Editor's Note: Below is a Hedgeye Guest Contributor research note written by our friend Doug Cliggott. Cliggott is a former U.S. equity strategist at Credit Suisse and chief investment strategist at J.P. Morgan. He is currently a lecturer in the Economics Department at UMass Amherst.
A brief note on our contributor policy. While this column does not necessarily reflect the opinion of Hedgeye, suffice to say, more often than not we concur with our contributors. In the piece below, Cliggott writes, "The footings now supporting US equity prices are looking pretty tired and fragile."
Total income has expanded at a slow, but steady pace in the U.S. during the past several quarters – national income grew by 3.1 percent during 2015 and 2.9 percent in Q1.2016. Not much change there. What has changed in an important way is the composition of overall income – labor compensation grew by 4.5 percent in 2015 and accelerated a bit to 5.0 percent in the first quarter.
The flip side of the pick up in labor compensation is a weakening of corporate profits. They contracted by 3.1% in 2015 and by 5.8% in the first quarter. So what we are seeing is a clear weakening of profit margins – a very natural outcome 7 to 8 years into a profit cycle.
The dismal trend in U.S. labor productivity and OECD data on leading economic indicators of the most relevant markets for large US corporations – the US, Europe, China – strongly suggest a further intensification of “profit problems”.
Corporate America has reacted to weakening profitability in traditional fashion. They have scaled back capital spending (down about 2% versus a year ago in the first quarter) and they have slowed their pace of new hiring, from about 200,000 jobs a month this time last year to about 100,000 per month during the past three months.
We know what usually happens next – weaker capex and slower job creation slows demand growth, this weakens profitability further, and down we go in a negative, re-enforcing cycle. The normal “end game” – outright declines in total income and employment – may now be just months away in the U.S.
What corporate America has not done – yet – is slow their accumulation of new debt. Non-financial corporations increased their borrowing in the first quarter by $180 billion, to $8.28 trillion. The last time U.S. corporations borrowed this much in a 3-month period was the last quarter of 2007. And it looks like their primary motivation for borrowing in 2016 is exactly the same as it was back then – to support their stock prices by ratcheting up the amount of cash they give back to shareholders even as their profits and cash flows weaken.
The shrinkage in equity outstanding through both mergers and share buybacks added together with dividend payments totaled $1.27 trillion (at an annual rate) in the first quarter, up about 10 percent from the $1.15 trillion pace during 2015. These shareholder payments represented 59 percent of the after-tax cash flow of non-financial corporations in Q1 2016, up from 53 percent in 2015 and 43 percent in 2014. By contrast, capital spending as a share of cash flow declined modestly, to 80 percent in Q1.2016 versus 83 percent in 2015.
Looking back at seventy years of US financial history, the only time corporate America devoted a similar amount of their cash flows to dividend payments and share buybacks was in 2006 (56 percent) and 2007 (70 percent). And then when corporate borrowing slowed, total shareholder payments were cut hard – to 46 percent of cash flow in 2008, and 25 percent of cash flow in 2009.
The key lesson from this time, I think, is that while corporate cash flow declined by less than 5 percent between 2007 to 2009, shareholder payments were cut by two thirds – from $1.20 trillion to $400 billion.
Since it is commonly acknowledged that shareholder payments are now the primary, and in some months, the sole, source of demand for US equities, the pace of corporate borrowing may be our best guide to the direction stock prices in America. With profits declining and cash flow stalling it wouldn’t be too surprising to see borrowing slowdown real soon.
So here’s the punch line: The footings now supporting US equity prices are looking pretty tired and fragile.