Blue chip companies are borrowing from investors at insanely low interest rates. This is not a good sign.
It's back again, and the drumbeats are growing louder... the dreaded "D" word. Not doom or death or destruction, but deflation.
Investors by all rights should be scared silly by the prospect of deflation, based on what it did to Japan. During Japan's long march into the abyss from 1990 onward, the Nikkei lost more than 75% of its value... and still has not gained it back. Japanese equities – and investors who held on for the ride – were absolutely destroyed.
In a nutshell, that's why deflation is bad. As valuations get compressed and general price levels fall, business activity dries up. Expectations of further deflation become a self-fulfilling prophecy. The great whirring machine that is the economy sputters and wheezes, and then grinds to what feels like a halt.
Understanding the Trap
To understand the mechanics of why deflation happens, it helps to start with the concept of the "liquidity trap."
Via Wikipedia, "the term liquidity trap is used in Keynesian economics to refer to a situation where monetary policy is unable to stimulate an economy, either through lowering interest rates or increasing the money supply."
If one thinks of money like water, a liquidity trap is like a giant gaping hole in the ground. No matter how much water (i.e. money) is pumped in, it just keeps disappearing into that hole. Another way to think of it is to imagine giant bank vaults, all across the country, in which Olympic-sized swimming pools of liquidity sit stagnant.
The way the Federal Reserve stimulates the economy is by making credit cheap and money freely available. But when no one wants to spend, these efforts come to naught. That's why another term associated with liquidity trap conditions is "pushing on a string." No matter how hard the Federal Reserve pushes, the string simply bunches in on itself. No satisfaction is had.
It's also helpful to understand that debt is the main creation mechanism for a liquidity trap. When a bank hoards cash and refuses to lend, it is generally because the bank is afraid to lend... and the bank is afraid to lend because those who want to borrow are such poor credit risks, or because the bank itself is in very bad shape. A gross accumulation of debt creates both these conditions.
Mr. Market's negative reaction to the Federal Reserve last week shows just how seriously investors are considering the prospects of a liquidity trap, as contrasted against the backdrop of a slowing economy a la Japan.
And now a new reality is slowly dawning on queasy investors. When it comes to cash hoarding, blue chip corporations might be the new banks...
Sucking Up the Cash
We already know the story of how at least half the economy – the small-business half – is parched and suffering for lack of credit and prospects. We also know consumers and homeowners, besieged by unemployment, stagnant wages and upside-down home valuations, are in the same boat.
We further know that, when it comes to largesse from the Fed, the banks have acted like roach motels for cash... the stimulus gets pumped in by the Fed, but never really comes back out.
(My fellow editor Adam Lass wrote about the Federal Reserve's recent actions this week. Sign up for Taipan Daily to receive his and my investment commentary.)
The latest twist in this whole saga is that big blue chip corporations are starting to look like the banks. They are taking in mountains of cash and simply sitting on it. They are Wall Street's new liquidity traps.
The poster children of this phenomenon are IBM, Johnson & Johnson and McDonald's Corporation. As blue chips go, they are the bluest of the blue – "Big Blue" being, quite literally, IBM's nickname.
Last week, IBM broke records by selling a three-year debt offering to investors at a yield of just 1%.
"That is the lowest rate on record," notes The Wall Street Journal, "and just three-tenths of a percentage point higher than comparable U.S. Treasury’s, a spread also near a record low."
Would you be anxious to lend to a corporation – even one as solid as IBM – at a lousy 1% per annum for three years' time? Apparently many investors were. The offering was twice oversubscribed.
And that's not all. In similarly impressive fashion, McDonald's recently sold 10-year notes to investors at an annual payout rate of 3.5%. Commonwealth Edison, a utility subsidiary of Exelon, sold 10-year debt at 4%, its lowest payout since the 1950s.
Not to be outdone, the triple-A rated Johnson & Johnson just broke the 10- and 30-year records for stingiest payouts. Investors last week bought $550 million worth of JNJ 10-year notes at an astonishingly low 2.95% interest rate... and another $550 million worth of 30-year JNJ bonds at just 4.5%.
Hiding Out
Investors are locking in these lousy rates of return because they are scared witless by the prospect of deflation in a weakening economy. They see super-safe bond obligations from bulletproof blue chips as a place to hide their cash and wait out the storm.
But what about the bullish implications of all that cash on corporate balance sheets? As numerous pundits have breathlessly noted, public companies are now sitting on a collective cash and liquid assets hoard of $1.84 trillion. That's trillion with a "T" and, per the WSJ, "up 26% from a year earlier and the largest-ever increase in records going back to 1952."
Such news should be bullish, yes? All those dollars waiting to be spent?
Actually, no. As financial reporter Brett Arends reports,
A look at the facts shows that companies only have "record amounts of cash" in the way that Subprime Suzy was flush with cash after that big refi back in 2005. So long as you don't look at the liabilities, the picture looks great. Hey, why not buy a Jacuzzi?
According to the Federal Reserve, nonfinancial firms borrowed another 9 billion in the first quarter, taking their total domestic debts to .2 trillion, the highest level ever. That's up by .1 trillion since the first quarter of 2007; it's twice the level seen in the late 1990s.
Ah, there's the rub. The problem with the "gobs of corporate cash" argument is threefold:
- Most of that cash is borrowed.
- Public companies on the whole are still significantly leveraged.
- Companies are borrowing not because they need to, but because they can.
Why are IBM, Johnson and Johnson and the like borrowing gobs of cash from investors at ridiculously low rates? Because my God, man, why wouldn't they? When someone offers you a financing coup like that, you don't ask whether you actually need the money. You just take it, and figure out what to do with it later.
Hoarders Extraordinaire
And so, when we ask "are blue chips the new banks," the answer is "yes" in the context of liquidity trap dangers. Investors are lending at insanely low rates, to public companies they see as immortal, because they don't know what else to do with the money.
Meanwhile, it's true these companies are building up war chests of assets... but much of the cash in the chest is borrowed, and that which is not borrowed is matched by liabilities (older debts) that already existed.
It is the difference between a man who has 0,000 in his bank account free and clear, and the man who has the same amount listed on his bank balance, but knows the bulk of it is borrowed and owed. There is a difference between free and clear cash to deploy on expansion, and borrowed cash hoarded as rainy day insurance.
The market implications here have to do with a painful realization that is dawning on once-optimistic investors. When it is more widely realized that huge piles of corporate cash are actually a deflationary liquidity trap phenomenon – rather than a reason to be bullish, as the hopefuls have tried to spin it – the fallout could be less than pleasant.
Originally published:
https://www.taipanpublishinggroup.com/tpg/taipan-daily/taipan-daily-081610.html
