Happy Days Are Still Far Off!

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The US corporates are seemingly having a better time now, what with some encouraging numbers reported by them following some dismal performance last year. While the stock markets seem to be gung-ho about possible US economic revival and hence improved corporate performance, it is quite likely that things might go sour for some time to come.

However, before getting into this, it is important to understand the business cycle and see how the US companies might have been affected this time around.

As can be seen, generally towards the end of the recession, corporate profits start to move up, while unemployment peaks some time after recession. With high level of unemployment and recovering corporate profit, the share of profit in national income tends to rise. This is not difficult to understand. As the cost savings from retrenched workforce starts to take effect, the bottomline improves. Improved bottomline is generally accompanied by flat to marginally positive topline as demand remains low. Thereafter, as confidence returns and demand recovers, demand starts improving, new jobs start getting created and the economy starts to straddle the growth path till the excesses hit again to slow down the economy.

However, as mentioned earlier, the recession this time is different and the impact has been quite severe. Here’s why: This time, the corporate (non-financial non-farm) have started to leverage too fast for their comfort.

While their debt to networth percentage was marginally lower than the peak of early 90s, the pace of leverage accumulation was way too fast. Clearly high growth and consistently high capacity utilization prompted them to increase leverage to fuel further expansion and growth. This was reflected in the spurt in business fixed investment (BFI) till it started to wane toward the end of 2008.

A large number of US corporate also went on acquisition spree with increased leverage being the preferred vehicle for the same.

High leverage level

As is clear, the corporates started traversing the path of increased leverage towards end-2006 and started accumulating debt with gusto, aided as they were by ultra low interest rates and benign domestic as well as global inflation scenario. Unfortunately, the excessively leveraged US consumers started retracting soon.
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As the recession began (resulted in a domino effect that afflicted the world), average capacity utilization started to fall sharply while leverage continued to increase at possibly the sharpest pace. In fact, the rise has been the steepest as compared to the previous four recessions, but also otherwise.

Increased capacity and stagnant demand led to fall in capacity utilization. As demand destruction became severe, the companies started to reduce production (to save on the variable cost) and started to draw down the inventories quite heavily. As a result, they were hit by a double whammy. Lower capacity utilization implies lesser number of units being manufactured. This has resulted in a rise in unit cost of production as the fixed cost of debt service could be spread over lesser number of units. With falling revenue and shrinking margins, the companies were in for a tough time and their profitability dipped dangerously. As a corollary, retrenchment became widespread. Of late, the cost savings resulting from large scale retrenchment has resulted in some companies being able to show improved profitability. This, however, is being taken by the market very positively. And along with the belief that the recession is over, the stock markets are heavily upbeat.

It is interesting to note the sharp rise in P/E. This clearly indicates the amount of pain that the companies have gone through. While increase in P/E is quite common during periods of recession, what needs to be noted here is that the market seems to be quite optimistic as it has already regained more than 25 per cent from its recent low. And the market is comfortable with a higher P/E in the expectation that the future profit growth rates will take care of valuation.

This is quite unlikely. While the recession has probably just ended or will end soon, there’s no clear indication where the growth will come from. Let’s look at the potential impact on growth by important constituents.

Deleveraging continues

The government sector, with its stimulus package, will be an important growth driver for sure. But currently, there are enough discussions going on around exit strategy that reduces the probability of big bang impact. Business fixed investment will not be a growth driver for quarters to come. Given the existence of substantially high excess capacity and high degree of leverage by the companies, there’s hardly any appetite left for further investments.  While the falling trend of BFI might lose steam, it will not add much muscle to the growth story.

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This leaves the consumers. As I have been maintaining, the most indebted consumers are yet to show any signs of reversing the trend of falling demand any time soon. While I have enumerated my concern in my article in the previous edition, there are a few other evidences that shows not only the extent of demand destruction that has taken place but how their confidence has been scythed which will prevent them from coming back to the market place in droves in quite some time to come.

The July number of US consumer credit recorded the worst ever decline. Total seasonally adjusted consumer debt fell $21.55 billion, or at a 10.3 per cent annual rate, in July to $2.47 trillion. This is the sixth straight monthly drop in consumer credit. Consumers have retrenched since the financial crisis hit the economy in full force last September. Credit has fallen in every month since then except January and is the longest consecutive string of declines in credit since the second half of 1991. And, despite this massive drop, the consumer credit level is way above long term average. Clearly, the deleveraging of the consumers has only just begun and it still has a long way to go before settling down.

Curtailing spending

Not surprisingly, a recent poll by Bloomberg revealed that Americans plan to refrain from boosting their spending even after the biggest drop in consumption since 1980, signalling concern about the direction of the economy over the next six months. Only 8 per cent of US adults revealed that they plan to increase household spending, while almost one-third will spend less, and 58 per cent expect to “stay the course”. More than 3 in 4 said they reduced spending in the past year.

While a lot of hope is pinned on the recently released retail sales number, it is important to note that a lot of credit for the same has to go to the ‘cash for clunkers’ scheme (which incidentally ends in September) wherein the US government offers cash credit to households buying a new car by selling the old one. The number was also buoyed by the rising oil prices. Leaving those two components aside, the growth remains benign.

In fact, the massive pullback back by the US consumers is reflected in the sales tax collection in the various states. As per the monthly survey of all states on their tax collection (which is part of the Liscio Report by Philippa Dunne and Doug Henwood), about 30 per cent of the states surveyed met or exceeded their sales tax projections, while only 1.43 per cent of the states reported an increase in collection over the year. Although their survey point to some sense of stability, retail sales post the expiration of the ‘cash for clunkers scheme’ will be an important indicator.

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Thus, while we might see some picking up of economic activities as inventory rebuilding takes place, sustenance of the same will depend on how soon the consumers start acting. If the consumers do not start to loosen their purse strings (which I do not think will happen soon), the projected profit growth is unlikely to materialize, even after we consider a lower base effect. At this point in time, the sheer optimism of the market seems to be highly misplaced and the growth expectation much more farfetched. With low growth potential, the market needs to retrace so that the P/E comes back to a more normal 15 to 18 range.