Eating The Seed Corn-----The Fed's Calamitous Corruption Of Corporate Finance

Central bank financial repression results in the systematic and severe mispricing of financial assets. And that has sweeping consequences far beyond the munificent windfalls it bestows on the thin slice of mankind that frequents the casinos of Wall Street, London, Tokyo and Shanghai.

The fact is, the prices of money, debt, equity, traded commodities and all their derivatives comprise a vast and instantaneous signaling system that cascades through every nook and cranny of the real economy. When these signals are systematically falsified by a few dozen central bankers they cause hundreds of millions of ordinary businessmen, workers, investors and entrepreneurs to alter their economic calculus.

And not in a good way. False signals lead to mistakes, excesses, losses and waste. They ultimately reduce economic efficiency and productivity and lower the rate of economic growth and real wealth gains.

Since the Greenspan age of financial repression incepted in the late 1980s, for example, the returns to savings have been obliterated while the rewards for speculation have soared. That's important because only savings from current production and income generate additional primary capital that can foster future wealth. By contrast, leveraged speculation merely causes existing financial assets to be re-priced and a temporary redistribution of paper wealth from the cautious to the gamblers.

In an honest free market, in fact, there is no excess return to leveraged speculation at all. Natural market makers arbitrage out the spread between the costs of carry and the returns to carried assets such as long-dated futures contracts, term debt and various and sundry forms of equity and other risk assets. A relative handful of market makers can make a decent living arbing an honest market, but the mass of investors can not speculate their way to wealth. The latter can happen only when the central bank has its big fat thumb on the financial scales, pressing the cost of carry----that is, leveraged financial gambling----toward the zero bound.

It is not surprising, therefore, that the household savings rate went into a secular free fall after 1987. But even the standard graph on the personal savings rate does not tell the full story---notwithstanding its decline from a 11% average between 1955 and 1987 to less than 5% during most of the post-2000 period.

The skunk in the woodpile is that the baby boom was reaching its peak earnings years after 1987, and its savings rate should have been going up in preparation for the long grey twilight of generational retirement. So the economic impact of the Fed's war on savers reaches way beyond the GDP reckoning for the current quarter or year.

It has caused more than half the household population to not save at all, and they are entirely rational in doing so. The after-tax and after-inflation return on liquid savings of a median household saving 10% of its income is $8 per year. And even after 30 years of thrift at the same rate, the annual return would amount to 60 cents per day!

So, implicitly, a large share of the public has concluded that the rational course of action is to fall back on the state's safety net and disability insurance when confronted with adversity during their working years and social security and Medicare during retirement. Moreover, the adverse consequences of that social default are further compounded by financial repression.

Under even optimistic economic and demographic assumptions, the unfunded liability for social security, federal retirement and Medicare is upwards of $100 trillion on a 75- year basis. That huge number is often dismissed as a factoid from deep space, but the more practical way to look at it is that the social insurance system is a ticking time bomb. Each and every year, solemn promises are being made to the non-saving working age population that raise the cost of the system by upwards of $5 trillion more than current tax rates will generate.

So, yes, future generations will handle it one way or another-----and that will mainly mean dramatically higher tax rates as far as they eye can see. Yet this is where central bank financial repression rears its ugly head. In an honest free market, a nation accruing $5 trillion per year in off-balance sheet liabilities would experience the wonders of "price discovery".

To wit, interest rates would rise to account for the evident risk of future fiscal failure. But not under the current regime of massive financial repression, where even today Uncle Sam can borrow 1-year money at 21 bps and 3-year funds at 85 bps.

All told, the weighted average cost of the $18 trillion of on-budget public debt is less than 2%. That is far below an honest economic price on even the acknowledged public debt; it doesn't even begin to account for the present value of the fiscal risk being built by an entitlement state where half the citizens do not save and none of the citizens are willing to curtail the  benefit promises or raise the taxes needed to accumulate the necessary reserves.

And that gets to the 10% of households which own 80% of the financial assets and nearly as large a share of the residential real estate assets (by market value, not units). Since Greenspan's arrival at the Eccles Building, the market value of household financial assets has risen from $11 trillion to $68 trillion. That's a 7% annualized gain, and upwards of 5% after adjustment for the annual gain in the GDP deflator over the same period.

Folks, no way has the real productivity and output of the US economy grown at even close to the rate over the last 27 years. In fact, even if you credit the Washington statistical mills' chronic under-measurement of inflation, real GDP has risen by only 2.5% annually since 1987.

In short, there has been a whole lot of financial asset inflation going on. Owing to deep and sustained financial repression, cap rates have been driven toward the zero bound, meaning that asset values and PE ratios have been inflated by equal proportion.

So the asset owning households did what the monetary politburo incentivized them to do------they piled into risk assets. And they were rewarded prodigiously. The broadest measure of the stock market, represented by the Wilshire 5000 index, is up 16X since 1987 or by a 11% compound annual rate.

Here's the problem, however. A full generation of financial repression has left financial assets drastically over-valued because at the same time that current capitalization rates and PE multiples were soaring, the main street economy was eating its own seed corn. That is, the false financial signals emanating from the financial markets were generating behavior in both the public and private sector that will drastically reduce the future growth potential of the US economy, and therefore the earnings capacity of the companies which comprise it.

