2006
2007
2008 20092010
20112012
2013201420152016201720182019
2020
1%
3%
5%
7%
9%
11%
13%
0% 2% 4% 6% 8% 10% 12% 14%
AV
ERA
GE
EARN
ING
S YI
ELD
(INV
ERSE
OF
P/E
RATI
O)
10-YEAR TREASURY YIELD
CORREL: 65.5%
2021
The impact of higher rates will not be uniform across
assets, however. As is well known in bond markets,
the sensitivity of an asset’s price to a change in
interest rates depends on the duration of its cash
flows. The further into the future cash flows arrive,
the more heavily they’re discounted and therefore
the more sensitive to a change in rates. A $100
payment due in 10 years is worth $82 when rates
are 2% but just $60 if rates rise to 5% (-27% lower);
the same $100 payment due in 30 years is worth
$55 today if rates are 2% but only $21 if rates are 5%
(-61% lower). This impact is not limited to bonds; all
assets are exposed to the same risk. But rather than
calculated based on a schedule of coupons and
principal payments, equity duration depends on the
timing of a company’s free cash flow.
Figure 14. Source: Carlyle Analysis; S&P Capital IQ; Federal Reserve Board of Governors. July 2021. There can be no assurance these market conditions will continue to be achieved.
14
While the effective duration of corporate assets
cannot be observed directly, because their free
cash flow is not fixed like bond coupon payments, it
can be approximated using an algorithm calibrated
to current valuations, growth rates, and profit
margins.12 No surprise that the assets with the
highest implied duration tend to be fast-growing
businesses with large near-term operating losses
and the highest valuation ratios (enterprise value
Estimating the Duration of Free Cash Flow relative to sales or book value). Effectively, all
of the enterprise value of these businesses is
embedded in their terminal value, which is the
discounted present value of all of the free cash
flow expected to be generated outside of the
10-to-15 year underwriting window (see illustrative
case, Figure 15). The lower the equivalent duration
Treasury yield, the more people are willing to pay
for that terminal value.
Figure 15. Illustrative Annual Free Cash Flow by Asset Type
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L 15
10-YEAR UNDERWRITING WINDOW FUTURE GROWTH IMPLIED BY TERMINAL VALUE
Source: Carlyle Analysis; For illustrative purposes only. August 2021. There can be no assurance these market conditions will continue to be achieved.
Figure 15: Illustrative Annual FCF by Asset Type
-$30
-$20
-$10
$0
$10
$20
$30
$40
$50
1 2 3 4 5 6 7 8 9 10
FREE
CA
SH F
LOW
YEARS INTO THE FUTURE
9 Years Duration (Old Economy) 19 Years Duration (Median)
35 Years Duration (Digital)
-$1,000
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
FREE
CA
SH F
LOW
YEARS INTO FUTURE
9 Years Duration (Old Economy)19 Years Duration (Median)35 Years Duration (Digital)
12 The basic idea is that businesses with the high market valuations (relative to current sales) tend to have cash flows weighted more to the future, the precise timing of which can be estimated based on sales growth and current profit margins. This algorithm was first proposed in Dechow, P., R. Sloan, and M. Soliman. (2004), “Implied Equity Duration: A New Measure of Equity Risk,” Review of Accounting Studies. C.f. Dechow, P., et al. (2021). “Implied Equity Duration: A Measure of Pandemic Shutdown Risk,” Journal of Accounting Research. An industry-specific algorithm was introduced in Fullana, O., J. Nave, and D. Toscano. (2016), “The Implied Equity Duration When Discounting and Forecasting Parameters are Industry Specific,” Accounting & Finance. Finally, the higher covariance of growth stocks and discount rates is presented in Lettau, M. and J. Wachter. (2007), “Why is Long-Horizon Equity Less Risky? A Duration-Based Explanation of the Value Premium,” The Journal of Finance.
Figure 15. Source: Carlyle Analysis; For illustrative purposes only. August 2021. There can be no assurance these market conditions will continue to be achieved.
