Interest rates and capital costs are capitalism's most consequential yet misunderstood prices, connecting the future to the present.

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The European Central Bank (ECB) raised interest rates by 50bp, the first increase in 11 years. Consumer prices have risen 8.6% in the past year, forcing the bank to do something. Russia’s invasion of Ukraine has created an energy crisis, and consumer confidence indicators are already pointing to a slowdown. Increasing the rate will strain public and private spending, but inflation needs to be controlled. It is unclear whether the bank will keep raising the rate.

Rates are only part of the job. Christine Lagarde, and her troop of central bankers, must also figure out how they will buy bonds to prevent the yields of highly indebted countries from exploding and triggering a debt crisis—all without stoking inflation. Italy looks particularly shaky. The government owes a lot, and the prime minister, Mario Draghi, has resigned.

Stock markets rose last fortnight. The S&P 500 $SPY, an index of big American companies, rose 3% to 3,960. The market has fallen 17% since January and 8% over the past year. Investors added $2.4trn to global stock markets (see: Global stocktake) while discounting the price of risk for both equity and debt.

Traders have mixed feelings about the effects of inflation on stock valuations. They’re also mulling over whether the Federal Reserve, America’s central bank, can control inflation without destroying the economy. Punters are reckoning with the uncertainty of when and at what level rates will stop rising and how these higher borrowing costs will impact corporate earnings.

The price of government bonds fell. Yields, which move inversely to prices, rose as inflation expectations did. The yield on a ten-year American Treasury bond, a key variable for valuing financial assets worldwide, rose by 8bp to 3%. Bond investors’ forecasts for inflation over the next decade rose by 9bp to 2.4% per year.

Consequently, the real interest rate, the difference between yields and expected inflation, fell by one basis point. Fixed-income investors expect to increase their purchasing power by 0.6% per year. This return is 166bp better than a year ago but is still pathetic.

The equity risk premium (ERP), the extra return investors want for buying stocks instead of bonds, dropped. It fell 36bp last fortnight. The current 5.5% premium is slightly higher than the average over the past five years of 5.1%. It is up 74bp since January and 155bp over the past year.

The cost of equity, the return stock-investors demand to part with their money, is 8.5%, down 28bp from last fortnight when Valuabl last went to press. Equity costs—which we can think of as expected returns—have risen 223bp since January and 333bp in the past year. Stock buyers demand a much larger return now than they did then.

Financiers want both a higher risk-free return and a higher risk-adjusted return. Rising capital costs have hit both public and private valuations. Early stage private investment, from seed to venture to private equity, will continue drying up as the rise exposes the mismatch between entrepreneurs' and capitalists' valuation expectations. Klarna, a buy now pay later company, recently raised $800m at a $7bn valuation, down 85% from the $46bn valuation a year ago.

Creditors are charging less for risk than they did a fortnight ago. Corporate bond prices rose slightly as government ones fell. Credit spreads, the gap between corporate bond and Treasury yields, on BBB-rated bonds, fell 12bp. These spreads are up 73bp since the start of the year and 79bp over the last 12 months.

Risk is getting increasingly expensive, particularly for speculative borrowers. But at the other end, spreads on AAA-rated bonds have fallen over the past quarter. They’ve dropped from 66bp to 60bp. Bond investors are shifting out of speculative credit and into investment-grade assets.

Using the average ERP of the past five years, the current ten-year Treasury bond yield, analysts' consensus earnings estimates, and a stable payout ratio based on the S&P 500's average return on equity over the last decade, I value the index at 4,266 compared to its level of 3,960. The slight drop in earnings forecasts was slightly offset by the decrease in equity costs over the past two weeks. Consensus earnings for 2023 fell to $249.13 from $250.70.

This valuation suggests the S&P 500 index is 7% undervalued compared to 9% overvalued at the start of the year and 21% overvalued last year. Although investors buying stocks can expect an 8.56% per year return at these prices, the index isn’t good value.

(1) The Federal Reserve buys and sells securities and (2) sets interest rates to influence: (3) borrowing costs, (4) lending activity, (5) inflation and employment; (6) with varying effects.

