Why Investors Are Misreading the Significance of Corporate Cash Piles
High profit margins, not corporate uncertainty, explain today’s elevated cash levels — and why they are likely to persist.
The rise in corporate cash positions has attracted considerable attention in the past few years. Large cash balances have become linked in many observers’ minds to an overall atmosphere of corporate caution, with firms reluctant to spend against a backdrop of elevated uncertainty. The growing pool of cash, though, owes more to historically strong corporate profitability than to a broader hesitation to invest on companies’ part. Indeed, business investment spending has grown fairly strongly during the current expansion, and corporate cash has been on the rise for the better part of two decades. With profit margins still high, companies would remain awash in cash even if capital spending were to pick up sharply. Share buyback activity thus seems likely to become increasingly prominent. Meanwhile, swings in corporate cash management techniques may exercise significant effects on short-term interest rates.
Various ways exist to measure cash on corporate balance sheets. One simple method relies on the Federal Reserve Board’s quarterly flow of funds data (which is limited to U.S.-domiciled companies). Adding up cashlike assets (basically, bank deposits and money market fund holdings) of the nonfinancial corporate sector from this source produces a figure of nearly $1.4 trillion as of September 30, 2012 (see Chart 1). That number, a record high, equates to almost 9 percent of U.S. gross domestic product . The cash stockpile has not risen enormously over the past year but is roughly double the amount from ten years earlier.
Chart 1: Cash on nonfinancial corporate balance sheets (USD bn)
Source: Federal Reserve Board, JPMAM; data as of second quarter, 2012
As chart 1 suggests, the corporate cash stockpile does not represent a recent, postrecession phenomenon associated with unusually weak capital spending. Business investment spending, while not spectacularly strong, has grown at a reasonably solid pace during the current expansion. Although it did drop more sharply than usual during the 2008-09 recession (like most other aspects of the economy), its growth rate since bottoming out has broadly mirrored the experience of the previous three recoveries (see Chart 2). As a share of GDP, business investment does not look extraordinarily low at the moment — 10.2 percent in the third quarter of 2012, compared with 10.7 percent on average since 1950 (see Chart 3). In other words, elevated uncertainty may be crimping capital spending at the margin, but businesses have not engaged in an all-out investment strike.
Chart 2: Business investment in GDP (quarter prior to recession start = 100, sa)
Source: JPMSI, JPMAM; data as of third quarter, 2012. Dates in legend show beginning of each data period.
Rather, the multiyear accumulation of cash on company balance sheets primarily reflects the secular increase in corporate profitability that began around 1990 and has continued until today. Corporate profits, as a share of national income, averaged just above 6 percent between 1947 and 1990, with small cyclical fluctuations. After that point, a steady climb began, with profits peaking in the fourth quarter of 2011 at 11.7 percent of GDP and holding in double-digit territory through the third quarter of this year (see Chart 4).
The rise in corporate profitability, which came at the expense of the so-called labor share of income, remains poorly understood, but almost certainly owes a great deal to globalization. Profit margins began to soar just at the moment when a fresh, large and inexpensive labor source — in China, the former Soviet bloc, and other newly open developing countries — entered the global trade system. As firms took advantage of this workforce by relocating production, margins climbed and cash flow significantly increased. Although global growth did accelerate somewhat during this period, companies faced no need to invest all of their newly large share of national income. Instead, they began accumulating cash.
The profit-margin origin of the corporate cash stockpile carries several implications.
Chart 3: Business investment as share of GDP (%)
Source: JPMSI, JPMAM; data as of third quarter, 2012
First, large cash balances will likely remain a prominent feature of the landscape for some time. The increase in margins may have run its course, in particular as wage costs have risen in China and other emerging economies. But a significant near-term reduction in profitability appears unlikely, given labor-market slack in most economies. As firms continue to capture an unusually high share of national income, they will keep adding to their cash pile.
Second, reduced uncertainty — for example, via resolution of the fiscal cliff problem in the U.S. and through ongoing European Central Bank support for markets in the euro area — can go only so far in boosting growth. Business capital spending softened in the second half of 2012, and reacceleration would provide a nice fillip to growth early this year. Investment has not, however, displayed extraordinary weakness during the expansion as a whole, and elevated corporate cash balances do not signal a potential boom from this source that might shift the economy onto a sustainably higher growth path.
Chart 4: Corporate profits as share of national income (%)
Source: JPMSI, JPMAM; data as of third quarter, 2012.
Third, companies will remain under pressure to return cash to shareholders, given that increased investment alone appears unlikely to absorb the stockpile. The prospect of higher marginal tax rates on dividends may somewhat dampen enthusiasm for payouts via this channel, but the sheer size of cash balances means dividends are unlikely to disappear (even aside from the fact that companies generally dislike cutting dividends for fear of sending negative signals about their businesses). Share buybacks, meanwhile, are likely to take on greater prominence. After all, companies possess considerable firepower as the cash stockpile equates to roughly 10 percent of current market capitalization. Equity investors will need to incorporate rigorous estimates of share buybacks into their return forecasts.
Fourth, evolving corporate cash management practices may affect relative valuations at the short end of fixed-income yield curves. The possible expiration at year-end of unlimited deposit guarantees for so-called transactions accounts, widely used by firms, would throw corporate cash managers into a new environment. Money-market funds will likely absorb a significant share of any resulting outflows from checking accounts, but some corporate treasurers may dip a toe into other, higher-yielding (but presumably still short-duration) fixed-income assets. Institutional investors will need to keep an eye on changing corporate cash management habits as they form their own expectations for interest rates at the short end of yield curves.