Animal spirits is a phrase coined by economist John Maynard Keynes in the 1930s in reference to risk taking, which is an essential part of any economic and financial system. Choosing which risks to take and which to avoid determines the fate of economies, companies and investors. In the 1930s, there was obviously a reluctance to take on a lot of risk, thus the lack of animal spirits. Similarities exist today.

The financial crisis and Great Recession of 2007-2009 had the same effect on today’s corporate executives. They had never experienced a financial crisis or such a severe recession whereby the credit markets completely shut down, prohibiting the issuance of corporate debt, and at the same time unable to increase borrowing from banks because of their problems. This was the first time credit was constrained for the corporate sector and it changed corporate behavior.

In addition to the credit market constraints, the recession caused corporate profits to decline by one-third for the S&P 500 and two-thirds for the finance sector. As a consequence, the S&P 500 stock index fell by 57 percent from October 2007 to its low point in March 2009, destroying $8 trillion of wealth. Corporate executives usually have a large part of their portfolios tied up in company stock, so their wealth took a big hit. If that wasn’t enough, housing prices started to decline in 2006, falling 33 percent by 2010.

The end result of the financial crisis and economic recession was an increase in risk aversion on the part of corporate executives. In addition to financial and economic uncertainty, they had to face political, policy and regulatory uncertainties such as the Affordable Care Act, Dodd-Frank Act, budget and debt ceiling battles in Congress, problems in the Eurozone and a multitude of other issues. The reaction of corporate America was predictable.

One of their first steps was to go on a cost-cutting binge, which included capital expenditures, employees and research and development, and just about anything else that could be cut. The purpose was to maintain and increase profit margins and earnings per share, and in that corporations have succeeded. After-tax net profit margins for the S&P 500 were an all-time high of 10 percent in the second quarter of 2014 v. a 20-year average of 7.5 percent. S&P 500 profits are up 82 percent since 2009 and were more than $1 trillion in 2013. Corporate profits in general are at historical highs in absolute dollars and relative to gross domestic product (GDP). This has become a political issue because labor’s share of GDP has declined.

Corporate America will have to become less risk averse and rekindle its animal spirits to increase funding for capital expenditures, research and development and hiring.

A second reaction of corporate America was to strengthen corporate balance sheets. Nonfinancial corporations were not a factor in the financial crisis, as were financial corporations, but they have built up huge cash reserves — $2 trillion currently representing 12 percent of GDP. Companies in all sectors of the economy have built up cash reserves but particularly the technology sector; at the end of 2013 Apple had cash reserves of $147 billion, Google $57 billion, Cisco Systems $48 billion and Oracle $37 billion. Much of the corporate cash is offshore, so there would be tax implications in repatriating it; U.S. companies do not pay U.S. taxes on offshore profits, which had accumulated to $2 trillion at the end of 2013. But cash-rich companies are facing intense pressure from investors to return more of it in the form of dividends and/or share buybacks.

And that is exactly what corporate American has been doing. S&P 500 companies have increased dividends about 60 percent since 2009 and share buybacks by 100 percent. S&P 500 dividends were approximately $320 billion in 2013 and share buybacks about $560 billion, so buybacks were 75 percent greater than dividends. In the first six months of 2014, share buybacks have been $338 billion, approaching the record levels of $700 billion set in 2007 just as the stock market hit its peak. Ironically, buybacks fell to $150 billion in 2009 just after the market bottomed out in March 2009, so many are questioning the wisdom and timing of the money spent on share buybacks today given the level of stock prices.

But don’t expect share buybacks to go away anytime soon, as corporations are not doing these only to appease shareholders. They reduce shares outstanding and increase earnings per share. Since 2009, revenues for the S&P 500 companies are only up 10 percent while earnings per share are up 80 percent. One way for companies to increase earnings per share and share prices has been to cut costs, increase cash flows and buy back shares.

