A NOTABLE phenomenon, following the credit crisis, has been the financial strength of the corporate sector – with the exception of the banks – which has been in sharp contrast to the indebtedness of governments in the developed world.
Companies controlled their costs going into the downturn, so that the subsequent revenue recovery has led to well above average corporate profit margins. Companies also pared back their capital expenditure in order to conserve cash, with the result that their balance sheets are now very strong, and returns on capital abnormally high.
American companies have $1.9 trillion of cash while European companies have $354bn; while this must be viewed in relation to the longer term debt that corporates also carry, the proportion of net debt to equity in the US is now at a 50-year low.
A source of frustration in 2010 was that these healthy profit margins and cash piles did not lead to a material increase in corporate spending on capital equipment and job creation.
The European sovereign debt crisis alarmed corporate managers and engendered fears of a double dip, and this delayed the investment upturn, despite the fact that the ratio of capital expenditure to GDP was at multi-decade lows in the US and Europe.
We are now finally starting to see evidence that US corporates are beginning to hire again (judging by improved weekly jobless figures), as well as increase their capital expenditure.
This is encouraging and important because, given consumer fragility and governments unable to afford further economic stimulus, Western economies are now unusually dependent upon the corporate sector for future growth.
Another way that strong corporate cash positions can be deployed is through acquisitions. Thomson Reuters estimates that global mergers and acquisition activity in 2010 totalled $2.4 trillion, up 23% on the year before. However, this is only just over half the level of spend that was seen in 2007 prior to the banking crisis, despite the fact that company valuations are undemanding.
Acquisition activity therefore ought to grow significantly in 2011. This is positive for stock markets in the near term – as companies pay a premium in order to secure their bid targets – which should, in turn, enhance confidence about the economic outlook.
However, a longer-term risk is that acquisitions could lead to job cuts as companies seek to generate cost efficiencies. As in so many other economic spheres, emerging markets are of rapidly growing importance in relation to mergers and acquisitions, both as bidders and targets, and they represented one third of global acquisition activity last year.
Provided that there are no nasty surprises to derail corporate managers’ burgeoning confidence – for example a “hard landing” in China, or failure to satisfactorily resolve European sovereign debt concerns – then the corporate sector should be a powerful engine of growth in the West for the foreseeable future.
In this context, we feel that large, high-quality, globally diversified blue- chip equities with strong balance sheets represent the most attractive asset class.
John Haynes,
Head of Research,
Rensburg Sheppards
