One of the great constants in this otherwise inconstant environment is the strength of corporate finances. Financial excesses and the need to de-leverage concern both the government and households. The corporate sector actually came out of the 2008–09 financial crisis and recession with its finances in good order. It has only strengthened them since. The question now is how and when companies will deploy these impressive financial resources. Will they spend it on capital spending, hiring, and especially the mergers and acquisitions (M&A) that typically proceed from strong corporate finances?

Huge cash holdings constitute the most impressive aspect of this financial strength. As of spring 2011 (the most recent period for which complete data are available), cash on non-financial corporate balance sheets had risen to more than $1.6 trillion—a jump of more than 10% a year from the dark days of 2008, and a full 6.0% annual rate of advance from the last cyclical peak in 2007. Cash and cash equivalents have risen too, so that today they constitute fully 11% of all corporate financial assets, up from 9.4% in 2008 and 9.1% in the cyclical peak year 2007. As a percentage of all corporate liabilities, these assets amount to some 12%, up from 9.2% in 2008 and 9.7% in 2007, and almost 11% of corporate net worth, up from 8.9% in 2008 and 8.0% in 2007.

Aside from the powerful cash flows that permitted such accumulations, it is the high and persistent levels of uncertainty that have kept the funds in cash instead of flowing into other corporate uses. Speaking volumes to this motivation is the fact that the bulk of this cash sits neither in time nor savings deposits nor money market shares nor commercial paper but rather in checkable deposits. These have, in fact, grown remarkably, at a yearly rate of more than 30% since 2008. The influence of uncertainty in this behavior is hardly surprising either, on at least four counts:

1. The legacy of the 2008–09 financial crisis surely has kept corporate managements sensitive to how suddenly economic and financial conditions can change and, consequently, how valuable ready, liquid assets can be. But more, because credit standards during the crisis and since have tightened, and because banks have even withdrawn formerly well-established corporate lines of credit, managements must also feel a need to replace such vehicles with their own ready cash. The sovereign debt problems in Europe, promising a rerun of 2008– 09, only reinforce this continuing caution.

2. “Obamacare” has contributed, too. Whether a good idea or a bad one, good legislation or not, the huge changes built into this complex law impose tremendous uncertainty on corporate decision making, particularly about hiring. The natural response is to hold back on major corporate decisions, and the enlarged cash holdings are an obvious financial reflection of that posture.

3. The Dodd–Frank financial reform has had its own separate influence. Although this incredibly complex piece of legislation covers only financial corporations, it does nonetheless create uncertainty among all companies by raising questions about future credit availability and cost. In this regard, whether Dodd–Frank is good law or bad, it has surely had a similar affect on the liquidity problems of 2008–09, even though it was ostensibly designed to correct them. The reform has further convinced managements that they can no longer rely on credit lines from financial institutions and, thus, need to do more than previously to cover their short-term cash needs for themselves.

4. If these matters did not weigh heavily enough, corporations must also cope with the uncertainties surrounding the federal budget debate. Without knowing the nature and size of future federal spending or taxes or even the federal government’s prospective borrowing needs, it is difficult for managers to gain any sense of the future and consequently deploy their resources.

But for all this, there are tentative—very tentative—signs that corporations are beginning to use some small portion of this cash accumulation. Of course, hiring has remained virtually stagnant on balance, which is hardly a surprise in such an uncertain environment. Corporations have, however, increased capital spending, raising outlays by more than 12% over the year through spring 2011—hardly a boom, but certainly faster than sales have risen and a use for some of these surplus funds. In another sign that managements are preparing to use the cash, corporate lending has fallen precipitously. Whereas in 2009, corporations lent out almost $700 billion and in 2010 almost $200 billion, as 2011 has progressed, they have cut back such lending to less than $10 billion. At the same time, corporations have shown a modest willingness to extend themselves by accepting a rise in their trade and tax payables. Together, these have risen about 11% during the past year, faster than sales and even than cash balances, which now cover only some 80% of these payables, compared with more than 90% back in 2008.

Still, it will take time before a return of confidence can move matters beyond the recent, tentative expressions. Cash and the lack of confidence it reflects remain high. But investors should, nonetheless, remain aware of the tremendous potential for dramatic expansion in corporate spending, hiring, and M&A activity from even a modest improvement in confidence. Especially since equity market valuations these days make it cheaper to buy than to build, the M&A potential, with its always immediate market impact, looks particularly powerful.

 

 

 

(C) Lord Abbett

www.lordabbett.com