A notorious example of this has been IBM, which at the end of 2004 had 1.646 billion shares outstanding, 1.304 at the end of 20009 and 998 million shares today. Since 2009 IBM has spent $75 billion on share buybacks which, in conjunction with cost cutting, has allowed IBM to increase earnings per share by 40 percent. Meanwhile revenues have declined on a year-over-year basis for the last nine quarters in a row. This has helped the stock price, although IBM stock has underperformed the market. That is why The Economist recently referred to share buybacks as “corporate cocaine.”

Corporations initially strengthened balance sheets by reducing debt, both short term and long term. But in the last three years record amounts of debt have been issued by U.S. corporations, a record $1.2 trillion in the first nine months of 2014; today total corporate debt is 15 percent higher today than pre-crisis 2007. This may seem to contradict increased risk aversion by corporate executives, but it doesn’t.

Borrowing long term to finance a business is less risky than borrowing short term because short-term debt has to be continuously refinanced, which was a problem during the financial crisis. Plus, corporations can borrow at low central bank-induced interest rates which have motivated many companies to borrow whether needed or not, such as Apple borrowing $17 billion in 2013 while sitting on $150 billion in cash. Also, many of the funds borrowed have been used to finance share buybacks, but this has not dramatically impacted debt-to-equity leverage ratios because of the record corporate profits in recent years.

In The Spotlight

Another reaction to the financial crisis and economic recession has been corporate reluctance to spend more on capital expenditures (cap ex) and research and development. Cap ex fell about 25 percent during the recession, and the growth since is below the rate of past recoveries. Cap ex usually lags in an economic recovery but picks up later in the economic cycle. That has not happened yet in the U.S. There has been a cap ex drought especially outside of the energy, material and utility sectors, which have accounted for 70 percent of cap ex in recent years.

There are numerous reasons why cap ex growth has not accelerated: lack of demand by the ultimate consumer, too much manufacturing capacity especially in China, technological innovations and misaligned management incentives, to name a few. Whatever the reason, corporate executives consider it less risky to increase earnings per share via share buybacks than make long-term investments where payoffs are in the future. Long-term underinvestment is deemed less risky than investing in long-term projects. Standard and Poor’s estimated that cap ex fell by 1 percent inflation adjusted in 2013 and forecasts it to decline by .5 percent in 2014.

Productivity is the most important measure of economic progress. Increased productivity allows wages to rise without creating inflation. As the U.S. economy emerged from the recession in June 2009, companies were lean and efficient and productivity per worked hour increased at more than 5 percent annually. As the economy has chugged along, productivity has grown at less than 1 percent since 2011 and was actually negative in the first quarter of 2014. Why the low productivity? There has been no growth in the amount of capital per hour worked in this economic recovery. The average age of U.S. corporate capital such as plant and equipment is the oldest in decades. And old capital is not as productive as new capital. Stagnant productivity will stifle income growth in the longer term and impede economic growth.

Flush with cash and high stock prices, American companies also are starting to buy or merge with other companies at the levels last seen in the dot.com era and pre-financial crisis. In 2013, $1 trillion of merger and acquisition (M&A) deals were done in the U.S., and 2014 deals already exceed 2013 levels. Not all M&A deals are financed with cash only, but historically companies have used excess cash for this purpose. It is a way to grow, transform business or reduce taxes.

June 2014 marked the fifth anniversary of the economic recovery, and it has been one of the weakest in the post-WWII era. For the economic recovery to be sustained, corporate America will have to become less risk averse and rekindle its animal spirits to increase funding for capital expenditures, research and development and hiring. It is critical for the future growth and competivtiveness of the U.S. economy.

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Robert Klemkosky
About The Author Robert Klemkosky
Robert C. Klemkosky is professor emeritus of finance at Indiana University Kelley School of Business. He was the founding dean of SKK Graduate School of Business at Sungkyunkwan University in Seoul, a top MBA program in Asia, and currently is chief investment strategist at Wallington Asset Management, an Indianapolis-based money management firm.




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