Why companies are saving more and investing less

The global economy is suffering from an unusual problem of too little demand rather than the usual problem of scarcity, ie too little produced and so too little earned. Hence the relative abundance of the global supply of savings over the demand to utilise them, so causing some interest rates in the developed world to become negative and prices to fall (deflation rather than inflation) and growth to slow.

Since much of the savings realised are made by companies in the form of retained earnings and cash (that is earnings augmented by depreciation and amortisation) the question then arises – why are companies saving as much as they are rather than using their cash and borrowing power to demand more plant and equipment that would add helpfully to both current spending and future production?

In the US, where an economic recovery from the recession of 2008-09 has been well under way for a number of years, fixed investment spending (excluding spending on new home and apartments), having recovered strongly, is now in decline and threatens slower GDP growth to come.

It is not coincidental that demand for additional capacity credit by US corporations remains subdued while balance sheets have strengthened. The debts of US non-financial corporations, compared to their market values are proportionately as low as they have been since the 1950s.

 

With the cash retained by non-financial corporations, the financial assets on their balance sheets have come to command a much higher share of their net worth. The share of financial assets of total assets has grown significantly, from the 30% ratios common before 1970 to the well over 55% today, a ratio reached in the early 2000s and sustained since then and now seemingly increasing further.

 

 

The ability of US corporations to save more and build balance sheet strength has been greatly assisted by improved profit margins – now well above rates of profit realised in the fifties. As may be seen these profit margins peaked in 2011 at about a 12 % rate and are now running a little lower, with profit margins running at a still impressive 10% of valued added by non-financial corporations.

The lack of competition from additional capacity has surely helped maintain these profit margins, as well as cash flows and corporate savings. But it does not explain why the typical US corporation has not invested more in real assets nor why they have preferred to return relatively more cash to shareholders in dividends and share buy backs. Even so called growth companies, with ambitious plans to roll out more stores or distribution capacity, seem able and willing to fund their growth and yet also pay back more. They paying back to institutional shareholders (in the form of dividends and buy backs) who themselves are holding record proportions of highly liquid assets in their portfolios.

There is incidentally, no lack of competition between US businesses. Competition is as intense and disruptive as it has ever been. The competition to know your customer better and so be more relevant than the competition in the offerings you can make to them is the essential task facing business managers. And so part of the answer to the reluctance to add to capacity is the fact that capital equipment (hardware supported by software) is so much more productive than before. A dollar of capital equipment utilised today does so much more than it used to – meaning less of it is needed to meet current demands of customers.

It must take higher levels of demand from households and perhaps also governments to stimulate more capital expenditure and less cash retention by the modern business corporation. Capital expenditure typically follows growth in demands by households. Households in the US account for over 70% of all spending. In SA, households’ share of the economy is also all important, at over 60% of spending. It is the growth in household spending that puts pressure on the capacity of firms to satisfy demands and to improve revenues and profit margins doing so. It is the weakness of household spending in the US and even more so in SA that explains much of the reluctance to build physical capacity.

Why are households in the US and SA not spending and borrowing more in ways that would encourage more capex by firms? In SA’s case the answer is perhaps more obvious. Household spending has been strongly discouraged by rising interest rates. Until interest rates reverse direction in SA, it is hard to anticipate a cyclical recovery reinforced by capex.

In the US and SA, what will be essential to faster growth will be the confidence of households in their future income prospects. It is this confidence, much more than changes in interest rates, that is essential to the purpose of economic growth. The role of politics in building or undermining confidence in the future prospects of an economy is all important. Perhaps it is the failure of the politicians (and perhaps also central banks) to build confidence in both households and the firms in their prospects, is the essential reason why spending remains as subdued as it is.