15
Figure 16. Long Horizon Equity 5x as Sensitive to Bond Yields
Figure 17. Record Dispersion in Valuations Between Top & Median
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L 16
ROLLING 5YR AVERAGES IN YIELDS & VALUATIONS ROLLING 5YR AVERAGES IN YIELDS & VALUATIONS
Figure 16: Long Horizon Equity 5x as Sensitive to Bond Yields
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x-1.5
0.5
2.5
4.5
6.5
8.5
10.5
12.5
1963
-1968
1968
-1973
1973
-1978
1978
-1983
1983
-1988
1988
-1993
1993
-1998
1998
-20
03
200
3-20
08
200
8-20
13
2013
-20
18
2018
-20
21
MA
RKET
-TO
-BO
OK
RATI
O
10 Y
EAR
YIEL
D (IN
VER
TED)
10yr Yield Market-to-Book (Top 5% by Duration)
0.0x
2.0x
4.0x
6.0x
8.0x
10.0x
12.0x-1.5
0.5
2.5
4.5
6.5
8.5
10.5
12.5
1963
-1968
1968
-1973
1973
-1978
1978
-1983
1983
-1988
1988
-1993
1993
-1998
1998
-20
03
200
3-20
08
200
8-20
13
2013
-20
18
2018
-20
21
MA
RKET
-TO
-BO
OK
RATI
O
10 Y
EAR
YIEL
D (IN
VER
TED)
10yr Yield Market-to-Book (Median)
Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 17: Record Dispersion in Valuations Between Top & Median
Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
-1.0
1.0
3.0
5.0
7.0
9.0
11.0
13.0
15.0-1.00x
0.00x
1.00x
2.00x
3.00x
4.00x
5.00x
6.00x
7.00x
8.00x
9.00x
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
200
0
200
2
200
4
200
6
200
8
2010
2012
2014
2016
2018
2020
TREA
SURY
YIE
LD (I
NV
ERTE
D)
RELA
TIV
E V
ALU
ATI
ON
RA
TIO
95th Percentile-to-Median Valuation Ratio 30Yr Treasury
Figure 16. Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.Figure 17. Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
Since these businesses’ expected free cash flow
arrives furthest into the future (a discounted
weighted average of 35 years at the 95th
percentile), their valuations tend to be far more
sensitive to interest rates than those of the median
company (18-20 years duration). This is evident if
one looks at the time series evolution of market-
to-book ratios and bond yields (Figure 16): while
the valuation of the median-duration company
has doubled over time as rates have declined,
the valuations of the longest-duration businesses
have risen more than 5x. It also helps to explain
why the highest-priced 5% of businesses now sell
for 8x the median company, an all-time high in
terms of price-to-adjusted earnings (Figure 17).
16
‘You Might Not Be Interested in Inflation, But It’s Interested in You’
By measuring the duration of free cash flow, one
can see how inflation risk may have surreptitiously
embedded itself into portfolios of investors that had
no idea they were assuming this risk. Fast-growing
but loss-making businesses do not “look like a bond,”
nor do they typically have to worry about the rising
costs of copper, trucking, or corn. But persistently
high inflation will inevitably lead to higher nominal
and real interest rates that are likely to impact these
businesses disproportionately. As Trotsky said of the
dialectic: you might not be interested in inflation but
inflation is interested in you.
Using available data for more than 6,500 stocks from
1963-2011 as a guide, the valuations of the top 5% of
businesses by duration have proven to be about 60%
more sensitive to movements in the 10-year Treasury
yield than the median business, and 2.5x as sensitive
to movements in the 30-year yield over time (Figure
18). Part of that may reflect the low correlation
between tech sector revenues and consumer
price inflation, which means that increases in rates
would not likely translate to faster nominal growth
rates.13 And when segmenting data by time periods,
one can infer how convexity causes interest rate
sensitivity to increase as valuations rise.14 When
controlling for other factors, like market-wide
returns, company growth differentials, profitability
ratios, and company size, a 100bp increase in
the 10-year yield would reduce valuations of the
longest-duration businesses by more than 25%
today, a magnitude that’s increased 3x over time
as nominal rates and term premiums have trended
towards zero (Figure 19).
13 The idea that higher inflation, realized or expected, will translate into faster revenue growth on anything like a 1:1 basis is wishful thinking. Nominal revenue growth for the IT and software business sector has been only 25% correlated with consumer prices at an annual or quarterly frequency since 1990. For the most “disruptive” businesses with the most idiosyncratic growth trajectories the correlation is likely to be even lower. Note, moreover, that the rate adjustment will not just be expected inflation, but also the real rate (to bring inflation back down to target) and the inflation risk premium, all of which have declined since 2011.
