Much has been made about the record amounts of cash that S&P 500 companies and corporations in general are holding onto, but few are talking about the record corporate debt.
According to the Federal Reserve, as of March 2012, U.S. non-financial corporations held a record $8.1 trillion in corporate debt. (Also see: “Bad Timing: Record Amount of Corporate Debt up for Refinance”). Returning to corporate cash-on-hand, the same Federal Reserve report shows that non-financial corporations held $1.7 trillion in cash at the end of March, down from $2.0 trillion last year.
Everyone wants those S&P 500 corporations to spend their record earnings to create jobs and thus spur economic growth. Investors in S&P 500 companies also want corporations to invest the money, because they certainly did not buy the shares just to earn interest in a bank account.
Despite these pressures, S&P 500 companies have bought back shares and increased dividends, instead of investing in capital projects, because they are uncertain that consumers will buy the products due to weak demand.
Yet, if S&P 500 corporations don’t create the jobs, consumers can’t buy products, and it’s the same old vicious circle.
The other side of this argument is the fact that corporations have record corporate debt and other problems they need the money for. A study from S&P Dow Jones Indices highlighted that, within the S&P 500, pension liabilities were under-funded by a record $354.7 billion at the end of 2011.
Because interest rates are so low, the S&P 500 companies can’t earn enough return to compensate for the payouts promised to pensioners, so their pension liabilities compound higher.
States and municipalities have the exact same problem, while savers in the U.S. economy can’t earn any money on their savings. (These are two prime examples of zero interest rate policies not working for the good of the economy!)
In total, S&P 500 companies set aside $1.96 trillion in cash in 2011 to pay for pensions and other employment benefits!
There is no question that more companies are shifting the burden of the pensions to the employees themselves, but legacy pension plans still exist and these deficits highlight how vulnerable S&P 500 companies are to a fall in earnings and how vulnerable pensioners are especially when they expect that check to come in every month.
Corporate balance sheets are not as healthy as they first look, with corporate debt and pension deficits a big problem. The best way to pay for this corporate debt is to invest the record cash on hand and generate a greater return on it in order to pay down the corporate debt and close the pension deficits.
However, S&P 500 companies have no confidence in the economy to generate a sufficient return on their money. The question is: why do investors still have confidence in the stock market when S&P 500 companies don’t?
Rome Burns; Europe Can’t Help
One of my favorite countries to visit, Italy, is in big trouble.
Just a few years ago, Italy’s government debt was roughly equal to its gross domestic product (GDP)—it had a debt-to-GDP ratio of about 100%. This is high, but Italy was able to maintain a budget surplus, which means after the bills were paid for the year, there was money left over from taxes the government took in to pay down government debt.
Like a household, the problem with holding high debt levels is that if something goes wrong, it can place the household in serious financial difficulties.
Enter the eurozone financial crisis and Italy’s government debt has now reached a debt-to-GDP level in excess of 120%!
To give some perspective to the problem, remember that the eurozone has been consumed by the problems of Greece, but Greece has government debt of 350 billion euros, while Italy carries government debt of 1.9 trillion euros!
With Italy’s economy in a recession and the unemployment rate at a decade high, this is making its budget targets almost impossible to hit. The prime minister has instituted spending cuts to offset the decline in tax revenue, but the economy continues to contract.
The bond market has attacked Italy, sending its 10-year government debt interest rate above six percent, when two years ago it just was four percent!
Moody’s Investor Services has also downgraded Italy’s government debt to just two levels above junk status, which further puts pressure on interest rates.
While Italy can say it has still been able to maintain a budget surplus despite the eurozone financial crisis, this surplus does not include the interest payments on its government debt.
For example, this month, Italy sold three-year government debt of 5.25 billion euros at an interest rate of 5.6%. Just three months ago, it was able to sell its three-year government debt for 4.3%.
Due to the eurozone debt crisis and the downgrade by Moody’s, how did this affect Italy? Well, 5.25 billion euros at an interest rate of 5.6% means Italy must pay bondholders of its government debt 68.25 million euros more per year for the next three years than if the country was able to issue the government debt at an interest rate of 4.3% (like it used to only 90 days ago)!
And that is just one example. It is estimated that Italy must roll over almost 310 billion euros of its 1.9 trillion euros in government debt in the next 12 months!
So, while interest costs go up dramatically, this will create budget deficits. Lower tax revenues will persist due to the weakening economy, the eurozone crisis, and a continued rise in unemployment. Should the prime minister institute more cuts in a recession—the austerity measure demanded by the eurozone—this will only exacerbate the budget deficit further.
Another vicious circle, which will lead to the bond market demanding higher rates, which will lead to higher interest costs, and on and on.
The eurozone crisis is worsening, dear reader. Just because it is not making headlines right now does not mean it will not be back very, very soon. Greece is a problem, but there is no way the countries of the eurozone can handle the government debts of both Spain and Italy: their government debts are just too large.
What does all this mean for us here in North America? The crisis in Europe results in softer sales for the big companies that make up the S&P 500 stock index—40% of those companies have exposure to Europe.
China is affected because Europe is China’s biggest export market (see: “Chinese Economy Contracting Much Quicker Than Originally Thought”). As the Chinese economy softens, it affects North America in a variety of ways. Bottom line: we are progressively moving deeper into a global recession.
Where the Market Stands; Where it’s Headed:
We are in Phase II of a long-term secular bear market in stocks. Phase II is usually referred to as the “bounce” or “sucker’s rally.” After the initial Phase I take-down, Phase II of a bear market rally gives investors the false sense the economy is improving and the stock market is a safe place to invest again—this is exactly where we are today.
Phase II of the secular bear market started in March of 2009. We are nearing its end. Phase III of the bear market, the next phase, will bring stocks sharply lower.
What He Said:
“When property prices start coming down in North America, it won’t be a pretty sight, because consumers are too leveraged. When consumers have over-borrowed so much that they have no more room in their credit lines to borrow more, when institutions start to get tight on lending, demand for housing will decline and so will prices. It’s only a matter of logic, reality and time.” Michael Lombardi in Profit Confidential, June 23, 2005. Michael started warning about the crisis coming in the U.S. real estate market right at the peak of the boom, now widely believed to be 2005.