REGARDING THOSE “STRONG” CORPORATE BALANCE SHEETS
Brett Arends had an excellent piece on MarketWatch yesterday regarding the true state of US corporations. You’ve probably heard the argument before that corporations are sitting on record piles of cash – their balance sheets are in immaculate condition. Right? Wrong! These comments are generally made without accounting for both sides of the ledger. What is often ignored is that the total debts of these companies has also skyrocketed. Admittedly, I’ve been guilty of this in the past when discussing corporate cash levels and Arends (rightfully) sets the record straight. He notes that corporations are even worse off today (in terms of debt levels) than they were when the crisis began:
“American companies are not in robust financial shape. Federal Reserve data show that their debts have been rising, not falling. By some measures, they are now more leveraged than at any time since the Great Depression.
You’d think someone might have noticed something amiss. After all, we were simultaneously being told that companies (a) had more money than they know what to do with; (b) had even more money coming in due to a surge in profits; yet (c) they have been out in the bond market borrowing as fast as they can.
Does that sound a little odd to you?
A look at the facts shows that companies only have “record amounts of cash” in the way that Subprime Suzy was flush with cash after that big refi back in 2005. So long as you don’t look at the liabilities, the picture looks great. Hey, why not buy a Jacuzzi?
According to the Federal Reserve, nonfinancial firms borrowed another $289 billion in the first quarter, taking their total domestic debts to $7.2 trillion, the highest level ever. That’s up by $1.1 trillion since the first quarter of 2007; it’s twice the level seen in the late 1990s.”
This will also sound familiar to readers of John Hussman who has debunked the cash on the sidelines story more than once:
Interestingly, some observers lament that corporations and some individuals are holding their assets in “cash” rather than spending and investing those balances, apparently believing that this money is being “held back” from the economy. What is preposterous about this is that the “cash” that companies and individuals are observed to be holding is primarily in the form of government securities and base money created over the past couple of years, which somebody has to hold at every point in time until those liabilities are retired. This is not money that is waiting to be spent. It is a stack of IOUs representing resources that have already been squandered, and now somebody has to hold these pieces of paper until they are retired.
In short, instead of directing savings toward investments in real, productive assets that we would observe as physical output, fixed capital, and equipment (and claims on those assets in the form of corporate stocks and bonds), our economy has been forced to choke down a massive issuance of government liabilities in order to bail out bad debt. For every dollar of debt that should have defaulted, we now have two dollars of debt outstanding (the original debt, and a newly issued government security). What appears to be “sideline cash” is simply the evidence of past spending. Again, the crucial consideration is how the government spent the funds in the first place. Rapidly mounting evidence suggests that the answer is “not very well.”
Our friends at Annaly Capital added to the Hussman story several weeks ago when they showed that non-financial firms are indeed worse off than they were when the crisis began:
“We decided to scale the aforementioned $1.8 trillion of liquid corporate assets by the total credit market debt owed by those corporations, with predicable results.
As it turns out, in relation to their debt outstanding, corporations are less liquid than they were prior to the recession.”
Arends continued his piece with a similar conclusion to those by Hussman and Annaly:
“The debt repayments made during the financial crisis were brief and minimal: tiny amounts, totaling about $100 billion, in the second and fourth quarters of 2009.
Remember that these are the debts for the nonfinancials — the part of the economy that’s supposed to be in better shape. The banks? Everybody knows half of them are the walking dead.
Central bank and Commerce Department data reveal that gross domestic debts of nonfinancial corporations now amount to 50% of GDP. That’s a postwar record. In 1945, it was just 20%. Even at the credit-bubble peaks in the late 1980s and 2005-06, it was only around 45%.”
The obvious conclusion here is quite simple. It’s not just the consumer and banking sectors that remain overly indebted and poorly positioned in the long-run. The period of de-leveraging (balance sheet recession) is likely far from over and the continuation of the private sector weakness likely to continue until the problem of debt is accepted and dealt with. At the bank level we’ve merely kicked the can down the road. In the housing market we’ve attempted to fix prices without accepting natural market forces as a long-term positive. All of this means the “workout” period and a Japanese scenario likely lies ahead. Government can delay the inevitable, but much like Japan, they cannot fix all of our problems with misguided bailouts and stimulus programs that do more harm than good. The ponzi debt cycle cannot continue ad infinitum and we have certainly hit a wall. Private sector demand for debt is likely to remain very tepid and this will exacerbate the risk of deflation and economic weakness.