14 If the relationship between interest rates and earnings yields, for example, is linear then the effect on valuations (the reciprocal) is nonlinear. For example, if a 100bp increase in rates causes a 50bp increase in earnings yields, valuations will decline by 14% if the initial earnings yield is 3% but by just 7% of the initial earnings yield in 7%.
17
Figure 19. Sensitivity of Valuations to 100bps Increase in 10 Year Yield
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 19: Sensitivity to 100bps Increase in 10 Year Yield
Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
-30.0%
-25.0%
-20.0%
-15.0%
-10.0%
-5.0%
0.0%
33.5 27.7 26.1 25.2 25.0 24.0 23.0 22.1 22.1 20.2 19.9 19.2 18.5 16.9 16.1 15.9 11.6 10.2 9.3
IMPA
CT
OF
100
BP S
HO
CK
TO
LON
G-T
ERM
YIE
LDS
DURATION OF FREE CASH FLOW (YEARS)
Post GFC (2009-2021) 2013-2021 (QE Era) Full Data Set (1963-2021)
Figure 18. Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.Figure 19. Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
Figure 18. Free Cash Flow Duration & Interest Rate Sensitivity
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L 18
SENSITIVITY TO 10-YEAR YIELD BY FCF DURATION SENSITIVITY TO 30-YEAR YIELD BY FCF DURATION
Figure 18: FCF Duration & Interest Rate Sensitivity
Source: Carlyle Analysis; CRSP Database, U.S. Treasury. August 2021. There can be no assurance these market conditions will continue to be achieved.
34.4%
26.6%24.6% 25.9%
21.3%
16.7% 18.0%
11.2%8.2%
0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
30.0%
35.0%
40.0%
Long
est D
urat
ion
15th
Per
cent
ile
25th
Per
cent
ile
35th
Per
cent
ile
Med
ian
65th
Per
cent
ile
75th
Per
cent
ile
85th
Per
cent
ile
Shor
test
Dur
atio
n
% C
HA
NG
E IN
VA
LUA
TIO
NS
FCF DURATION
68.0%
45.5%
31.9%36.1%
26.9%19.6% 21.1%
11.3% 8.8%
0.0%
10.0%
20.0%
30.0%
40.0%
50.0%
60.0%
70.0%
80.0%
Long
est D
urat
ion
15th
Per
cent
ile
25th
Per
cent
ile
35th
Per
cent
ile
Med
ian
65th
Per
cent
ile
75th
Per
cent
ile
85th
Per
cent
ile
Shor
test
Dur
atio
n
% C
HA
NG
E IN
VA
LUA
TIO
NS
FCF DURATION
18
Implications for Investors’ PortfoliosThe point of making this risk more visible is not
to encourage investors to run from it, but to
contextualize past returns and emphasize the
importance of diversification moving forward.
Many technology-focused funds, public and private,
have performed so well over the past several years
partly because they hold long-duration assets whose
terminal values spike when long-term interest rates
fall. The average price-to-book ratio of the top
5% of stocks by FCF duration has been more than
80% correlated with the market value of the 50-
year Austrian bond issued January 2012 (Figure
20). Before doubling down on such allocations,
investors worried about inflation risk should
consider how much exposure they’d like to call
options written on government bonds maturing in
the 2050s and 2060s.
Figure 20. Terminal Values Depend on Long-Term Bond Prices
T R A D E S E C R E T & S T R I C T L Y C O N F I D E N T I A L
Figure 20: Terminal Values Depend on Long-Term Bond Prices
Source: Carlyle Analysis; CRSP Data, August 2021; Bloomberg. There can be no assurance these market conditions will continue to be achieved.
