Don’t expect economic boost from cash-rich companies

Growth in the developed world will continue in 2012 to be hostage to the deleveraging process that is required to address the huge debts that piled up during the credit bubble. Yet the pattern is distributed unevenly across economies. In the US non-financial corporate sector, to take a striking case in point, the balance sheet recession has long been over. Profit margins are at record levels thanks to savage labour shedding and companies are awash with cash.

A similar accumulation of cash has occurred in Europe, though without comparable shrinkage in the workforce. Bin Jiang and Tim Koller of McKinsey estimate that European and US companies hold about $2tn of surplus cash, defined as the amount outstanding over and above operating cash, which is deemed to be two per cent of revenue. The question is how these cash balances will be deployed.

Ideally, companies should be investing, which would have the benign effect in current account deficit countries such as the UK and US of helping to rebalance the economy away from domestic consumption and public spending, and to jog them out of the habit of underinvesting relative to Germany, France and Japan. Yet this seems unlikely to happen. The effect of the recent credit bubble has been to bring forward many corporate spending decisions. This bunching of investment has been further exacerbated by the Obama administration’s investment tax breaks, now coming to an end. So it is a racing certainty that investment will fall sharply in the first half of the year in the US.

In Europe, meantime, the troubles of the eurozone banking system mean that a strong precautionary motive is at work. Many industrialists are hanging on to cash that earns very little interest because they fear that banks may be unable to finance their working capital requirements. The likelihood of recession in the eurozone likewise damps animal spirits.

Historically, profit margins have tended to revert to the mean, so excess cash may anyway dwindle. I suspect, too, that the English-speaking countries may be moving to a new, low-investment paradigm and not merely because, as in the case of the UK, they have a service sector bias. The practice of rewarding executives increasingly with equity is imposing a far greater focus on short-term measures of performance. Academic evidence in the US has, for example, shown that a high proportion of chief financial officers admits to a willingness to sacrifice economic value to meet short-term earnings targets. The current record profit margins and exceptionally high unemployment reflect that ruthless focus.

The capital market culture of these countries also has a strong emphasis on merger and acquisition activity which, from a managerial perspective, substitutes the thrill of the chase for the hard slog of managing operating businesses and investing in fixed capital. Business becomes transactional at the expense of relationships and performance is seen in narrowly financial terms. Far too many of the deals fail in economic terms, partly because stock options and rewards for failure give managers a huge incentive to bet the ranch.

That brings us to the most likely outlet for all that corporate cash. Much of it will go into share buy-backs, which are relatively painless for managers since, unlike dividends, they entail no continuing commitment to pay. Part of this activity will be arbitrage because corporate bond yields for many companies are now below the yields on equity.

This carries an interesting echo of the Japanese experience in the bubble of the 1980s. As the stock market soared, big corporations turned increasingly to financial engineering, using leverage to boost short-term earnings through speculation. That all ended in tears and a painful deleveraging process.

Charles Kindleberger, the economic historian, speculated that a shift in emphasis from production to consumption and a preoccupation with financial manipulation might be symptoms of national decline. That is hard to prove. Financial sophistication is arguably a natural accompaniment of advanced forms of capitalism.

Moreover, it is a mistake to consider investment as inherently virtuous. Japanese corporations have over-invested for decades and consequently shown poor returns on capital. Much the same is now happening in China, where investment is running at close to half gross domestic product. This is hugely wasteful and causes big distortions in global as well as domestic markets.

Yet it remains the case that the increasingly financial focus of anglophone business is not doing much for the ultimate shareholders, who are chiefly pension beneficiaries. The supposed alignment between the interests of managers and beneficiaries on the basis of stock options and other equity incentives is a fiction. Perhaps the poor equity returns of the past decade partly reflect that fact.

Source: http://www.ft.com/intl/cms/s/0/d7ff64c2-361f-11e1-9f98-00144feabdc0.html#axzz1iUVbDoKd