Unfortunately, the government continues to misdiagnose our problems as having originated in the banking sector so they continue to throw money at the issue while misallocating resources, increasing moral hazard and destroying public sentiment. Our monetarist friends at the Fed have convinced themselves (and our politicians) that they control the economy with their insignificant press releases on monetary policy. Until this changes the risks in this economic and market environment will remain abnormally high. Konnichiwa my friends!
While everybody expects QE2- I think the fed has another plan– Do Nothing!
Why is this THE Plan? 2 reasons— a Weaker US Dollar helps exports and helps GDP, the recent 2.5% would have been much higher had imports not reduced the number. Weaker Dollar
fights deflation naturally. In point of fact Bernanke will talk up the weak economy and show grave concern as markets drive down the USDollar and do the job of fighting deflation for the FED!
I’m sure Mr. Hussman has a good grasp of the financial markets and I do enjoy reading his articles, but he dose not seem to understand modern market theory. Also, he really does not seem to understand Keynes very well. And to relate what Bernanke and Guitner are doing to Keynes is ridiculous. What is being done today is nothing like was done in the 30′s. Besides, TPC himself called Bernanke a monetarist and are monetarist not the opposite of Keynes? As I see it, Bernanke’s throwing money at the banks to help his buddy’s in the banking system has nothing to do with increasing aggregate demand, that would take spending by the fiscal side of the government. Also, even if corporations do have money why would they spend it they already have excess capacity and no demand for their products? Another thing is that if you were expecting deflation would you invest in plant and equipment or would you buy up treasury bonds? I know what I have done.
There is something I would like to suggest to TPC. You posted the comment by David Stockman the other day, why not also post the times article by Robert Schiller, “What Would Roosevelt Do?” (July 31,2010). I liked billy blog’s review of it.
Moin from Germany,
another point missing is that at least to my knowledge a not insignificant percentage of the cash is “trapped” outside the US….
Without a special “tax holiday” there is only a very small chance that this money can be used freely
Here is Floyd Norris
It was called the “Homeland Investment Act,” and was sold to Congress as a way to spur investment in America, building plants, increasing research and development and creating jobs. It gave international companies a large one-time tax break on overseas profits, but only if the money was used for specified investments in the United States.
The law specifically said the money could not be used to raise dividends or to repurchase shares.
Now the most detailed analysis of what actually happened — using confidential government data as well as corporate reports — has estimated what happened to the $299 billion companies brought back from foreign subsidiaries.
About 92 percent of it went to shareholders, mostly in the form of increased share buybacks and the rest through increased dividends.
There is no evidence that companies that took advantage of the tax break — which enabled them to bring home, or repatriate, overseas profits while paying a tax rate far below the normal rate — used the money as Congress expected.
From the B.E.A. data, the researchers were able to calculate that $300 billion in overseas profit was repatriated by American companies in 2005, when they had to pay a tax rate of just 5.25 percent, rather than the normal corporate tax rate of 35 percent. The amount was five times the normal amount of repatriations.
http://www.nytimes.com/2009/06/05/business/05norris.html?_r=1
After this “spectacular” outcome last time the chances for another tax break are probably not “overwhelming”…
I dont think Hussman’s cash on the sideline argument is relevant to this discussion as this about looking at both sides of the balance sheets while Hussmans tome is about the fallacy of long only managers using cash in money markets as a sign of pent up demand for equities.
Right now, debt is cheap. It makes perfect sense for companies that have borrowing capacity and future growth prospects to sell bonds today, and to bank those proceeds until later in the economic cycle when they have more customers and worthwhile projects. For those companies that are well managed, this is not a problem, and actually a positive.