6.0x
7.0x
8.0x
9.0x
10.0x
11.0x
12.0x
100
120
140
160
180
200
220
240
260
Jan-
12
May
-12
Sep-
12
Jan-
13
May
-13
Sep-
13
Jan-
14
May
-14
Sep-
14
Jan-
15
May
-15
Sep-
15
Jan-
16
May
-16
Sep-
16
Jan-
17
May
-17
Sep-
17
Jan-
18
May
-18
Sep-
18
Jan-
19
May
-19
Sep-
19
Jan-
20
May
-20
Sep-
20
Jan-
21
May
-21
PRIC
E TO
BO
OK
VA
LUE
BON
D PR
ICE
PER
100
OF
PAR
VA
LUE
50-Year Austrian Bond Longest Duration Equity Price-to-Book Ratio
Figure 20. Source: Carlyle Analysis; CRSP Data, August 2021; Bloomberg. There can be no assurance these market conditions will continue to be achieved.
19
The only zero duration asset is cash, but there are
alternative non-zero-yielding inflation hedges,
including floating-rate loans, many types of real
estate and infrastructure assets, as well as unloved
but cash-generative corporate assets whose
enterprise value depends disproportionately on
near-term FCF. Relatively low valuations and interest
rate risk sensitivity make traditional buyouts of
such businesses attractive portfolio additions in the
current environment.
But investors will have to continue to add exposure
to fast-growing, nearly infinitely scalable digital
businesses concentrated in the technology and
health care sectors because that’s where the growth
is. If inflation moderates, as expected, and interest
rates remain in the current range, today’s sky-high
valuations could persist. And even if they don’t, the
faster idiosyncratic growth of these assets will offset
some of the loss on terminal value.
Much of the productivity growth observed over
the past year reflects the conscious desire of
management teams to make better use of available
technology to get to the future faster than their
competitors.15 It has never been easier for digital
software and automation solutions firms to get
in front of prospective customers. “Workers
shortages” only increase the attractiveness of such
technology.16 It is neither the time to “bet against”
tech-enabled productivity growth nor to put all of
one’s eggs in that basket.
15 C.f. “When the Future Arrives Early,” Carlyle, September 2020.16 BCG, 5Yr Average of Total Factor Productivity and Cyclical Tightness in Labor Markets.
20
Conclusion The market does not seem to share the market commentariat’s obsession
with inflation. That makes sense, in that elevated inflation is a temporary
phenomenon tied to pandemic-specific supply-demand imbalances that
should ease over time. But it also accentuates risk, as valuations provide little
compensation for the chance that inflation proves more enduring, especially
for the long duration assets most sensitive to an increase in interest rates.
In this environment, investors should heed Daedalus’ advice to Icarus. Avoid
flying “too high” by hubristically accelerating deployment into early-stage
digital assets that have benefitted disproportionately from the fall in rates
and surreptitiously embed the most inflation risk. But also avoid flying
“too low” by becoming consumed with risk aversion and losing sight of the
tech-enabled productivity boom and its potential extension to businesses
operating in a broader set of industries and geographies.
Till swollen with cunning of a self-conceit,His waxen wings did mount above his reach,And melting, heavens conspired his overthrow
Chorus of Marlowe’s Doctor Faustus
21
Jason Thomas
Jason Thomas is the Head of Global Research at The Carlyle Group, focusing on economic and statistical
analysis of Carlyle portfolio data, asset prices and broader trends in the global economy. He is based in
Washington, DC.
Mr. Thomas serves as Economic Adviser to the firm’s Global Private Equity and Global Credit Investment
Committees. His research helps to identify new investment opportunities, advance strategic initiatives
and corporate development, and support Carlyle investors.
Prior to joining Carlyle, Mr. Thomas was Vice President, Research at the Private Equity Council. Prior to
that, he served on the White House staff as Special Assistant to the President and Director for Policy
Development at the National Economic Council. In this capacity, Mr. Thomas served as primary adviser
to the President for public finance.
Mr. Thomas received a BA from Claremont McKenna College and an MS and PhD in finance from George
Washington University, where he studied as a Bank of America Foundation, Leo and Lillian Goodwin
Foundation, and School of Business Fellow. Mr. Thomas has earned the chartered financial analyst
designation and is a Financial Risk Manager certified by the Global Association of Risk Professionals.
HEAD OF GLOBAL [email protected] / (202) 729-5420
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. References to particular portfolio companies are not intended as, and should not be construed as, recommendations for any particular company, investment, or security. The investments described herein were not made by a single investment fund or other product and do not represent all of the investments purchased or sold by any fund or product. 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.