By now it is a well-known fact that corporations have no real way of generating organic profit growth in this economy (the recent plunge in Q1 EPS was a stark reminder of just that), so they are relying on two things to boost share prices: multiple expansion (courtesy of central banks) and debt-funded buybacks (also courtesy of central banks who keep the cost of debt record low), the latter of which requires the firm to generate excess incremental cash. Incidentally, as SocGen showed last year, all the newly created debt in the 20th century has gone for just one thing: to fund stock buybacks.
One doesn’t have to be a financial guru to grasp that the problem with this “strategy” is that if a firm is going to continue to add debt to its balance sheet in order to fund buybacks (and dividends), then it needs to be able to generate enough operational cash flow in order to service the debt. Even if one makes the argument that debt is cheap right now, which may be true, or that central banks are backstopping it, which is certainly true in Europe as of the ECB’s shocking March announcement in which the CSPP was revealed, the fact remains that principal balances come due eventually, and while debt can be rolled over, at some point the inability to generate cash from the operations catches up; furthermore even a small increase in rates means the rolling debt strategy is dies a painful death, as early 2016 showed.
Then, as we showed to months ago using another stunning chart from SocGen’s Andy Lapthorne, what has gone largely unnoticed in the recent past, is that the differential between the growth rate of net debt and underlying cash flow or EBITDA, now at a staggering 35%, have never been greater, and in fact “Debt Is Growing Faster Than Cash Flow By The Most On Record.” As Andy Lapthorne politely put it in the chart below, there is “crazy growth in net debt.“
One also does not have to be financial wizard to to know that a firm which has to borrow more than it can generate from core operations is not a sustainable business model, and yet today’s CFOs, pundits and central bankers do not.
But more are starting to notice, as the corporate debt pile hits unprecedented proportions.
As Bloomberg writes this morning, when it also issued a stark warning about the next source of credit contagion, while “consumers were the Achilles’ heel of the U.S. economy in the run-up to the last recession. This time, companies may play that role.“
Among the warning signs: rising debt, lagging profits and mounting defaults. While the financial vulnerabilities aren’t likely to lead to another downturn soon, economists say they point to potential potholes down the road for an expansion that’s approaching its seventh birthday.
The chart below, very familiar to frequent Zero Hedge readers, is the reason why the next debt crisis will be one where corporations, not individuals, are dragged down. It shows that enticed by record-low interest rates, companies increased total debt by $2.81 trillion over the past five years to a record $6.64 trillion. In 2015 alone, liabilities jumped by $850 billion, 50 times the increase in cash by S&P’s reckoning.
Others are finally noticing too that thanks to ultra low rates, and in a world in which cash flow is increasingly more scarce, corporations have only one choice: to lever up as much as their creditors will let them. To wit:
“Companies have been adding to their debt and their debt has been growing more rapidly than their profits,” said John Lonski, chief economist of Moody’s Capital Markets Research Group in New York. “That imbalance in the past has usually led to problems” in the economy as companies cut back on spending and hiring.
This time will not be any different: case in point is last week’s news that so-called core capital goods bookings fell for the third straight month in April. The seasonally-adjusted total of $62.4 billion for non-defense orders excluding aircraft was the lowest in five years, prompting Neil Dutta of Renaissance Macro Research to label business investment “pathetic.”
Bloomberg’s troubling analysis of matters well known to most “skeptics” continues:
The similarities between the pre-recession debt binge by consumers and today’s burst of borrowing by companies are striking. Like households, corporations are using the money for short-term purposes rather to prepare themselves for the future. They’re basing their bets on rosy expectations that may not pan out. And it’s the bottom 99 percent that are most at risk should credit conditions tighten.
Even the tradtional fallback response, namely that cash is at all time highs, no longer works: “While corporations as a whole possess a record $1.84 trillion of cash and liquid investments, it’s heavily concentrated among a small number of companies, mainly in the technology sector, according to a study this month by S&P Global Ratings analysts Andrew Chang and David C. Tesher.” Hardly news to our readers, consider it was back in January 2014 when we wrote that “Corporations Have Record Cash: They Also Have Record-er Debt, As Net Leverage Soars 15% Above Its 2008 Peak.”
