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Amid everything else going on, we still continue to look for signs of a recovery. This weekend I spent some time looking at the investment side of the economy to see if I could pick up any sign of life on the capital spending front. At the end of the weekend, I gave up looking for encouraging information, either in terms of business investment or investment in real estate.

Let’s look at the supply side first, the companies and businesses that supply physical capital, either in terms of real estate or in terms of business equipment. In order to summarize the information on the supply side of the market there seems to be one favorable factor that would encourage the production of investment goods and two that are not encouraging concerning the production of capital goods or real estate.

The positive factor is short term interest rates. The supply of capital goods in the past has been dependent upon the cost of short term funds and right now, of course, short term interest rates are as low as we can ever expect them.

If these rates stay at these levels and other factors encouraging investment production improve, we should start to see the economy recover. The word out of the Federal Reserve is that short term interest rates are going to be kept low for an extended period of time and this weekend we heard that these rates may stay low into the year 2011.

The two negative factors relate to the internal cash flow of firms and the terms on which lenders are willing to lend. In terms of internal cash flow, potential suppliers of investment goods are still in a position in which they are trying to de-leverage and actually reduce the amount of debt they have outstanding relative to their internal sources of funds. Thus, there is not much effort to expand production from the suppliers of goods because they have not yet got their balance sheets back in order as of this time.

Lenders, of course, are not lending. If anything, most lenders are still risk adverse and continuing to tighten up on the maturities and terms of any lending they do. As a consequence, we see very little willingness on the side of lenders to encourage the supply of funds to expand.

Therefore, whereas the Federal Reserve is consciously keeping short term interest rates very low and intends to keep them low for a long period of time, potential suppliers of capital have not seemingly restructured their balance sheets sufficiently to begin to produce again and lenders seem far from willing to take any chance on who they lend to.

We are back in the position where bankers, and others, will not lend to someone unless the potential borrower does not need the money.

In terms of the demand side of the market the factors that tend to support investment expenditures all seem to be in the negative range. Long term corporate interest rates have fallen some over the summer and this is encouraging. Moody’s AAA corporate bond rate was at a yearly high in June averaging 5.61% for the month. This rate moderately bounced downward in July but seemed to be rising into the 5.50s toward the end of the month. Moody’s BAA corporate bond rate has declined significantly from March 2009 when it averaged around 8.40% and has fallen to the 7.10% range toward the close of July.

The decline in corporate rates has been encouraging and indicates that the financial market’s taste for risk has improved at the expense of longer term Treasury issues whose yields have been rising since March.

The question here is whether there will be a continued rise in Treasury bond rates over the next 12 months or so. If Treasury interest rates continue to rise, as I believe they will, this will put a floor under corporate rates, one that will tend to rise as longer term rates rise in general.

And, with the spread between AAA and BAA securities around 150-160 basis points one cannot see this spread getting much narrower as long term interest rates rise over the next year or so.

Less favorable trends appear to be the lack of growth in cash flows This means that those that want to acquire capital goods or real property still face the need to continue to de-leverage their balance sheets.

This concern can be combined with the fear that many economic units have about the possibility that they could face default or foreclosure in the upcoming twelve month period. There are still a lot of financial issues that must be resolved and this attitude does not produce a lot of optimism on the part of businesses or individuals to extend their own resources into risky investments in the near future.

This attitude coupled with the economic forecasts that the recovery will be tepid at best for the next 12 to 18 months does not do much to create optimism about future profit expectations. Profits have increased but the general consensus is that a large portion of these profits have been achieved either through cost cutting or through trading operations. Neither one of these can be expected to contribute to a general increase in profit expectations for the future since cost cutting can only do so much and trading profits are sporadic and cannot be counted on on a regular basis. The prospect for growing profit expectations is not strong presently. Confidence can change rapidly, but it appears that it will remain relatively low for the near term.

There are some firms and some industries that are producing solid profits and can be expected to generate profits going forward. How much they will stimulate the sectors that are not performing well and how much they will contribute to a growing optimism concerning the future performance of the economy is anybody’s guess right now. These companies continue to look for an uptick in their business in the coming months as well. It is possible that these companies could lead the economy out of the recession, but they don’t seem to be in a mood to over extend themselves or to take on too much more than they are doing at the present time. They are happy to be making profits and intend to do so in the future: but, in a controlled and conservative manner.

The needed conditions for coming out of a recession are not really present at the current time. The Federal Reserve has, of course, have kept interest rates quite low and there has been the favorable movement in longer term, non-Treasury yields which have declined in recent months as financial markets have moved back into securities that are riskier than U. S. Treasuries.

In respect to the cost of money, everything is in place for the recovery. The problem of achieving a sustained increase in real investment, either in plant or equipment or in real estate, rests upon the potential borrowers and the possible lenders. Neither seems to be in any shape to begin borrowing or lending in the near term and this shows both on balance sheets and in the market place.

We have observed in the past that “animal spirits” can be revived and they can be revived relatively quickly. Question marks are always present relating to the issues of what is going to set off the animal spirits and when are they going to be set off. We can only keep looking at the major factors that are related to the psychology of economic units and attempt to determine when the direction of the economy is going to change.

At present, there are indications that a recovery is possibly starting to mount. For example, the index of leading economic indicators rose recently for the third month in a row.

Still, the dark clouds fail to go away. Unemployment is, of course, still a big concern. And, with unemployment benefits increasingly running out while unemployment continues to grow and with the further prospect of additional credit difficulties in the banking system while bank failures continue to rise, care still must be exercised before one extends ones self by taking on more debt and by committing ones self to the purchase of expensive capital goods.

I don’t believe that animal spirits will be on the rise anytime soon.

Source: Looking for Signs of Recovery