The United States of debt

The hidden message in American companies’ balance-sheets

POLITICS in America may be an arena of mutual incomprehension with few settled facts, but the debate about the health of American firms’ balance-sheets is, if anything, even more bewildering. Ranged on one side are those who complain that America Inc is hoarding $2trn of idle cash and that this acts as a powerful drag on the economy. On the other are those, including the IMF, who yell that firms are bingeing on debt, with borrowing hitting an all-time high of $8.4trn last year. As a result firms are simultaneously accused of being timid wimps and reckless idiots.

In fact, the numbers show that they are by and large a sensible bunch (especially compared with the country’s bankers and politicians). What is more, the debate over debt, as framed, misses the most intriguing thing about their balance-sheets. These have been radically reshaped to adapt to three national economic sicknesses—a financial system that companies still mistrust after the crisis; a broken tax code; and monopoly profits.

Measuring a firm’s balance-sheet leverage involves a few moving parts, which may explain some of the muddle over borrowing. There is debt, cash and the profits that go to making interest payments. For the current members of the S&P 500 index, excluding financial firms, all three measures have soared in the past decade. Debt has risen by 114% and cash by 162%; gross operating profits are 51% higher. It is easy to cherry-pick from among these figures to make contradictory claims.

What matters, however, is the size of firms’ net debts (debts less cash) relative to profits. Comparing these is rather like deducting the cash in your bank account from your debts and comparing the net amount to your salary. The ratio for S&P 500 members, adding up all their accounts, is a reasonable 1.5 times, slightly higher than a decade ago and lower than in Europe and Asia. Some firms are more “geared” than others. But the share of total debt owed by highly leveraged firms has been fairly stable over time. Although figures for the S&P 500 capture only big, listed firms, national-accounts data include all of them and indicate similar trends, with the net-debt ratio flat compared to 2006.

That does not necessarily please central banks in rich countries, which since the financial crisis have kept interest rates low, in part to try to persuade companies to go on investment splurges funded by cheap debt. But companies do not work in the way that some economists would like. They invest in line with their long-term strategies, using tried-and-tested rules of thumb to gauge the attractiveness of new projects.

Even if American firms have spent a decade ignoring the Federal Reserve, they have altered their behaviour in response to the economy’s three ills. First, their suspicion of the financial system means they carry a bigger buffer of cash and liquid assets. Before the collapse of Lehman Brothers in 2008 firms assumed they could always tap the money markets or borrow from banks. Now they do not entirely trust either. For every dollar of total gross profits that the present constituents of the S&P 500 earn, they carry $1.25 of cash, compared with 72 cents a decade ago.

The second change is that firms have had to adapt to a decrepit tax code that is stuck in the 1980s, before business globalised. Companies must pay a levy if they try to bring foreign profits home, and as a result many do not bother. About half of the cash of S&P 500 firms remains offshore. Many multinationals now divide their balance-sheets according to geography. They build up cash abroad and borrow in America. Apple, for example, issues bonds at home to pay for its share buy-backs, rather than tapping the $240bn it has stashed abroad. So though America Inc’s consolidated balance-sheet, which adds up the domestic and foreign parts, is prudently leveraged, it is more complex than before.

The last change is that companies’ profits have soared, which partly reflects a decline in competition in the economy and the rise of oligopolies in many industries. Firms are implicitly assuming that this is a permanent change. They have allowed their net debts to rise roughly in line with their rising profits (using these bumper earnings and borrowings to finance share buy-backs).

Established oligopolists such as AT&T and Kraft Heinz now boast both massive profits and high levels of net debt, reflecting the fact that their managers do not expect much competition. Likewise, America’s airlines have increased debt as their profits have shot up. Younger monopolies such as Alphabet and Facebook have net cash positions, largely because the money has only just started pouring in. Eventually they may gear up, too.

God help America

Both arguments, that America Inc has either lost its nerve or become reckless, are wrong. But the corporate world’s revamped balance-sheet does carry risks. One is that the liquidity buffer of $2trn might be invested unwisely. Every company insists that it parks its spare money in safe banks and low-risk bonds, but this is an area where disclosure is poor, and it would be no surprise if a few corporate treasurers were making dangerous speculative bets. Another risk is that a geopolitical or financial shock could make it harder for capital to cross borders. America Inc’s geographically divided balance-sheet would be harder to manage.

A final risk is that abnormally high profits could fall, making it harder to service debts. Antitrust watchdogs could get tougher with telecoms and cable-TV firms, for example, pushing earnings down. Or the labour market could tighten, pushing wages up and prompting the Fed to raise interest rates. That would squeeze companies’ near-record margins and lift their interest costs.

That is clearly not what many CEOs expect. The message that is buried in balance-sheets is not that American firms are behaving stupidly in response to today’s business climate. It is that they think the disappointing status quo of high profits, muffled competition, sluggish wage growth and dysfunctional political and financial systems will continue for a long time to come.