We received an interesting letter from a reader today:
So far I have read nothing about QE2 causing high unemployment. Why do I say this…
1) Fed is printing free money for the markets (stock market included).
2) Every company wants their share of the free money.
3) Each company’s share is determined by how much the stock rises which is stimulated by rising earnings.
4) Organic sales growth is anemic, so in order to grow profits you have to lay off or maintain as lean as possible employment.
If a company started to hired and drive down their margins they would be crucified by their shareholders. In effect the Fed is spending hundreds of billions to prevent employment growth.
We would like to add a few thoughts to this.
First, a look at margin contraction. As Charles Hugh Smith pointed out earlier, the great uncertainty of what the Fed's policies are doing with input prices is one of the main reasons why everyone is guarding their margins like a hawk. And we use the term "uncertainty" loosely. Following surges in commodity costs that can only be matched by what happened to the commodity complex in 2008, it is now more than clear that the bulk of companies are now aggressively shoring up capital to eat through whatever sales they are unable to pass through to the consumer (remember sales = PxV). In essence, many are concerned that the price jump in the top line will result in lower sales volumes, in effect eating away at margins. And since variable costs are the only ones that can be controlled (read S,G&A which includes labor) few if any are proactively willing to hire into what is now abundantly clear is an inflationary environment at least on the cost side. Thus no hiring. This is mostly impacting the traditional driver of employment growth: small and medium-sized businesses.
How about the large, multinational companies?
David Rosenberg earlier had some thoughts on why the top line growth for many companies will soon be crippled considering the decline in the natural source of organic revenue growth: that coming from international subsidiaries. With ever more developing countries, not to mention an austere Europe, in monetary tightening mode, there is less incremental money flowing through to the bottom line, and to employees.
But the bigger risk has to do with the ongoing spike in M&A activity. Suddenly every company has become either an acquiror or a target. Those which are shopping themselves on the block, in plain sight or hidden, are doing everything in their power to be cash machines: i.e., to generate gobs of EBITDA and Free Cash Flow. This means a cut to all variable costs (again), as well as to CapEx, as many shareholder groups are looking for a quick exit from their investments courtesy of an uber-frothy market.
On the other hand, the companies that are closer to the Fed's free liquidity, and are thus perceived as "strategic acquirors", are looking at their business models in the context of an expanding or rolling up paradigm. Simply said, they are all evaluating "synergies" from possible acquisitions, and as everyone is fully aware, synergies and organic labor expansion rarely if ever go hand in hand. Ironically, Bank of America noted in a recent note that financial purchasers (read LBO firms) are getting increasing pressure from strategic conglomerates as cheap credit is now an ubiquitous phenomenon, and in world of rising stock prices, the acquisition currency - stock - has greater value if all go "all in" on the ploy. In other words, this creates a closed loop whereby both buyers and targets focus on keeping their income statement in the slimmest possible state, especially with Commercial Paper holdings continuing to decline, as the bulk of companies who used to rely on such short-term funding, have become increasingly their own lender banks (courtesy of the much discussed "cash hoard" even if the bulk of it is overseas and thus not readily accessible: how long until the HIA2 is finally announced?).
The bottom line of this line of thinking is that in addition to being a gross failure at where it was supposed to be a success, namely keeping interest rates low, the Fed's policies have wiped out a quick 10% in consumer purchasing power due to a commensurate decline in home prices, the Fed has also succeeded in inverting the main drivers for hiring. In fact, it was up to the president yesterday to tell companies it is their duty to do the right thing for the public and hire. David Rosenberg skewered this argument earlier:
President Obama showed off his apparent lack of knowledge on how the economy works by openly pressuring businesses to start hiring more workers as a quid pro quo for all the government support that has been bestowed upon them. So let’s see — the way to have the economy operate efficiently and competitively is for companies to hire people they don’t think they need. Somehow that is the road to long-term prosperity. Adam Smith must be rolling …
And not only Adam Smith but certainly Milton Friedman. Because on his slash and burn path toward central planning, the President and the Fed Chairman are doing precisely the inverse of what they should be focusing on in order to actually generate organic economic growth. Instead, with everyone, small, medium and large corporations most certainly included, doing all in their power to get as close to the Fed's free money (alas, not everyone is a Primary Dealer), virtually all CFOs and Treasurers are now merely focused on generating the highest Return on Shareholder Capital, with hopes that the capital markets reward them promptly (and terminally) before the inflation game kicks in and EPS have to be slashed everywhere. It is no surprise that as we pointed out previously there has been for the first time years, a huge divergence between management team guidance and sell-side optimism.
And one last point: all those cheering the ongoing wave of M&A transactions should be far more concerned about the word that always accompanies such deals: synergies. Because if there is one thing that word never translates to, it is NFP gains... with or without the excuse of snow in January.