American companies hoard cash as a safety-net against falling margins. But superficial data gives a false picture of economic health - corporate spending needs to increase to aid recovery.
The large amounts of cash held on American corporate balance sheets is the subject of frequent comment. It is often accompanied by ill-informed claims to the effect that “corporate balance sheets are in excellent shape”.
The official data shows that both cash and leverage are high, but these data are often ignored and, when looking at debt levels, many analysts prefer to look at the data from the published accounts of corporations. This gives a misleading picture of the change in debt ratios for two reasons. The first is they make no adjustment for changes in the composition of the indices. The second is that book values make no allowance for changes in inflation. Thirty years ago, after a long period of inflation, the real value of corporate assets was much higher, relative to their book values, than it is today after a long period of falling inflation.
The offical data published by the Federal Reserve in the Flow of Funds Accounts seeks to avoid both these distortions and should therefore be used in preference to the data derived from the published accounts of companies. The latest available Flow of Funds accounts for the second quarter of 2011 show that $1,836 billion (£1,166 billion) in cash or equivalents was held on the domestic balance sheets of American non-financial companies at June 30. In addition they hold substantial cash in their foreign subsidiaries, though we have no data on the actual amount.
Cash is high relative to historic ratios whether measured as a percentage of output or as a percentage of debt. As companies raise and repay debt in lumps, companies will tend to have excess cash after a bond issue or before one. There is therefore a tendency to hold more cash when leverage rises. (Trends continues below)
Part of the explanation for the high cash levels is that debt is high but, as the high ratio of cash to output shows, this is only one part. Another likely explantion is that long-term interest rates are historically low and companies may therefore be borrowing long and holding more cash than usual as a precaution against rises in long-term interest rates.
Yet again companies may be holding cash because they expect a deterioration in their cash flows. This would be rational as corporate cash flow is almost certain to fall once the fiscal deficit starts to decline. Alternatively, companies may be holding cash because they expect to spend it on more invesment, buy-backs and corporate acquisitions.
It is unlikely that companies are holding cash in anticiption of a rise in capital spending. Business investment is low as a proportion of GDP, but it was at this level or lower between 1947 and 1967. To rise much above the current level would probably require either an increase in business confidence about the growth of the economy, or a rise in demand for exports.
There is a huge difference in the composition of output for export compared with produce for domestic demand. Goods constitute 70% of exports but only about 15% of total output. Goods require more capital for their production than services and a boom in exports would require a marked increase in fixed capital investment. As a marked rise in exports is almost certainly necessary for an American recovery, it is likely to accompany and reinforce a rise in confidence about the growth of the economy. We are yet to see a surge in American exports and, until then, a large rise in business investment seems unlikely.
The remaining possibility is that companies are holding cash so that they can buy back their own shares or use the money for corporate acquisitions. This is potentially good news for the stockmarket. The stockmarket has, in recent years, risen and fallen in line with corporate buying. Although the sharp fall in the market in early October made it doubtful whether this pattern would be repeated this year, it looks possible as the recovery in share prices has been such that the S&P 500 is almost at the same level as it was at the end of 2010.
Corporate buying is likely on the basis of experience to continue, as it seems to have a lagged relationship with the level of cash as a percentage of debt. It seems possible that corporate buying has been a significant factor in the market’s rally and could take it further.
The rally may go further but, as the market is overvalued by about 50% using either the Cyclically Adjusted PE (“CAPE”) or q and the prospects for corporate cash flow and profits are poor, it would be perilous for investors to put much hope in being able to sell shares at higher prices than those ruling on November 4.
The poor outlook for profits and corporate cash flow are clear from both current profit margins and from the need to reduce the American fiscal deficit, which is running at more than 10% of GDP. Profit margins, which are mean reverting, according to economic theory and which have proved to be in practice, are at their widest recorded level.
”A large fall in the cash flow of the American business sector is necessary for the reduction of the fiscal deficit”
The need to reduce the fiscal deficit is another reason to expect poor profits and corporate cash flow. An improvement in the fiscal deficit must be exactly matched by a deterioration in the cash flows of the foreign, household and business sectors. As American national debt is estimated by the OECD to be at 102% of GDP in 2012, the deficit will need to be reduced to nearly zero to prevent the debt rising steadily as a proportion of GDP. The household sector has low savings and a weak balance sheet; it is neither likely, nor desirable that it should have a significant fall in its cash flow. A large improvement in the American current account balance, which is the same as a fall in the foreign sector’s cash flow, is likely to be an essential condition for a recovery, but it is massively improbable that this will amount to 10% of GDP.
A large fall in the cash flow of the American business sector is thus necessary for the reduction of the fiscal deficit. Such a reduction can be achieved either by increased investment or by lower profits. Given the size of the required adjustment, both rising investment and falling profits are likely to be needed.
ANDREW SMITHERS is the chairman of Smithers & Co.