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A downward revision in earnings, in traditional circumstances, signals slowing investment. This time around, corporate debt levels and malinvestment are such that a pullback in private sector-led investment could trigger the protracted downturn skeptics have been calling for.
We have seen some of this before. In 2001, investment levels fell as corporates de-levered and pulled back on their investment spending. This, in turn, removed a fair bit of liquidity from the system. The 2001 period offers a reasonable template for what might be in store over the next few months, but this time around, the triggers are systemic, and the consequences, far worse.
The strong market performance in the first half of this year betrays some worrying developments at the corporate level. Take Kroger (NYSE:KR), a company with roots in retail and grocery. Here's what Kroger's CEO said on a recent conference call:
'We pulled forward price, digital and store investments in 2018, in part using tax reform dollars. This should provide a tailwind for sales and earnings in 2019'.
Source: Kroger Conference Call
The additional investment in digital initiatives has boosted digital sales growth to 42% YoY. Over the last year, Kroger has allocated its investment dollars to the following:
- $589 million to Ocado securities and Home Chef
- $185 million pre-tax to company-sponsored pension plans
- $216 million to share repurchases
- $440 million to dividends
- $3.0 billion to capital investments
Unless Kroger can sustain its elevated levels of investment for a while, it seems only natural that the one-off boost to sales and earnings will fade sooner rather than later.
My belief has only been strengthened by a review of the latest changes in S&P 500 earnings per share (EPS) estimates. According to FactSet, Q1 2019 saw the largest decline in EPS estimates following a 5.4% rise in Q1 2018.
Comparisons with 2001
The inevitable consequence of a sudden drop-off in investment in the face of unbridled optimism brings back memories of 2001. Back then, lower tech investment in the aftermath of the dot com boom triggered a protracted slowdown in investment. 2019 feels a lot like 2000, but it is unlikely to be turn out the same. After all, history does not repeat; it rhymes.
One of the key differences today is corporate debt, which is orders of magnitude higher today than it was in 2000 and 2001. As a percentage of GDP, it has now far exceeded the record levels seen in 2008 and 2001.
Furthermore, exceedingly loose monetary policy by central banks has led to system-wide capital misallocation, to a degree we have never witnessed at any point in history. Malinvestment, which used to be concentrated in the tech sector, is not only orders of magnitude higher than 2000, but it has also seeped throughout the economy.
Record debt and malinvestment levels are a recipe for disaster. The combination distorts incentives in a way we have never seen before, and when the tide finally runs out, we could be set for a mass run for cash. Leverage works both ways, and what juiced corporate EPS to record levels could also result in a disproportionately large downside when tightening inevitably arrives.
Unfortunately, the threat of over-financialization seems to be at the back of market participants' minds as the market has roared on regardless.
The normalization of corporate investments by the likes of Kroger might just be the trigger for a long overdue re-balancing. Unlike 2001, the problem is not limited to the tech sector, and we are likely to see corporates across the board cut buybacks and investment in a downturn.
No safe haven in equity
As the excesses of the last decade have seeped into the entire system, traditionally defensive stocks such as consumer staples may not be the safe haven they used to be. Most consumer staples companies have now been forced into an investment race to the bottom, competing against the likes of Amazon (AMZN). When the taps dry, these defensives will suffer as well.
In the past, staples were high margin businesses with safe and sustainable cash flows. This time, however, is different. Thanks to activists, many consumer staples now employ leverage to fund their investment programs, which has increased their exposure to an inevitable tightening. The case of Kraft Heinz, led by the likes of 3G and Berkshire (NYSE:BRK.A), is but one infamous case study. Since then, Unilever (NYSE:UL) (NYSE:UN) and Nestlé (OTCPK:NSRGY) have been pressured into similar moves.
These companies now operate in an environment where brand recognition counts for little, and pricing power has largely eroded. When the downturn comes, these ostensibly defensive companies, suffering from the double whammy of both earnings and debt pressure, will have to cut investments, buybacks, and revert to cash to shore up a weakened balance sheet.
Even worse is the latest generation of VC-funded companies (Uber (NYSE:UBER), Lyft (NASDAQ:LYFT), We Company) which continually burn cash in pursuit of growth. These 'zombie' companies have little regard for profits, instead relying on excessive levels of debt and equity funding to fund their investments. Over-financialization is everywhere around us, and the last place you'd want to be in a downturn is tech.
Not that all is guaranteed to be doom and gloom. I have considered the other side of the argument here, and whether or not we slip into a long, drawn-out investment slowdown, in my mind, depends on developments in the US corporate sector. If corporates can sustain their funding levels in light of a temporary tightening once the tax reform boost normalizes over the course of the next year or so, further easing by the Fed should kick the can down the road for yet another day.
Unfortunately, I fear central banks have gotten themselves into a precarious position, such that they simply cannot afford to return to normal monetary conditions. This does not change the dire corporate situation, which has become increasingly dire. Eventually, the day will come when corporates have to bite the bullet and delever, and when that day comes, an investment slowdown awaits.
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.