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latest data: July 20, 2022

TLDR: Last week, the Fed trimmed $10.5bn net from its Treasury security holdings and added $21.5bn net to its mortgage-backed security holdings. The total amount of Reserve Bank credit increased by $11.2bn net.

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The Federal Reserve creates money and uses it to buy bonds. They do this to push interest rates down and to put more money into the economy. Low rates mean people can borrow more, spend more, and afford higher prices. More spending and higher prices mean people feel rich, and businesses hire new employees.

But, if prices rise too quickly or people borrow too much, the Fed does the opposite. It sells the bonds it has and then destroys the money it receives. These sales push interest rates up and take money out of the economy. Higher rates mean people can't borrow or spend as much and must pay lower prices. It makes people feel poorer than before, stops them from being able to spend as much, and makes businesses trim employment.

In addition to this, the Fed borrows and lends to banks. If a bank doesn't have enough money for a day or two, it can borrow from the Fed. If it has too much, it can lend to the Fed. A group of people who work for the Fed, the Federal Open Market Committee (FOMC), decide the interest rate that the Fed will pay for, or demand of, these short-term loans.

The Fed does these because they believe in two objectives: first, a low and stable inflation rate is good for the economy, and second, that minimising unemployment is desirable.

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It takes mortgage-backed securities up to 180 days to settle. Increases in the MBS position are most likely old purchases settling. The Fed is letting $17bn of mortgages amortise off the balance sheet per month. The MBS position will shrink, but on a week-to-week basis, it will fluctuate.

It takes time for asset settlement to occur. The holdings on any given day will fluctuate wildly—especially given that the Fed owns almost $9trn of assets. The weekly average is smoother and more indicative of the monetary policy trend.

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A preview of tomorrow's cartoon in Valuabl by the talented Harriet Lawless.

A brand new issue of Valuabl is coming to you fresh off the presses this Friday. This issue will be hotter than the weather and inflation combined.

For the uninitiated, Valuabl is my fortnightly journal of the financial markets. Subscribers get:

Subscribe now. Both free and paid memberships are available.

What metrics would you choose if you could only look at one or two when evaluating whether to invest in a stock?

(1) The Federal Reserve buys and sells securities and (2) sets interest rates to influence: (3) borrowing costs, (4) lending activity, (5) inflation and employment; (6) with varying effects.

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latest data: July 13, 2022

TLDR: Last week, the Fed added $1.1bn net to its Treasury security holdings and $7m net to its mortgage-backed security holdings. The total amount of Reserve Bank credit increased by $3.6bn net.

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The Federal Reserve creates money and uses it to buy bonds. They do this to push interest rates down and to put more money into the economy. Low rates mean people can borrow more, spend more, and afford higher prices. More spending and higher prices mean people feel rich, and businesses hire new employees.

But, if prices rise too quickly or people borrow too much, the Fed does the opposite. It sells the bonds it has and then destroys the money it receives. These sales push interest rates up and take money out of the economy. Higher rates mean people can't borrow or spend as much and must pay lower prices. It makes people feel poorer than before, stops them from being able to spend as much, and makes businesses trim employment.

In addition to this, the Fed borrows and lends to banks. If a bank doesn't have enough money for a day or two, it can borrow from the Fed. If it has too much, it can lend to the Fed. A group of people who work for the Fed, the Federal Open Market Committee (FOMC), decide the interest rate that the Fed will pay for, or demand of, these short-term loans.

The Fed does these because they believe in two objectives: first, a low and stable inflation rate is good for the economy, and second, that minimising unemployment is desirable.

•••

It takes mortgage-backed securities up to 180 days to settle. Increases in the MBS position are most likely old purchases settling. The Fed is letting $17bn of mortgages amortise off the balance sheet per month. The MBS position will shrink, but on a week-to-week basis, it will fluctuate.

It takes time for asset settlement to occur. The holdings on any given day will fluctuate wildly—especially given that the Fed owns almost $9trn of assets. The weekly average is smoother and more indicative of the monetary policy trend.

