Juggling Dynamite

Thirty years of progressively higher consumer spending and debt have coincided with rising corporate profits, low savings rates, gambling preoccupation and boom-bust asset cycles.  All were deleterious to present resilience as we encounter the first economic depression since the 1930s.  Case in point:  a decade long economic expansion, with record corporate profits and rock-bottom unemployment and interest rates, ended this year with the majority of households and businesses unable to withstand even a month of lost income.

Financial discipline is deficit just as expected returns for most investable assets are nil to negative and further capital losses untenable.  Adding more household debt and risky assets at extreme valuations to try and reboot spending will not work this time.  That trick is done.  The last decade was all about boosting the income statement at all costs the next will be all about improving balance sheets.  This is an entirely different way of thinking.

The way forward dictates spending less, paying down debt and building up savings again.  Frugality and proactive measures are coming back in vogue.  For the economy overall, this means lower spending from the consumption sector that has driven about 60% of Canadian and 70% of US GDP over the last two decades.

It also suggests a secular downturn in sales and profits for most businesses (always reliably mean-reverting through history) with a reduction in debt, share buybacks, dividend payout ratios and a laser focus on improving efficiency and productivity.

Governments will have to pick up on spending as the private sector rebuilds its balance sheets.  But what we spend on will make all of the difference in the world.  Spending to fund consumption or elongate dying business models will not cut it.  Tax dollars will need to be invested in big picture improvements, infrastructure and innovation that will reduce waste and illness, increase health and productivity–New (Green) Deal thinking, not old.

To pay for all of this, tax rates are headed up across the board and blood doesn’t come from stones.  Those who have income and property will be tapped to pay the lion’s share, obviously, while consumption taxes will move higher for everyone.  It’s just the math of it.  There is no government benefactor, there’s only us.

In the decade of the 1930s, corporate and capital gain tax rates nearly doubled while personal income tax rates rose about 150%.   We should expect similar trends ahead, along with a tightening of loopholes and reinvigorated prosecution of tax evaders and their helpers.  This is long overdue.  Our next war effort has arrived.

As I have mentioned many times, in recent years public corporations have squandered trillions in cash on stock buybacks (deemed illegal until 1982) at the expense of their balance sheet strength and cash reserves for unexpected events (which always happen).

Adding insult to injury, in many cases, the companies took on imprudent levels of debt to pay for said buybacks.  In this way, short-term ‘activist’ shareholders, including company executives and board members, were enriched by dividends and pushing up share prices at the expense of the company’s longer-term stability and resilience.  And then came COVID-19.

Now cash deficits, debt weight, and a sudden stop/loss of cash flow are, not surprisingly, proving financially fatal for many businesses.  Notwithstanding mindboggling taxpayer support and ongoing re-opening efforts, the largest wave of bankruptcies in many years is already in motion.

The plot thickens because when a company enters bankruptcy proceedings, cash that was used for previous share buybacks may be clawed back as a fraudulent transfer and the directors who authorized the transactions can be held liable for a breach of their fiduciary duty to shareholders, creditors and employee pension plans.  See Are recipients of stock buybacks the next time bomb for bankruptcy clawbacks?

The results of all of this create a precarious position not only for corporate shareholders that received cash in exchange for the stock buybacks, but also for members of boards of directors that have authorized the stock buybacks. If these entities were to need to seek bankruptcy court protection, the shareholders who were the recipients of stock buyback cash which left the corporate entities cash poor once the economic slowdown hit can easily become the targets of claw back actions to recover the cash paid for the stock buybacks.

Additionally, non-bankruptcy courts have held that members of boards of directors have certain fiduciary duties to shareholders and creditors. It remains to be seen whether in light of the economic slowdown created by the pandemic crisis, members of boards of directors who authorized stock buybacks will be held to have breached their fiduciary duty in authorizing the stock buybacks. If this is the case, it could lead to a proliferation of D and O claims against the directors and their insurers.

Nothing sobers up business people and shareholders like cash clawbacks and personal liability suits.  The executives who sold their personal shares into the buyback flow they were directing on behalf of the corporations should be particularly vulnerable here.

This is the type of accountability needed to re-orient thinking and policies toward prudent balance sheet management and away from enriching ‘activist’ short-sighted shareholders ahead of, and at the expense of, the enterprise, its employees, creditors, long-term investors and taxpayers.

Investors are supposed to be at the back of the payment line bearing financial risk for the possibility of longer-term rewards.  It’s called capitalism.

Some important observations in this segment.

Hedgeye President Michael Blum presented a nuanced look at how various governments around the globe have approached their respective Covid-19 lockdown policies so far. And, more importantly, what their plans are going forward. Blum also offers interesting insight on whether the United States’ pandemic path may resemble that of Sweden.  Here is a direct video link.