The recent decline in US corporate cash hasn’t raised a lot of eyebrows, but it has caused one of our balance sheet quality indicators to flash a warning. Since balance sheet quality is one of the signals with a strong track record of predicting market sell-offs, should investors be worried?
According to Moody’s, US non-financial corporations’ cash holdings fell to a three-year low of $1.7 trillion in 2018 from $2 trillion at the end of 2017. That cash was deployed in different ways, but the overall cash decline triggered one of the signals that we use to track balance sheet quality. As we’ve discussed previously, balance sheet quality is one of four indicators that help us monitor the potential for an equity market sell-off (Display).
Three Signals for Balance Sheet Quality
There are many ways to assess the underlying quality of corporations, but we believe that three indicators do an effective job, highlighting conditions that suggest either deterioration or improvement in balance sheet health:
1. Net Debt Issuance: Change in total debt minus cash
2. Net Equity Issuance: Change in common shares outstanding
3. Capital Expenditures: Capital expenditures as a percent of depreciation and amortization
If any of these signals is unusually high, it could be a bearish sign for equity markets. The rationale boils down to an intuitive notion: corporate excess. As economic cycles advance, businesses tend to become overly optimistic. They’re prone to expect unreasonably high demand, and they respond by building excess capacity (funded by debt or equity capital), only to see demand eventually fall short. The technology/media/telecom bubble in the late 1990s is a classic example of overextension.
Corporations Don’t Seem to Be Overindulging
So, today’s elevated net debt signal relative to the last few years could be one sign of overextended corporate balance sheets (Display). But it requires a fundamental assessment to understand not only what’s driving the net debt change but also the motivations behind it and how it relates to the other two pieces of the balance-sheet-quality puzzle.
Net debt issuance, according to our analysis, has risen, but the main reason is due to a decline in cash on corporate balance sheets. Rather than feeding corporate excess, much of the cash seems to have gone to share buybacks, which return cash to shareholders—a shareholder-friendly activity. This assessment is supported by improvement in the net equity issuance indicator, which shows a decline in overall shares outstanding. Notably, debt that is funding buybacks has generally been issued by corporations at historically low interest rates, enabling them to maintain financial flexibility.
One catalyst for the recent usage of cash for share buybacks was the 2017 tax act which encouraged firms to bring back cash from overseas.
What about the third indicator, capital spending relative to depreciation and amortization?
The intuition behind this signal: Businesses that spend too much on capital projects relative to replenishing or replacing aging equipment are overreaching. Right now, this signal isn’t in bearish territory. In fact, business investment as a percentage of corporate cash has been in secular decline since the mid-1980s, a trend that has continued over the recent cycle (Display). Instead, cash has been returned to shareholders.
Balance Sheet Quality Indicators Still Bear Watching
While we’re not concerned about balance sheet quality at this time, investors should continue to monitor this metric. Although it’s been relatively steady for the last few years as balance sheets have been strong, and behavior has been shareholder friendly, lower cash balances do reduce corporations’ cushion somewhat. If net debt issuance continues to rise because firms have taken on more debt, or if capital spending relative to depreciation and amortization becomes unusually high, it could leave businesses more vulnerable in a slowdown.
For more on trends in the economy, markets, and asset allocation for long-term investors, explore The Pulse, a Bernstein podcast series, and for additional thought leadership, check out the related blogs here.
- Sharat Kotikalpudi
- Director of Quantitative Research—Multi-Asset Solutions
- Caglasu Altunkopru
- Head of Macro Strategy—Multi-Asset Solutions