Evolution of the Cost of Capital Over the Business Cycle

Equity capital is one factor in financing economic growth and yet the cost of equity capital varies over the business cycle. In a similar way, bank credit also has a cyclical character.

Who's Steering the Ship?

When evaluating growth patterns over the business cycle, it is useful to examine the underlying components of GDP. As the top graph shows, the composition of our economy continues to evolve over time. Personal consumption expenditures (PCE), which once made up just 61 percent of GDP in 1980, now accounts for nearly 70 percent of our economic output. Interestingly, PCE as a share of GDP has rarely experienced a prolonged decline, even during recessions. This pattern corroborates the notion that the consumer has been driving much of the growth in our current economic expansion. In contrast, business fixed investment (BFI) as a share of GDP exhibits distinct cyclical behavior. This observation makes intuitive sense, as businesses tend to delay new equipment financing and structural development until the economic backdrop becomes more favorable. Financing long-term projects in the midst of economic cyclicality may take on significant risk, which is why business investment is much more responsive to the economic cycle than consumer spending.

The Price-Earnings Ratio: Another Non Mean-Reverting Series

Commentators frequently argue that equity price-earnings ratios are either above or below some average value and that this difference indicates the equity market is under or overvalued. However, as illustrated by the middle graph, an average value can be calculated for any time series, but that does not indicate that the behavior of that series will return to some average value. Mean-reverting behavior for a series cannot simply be assumed.

In fact, the P/E ratio is not mean reverting. There have been significant shifts in the series in October 1987 (downward) and in October 1991 (upward) and then down again in July 2002. In fact, the P/E ratio is dependent on the behavior of several economic fundamentals such as expected nominal growth and interest rate polices as well as regulatory changes and exogenous shocks that alter the risk/reward calculus. The P/E ratio is not independent of the economic cycle and, instead, a product of the many economic forces.

C&I Lending: Follow the Leader

Much like BFI, commercial & industrial (C&I) lending and business inventories exhibit pronounced cyclicality. It is also interesting that inventories react quicker than C&I lending, tending to rise and fall several quarters before loan activity responds. The leading nature of inventories over C&I loans makes intuitive sense. When emerging from a recession, companies are likely to ramp up production and require larger amounts of inventories. However, companies are likely to refrain from taking out fresh debt to finance the initial buildup, as capital-related wounds are likely still fresh from the economic downturn. Once it is clear that an expansion is underway, C&I lending accelerates and resumes positive growth patterns.

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