Right now, debt is cheap. It makes perfect sense for companies that have borrowing capacity and future growth prospects to sell bonds today, and to bank those proceeds until later in the economic cycle when they have more customers and worthwhile projects. For those companies that are well managed, this is not a problem, and actually a positive.
Why is debt cheap? Because of low nominal interest rates? Debt is only cheap if you are able to re-invest it in something that is going to generate returns above the rate of interest. In a deflationary environment, low nominal rates can still be quite burdensome. Grabbing “cheap” debt to invest in overcapacity will magically transform that cheap debt into very expensive debt.
Debt is only cheap if you are able to re-invest it in something that is going to generate returns above the rate of interest.
Unless you have intelligent reasons to believe that US companies will have no investment prospects over the next couple of years, your position is not sensible.
Most of the business world is not banking on permanent deflation, nor should it. Unless the world falls off of a cliff, that debt is dirt cheap and this is a great time to raise it. The long run survival and prosperity of companies is created through earnings, and debt is a basic tool for generating earnings. Do things your way, and companies will wait to borrow until debt is twice today’s price, which would only drag down future performance.
I agree to some effect, though drowning in debt is not exactly a good thing. However, this will take A LOT of pressure off of interest rates come 2012 when tons of new debt is scheduled to be issued (both public and private).
Additionally, a lot of people don’t realize that selling debt at these levels means that there could be a direct earnings upswing if the company can later buy it back at much lower levels.
Angry MBA,
In my thinking, debt is cheap if the return on capital exceeds the cost of capital. I certainly agree that the nominal cost of capital is historically low, but my point is that this in itself does not NECESSARILY imply that returns on capital will exceed the cost.
Ultimately, I am influenced by a bearish outlook on the global economy and believe that returns on capital will be low. You sound reasonably bullish and, in that scenario, I agree that debt is “cheap.” However, there is plenty of evidence that actual corporate investment is out of phase with ideal corporate investment. Stock repurchase is one glaring example. As another example, I work for a pretty large company that issued some debt in early 2009 and yet we reduced capex in both 2009 and so far in 2010 (and we are a very capital intensive business.) So, that debt was not used to invest in future growth but rather to shore up our balance sheet. All of this in spite of the fact that we have a pretty clean balance sheet and can internally fund most investments.
Perhaps deflation won’t happen. But it is within the risk spectrum.
This post was written by an academic most likely, or a journalist.
There is currently (most likely) a corporate bond bubble going on right now. Companies are choosing not to extinguish debt (and even take on more) because its so friggin cheap to finance. Companies are restructuring their balance sheets in terms they could only have dreamed about even 5 years ago.
Trust me, they might be worried about customers, but thats a different argument.
Right now they have been thrown a 5-10 year lifeline from the bond market . They currently are financing the most absurdly ridiculous terms is the history of corporate finance.
the money shot from the must read below
“The dividend yields of some of the highest quality companies in the world are comparable to or exceed the bond yields of the debt of those same companies.
Frankly, that’s nuts.”
http://runningofthebulls.typepad.com/toros_running_of_the_bull/2010/08/the-bond-market-has-lost-its-mind.html
Scharfy “The dividend yields of some of the highest quality companies in the world are comparable to or exceed the bond yields of the debt of those same companies” Frankly, that’s nuts.”
You are over looking the Wonderfull World of JNK Bond Investing
In this World you can Double your Pleasure / Double the Fun
JNK Bonds = “Pure Speculation” by Investors looking for love in all the wrong places!
nice article and excellent comments TPC
Build up in cash on corporate balance sheets is more likely a function of wanting to maintain excess liquidity in the face of still significant economic headwinds. There is a cost to “parking it”, but that cost will seem cheap if it buys cash flow survival through more bad times (which I believe, and obviously a lot of CFOs believe, is on the horizon).
Presuming that corporate leaders (not to mention gov’t leaders) are making prudent financial decisions based on their unique ability to forecast the future is truly a leap in faith…the past 30 years has produced an abundance of evidence to the contrary.
Perhaps instead these same corporate leaders who lead us into this disaster are merely imbeciles. Imbeciles who are unable to navigate in any economic environment that does not include a flat interest rate curve.
