One of the few things Wall Street, Main Street and politicians of all stripes can agree on is that the economic recovery since the last recession has been slower than expected. If we listen closely to the speeches of various policy makers, there is an undertone of frustration in their voices.
An Embarrassment of Riches
One of the few things Wall Street, Main Street and politicians of all stripes can agree on is that the economic recovery since the last recession has been slower than expected. If we listen closely to the speeches of various policy makers, there is an undertone of frustration in their voices. The frustration stems from the tepid and halting pace of the economic recovery. Policy makers feel like they have done all that they can and they are starting to run out of runway with respect to getting the economy to reach liftoff.
The ‘running out of runway’ analogy is rooted in the belief that with interest rates about as low as they can go, any further reductions will not have a meaningful impact on the economy. In short, there are no more arrows in the quiver of policy makers. As real estate markets in the US, UK and Canada continue their rebound since the end of the last recession they have made a meaningful impact upon economic growth and confidence. The auto industry has also been a key contributor and has lent a much needed hand to global economic growth. Historically, this is how most economic recoveries begin.
This time is different. Once the initial recovery led by the auto and real estate sectors has become entrenched, capital expenditures by businesses tend to then strengthen economic momentum. Capital expenditures consist of business investments in things such as new software, plants, property and equipment. Across the globe, this pillar of the economy has been missing. The level of capital expenditures across most nations has been slow to recover since the recession of 2008.
Corporations Flush with Cash
Critics of corporations say that while corporations have record amounts of cash on their balance sheets they are holding back on capital expenditures. Globally, corporations have over $7 trillion in cash and cash equivalent securities on their books. Canadian corporate cash balances are approaching $700 billion and are equivalent to about 35% of the Canadian economy while the figure for US companies is slightly lower. In fact, amongst the G7 nations, Canada has the highest ratio of corporate cash to GDP.
Measured another way corporate cash balances currently exceed Canada’s national debt.
A Driver of Growth is Close at Hand
Economists believe that if only corporations would start to focus more on investing these significant cash reserves into the real economy (capex, or capital expenditures) vs. the financial economy (dividends and stock buybacks), the rate of economic growth would go from mediocre to supercharged. Furthermore, a meaningful boost to capex would be a loud vote of confidence from corporations in their outlook on the global economy. There is an increasingly loud chorus of voices that are looking towards capex increases this year to underpin the economy and also stock markets.
Current economic growth forecasts from the Bank of Canada are based on a 4% increase in the capex growth rate. This forecast could prove to be optimistic as the growth rate in capex since 2008 has only averaged 1 percent annually. However, according to most economists, capex must increase by 8% annually in order to just replace the level of capital that is worn-out through wear and tear. The Bank of Canada has estimated that if businesses were to just replace the capital stock of the Canadian economy by this much each year, the Canadian economy could assume a growth rate closer to 3 percent. This level of GDP growth would begin to fuel better wage growth and lower unemployment.
Chart Source: Bank of America Merrill Lynch Click here to view a larger version of this chart.
As the chart above shows, Canadian capex is heavily influenced by commodity prices. Given this historical relationship, Canada’s economy will have to wait for a global upturn in commodity prices before a sustainable increase in capex is in place.
Critics of Corporations
Former Bank of Canada governor Mark Carney was one of the most vocal critics of corporations for choosing to allow their cash balances to build up to what he deemed to be excessive levels. Carney stated in a speech in August 2012 that “Cash holdings relative to assets have doubled over the course of the last decade. Doubled. So, at some point – companies will make these judgements, shareholders would make those judgements, managements will make these judgements – those cash balances could become excessive”. Carney made it clear that if corporations could not decide what to do with their cash, then shareholders should be paid the cash and they would be able to spend the money.
US corporations have also come under criticism. Corporate cash balances are approaching $5 trillion while capital expenditures are not keeping up to basic maintenance levels. Recent data shows that US capex is running at the lowest level in over 40 years and the age of the US capital stock is at a record high. In the short term, this is obviously a negative. From a longer term perspective, the fact that the US capital stock is starved for investment means that at some point there is going to be a significant upgrade cycle.
Click here to view a larger version of this chart.
