National income has been growing consistently around 3%. Even during the 1st quarter of this year, when adjusted GDP was only 0.8%, total income grew by 2.9%. Although the income number has remained stable, the composition of it is beginning to change. Labor compensation increased 4.5% in 2015 and moved up to 5.0% in the 1st quarter. To compensate, corporate profits declined 3.1% in 2015 and 5.8% in the 1st quarter. Weakening profit margins are not unusual at this point in the profit cycle. This trend could well continue. U.S. labor productivity is on the decline. Leading economic indicators provided by the OECD for the U.S, Europe and China, principal markets for U.S. corporations, suggest that profits will remain under pressure.
Recent data showed total capacity utilization falling to 74.9% in May from 75.3% in April. Economists at Deutsche Bank have pointed out that that the last two times capacity utilization was close to 75%, both demand and inflation were weak. The sort of poor pricing power associated with low capacity utilization perhaps explains the disappointing corporate capital expenditure figures. Why invest when demand is weak, inventories are high compared to sales and inflation is very low?
So what are corporations doing? They are doing what they always do – scaling back capital spending and reducing the pace of new hiring. Capital spending is down about 2% from where it was a year ago. Last month’s employment number of only 38,000 new jobs may not continue at such a low level, but it indicates that hiring is slowing down. Ultimately, reduced capital spending and slower job creation affects consumer demand. Profitability declines further, and the cycle downward renews itself.
Corporations, though, have not stopped issuing new debt. Non-financial corporations increased their borrowing in the last quarter by $180 billion (to $8.28 trillion). Notably, the last time U.S. corporations borrowed this much in a quarter was during the last quarter of 2007. The purpose now appears to be the same as it was back then, to buy back stock even as profits weaken.
The reduction in equity outstanding through mergers, share buybacks and dividend payments totaled $1.27 trillion (annual rate) in the 1st quarter, up approximately 10% from $1.15 trillion in 2015. These shareholder payments represented 59% of the after-tax cash flow of non-financial corporations, up from 53% in 2015 and 43% in 2014. Capital spending as a percentage of cash flow declined modestly to 80% in the 1st quarter of 2016 from 83% in 2015.
Over the past 70 years, the only time American corporations devoted a similar amount of their cash flows to dividend payments and share buybacks was in 2006 (56%) and 2007 (70%). When corporate borrowing slowed, total shareholder payments were drastically reduced (46% of cash flow in 2008, 25% in 2009). Corporate cash flow went down less than 5% between 2007 and 2009. Yet, shareholder payments were cut by two thirds, from $1.20 trillion to $400 billion.
If shareholder payments are one of the principal sources of demand for U.S. equities, we should keep our eyes on the pace of borrowing as an indicator of support under equity prices. With profits declining and cash flow stalling, pressure may mount on corporations to reduce their borrowing.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you consult your financial advisor.
- The economic forecast set forth in this presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful.
- Data provided Bloomberg and Gary Schilling.
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