Toby Birch

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By Toby Birch September 2005 TTG Newsletter

Our personal planning and that of many large financial institutions is full of broad assumptions. Time and again we are caught out by widely held beliefs that are subject to small print that no one reads until after the event. One classic example was in 1998 where everyone assumed that Russia's burgeoning levels of debt were guaranteed by the International Monetary Fund. This proved not be the case and shell shocked investors woke up one day to find that government bonds with a face value of $100 a few weeks before were suddenly worth less than $30.

It is fair to say that consumers, governments and many investment funds have had a great party on the back of borrowed money. Sadly, the intoxicating flow of ready cash is coming to an end through higher interest rates and the hangover is as inevitable as the dawn of the following day. However, there has been one group of party poopers during this orgy of debt. They come in the form of finance directors who hold the corporate coffers of large companies. A good example of the difference in their behaviour compared to consumers can be seen with Telecom companies since 2000. When the Internet boom was in full swing third generation mobile telephone licenses were being sold by European governments to Telecom companies for many billions of Pounds or Euros. A few research reports at the time pointed out the ridiculous mathematics required to break even on these licenses but the companies still went ahead. In some cases, they paid more money for these licenses than their own stock market value just two years later once their shares had collapsed. Having got themselves swamped in debt, they were in no mood to join in the easy money party hosted by American Central Bankers. The last five years have been a period of healing for many organisations that took on too many staff and bought too much worthless technology at just the wrong time. Such is the nature of herd following behaviour. Once bitten, twice shy has become their motto having been caught once too often in the collective madness of a fake gold strike. They have since been encouraged to invest and to create more jobs. They have also been given tax breaks to do so. However, all of these inducements to let loose the purse strings have once again been in vain.

Companies have been using better conditions and earnings to pay down and reduce their debt. Much like the balance sheet repairs carried out by banks in the aftermath of the Savings & Loans crisis, mainstream companies have carried out the same exercise. One piece of evidence for this is that yields on corporate bonds have been falling such that there is little differentiation in return between a top quality government bond and a large company. The 'so what' of this conservative corporate approach is that anyone expecting them to launch into an investment binge like that seen in the late '90s is likely to be disappointed. And yet it has never been easier for them to raise money as borrowing costs are low and investors are begging them to issue more debt to satisfy their hunger for yield. However, this reluctance to borrow is entirely logical as companies understand that much like property price rises, the consumer binge is likewise unsustainable. There is therefore no point in investing to produce more capacity in a declining economy because the return on investment will dwindle.

This is where the Multiplier effect turns mean. Corporate planners will be scaling back their investment plans and therefore do not require more employees. However, employment growth is the prop for income and hence ongoing consumption. This looks hideously like a vicious circle in the making where one negative factor begets another. If you need a worked example then all one need do is look at the state of the Japanese economy since the stock market peaked back in 1989.