Lean and Efficient
When that happens exactly is difficult to pinpoint. One data point to monitor is the capacity utilization level. It measures the percentage of a nations productive capacity that is being used to produce economic output. Generally, somewhere close to 80% is considered mediocre and anything north of 85% tends to bring about inflationary pressures as capacity is squeezed and wages begin to be pressured upwards. As the above chart shows, capacity utilization for the world’s largest economies is not running at anywhere close to peak levels. However, the stock of capital equipment is getting older and just normal wear and tear means a capex upturn is likely sooner rather than later.
In their defense, corporations have stated that their cash reserves are at record levels because they are running their businesses with record efficiency and maintaining profit margins that allow them to grow profits even in a slow economic growth environment. The usual answer from CEOs is that they are waiting for more certainty before they embark on an extensive deployment of their cash for capital expenditures. Their anxiety stems from a number of factors. One is that during the financial crisis, many corporations were faced with a liquidity problem in which they could not access credit. Memories seem to be long from that period and corporations want a high level of visibility around the economy before they commit to spending.
This line of thinking has been met with criticism. Jaime Dimon, CEO of US banking giant JP Morgan, has stated that CEOs who are holding back from further investments in their businesses should stop looking for certainty because it has never existed. In a shareholder’s letter, Dimon states ‘’It seems that just about everyone has become a risk expert and see risk behind every rock. They don’t want to miss it – like they did in 2008. They want to be able to say, ‘’I told you so.’’ And, therefore, they identify everything as risky’’.
Corporations are also nervously guarding their credit ratings. In the aftermath of the financial crisis, many pointed fingers at the credit ratings agencies. They were accused of being too lax in handing out AAA credit ratings which often resulted in investors buying investments that proved to be riskier than they thought they would be. To put this in perspective, in 1993 there were over 400 AAA rated bond issuers. Last year, there were only 147. This is despite the fact that interest rates are at generational lows, debt to cash levels are low by just about any standard and debt servicing costs are so low that they are helping to prop up profit margins in an era where few corporations maintain pricing power in the face of a strong competitive environment.
Markets Pressuring CEOs
But management is also likely swayed by another factor: shareholder demands for a return of cash through dividends and stock buybacks. Recent years have seen greater than usual activity levels from activist investors. These are investors who buy up large stakes in a target company and use this to influence corporations to make changes that will boost the stock price.
Armed with capital that is low cost and plentiful, activists are able to take aim at companies once thought to be out of reach due to their sheer size and ability to fend off attacks. Activist investing used to be seen as a less reputable type of investing but more recently pension plans have teamed up with activists to effect change.
Activist investors have both fans and detractors. Their supporters say that they are able to wake up sleepy CEOs and interrupt the sometimes overly cozy relationship a board of directors has with the executives of a corporation. As Warren Buffett recently stated, corporate boards are “in part business organizations and in part social organizations.”
On the other hand , the critics of activists say that too often the activist shareholder is only interested in a short term boost to the stock price—with little or no thought towards the long term interests of the corporation. The stigma from the practices of the corporate raiders of the 1980s is still fresh in the minds of many. Many companies were weakened whereby companies had to choose between paying off the corporate raider and making long term investments for the benefit of the company. In reality, there are some activist shareholders whose actions do result in long term benefits to the corporation and its shareholders. They help to maximize value for the long term benefit of all of the stakeholders in the company.
Retail investors have also shown a strong level of influence on corporations. Due to low interest rates, investors are seeking income from equities through dividends. As a result, many dividend paying companies have been rewarded with premium valuations– even though many of them might be slow growth companies.
A Long Term Cost
The longer term implications for an economy which does not reinvest in its capital stock are significant. Capital expenditures ultimately determine a nation’s ability to grow its economy and enhance its productivity and thereby improve its standard of living. The gap between corporate profits and corporate investments is wide by historic standards. Corporations have ample amounts of cash and have the choice to borrow at low interest rates but are choosing not to do so. Ultimately, corporations will begin to rebuild their capital stocks. This should help to lift the economy towards a growth rate that will help to ease the frustrations that are so prevalent with this economic rebound.
Pacifica Partners Capital Management Inc.
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