In the two and a half years since then, the situation has only gotten far more dire, and not even the record cash hoard is good enough to offset fears that it is all coming to a head:
The rich are getting richer as companies such as Apple Inc. and Microsoft Corp. add to their cash hoards, they wrote in their report.
Take away the $945 billion the 25 richest companies rated by S&P hold, and the picture doesn’t look particularly pretty for the bottom 99 percent of non-financial corporations. In fact, their cash-to-debt ratios are at their lowest levels in a decade, according to S&P. And more than 50 U.S. companies have defaulted on their debt so far this year.
Behind the deterioration in creditworthiness: surging corporate borrowing. Enticed by record-low interest rates, companies increased total debt by $2.81 trillion over the past five years to a record $6.64 trillion. In 2015 alone, liabilities jumped by $850 billion, 50 times the increase in cash by S&P’s reckoning.
Here Bloomberg notes something else we have been warning about quite literally since 2012: “For the most part, companies aren’t pouring all that money into capital expenditures to increase the efficiency and capacity of their operations. Instead, much of it has been used to finance share buybacks, dividend boosts and acquisitions.“
Since 2009, S&P 500 companies have spent more than $2 trillion to repurchase shares, helping sustain a rally where stock prices almost tripled. Mergers and acquisitions worldwide, meanwhile, jumped about 28 percent last year to a record $3.52 trillion, according to data compiled by Bloomberg.
Not surprisingly then that as companies reach their investment great thresholds (IBM famously halted buybacks a couple of years ago when the rating agencies threatened to cut it from Investment Grade to Junk leading to the biggest drop in the stock price since the crisis), in the absence of cash flow growth, they are finally cutting back on using debt to boost their stock price:
Now, both buybacks and takeovers are starting to tail off as companies increasingly feel the pinch from sagging profits. S&P 500 earnings from continuing operations fell 7.1 percent in the first quarter from a year earlier, data compiled by Bloomberg as of May 27 show. Even after stripping out energy companies hit hard by weak oil prices, earnings were still off by 1.5 percent.
The pressure will only keep rising: “there is newly intensified, broad-based pressure on business to cut capital spending and inventories,” David Levy, chairman of consultant Jerome Levy Forecasting Center LLC in Mount Kisco, New York, wrote in a report to clients this month.
Meanwhile, stagflation is starting to rear its ugly head, as earnings are being squeezed by lagging worker productivity and mounting labor costs as the tightening job market forces companies to pay employees more.
We warned about precisely this two months ago in “The Next Big Problem: “Stagflation Is Starting To Show Across The Economy.” This means that as the government pushes for increasingly more labor friendly policies, corporate profits at companies already levered to the hilt, are set to decline in the coming quarters even more.
Corporations also are confronting downsized economic-growth expectations. Richmond Federal Reserve Bank President Jeffrey Lacker told Bloomberg News this month that he now pegs the potential growth rate of the U.S. economy at 1.5 percent. That’s half the average pace in the quarter century that preceded the December 2007 start of the last recession.
It’s not only the U.S. where GDP is lagging. “We are seeing a slowdown in emerging and developing countries as well, and it looks increasingly likely that long-run, or potential, growth has fallen,” David Lipton, the International Monetary Fund’s No. 2 official, said at the Peterson Institute on May 24.
Bloomberg concludes that Lonski of Moody’s said it’s premature to predict that the U.S. is heading into a recession because the labor market is still strong. But the squeeze on companies is “a risk factor that’s worth watching.”
To an extent he is right: as long as rates remain low, companies will likely be able to generate a higher rate of return on their newly issued debt, assuming it does not go entirely into stock buybacks, than the cost of that debt. As such, profits should continue even if sharply reduced.
However, there is one thing that could easily derail this ever greater “risk factor” of unprecedented corporate leverage: rising rates. Ironically, that is precisely what the Fed intends to do in the coming months.
There is a saying that “economic expansions don’t die of old age”, and that instead it is Fed rate hikes that launch recessions. Well, as Deutsche Bank has been loudly warning in recent weeks, this is precisely what the Fed intends to do if and when it hikes rates once again in the coming weeks. Because all that the next debt crisis needs is a spark…
via http://ift.tt/1P1eiI6 Tyler Durden