BIG, deep, sophisticated, flexible:
America’s financial markets are the envy of the world. For how much longer?
Consider the mighty Treasury-bond market. This is the world’s biggest thanks
mainly to the government’s persistent inability to balance the books. But now the
Treasury is raking in huge surpluses; Bill Clinton has even claimed that the
government might pay off its debt by 2015. What on earth would bond
arbitrageurs do then? Thank heavens, there are plenty of reasons to doubt
Mr Clinton’s forecast. As other countries have found, surpluses have a
magical way of disappearing as soon as the politicians get to know about
them (see article).
Yet if America’s Treasury-bond market will not, after all, disappear, might
its stockmarket? America seems to be running out of shares. That may
seem surprising: what about all those extravagantly priced Internet offers?
They are small beer. Taken as a whole, American companies are now
buying back as much as 2% of their outstanding equity every year. If that
trend persists, in 50 years’ time there would be two-thirds fewer shares
than there are now; and 100 years from now, corporate America would be
financed almost entirely by debt.
A century may be rather longer than the average investor’s time horizon.
However, the trend matters today. On the face of it, corporate America is
hugely profitable: the latest quarterly earnings reports, starting this week,
will probably be pretty good. But they should be treated with caution. If
American companies continue to buy back their own shares, anything that
uses them as a denominator—such as earnings-per-share, or return on
equity—will automatically rise, even if underlying profits are unchanged.
Moreover, buying back shares by issuing more debt means that corporate
America is becoming ever more exposed to risk. Their ability to borrow so
much has a lot to do with lenders’ astonishingly generous attitudes to
companies with apparently over-extended balance sheets. Yet even this
does not solve the fundamental riddle: why would companies buy
something that is as dear just now as their own shares? With equity as
cheap to raise as it is, and interest rates threatening to rise, it might make
more sense to be selling shares rather than buying them.
The answer to the riddle might lie in an innovation that has often been
touted as a saviour of modern American capitalism, but could yet turn out
to be a false prophet: share options. These were supposed to align the
interests of companies’ managers with those of shareholders by
concentrating managers’ minds on profitability. They have not quite
worked out that way. Instead, many bosses have responded, entirely
rationally, by trying to sweat as much return in as short a time as they can
manage from as little equity as possible. In other words, stock options
have created a huge incentive for firms’ managers to borrow in order to
buy back equity—which is not at all the same as looking after
shareholders’ long-term interests.
As well as raising fundamental questions about the ownership of companies
in the long term, corporate America’s growing debt raises concerns about
their health in the short term. Clearly, inadequate leverage is bad for
shareholders, for too much equity leads to meagre returns. But too little
equity could also threaten a company’s solvency when the economy sours.
No doubt America’s ever-sophisticated financial markets will be ready to
pick up the pieces.