The State of Play, For Now
Since the announcement of sweeping U.S. tariffs on April 2, the outlook for global economic growth for the rest of the year has become cloudy and subject to widespread conjecture. Until public market investors find clarity and some of this uncertainty subsides, significant price volatility is likely to continue. Such volatility raises significant questions on the impacts on cost of capital, the value of public and private investments, capital spending and M&A activity and the potential impairment of goodwill and other assets.
Cost of Capital, Investment Valuations
Economists generally agree that broad-based tariffs will exert inflationary pressures, at least in the near term. This will make the Federal Reserve’s (Fed) job of trying to decide the timing and magnitude of interest rate cuts more difficult, especially given that the job market is cooling down and the US unemployment rate is starting to rise.
In the first quarter of 2025, the U.S. economy appeared to be resilient, particularly if the one-off acceleration in imports (in anticipation of tariffs) is not taken into account. However, growth expectations have now been severely downgraded by many economists. The soft-landing scenario (i.e., lower inflation, lower real growth, but no recession) that had been priced in by investors until early 2025 is being challenged. Several economists have revived concerns about stagflation or recession. In this context, markets are now pricing several policy rate cuts in 2025. Long-term U.S. Treasury yields have declined significantly from their January-February levels, a combination of flights to quality and an indicator that markets anticipate a significant economic slowdown.
The current decline in long-term U.S. Treasury yields can still reverse in 2025 due to inflationary pressures, which would be exacerbated if investors become more concerned about a rising U.S. budget deficit and/or if foreign investors reduce their appetite to purchase or hold U.S. Treasury securities. In addition, the greater the market uncertainty, the greater the variability in possible outcomes for projected cash flows--leading to a higher systematic risk premium. This translates into a higher equity risk premium required by investors. The combination of these trends in risk-free rates and equity risk premium can lead to a potentially higher cost of capital, and a lower value for many investments.
Capital Spending
Capital spending plans are likely to be delayed in the face of such heightened uncertainty. In addition to pausing existing spending plans, corporations may hesitate in reshoring manufacturing facilities to the U.S., despite the stated objective by the U.S. administration in using tariffs as a means to revive U.S. manufacturing activity. For corporations to expand and implement capital spending plans, they will need to see evidence that the announced tariff regime will remain in force.
While uncertainty persists, there is likely to be a delay in moving forward with the building of new factories in the U.S., which will exacerbate the impact of tariffs on the cost of goods sourced from outside the U.S. For businesses most impacted by a rise in input costs, there will have to be a management decision on whether to increase prices to their customers (which could potentially lead to a decrease in demand) or suffer shrinking margins. Either way, some companies will see lower earnings in this type of environment.
Mergers & Acquisitions
M&A activity is also likely to come to a halt, or at least take a pause, until companies can adapt to the new playing field. Uncertainty as to how other countries will react to the new U.S. tariffs is likely to delay global M&A momentum, slowing down a market that had been gaining traction later last year. Companies with U.S. exposure may appear riskier to potential buyers, meaning international acquirers could prioritize deals in their own regions.
Private Market Investing
Over the last several years, there has been a significant increase in private market assets under management, private credit, private equity and other less liquid investments. These investments are not completely immune to public market trends. Key valuation questions have arisen, driven by the recent public market volatility and the impact that tariffs may have on profits and cash flows. With the increased number of fund structures that allow more access to “retail” investors who are able to transact on a daily, monthly or quarterly basis, the need for greater valuation transparency and rigor has never been greater, especially given the judgement required to anticipate the impact of market volatility and direct tariff impacts on projected cash flows.
Key valuation considerations for private investments in the days and months to come include:
- Will credit spreads continue to widen, driving down the value of certain private credit investments?
- Will interest rates increase because of inflationary pressures, or decrease because of unemployment concerns, influencing the ability of managers to exit leveraged investments?
- Will tariffs increase a company’s cost of goods sold, driving decreased revenue or decreased profit or will suppliers be squeezed to take up the slack (such suppliers themselves may be owned by private investors)?
- To what extent does the public market sell off drive the multiples achievable by private investments in an exit scenario?
There are conceptual similarities between the current situation and the market volatility experienced in late March of 2020 and thereafter, in the aftermath of COVID-19 being declared a pandemic. Many private investment managers wrote down investments in the aggregate, although at about half of the public market declines. On the other hand, other investments reflected the downturn later, in June of 2020.
In the current environment, the impact of tariffs on the value of private investments will likely be most visible over the second quarter of 2025.
Interest rate cuts by the Fed to prevent a large increase in unemployment could provide an offset to tariff-driven decreases in fair value. Valuing private investments requires significant informed judgement to reflect the impact of the many factors affecting value. Greater valuation transparency and rigor will be required to navigate the impact of a new world order in the realm of U.S. tariff actions. Despite headwinds, pent-up demand for private investment exits remains. The ability to execute deals will depend on interest rate movements and evolving economic conditions driven by the new tariff regime.
Conclusion
The volatility of public markets driven by uncertainty as to the economic outlook will significantly impact asset values and deal activity for the foreseeable future.
Significant broad macro events, such as the 2001 internet bubble, the 2008 global financial crisis or the 2020 Covid-19 crisis, can lead regulators and politicians to employ a stringent use of 20/20 hindsight, which does not necessarily reflect the conditions on the ground as of a given valuation date.
Kroll professionals have weathered the storm in times of extreme volatility by advising clients as they exercise judgment when reporting the value of their assets transparently. Our professionals provide rigorous analyses that withstand challenges from regulators, auditors and investors.
