Moving Past Brexit: Looking Ahead To The Next Financial Crisis

by: Colorado Wealth Management Fund

Summary

The prevalence of share buybacks and lack of corporate investments in production reflect a deeper problem.

There is no investment case for corporations to increase productivity capacity without a reliable source of customers.

The most eligible customers are the people that choose to spend most of their money on stocks and bonds.

The lack of purchasing power for many Americans creates an enormous headwind to growth in sales.

If corporations are unable to grow sales, real GDP will be stagnant.

Investors are still bombarded with conversation about Brexit, but the relevance of Brexit to investors depends entirely on what sectors they are actively investing in. For certain sectors, Brexit is highly relevant. However, there is a much bigger problem looming on the distant horizon. This is a problem many investors may readily dismiss as being "natural", "political garbage", or simply being too difficult to analyze. Let me assure investors that this article is in no way political. This is assessing the economic reality of the current situation.

The Next Crisis Comes From Within

The fundamental challenge facing the American economy has been quietly lurking around for many years. It gets occasional coverage on news channels, but it doesn't get the kind of coverage it deserves. It doesn't get real financial analysis from experts looking at the investment implications, instead it gets populist coverage that can easily devolve into the kind of political garbage you won't find here.

The topic is "Disparity of Wealth" and the issue is often brushed aside because weak minds have brought it up and failed to make a credible investment case.

Can You See the Symptoms?

Since the last financial crisis there was a dramatic decline in interest rates. The low rates encouraged corporations to take out some loans and buy back some shares, but they didn't spur the kind of capital expenditures necessary to drive growth in GDP. In hindsight, the reason for that should be clear. Corporations don't invest capital simply because they have low interest rates. They invest capital to earn capital and that means not investing if expanding production will not improve earnings.

Buying back shares made sense for many companies since it is a simple analysis of the WACC (weighted average cost of capital). Cheap debt meant the optimal capital structure involved more debt and less equity.

Capital Expenditures Are Poor Planning

Despite low interest rates, heavy capital expenditures don't make sense. Large amounts of capital expenditures in the economy would reflect the corporations (as a whole) preparing to increase production dramatically. This was the goal of the low interest rate policies, but it won't work. Increasing production only makes sense if you can sell the new products. If you were selling hot dogs on Wall Street, would low interest rates encourage you to buy a new cart so you could grill twice as many hot dogs?

You shouldn't see the interest rates as a major factor. You would just want to know if there were going to be more customers to serve. If your stand was already operating at full capacity and you felt your prices were already optimal, then you would want a larger cart to handle new customers. The same business case plays out across corporations with market capitalizations in the hundreds of billions.

These companies don't want to ramp up capital expenditures because they don't want to ramp up production. Who would buy the new products?

A Lack of Customers

The fundamental problem for growth in our economy is not that no person has a desire to consume more. The problem is that the people that can afford to consume more have developed a strong taste for interest and dividends.

Don't misunderstand. There is nothing wrong with people wanting interest and dividends. The problem is that the vast majority of the wealth is now concentrated in the hands of the people who are smart enough and disciplined enough to know the value of investing. Again, the concept of smart people earning a return on their money and acquiring more money is not bad in itself. The problem is that all the companies trying to grow their sales and earnings are stuck selling to a group of consumers that have a smaller and smaller percentage of the wealth. This lack of purchasing power limits the ability of corporations to grow sales and eventually that limits the growth in earnings.

Propensity to Consume

Let us use "Jack" as our character of reference. Jack is a financial analyst. Jack already has a fairly solid income from his career and knows the value of investing. If Jack earns another $5,000 in after-tax income, he expects to invest between $4,000 and $4,500 of that income. As a result, Jack produces demand for financial assets but very little demand for consumer assets.

For a corporation to create the asset Jack wants to own, it would have to issue new bonds or stock. However, many corporations have little reason to issue new bonds or stock because they already have sufficient cash. If they had more cash, they would be likely to either sit on it or use it to repurchase shares. Clearly, issuing new shares for cash so the company can repurchase shares would be stupid.

If the corporation needed cash to build a new apartment, build a new store, or even build a cruise ship, that would lead to growth in the economy. New shares could be issued to fund the production and Jack would be able to buy a financial asset without further driving up the prices of existing assets. Obviously, one analyst investing a few grand will be like a drop in the ocean, but the cumulative impact across the country is creating a tidal wave.

The Sales Crisis

It comes to a head when the people consuming the goods and services cease to have enough purchasing power to keep sales growing. Income has grown across all segments, but it hasn't grown quickly enough for the consumers to be able to continue consuming. For sales across the economy to grow at a significant rate, it will be absolutely critical that corporations find a way to sell goods and services to the Americans holding most of the wealth.

If the corporations across America are unable to sell more products, growth in real GDP is severely handicapped. This isn't a "political problem" and candidates for office won't have the answers. This is a fundamental economic problem that has been swept under the rug. Investors don't want stagnant earnings. They want to see growth in earnings and growth in dividends. To get those things over the long term, they will need growth in sales. To get growth in sales, someone will need to buy the things that are produced. If new customers are necessary, the companies will need to figure out what those customers want.

In the short term, growth in earnings per share and free cash flows per share can be achieved through buying back shares. As the ratios (such as the P/E ratio) climb higher, those strategies become materially less effective. Eventually, the economy needs to grow.

The lingering question remains: what do you sell to someone that only wants stocks and bonds?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. This article is prepared solely for publication on Seeking Alpha and any reproduction of it on other sites is unauthorized. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

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