This is both strange and unpleasant. It’s strange because companies should often be net demanders of savings, not suppliers. And it’s unpleasant, because their reluctance to spending is depressing growth and employment. For this reason, the corporate sector’s financial surplus is the counterpart – and I would say the cause – of the government’s large deficit.
This matters for investors. Since 1992, there has been a strong correlation (minus 0.8) between companies’ financial balance and the price-earnings ratio on non-financial shares. A financial surplus has been associated with low equity ratings, and a deficit with high ones. For example, as companies began to invest more than they saved in the late 90s and the financial balance moved into deficit, PE ratios rose. They then fell steadily during the 00s as companies built up increasing surpluses.
This correlation probably does not reflect direct causality from one to the other. Yes, in theory low share prices should depress capital spending by raising the cost of finance. But in practice, capital spending has only rarely been financed by share issues.
Instead, the correlation reflects the fact that a financial surplus and low share prices are caused by the same things. Uncertainty and pessimism depress both share prices and firms’ capital spending.
It’s tempting to blame both of these upon the recession. This would be only partly true. The PE ratio has been below its post-1988 average since 2004, and firms have been running a financial surplus since 2002 – long before the recession.
What’s going on, then, is more than just a recession and weak sentiment.
Instead, low equity ratings and companies’ financial surplus are both symptoms of a longer-term problem. Capital spending and share prices have both been depressed by a dearth of monetizable investment opportunities and a slowdown in technical progress, both of which mean that firms and investors are pessimistic about longer-term growth prospects. The fact that speculative stocks today are not so much technology stocks as mining companies - businesses that our Victorian forefathers would have recognized (and avoided!) – tells us much about longer-term expectations.
But is the slowdown in technical progress and lack of investment opportunities temporary or permanent? We cannot know for sure, because technical progress is inherently unforeseeable; as Humphrey Lyttleton once said, “Madam, if I knew where jazz was heading, I’d be there already.”
Herein, though, lies a little reason for optimism. In the last few months, not only have PE ratios risen, but firms financial surplus has fallen; last year, it was 1.9 per cent of GDP, its lowest since 2002. This could be a sign that both firms and investors think our medium-term stagnation might be coming to an end.
Sceptics will say this might be due to irrational animal spirits rather than to a genuine improvement in our prospects. But I’m not sure the distinction is so sharp. It’s possible that increased confidence proves self-fulfilling, as it causes increased investment which in turn raises growth expectations further.
