The next debt cri­sis may be cor­po­rate

▶▶Com­pa­nies are bor­row­ing money faster than they’re mak­ing it ▶▶Man­agers face pres­sure “to cut cap­i­tal spend­ing and in­ven­to­ries”

Bloomberg Businessweek (Europe) - - CONTENTS - Rich Miller, with Tara Lachapelle

Con­sumers bur­dened by their large mort­gages and maxed-out credit cards laid the ground­work for the last U.S. re­ces­sion. This time, com­pa­nies may play that role: En­ticed by su­per­low in­ter­est rates, they in­creased to­tal debt by $2.81 tril­lion over the past five years, to a record $6.64 tril­lion. In 2015 li­a­bil­i­ties jumped $850 bil­lion, 50 times the in­crease in cash hold­ings by S&P Global Rat­ings’ reck­on­ing. Lag­ging prof­its and mount­ing de­faults are other dan­ger signs. Although these fi­nan­cial vul­ner­a­bil­i­ties aren’t likely to lead to an­other down­turn soon, econ­o­mists say they point to po­ten­tial risks for an ex­pan­sion ap­proach­ing its sev­enth birth­day. “Com­pa­nies have been adding to their debt, and their debt has been grow­ing more rapidly than their prof­its,” says John Lon­ski, chief econ­o­mist of Moody’s Cap­i­tal Mar­kets Re­search Group. “That im­bal­ance in the past has usu­ally led to prob­lems” once growth begins to flag. Some are con­cerned that’s al­ready hap­pen­ing, as ev­i­denced by cut­backs in cor­po­rate spend­ing and hir­ing. Case in point: the news that em­ploy­ers ex­panded pay­rolls in May at the slow­est pace since 2010, in what econ­o­mists at JPMor­gan Chase worry is a sign of in­creased com­pany cau­tion. Also, April marked the third straight month of fall­ing or­ders for busi­ness equip­ment. The $62.4 bil­lion fig­ure, which ex­cludes defense and air­craft or­ders, was the low­est in five years, prompt­ing Neil Dutta of Re­nais­sance Macro Re­search to la­bel busi­ness in­vest­ment “pa­thetic.”

The sim­i­lar­i­ties be­tween the pre­re­ces­sion debt binge by con­sumers and com­pany bor­row­ing to­day are strik­ing. Like house­holds, cor­po­ra­tions are us­ing the money for short-term pur­poses rather than for preparing for the fu­ture. A wide gap ex­ists be­tween a hand­ful of ul­tra­rich com­pa­nies and the rest of cor­po­rate Amer­ica.

The record $1.84 tril­lion of cash on com­pany books is heav­ily con­cen­trated among Ap­ple, Mi­crosoft, Google, and other tech gi­ants, shows a study re­leased in May by S&P an­a­lysts An­drew Chang and David Tesher. Com­pa­nies that don’t have big cash re­serves might find it harder to meet debt pay­ments when in­ter­est rates rise. Take away the $945 bil­lion the 25 rich­est com­pa­nies rated by S&P hold, and the pic­ture doesn’t look par­tic­u­larly pretty for the bot­tom 99 per­cent of non­fi­nan­cial cor­po­ra­tions. Their cash on hand as a per­cent­age of the debts they owe is

at its low­est level in a decade, ac­cord­ing to S&P. More than 50 U.S. com­pa­nies have de­faulted on bonds or loans so far this year, dou­ble the num­ber in the same pe­riod in 2015. Among the com­pa­nies that have missed pay­ments, ac­cord­ing to S&P: Pe­abody Energy and Mid­states Petroleum. For the most part, com­pa­nies aren’t pour­ing the money they bor­row into cap­i­tal ex­pen­di­tures to in­crease ef­fi­ciency and ca­pac­ity—in­vest­ments that could boost prof­its down the road. In­stead, much of it has gone to finance share buy­backs, div­i­dend hikes, and ac­qui­si­tions. Since 2009, S&P 500 com­pa­nies have spent more than $2 tril­lion to re­pur­chase shares, help­ing sus­tain a rally in which stock prices al­most tripled. Merg­ers and ac­qui­si­tions world­wide jumped about 28 per­cent last year, to $3.5 tril­lion, ac­cord­ing to data com­piled by Bloomberg.

“If you put your­self in the seat of some­one re­spon­si­ble for management of a com­pany, they see weak de­mand,” Fed­eral Re­serve Gov­er­nor Jerome Pow­ell said in a May 26 ap­pear­ance at the Peter­son In­sti­tute for In­ter­na­tional Eco­nomics in Washington. “They can cut costs, and they can buy back their stock, and they can make their num­bers that way for a pe­riod of time.” McDonald’s sold $6 bil­lion of bonds at the end of last year to help finance higher div­i­dends and share buy­backs.

Buy­backs and takeovers are start­ing to tail off as com­pa­nies feel the ef­fects of fall­ing prof­its. S&P 500 earn­ings from con­tin­u­ing operations fell 7 per­cent in the first quar­ter of 2016 from a year ear­lier, data com­piled by Bloomberg show. Af­ter strip­ping out energy com­pa­nies af­fected by weak oil prices, earn­ings were still down 1.4 per­cent. “There is newly in­ten­si­fied, broad­based pres­sure on busi­ness to cut cap­i­tal spend­ing and in­ven­to­ries,” David Levy, chair­man of con­sul­tant Jerome Levy Fore­cast­ing Cen­ter in Mount Kisco, N.Y., wrote in a re­port to clients in May. Earn­ings are be­ing squeezed by lag­ging worker pro­duc­tiv­ity and mount­ing labor costs as ris­ing de­mand for work­ers forces com­pa­nies to pay more. Cor­po­ra­tions also are con­fronting lower economic growth ex­pec­ta­tions. Rich­mond Fed­eral Re­serve Bank President Jef­frey Lacker says he now pegs the po­ten­tial ex­pan­sion rate of the U.S. econ­omy at 1.5 per­cent. That’s half the av­er­age pace in the quar­ter-cen­tury that pre­ceded the De­cem­ber 2007 start of the last re­ces­sion. Lon­ski of Moody’s says it’s pre­ma­ture to pre­dict that the U.S. is head­ing

into a re­ces­sion as em­ploy­ers are still adding work­ers to their pay­rolls, al­beit at a slower rate. Yet the pres­sure on com­pa­nies is “a risk fac­tor that’s worth watch­ing,” he says.

The bot­tom line U.S. com­pa­nies may have gone over­board bor­row­ing at cheap rates to fuel stock buy­backs, div­i­dends, and ac­qui­si­tions.

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