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> A titan of the global tourism booking industry, Booking Holdings Inc will look to acquire other small websites and bring them under its umbrella. The firm enjoys robust network effects powering incredible unit economics and helping it take a slice of a tenth of all global tourism bookings. The industry was walloped by the pandemic but will continue to rebound. It is likely to return to its pre-pandemic trend within a few years. Inflation is high, and interest rates are rising. Consumers whose wallets will be squeezed will become increasingly frugal; this benefits Booking.com as travellers hunt for the best price online. Starting a dividend or acquiring a company like Trainline, Webjet, or Seera could catalyse the value revelation here.

Booking.com is a global travel reservation business. It makes money by helping consumers book accommodation, transport, and restaurants online. The firm connects travellers with tourism service providers and takes a percentage of the booking as a finder’s fee. The business has six brands:

Many countries’ economies rely on tourism. Over the last few decades, modern communication, household wealth growth, and sustained periods of peace helped the industry flourish. But, the previous two years have been brutal for the sector. The COVID-19 pandemic stopped people from travelling as widespread infection uncertainty, and regional restrictions closed borders. Tourism revenues collapsed. Russia’s invasion of Ukraine has notably worsened the situation for Eastern European and Baltic countries.

Despite being battered, global tourism has bounced back somewhat and is set to strengthen as countries reopen to travellers. Total worldwide revenues for the combined vacation rental, package holiday, hotel, flight, and car rental markets (hereafter collectively referred to as tourism) had hit $1.3trn by 2019 but halved in 2020. Statista, a market analytics firm, expects tourism industry revenues to continue to rebound and increase at 18% per year, hitting $1.7trn by 2026. They also reckon industry revenues will return to the pre-COVID trend by 2024.

Since making reservations online has become more accessible, there are fewer barriers to travel, and more people are choosing to book this way. According to Statista again, in 2017, 60% of tourism-related bookings happened online. By 2021 it was 66%, and they expect it to reach 73% by 2026. This trend has been valuable for Booking.com. More people travelling while choosing to do their research and make their booking online means the firm's addressable market has been rapidly expanding.

While the company benefitted from these trends, its growth has mainly come from booking more rooms rather than airline tickets or car rentals. In 2000, the firm primarily sold airline tickets—they sold 4.6m tickets to fly that year but only booked 1.7m room nights and 1.8m rental car days. In contrast, almost all the firm's business is now hotels and vacation rentals. The company took reservations for 591m room nights, 47m rental car days, and 15m airline tickets last year. This change in product mix helped increase revenues as accommodation is usually the most expensive item on a per trip basis.

While the mix of services has changed, so has the business model. Two decades ago, the company almost exclusively operated as a merchant taking payments and trying to make a spread by completing the booking with the provider. Almost all the gross booking revenue flowed through Booking.com. However, in the early 2000s, they began switching to an agency model where they instead took a commission for bringing the reservation to the service provider. Under this model, little of the gross booking revenue flows through Booking.com; instead, they take a finder’s fee. These commissions increased from 0.1% of revenues in 2001 to 61% in 2021, after peaking in 2017 at 77%. As a result, the firm takes less responsibility for the booking, needs to process fewer transactions, and acts as a broker or agent rather than a merchant.

The shifting business model has meant that revenue as a percentage of total gross bookings has declined too. Their revenue structure has changed by selling rooms on a commission model instead of airline tickets on a merchant model. In 2003, 78% of the firm's processed gross bookings were revenue. This percentage dropped rapidly and has averaged 16% over the last five years—close to the standard 15% commission fee they charge.

As the company processes fewer transactions itself, it's registering less of that as revenue. Instead, it increasingly acts as a middleman between travellers and accommodation providers and takes a slice of the action. In 2021, 10% of all worldwide tourism revenue was booked through the company’s websites, up from 6% in 2017. The brokerage model is helping the firm process fewer bookings itself, expand more rapidly, and get a slice of more of the world’s travel bookings.

