Corporate America’s decision not to take advantage of low rates and easy terms to invest in new capacity may turn out to be a mistake of historic proportions.
Combine a lost decade of investment and some of the easiest debt terms in a long generation and the costs of delay look like they may be high.
Just as many argue that the US itself should be borrowing cheap and long to invest in infrastructure, so it seems that corporate chieftains should be locking in current easy debt terms and investing the proceeds.
Nothing lasts forever, including current easy financing conditions, which could tighten sharply if interest rates rise or if economic setbacks dampen risk appetite among lenders.
The slow pace of capital expenditure is one of the puzzles of the long, stuttering semi-recovery from the financial crisis. By almost all traditional measures, the past several years have been excellent times for companies to invest in new productive capacity.
Corporate profit margins are near record levels, the average age of industrial machinery is as old as it’s been since the waning days of the Great Depression and capacity utilization is now approaching pre-crash levels. All of this implies new investment could be made profitably, but this is not what is happening.
While non-residential investment is now about where it was during the pre-crisis period, there is a huge accumulated backlog of unmade investment since 2007 compared to previous trends. Net capital expenditure is at the same level as it was in 2000, since when there have been two huge plunges.
To be sure, to invest would require borrowing, as capex this year is outpacing internally generated funds for the first time since 2008.
“This means that corporate America is now reliant on external financing if it wants to merely maintain the current levels of investment, let alone boost capex further,” Societe Generale economist Aneta Markowska writes in a note to clients.
“But this is not necessarily a reason for concern. Positive financing gaps are in fact quite typical, especially in later stages of the business cycle.”
Indeed, financing markets are wide open, for the highly credit-worthy and the high-yield borrower alike. Bond yields for seasoned Aaa-rated bonds, while a bit higher than in 2012, are still at levels otherwise not seen since 1963, according to Moody’s data. For Baa borrowers it is a similar story, except you need to go back to 1958. High-yield borrowers are paying rates that, while not at pre-crisis levels, are still very attractive compared to most of the past 15 years.
Opportunity costs
These free and easy financial markets, which are in large part a creation of central bank policy, won’t last forever. Quantitative easing will likely cease after the Fed’s October meeting, and consensus is for modest interest rate hikes beginning next year. If things play out as most expect, interest rates should rise in absolute terms and the bid for riskier borrowers should become weaker.
And if the Fed is unable to raise rates as expected, financing will almost certainly get tighter anyway, as this scenario implies a spluttering economy which might make the risks taken by investors in recent years look overly bold.
In either of these scenarios financing costs will be higher, and those with a real need to replace and upgrade capital stock may wish they had acted earlier.
There are competing theories to explain the unusual decision-making by companies when it comes to investment.
One school holds that this is essentially the result of an agency problem, as corporate managers seek not to invest for the long term but to drive share options into the money in the here and now.
Companies have, after all, been borrowing, but not to invest in capacity, rather to fund share buybacks. This flatters earnings and drives up the price of shares, but leaves open the risk that companies are eating their seed corn and will, at some point when today’s managers are long gone, find themselves uncompetitive and under-resourced.
The second theory holds that low investment is the natural result of the high debts taken on in the past and the trauma of the financial crisis. Companies are being cautious because they recognize that their position is less secure and also because they, on the ground, see evidence to back up the theory that low growth is here for an extended stay.
All of this could be true, or simply a self-fulfilling prophesy. Both capital expenditure and financing costs are unusually low, a situation which is unlikely to last.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