If you loved your future capital projects at this rate last years rate…you’ll love them more at today’s lower rate so belly up to the interest rate bar boys and get your fill before interest rates soar again…the siren song of deflation.
Of course it makes perfect sense for corporations to refinance existing debt on capital projects already underway/complete when rates have fallen well below the initial funding costs, however, it takes a reckless corporate leader to authorize the issuance of debt, increasing their cash flow burdens at a time when top line revenue growth is flat at best.
What wise corporate leader would take such action…today’s corporate leaders.
GLH asnd Angry MBA,
Your ideas have been tried and they do not work. Actually there is nothing that is going to work except debt recognition. Hussman has an enviable and proven track record of calling the last two major recessions. You can access his past written wekly reports on his website. So when he says the indicators forecast a high probability of a recession, there is a high probability that we are in or heading into a recession.
The thing I respect about Hussman is not only did he called the last 2 recession correctly and ahead of almost everyone, he did not have ANY false calls in the last 10 years. If you check how many “economists” called recessions that never came, you know why they use the phrase “economists have called 10 of the last 2 recessions” or something like that.
Your ideas have been tried and they do not work.
Er, companies routinely borrow money and use debts to create earnings. Shouldn’t everyone on a trading forum understand something as fundamental and basic as that?
a lot of people don’t realize that selling debt at these levels means that there could be a direct earnings upswing if the company can later buy it back at much lower levels.
Exactly. There is a difference between a household loading itself up with credit card debt to buy jet skis, and companies taking on debt at low rates in order to be able to use that debt to fund future projects.
A business is not a household, and a successful should not be run like a household. A household’s primary use of funds is for consumption, while businesses use cash to create more cash. Big difference.
Companies can indeed issue debt at low rates and then buy the debt back at higher rates . That said if a company who primary business is to make widgets, speculating in the debt market to improve the earnings is reckless management….just what i would expect from today’s corporate leaders.
IBM just raised debt at 1%. You think they can’t beat that rate of return? If you could get a mortgage for 1% would you take it? Uh, yes.
I have spoken with some really sharp bond traders and they agree corporations are doing what any sane business would do: take the nearly free money. Yes it is debt. Yes it must be repaid. Companies like IBM, Microsoft, Walmart, and McDonalds are some of the biggest issuers. (Keep in mind: others like Apple and Google have zero debt.)
It’s very important to note that a conversation about debt without noting cash flow is simply a half thought. Some of these companies can pay down their debt with one year’s earnings. Is that scary? What if you took out a mortgage that was a high level of debt to your cash position, BUT you could pay it off in one year if you so chose.
The REAL and ONLY question that matters is how many of these companies are running negative cash flow or close enough that a hit to the economy would put them at threat of bankruptcy? The rest is academia and brain farting.
Second, there is a MAJOR skew to this data in the form of large industrial companies which hold high debt ratios in healthy markets, yet have even worse looking ratios in current market conditions. Again, so long as companies such as Alcoa have the cash flow, the debt to cash ratio can look “high” without a crisis. Yes, their returns may be poor in the near to mid term, but that’s a separate issue not addressed in this data set.
Unfortunately, I think Arends has neglected some very critical parts of this complicated conversation, and they will come back to haunt him as the real world behavior doesn’t unfold according to his thesis. As a side point: I think he has been a gold bear for ages and also missed most of the liquidity rally.
Yes, perhaps some of the multinationals can raise debt but these multinationals will be around long after governments fade into the sunset. JP Morgan didn’t have any trouble as the banker of last resort in the early 1900′s either, that does not mean that it is prudent for an average corporate executive to behave like JP Morgan or that the are a multinational.
Good to finally hear some level-headed optimism here in the comments if not in the post itself.
It is ludicrous to show charts of corporate balance sheets going back to the 50′s. It was a different world.
Almost as absurd that people are comparing the US consumer to Japanese corporations (aka “the balance sheet recession is coming”).
Another important point not mentioned above is the fact that these companies are also dealing with maturities and reducing the chance of potential near term defaults.
This year is on pace to have the lowest number of corporate defaults since 1981. Doesn’t seem like a bad thing to me.