As the company grew and its business model changed, it became increasingly profitable. The increased scale meant fixed costs represented a lower proportion of the cost base, and the change in structure drove the cost of providing its services down. Consequently, the company is now highly profitable with enormous margins—the agency model is attractive. Gross margins, which were 16% two decades ago, have averaged 86% (!!) over the last five years. While on an operational basis, the company has gone from not being able to make a profit to averaging 28% EBIT margins. Although high, these margins are not as high as they were pre-COVID. In the five years before 2020, these profit margins were 94% and 36%, respectively.

Booking.com has an efficient and lucrative business model, but they are not alone in the industry. Many other companies operate similar services, but this company does it better. Of the 97 global travel and tourism booking companies I sampled, Booking.com’s gross and operating margins, over the past five years, were in the top 10% and 6%, respectively. The firm has a competitive advantage driven by its scale and the network effects that brings.

The decline in the cost of revenues as the firm’s sales became increasingly commission-based freed up money to be spent on marketing and sales. This helped to feed the network advantage that the business was building. According to the company’s website, they have 28m total accommodation listings, including 6.2m listings of homes, apartments and other unique places to stay. Airbnb, a rival focused on home rentals, sports 7m listings. This is more than the number of homes and apartments on Booking.com but a fraction of the overall accommodation options. Expedia, another rival, has just 3m lodging properties.

The scale of the company’s operation makes it a more attractive place for customers to look first. This result makes it increasingly tempting for travel service providers to list and advertise through them. And because of this, Booking.com can strike better deals and have more money left to spend on sales and marketing, further driving service providers and consumers to the platform. Currently, the company is spending 41% of its revenues on sales and marketing mostly on national advertising and customer loyalty programmes. This expense ratio is at the 86th percentile of the companies I sampled. Not only can the firm spend more on sales and marketing than five-sixths of its rivals, but more money still comes out in profit than 94% of them.

This business’s competitive advantage and agency model means less capital must be reinvested to grow than for its competitors. Booking.com’s business model is fantastic at turning invested capital into revenue. On average, $4.42 of sales have been generated for every dollar invested in operating assets over the last five years. This ratio puts it in the top 5% of companies I sampled. The resilience and efficiency of the business model were especially highlighted during the pandemic and subsequent bounce-back as they could quickly scale down and up their operations.

> A titan of the global tourism booking industry, Booking Holdings Inc will look to acquire other small websites and bring them under its umbrella. The firm enjoys robust network effects powering incredible unit economics and helping it take a slice of a tenth of all global tourism bookings. The industry was walloped by the pandemic but will continue to rebound. It is likely to return to its pre-pandemic trend within a few years. Inflation is high, and interest rates are rising. Consumers whose wallets will be squeezed will become increasingly frugal; this benefits Booking.com as travellers hunt for the best price online. Starting a dividend or acquiring a company like Trainline, Webjet, or Seera could catalyse the value revelation here.

Each share has an intrinsic value of $2,885. At the current price, $1,735, the investment has a 66% upside.

The price of Booking Holdings Inc (NASDAQ: BKNG) common equity is $1,735 and is at the 15th percentile of the Monte Carlo sample of intrinsic values. For this reason, it has a rating of Add.

I did not already own the stock but am building a position.

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Companies are sacking more of their employees. Layoffs haven’t reached their COVID-19 peak, but tech startups fired 33,000 of their staff in the past two months. The recession is biting. Rising capital costs have crushed the shares of unprofitable companies and inhibited their ability to raise money. Workers have been miffed by stock-based compensation that’s now worth a fraction of what they expected. The economy is contracting.

Despite this, stock markets rose last fortnight. The S&P 500, an index of big American companies, climbed 2% to 3,831. The index has dropped 20% since January, its peak, and 12% over the past year. Investors added $734bn to global equity markets (see: Global stocktake) and again marked up the risk price for both equity and credit. Investors are struggling to reconcile the effects of a recession on monetary policy and valuations. The compromise has been to increase spreads. Punters reckon the recession is here and that central banks will turn dovish sooner rather than later.

