Where The Levered Corporate "Cash On The Sidelines" Is Truly Going
We have long been pounding the table on what in our view is the biggest detriment to any future growth for not only corporate America, but the entire US (where, sadly, government investment IRRs just happen to be negative - a fact that most won't understand until it is too late, especially not self-anointed economic wisemen whose only solution to everything is "do more of the same" yet who thought the utility of the Internet would be eclipsed by that of the fax machine): the complete lack of capital expenditures at the corporate level, and lack of (re)investment spending.
This was explained extensively previously here, and even the WSJ finally caught on to what is the most disturbing trend over the past "New Normal" 4 years. What was also explained, is that instead of investing in CapEx and hiring, or said otherwise, real sustainable future growth coupled with benefits for workers and consumers, companies have little choice but to pursue shareholder gratifying, short-term IRR boosting "projects" like M&A, dividends and buybacks, or else feel the wrath of scorned shareholders who will simply dump said prudent company's stock and move on to the next company which is more generous with its declining cash flows, and puts shareholders above all.
This is summarized simply on the chart below.
It turns out that, however, that there is more to the story, and as the following chart from SocGen's Albert Edwards shows, not only are companies using up what actual free cash flows they have for such stupid stock boosting gimmicks such as harebrained M&A (just look at the recent fiasco between HP and Autonomy to see how rushed M&A always ends), and of course buybacks, but they are now levering to the hilt to do even more of this. Think Spanish and Italian banks using repoed ECB "equity" to buy back not only their but their sovereign's bonds. The last time they did this? The golden days of the credit bubble.
The chart above also shows the rise in bank lending in recent months: it is not going to retail borrowers for such trivial Uses of Proceeds as buying houses. It is going almost exclusively to IG and high-HY rated companies to pursue buybacks.
This is how Albert Edwards sees the problem in a note relased today:
The charts below show the source of this recent recovery in bank lending to the private sector. It is clear that loans to the industrial and commercial sectors (dotted line) have been the key swing factor over the last two years for driving overall bank lending.
It is also notable, looking at a longer term chart, how small bank lending to the industrial and commercial sector is relative to the real estate related and consumer category, the former being some 3x larger. Yet despite the moribund lending activity to the real estate and consumer lending, the total aggregate lending data looks healthy as a cyclical recovery in corporate borrowing drives the aggregate data higher (see left-hand chart below).
But what are companies doing with this extra borrowing? They certainly don?t seem to be spending it on investment, which has been plunging.
And therein lies the rub: neither organic cash flow, nor incremental net debt issuance (not gross, as the balance merely goes to roll over maturing debt and to refinance the capital structure into a cheaper cost of debt) is being used for "invesment, which has been plunging." It is instead being used to fill the void created by Bernanke's ZIRP, now that equities have to be the new debt and provide the return to investors once obtained from fixed income.
So while we have beaten this particular dead horse to death many times, here it is straight from another horse's mouth, how in not so many words, Ben Bernanke's policies are actively destroying America's Corporate capital base, and are setting the stage for an epic collapse in Return on Assets, if not so much Return on Equities in the CapEx-free years to come:
So on this data the corporate sector is borrowing heavily, both in the markets and from the banking sector, to suck up their own stock at a 4% annual rate ?albeit not as heavily as in 2007 or 1987. So to that extent, Helicopter Ben?s approach of printing money to drive asset prices up actually seems to be working! Newly printed money is clearly finding its way into the hands of willing corporate buyers of equity via the banking sector.
Putting aside for one moment just how lunatic a policy this is (already tried and tested between 2001 and 2006), we think corporates borrowing by the bucketful to buy in their own equity will end badly -? it always does! I finish this note with an insightful, more bottom-up analysis of this practice from my Quant colleague Andrew Lapthorne.
Andrew wrote, ?Of course, there are some perfectly sensible reasons put forward by corporate financiers for swapping today?s expensive equity (i.e. cheap from an investor?s point of view) for cheap debt (record low yields), especially given the ability of many corporates to issue 20+ year bonds plus the incentive that interest payments currently remain tax deductible.
We know that buybacks are contrarian indicators, occurring at the top (and not the bottom) of the market. Why, we ask, are companies leveraging up now and not 12 months ago, when equity prices were much lower? We conclude that (contrary to what we read), US dividend payments are not enjoying a revival relative to cash flows and that buybacks remain the distribution channel of choice for corporates wishing to boost EPS and limit the effects of option dilution. Indeed, some of the biggest US names have issued debt to pay for buybacks (Home Depot, Microsoft, Amgen, Hewlett Packard, McDonalds, DirectTV, to name but a few) but there are also firms in Europe that have been doing the same (Siemens, Telenet, Adecco). In the current economic climate, you may find this surprising ? we do too! A buyback in this form is not a return to shareholders ? it?s called gearing or balance sheet risk and will come to haunt some firms when the economy enters a downswing.
Andrew shows just how awful the timing of companies buying in their own equity has been historically. Often the corporate sector ends up as the only major buyer of stock near the peak of the market and then switches to issuing as the market crashes. This inevitably has exacerbated the equity boom and bust in recent years. And as pension funds now cannot tolerate the 50% plus draw-downs of the last decade, it can also be said that this corporate finance zaitech has contributed to the death of the cult of the equity, where equities once totally dominated the portfolio of most pension funds.
But can this time around be different? I seriously doubt it. When the next leg in the ?structural bear market? occurs, expect the equity buybacks to end, contributing to a renewed steep downturn in bank borrowing and monetary aggregates. The recent surge in the money data should be seen as a sign of the ills in the US economy, not health!
We could not have said it better.
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