An Embarrassment of Riches

One of the few things Wall Street, Main Street and<br /> politicians of all stripes can agree on is that the economic recovery<br /> since the last recession has been slower than expected. If we listen<br /> closely to the speeches of various policy makers, there is an undertone<br /> of frustration in their voices.

Navigating a Sea of Opportunity

Embarrassment of Riches

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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.

Flush with Cash

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.

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.

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.

Global Currencies vs US Greenback

Source: Bank of America Merrill Lynch
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.

of Corporations

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
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.

MSCI Emerging Markets Index vs S&P 500

Click here to view a larger
version of this chart.

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.

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.

Pressuring CEOs

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.


Capital Management Inc.

Navigating a Sea of Opportunity

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