The price of government bonds rose. Yields, which move inversely to prices, fell as inflation expectations did. The yield on a ten-year American Treasury bond, a key variable for valuing financial assets, dropped 43bp to 2.9%. Bond investors’ forecasts for inflation over the next ten years fell by 31bp to 2.3% per year. These traders are giving the Federal Reserve, America’s central bank, credit for their plan to raise rates and bring inflation down.

Consequently, the real interest rate, the difference between yields and expected inflation, fell by 12bp. Fixed-income investors expect to increase their purchasing power by 0.6% per year. This return, albeit tepid, is 162bp better than it was at the start of the year.

The equity risk premium (ERP), the extra return investors want for buying stocks instead of bonds, is still rising. It rose 17bp last fortnight as recessionary fears continued to build. The current 5.9% premium is much higher than the average over the past five years of 5.1% and is the highest since the peak of COVID uncertainty in April 2020. It is up 110bp since January and 191bp over the past year.

The cost of equity, the return stock-investors demand to part with their money, is 8.8%, down 26bp from last fortnight when Valuabl last went to press. Equity costs—which we can think of as expected returns—have risen 246bp since January and 342bp in the past year. Equity costs a helluva lot more now than then.

Creditors marked up risk last fortnight. Corporate bond prices fell as government ones rose. Credit spreads, the difference between corporate bond yields and Treasury yields on BBB-rated bonds, rose 20bp. These spreads are up 84bp since the start of the year and 97bp over the last 12 months. Risk is becoming much more expensive, particularly at the speculative end.

Using the average ERP of the past five years, the current ten-year Treasury bond yield, analysts' consensus earnings estimates, and a stable payout ratio based on the S&P 500's average return on equity over the last decade, I value the index at 4,405 compared to its level of 3,831. The slight drop in earnings forecasts was more than offset by the decrease in equity costs over the past two weeks. Consensus earnings for 2023 fell to $250.70 from $251.99.

This valuation suggests the S&P 500 index is 13% undervalued compared to 9% overvalued at the start of the year and 21% overvalued last year. Although investors buying stocks can expect an 8.8% per year return at these prices, the index isn’t good value yet. Let’s see what happens over the next few weeks.

(1) The Federal Reserve buys and sells securities and (2) sets interest rates to influence: (3) borrowing costs, (4) lending activity, (5) inflation and employment; (6) with varying effects.

•••

latest data: July 6, 2022

TLDR: Last week, the Fed trimmed $19.7bn net from its Treasury security holdings and trimmed $11.2bn net from its mortgage-backed security holdings. The total amount of Reserve Bank credit shrank by $34.3bn net.

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The Federal Reserve creates money and uses it to buy bonds. They do this to push interest rates down and to put more money into the economy. Low rates mean people can borrow more, spend more, and afford higher prices. More spending and higher prices mean people feel rich, and businesses hire new employees.

But, if prices rise too quickly or people borrow too much, the Fed does the opposite. It sells the bonds it has and then destroys the money it receives. These sales push interest rates up and take money out of the economy. Higher rates mean people can't borrow or spend as much and must pay lower prices. It makes people feel poorer than before, stops them from being able to spend as much, and makes businesses trim employment.

In addition to this, the Fed borrows and lends to banks. If a bank doesn't have enough money for a day or two, it can borrow from the Fed. If it has too much, it can lend to the Fed. A group of people who work for the Fed, the Federal Open Market Committee (FOMC), decide the interest rate that the Fed will pay for, or demand of, these short-term loans.

The Fed does these because they believe in two objectives: first, a low and stable inflation rate is good for the economy, and second, that minimising unemployment is desirable.

•••

It takes mortgage-backed securities up to 180 days to settle. Increases in the MBS position are most likely old purchases settling. The Fed is letting $17bn of mortgages amortise off the balance sheet per month. The MBS position will shrink, but on a week-to-week basis, it will fluctuate.

It takes time for asset settlement to occur. The holdings on any given day will fluctuate wildly—especially given that the Fed owns almost $9trn of assets. The weekly average is smoother and more indicative of the monetary policy trend.

•••