As we have already seen, one source of that hit to future growth is the massive bow-wave of deferred taxes being generated by a welfare state economy which does not save. At the same time, the central banks' command to speculate instead of save is ripping a second hole in future growth potential. Namely, US corporations are consuming their own balance sheets in a spasm of financial engineering-----a process that is steadily reducing investments in productive assets and future growth.

In this case, the false signals end up in the C-suites where top executives have gorged on speculative winnings from stock options by plowing all of their cash flow, and massive borrowings to boot, into share repurchases, generous regular dividends and endless spasms of pointless M&A transactions that sooner or later are written off or lost in the fog of restructurings, spin-offs and other re-shuffles of corporate decks.

Altogether, upwards of $5 trillion of corporate cash flow and new borrowings have gone into stock buybacks and M&A deals since the 2008 financial crisis.

That reflects the fact that the stock market is completely broken and the buy-the-dips syndrome in place since March 2009 is exhibit #1. When traders are rewarded over and over and over for buying mini corrections of 1% to 3%, its evidence that price discovery has failed.

It is bad enough when its practiced by robo-traders, professional gamblers and Jim Cramer's pitiful home gamers. In practice, however, there is now an even more potent band of dip buyers. Namely, corporate CEOs and boards. The are taking absolutely foolhardy risks by leveraging up their balance sheets to engage in massive stock buybacks, but they do it for the same reason as ordinary Wall Street punters. Its working!

That is, it was working to artificially inflate stock prices and stock option values. But that is really just another indication that the false price signals generated by central bank financial repression are destroying corporate governance and business strategy management, as well. Just like the home gamers who buy on the dip with impunity, corporate executives and boards have been rewarded for the same behavior so persistently and powerfully that they are completely ignoring the damage to long-run growth and viability.

We have argued that IBM is the poster child for that syndrome. During the last ten years it has spent $150 billion on stock buybacks and dividends-------or nearly 120% of its net income. As a result, its debt has continued to soar. In essence, it is disgorging all of its net cash flow and impairing its balance sheet, too.

But in the last quarter or so, as Zero Hedge noted this morning, IBM has had to tamp back the buyout spigot drastically in order to preserve it credit rating. Yet once the buybacks stopped, IBM's stock price went south as well, and is now down 25% from its prior level.

IBM Chart

IBM data by YCharts



As Zero Hedge further noted regarding Viacom's shocking announcement yesterday, this is just the beginning:

Fast forward to yesterday afternoon, when Viacom revealed that as part of its "Strategic Realignment to Create Efficiencies and Drive Long-Term Growth" it would do something which the market loathes: it would stop its buybacks. Specifically it said that "Viacom will temporarily pause share purchases under its current $20 billion stock repurchase program in order to stay within its target leverage ratio."

What Viacom meant was that just like IBM, its net debt ratio had likewise soared in the past several years, and had reached a level where the Baa2/BBB-rated company was on the verge of being cut to junk status.

It was therefore not surprising that in order to "stay within its target leverage ratio" yet another major stock repurchaser was forced to give its primary share-price boosting strategy an indefinite break.

But is Viacom a harbinger for the broader market, a market which as we reported previously only, had a tremendous month of February only because of a record $100 billion in announced stock buybacks?

The answer is a resounding yes, because IBM and Viacom are not alone.

As Citigroup showed in a recent report, contrary to false and misleading reports of corporate deleveraging, median leverage for both Investment Grade companies and recent fallen angels is the highest it has ever been!

Yet by now the damage has already been done. Viacom operates in a fiercely competitive industry yet spent $27 billion on dividends and stock repurchases over the last 10 years compared to $17 billion of cumulative net income.

That's right. It distributed to shareholders 160% of what it earned by hocking its balance sheet. Accordingly, its debt went from $5 billion to $13 billion.

Needless to say, in an honest free market no Board or C-suite that did anything that stupid would have lasted more than a year or two-----even the mighty Sumner Redstone.

That's because Viacom's share price would never have artificially inflated by 2X during the course of its extended stock repurchase campaign when sales and profits were essentially flat. Stock investors in an honest market would have long ago voted "no" with their shares in the face of massive debt increases. Likewise, bond investors would have demanded higher and higher premiums.

In short, Viacom's  "eat the seed corn" strategy would not have led to the parallel march upward of both its debt level and stock price, as shown below. In an honest market, they likely would have gone in opposite directions since the borrowings amounted to nothing more than a mortgage on future earnings.
VIA Chart

VIA data by YCharts

So the falsified financial signals feed upon themselves. Debt which is already too cheap, even if used to acquire productive assets, is absurdly too cheap when it is used to essentially capture tommorrow's earnings and distribute them to shareholders today. At the same time, this works to further artificially inflate share prices in a buy-the-dips casino that is driven by the carry trade subsidies and safety net puts of the central bank. Consequently, the C-suite becomes even more incentivized to rinse and repeat these destructive financial  engineering exercises.

The proof is in the pudding. On an aggregate basis, US business have continued to pile on the net debt. At the same time, net investment is at a 20 year low.

Non Financial Business Net Debt- Click to enlarge

Non Financial Business Net Debt- Click to enlarge


In short, financial repression is a weapon of mass financial destruction. It is enabling a bow-wave of deferred taxation in the public sector and an orgy of seed corn liquidation in the business sector.

Both of those powerful trends suggest that the long-term outlook for profits is well less than stellar. Accordingly, cap rates and valuation multiples should be going down.

In due course they will.


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