A significant article was buried in the back of the Wall Street Journal on Saturday about how, according to the latest Fed Funds Flows release, cash flows generated by corporations are drying up.
One of the most enduring justifications for the current credit boom has been the idea that corporations continue to sit on healthy cash hoards. Robust cash flows, the thinking goes, help hold down the risk of default and imbue bond investors with the confidence that even their riskier holdings will hold up, at least in the short term.
But the underlying assumption that companies remain awash in cash may be eroding, and without many investors realizing it. The most recent flow-of-funds data released by the Federal Reserve shows that free cash flow in the nonfinancial corporate sector plummeted late last year, according to Dominic Konstam, head of rates research at Credit Suisse. As credit spreads show signs of inching upward, a ramping up of corporate leverage at a time when cash is flowing to share buybacks could send bond spreads surging higher.
Free cash flow, calculated as internal funds less capital spending and buybacks, typically runs slightly negative and at most reaches about 2% of gross domestic product, according to Mr. Konstam. In the most recent flow of funds report, however, that figure plummeted to minus 5% of GDP, about as low as Mr. Konstam said he has ever seen it.
"I think it's alarming, and I think a lot of people are unaware," Mr. Konstam said.
The major culprit, Mr. Konstam said, is share buybacks. As risk premiums, or spreads over Treasurys, for corporate bonds hover near historic lows, companies have been able to borrow money at unusually low-cost interest rates. Many companies have then used their cash borrowings to repurchase stock shares, boosting the value of remaining shares. With this surge in buybacks, Mr. Konstam said, earnings growth has not been able to keep pace.
"Weak cash flow historically is not sustainable," Mr. Konstam said. "Either earnings must go up or investment or buybacks down."
In fact, corporate investment poses another major concern, according to Tom Higgins, chief economist at Payden & Rygel. Mr. Higgins noted that companies are increasingly turning their backs on capital investment at a time when profits are peaking.
Given the general health of corporate credit, Mr. Konstam said that deteriorating cash flow is unlikely to produce sudden, catastrophic effects such as those seen when funding dried up in the subprime lending sector. Instead, he predicted a steady widening of spreads, one that he says has already begun.
As we recently pointed out, total yield of the market is high by historical standards. However, corporations cannot borrow to buy back shares forever. At some point, companies must generate enough cash to retire shares. If not, the buybacks will stop.
I cannot ignore the near-term strength. Though a pull-back may be coming, I think we're going to see higher highs some time over the next few months. But I do think the sell-off last month was a warning, and sometime in the not too distant future, you will want to be out of stocks. This is another reason why.
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