By Shaniel Ramjee, investment manager, Global Multi Asset Group, Barings
One of the key questions for market participants and policymakers is why the level of investment by businesses remains so subdued at a time when interest rates are at, or close to, record lows. After all, a lower cost of capital brings down the hurdle rate for new investments. So, in theory, we should be seeing a surge in investment levels.
In practice, appetite for new investment is as much about corporate confidence as it is about interest rates. Uncertainty about the future path of economic growth and policy seems to be plaguing corporate decision makers just as much as equity and bond investors. Market participants have responded to the high level of uncertainty by favouring securities which offer income, particularly high yielding equities and corporate bonds. These areas of the market have seen large capital inflows, and the composition of the investor base has started to change, particularly on the equity side. When it comes to decide how best to finance investment, corporates face a trade-off between equity and debt financing. For most of the period, equity financing, as represented by the free cashflow yield, has been a more cost effective way for companies to finance expansion. Recently, however, its place has been taken by debt issuance, as represented here by the Moody’s A-rated corporate yield. The picture looks slightly different for companies of different qualities, but the general conclusion is the same. Equities and corporate bonds have very different risk and return profiles, with more governance involvement for equity holders, as owners of the company, and greater security of principal for bond holders, as creditors. In exchange for their capital, equity holders receive participation in the growth of the company together with any dividends. Corporate bond holders receive merely a fixed yield, with the right to certain assets of the company should there be a failure. As the providers of capital change, the evidence suggests that there may be a shift from stakeholders focused on growth towards those that are not. Equity income investors fit in between these two camps, but if the proportion of equity holders moves towards those that are income orientated, the pursuit of growth may be compromised. The demographics of the providers of capital could further influence this change with the baby boomer generation showing a further preference for annuity- like investments over those that focus on growth. If the major providers of capital are concerned with sustaining cashflow, interest coverage, dividends and buy-backs, corporates are also likely to become increasingly focused on these aspects at the expense of growth. As the relative cost of equity increases and the implicit influence of equity investors falls, capital spending as a proportion of sales has also fallen. On the basis of this analysis at least, it appears that corporate boards do adjust their spending to reflect the priorities of capital providers. In a world where growth is scarce, rates are low and policy is uncertain, investors look to be shifting their preference to areas where they have greater ability to extract a return on a consistent basis, rather than investing for growth. This may result in persistently high corporate profit margins, at the expense of greater employment and capital expenditure. The reluctance of companies to invest capital is most likely due to the uncertain world in which we live, but it could also be the case that companies are increasingly being run for the interest of yield investors and less for those focused on growth. While on an individual basis corporate decision makers may believe it prudent to build balance sheets that appeal to the preferences of these sources of finance, on an aggregate basis this may be contributing to the lack of growth in the economy. Whether this has a lasting impact on corporate behaviour has yet to be seen.
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