U.S. Corporate Flow of Funds in Fourth-Quarter 2013: Equity Valuations Surge As Capital Expenditures Lag

Credit Trends:
U.S. Corporate Flow Of Funds In Fourth-Quarter 2013: Equity Valuations Surge As Capital Expenditures Lag
Global Fixed Income Research: Diane Vazza, Managing Director, New York (1) 212-438-2760; diane.vazza@standardandpoors.com Evan M Gunter, Associate Director, New York (1) 212-438-6412; evan.gunter@standardandpoors.com Research Contributor: Aniket Sakhare, CRISIL Global Analytical Center, an S&P affiliate, Mumbai
Table Of Contents
Despite A Rise In Capex, The Financing Gap Remained Negative For The Fifth Consecutive Year Market Capitalization Surpasses Corporate Net Worth For The First Time Since 2002 Corporate Funding From The Financial Markets Who's Buying Corporate Bonds? Related Research
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Credit Trends:
U.S. Corporate Flow Of Funds In Fourth-Quarter 2013: Equity Valuations Surge As Capital Expenditures Lag
According to the Federal Reserve's Z.1 Financial Accounts of the United States report, U.S. companies continued to recover in fourth-quarter 2013 as profits rose and corporate valuations grew. After an agreement was reached to lift the federal debt ceiling in October, the credit markets opened up. Total debt for the nonfinancial sector (including corporate, government, and household sectors) expanded at a 5.4% annualized rate as a surge of Treasury securities came to market while corporate borrowing remained brisk. With rising profits, companies generated substantial internal funds that exceeded reinvestment for the fifth consecutive year. As the S&P 500 closed 2013 at a record high, the Tobin's Q ratio of market capitalization to corporate net worth (at market value) exceeded 100% for the first time since first-quarter 2002. While U.S. corporate profits and net worth have recovered from the Great Recession, we're beginning to see some potential instabilities emerge, as capital expenditures (capex) have lagged profit growth and companies' equity valuations have begun to exceed their net worth. Key Takeaways While the net worth of U.S. companies continues to climb, substantial equity gains in 2013 have lifted the total market capitalization of U.S. companies above the replacement value of their assets. This is the first time since the dot-com bust in 2002 that Tobin's Q ratio of equity value to net worth (based on market value) has surpassed 100%. Since the Great Recession, companies' capital expenditures have lagged their profits and internally generated funds. 2013 marked the first time that the financing gap had remained negative for five consecutive years. As corporate bond yields remain below their historical averages, companies have increasingly shifted more of their funding to bonds from equity and loans.
Nonfinancial company profits rose 2% in the fourth quarter, reaching a new high of $1.37 trillion (annualized), and are up 4% compared with fourth-quarter 2012. Meanwhile, nonfinancial corporate debt grew at a rate of 9% in 2013 to $9.4 trillion. As a share of GDP, corporate profits held steady at 8%, while corporate debt outstanding climbed to 55% (see chart 1).
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Credit Trends: U.S. Corporate Flow Of Funds In Fourth-Quarter 2013: Equity Valuations Surge As Capital Expenditures Lag
Chart 1
Despite A Rise In Capex, The Financing Gap Remained Negative For The Fifth Consecutive Year
Companies' investments in productive assets continue to climb in nominal terms, though the level of corporate investment has lagged profit growth. Capital spending (or investments in property, plant, and equipment) rose 4.7% in 2013 to $1.56 trillion (see chart 2). Capex has been steadily rising over the past five years, after bottoming out at $1.0 trillion in 2009, and is now above its pre-recession high. Capex fell by 26% in 2009 and spending fell short of even covering the year's expected capital consumption. Despite the increase in capex over the ensuing years, companies are still investing at a level that is below their historical average when compared with internal funding. Since 1952, companies as a whole typically invested more money than they made in a given year. To measure this we look at the financing gap, which shows capex less the sum of U.S. internal funds (profits plus depreciation and inventory adjustment minus dividends). Since 1946, the financing gap has periodically turned negative, but 2013 marked the first time that the financing gap
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remained negative for five straight years (see chart 3). The longest previous period when the financing gap remained negative for an extended amount of time was the four years from 1961-1964. The financing gap was at -$133.9 billion for 2013, and over the past five years companies have generated nearly $975 billion more in internal funds than they have reinvested. With companies generating more internal funds than they are reinvesting, their financial assets have expanded. Since 2009, corporate financial assets (excluding miscellaneous assets) have grown by $738 billion. Meanwhile, this buildup of financial assets could potentially provide the fuel for a sudden surge in investments or mergers and acquisitions (M&A) should businesses expect a significant increase in demand. In its March 2014 Business Outlook Survey, the Federal Reserve Bank of Philadelphia reported that 48.6% of companies surveyed said that they planned to increase capex spending in 2014.
Chart 2
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Chart 3
Market Capitalization Surpasses Corporate Net Worth For The First Time Since 2002
The net worth of nonfinancial corporates (with assets at market value) climbed 2.3% in the fourth quarter to reach a new high of $20 trillion, and is now up 11% from the year ago period (see chart 4). Meanwhile, corporate net worth as a percentage of GDP is also regaining ground it lost during the recession. Corporate net worth (at market value) is 117% of GDP, up from 110% in the year prior. However, this is still shy of the 127% peak we saw before the recession. Much of the gains in corporate net worth stem from the appreciation of corporate real estate and the growth of financial assets, particularly miscellaneous assets, as corporate profits increased for the year.
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Chart 4
Despite the gain in companies' asset values, their equity values increased even more sharply as the stock market gained. For the first time since the bursting of the dot-com bubble in 2002, Tobin's Q ratio exceeded 100%. The Tobin's Q ratio compares companies' market capitalization with their net worth (at market value), essentially comparing the value of a company's stock to the replacement costs of its assets. Ideally, this figure should be near 100%. If the ratio is greater than 100%, the market values the aggregate equity of a group of companies more highly than it values the aggregate assets of those companies. Tobin's Q climbed to 106.6% in the fourth quarter from 99.9% in the third (see chart 5). During the run-up to the tech-bubble, Tobin's Q provided several warning signs that equity valuations were too far removed from asset valuations. This ratio surpassed 100% for the first time in its history in 1995, and remained above 100%, for the most part, until the dot-com bubble burst in 2002. At the height of the bubble, Tobin's Q reached the unparalleled height of 164% (first-quarter 2000). While the ratio's rise in fourth-quarter 2013 is something to take note of, it still remains far short of the highs we saw during the tech bubble.
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Chart 5
In contrast to equity valuations, one of the key drivers of the increase in corporate net worth (by market value) is the rebounding market for corporate real estate. Corporate real estate assets (at market value) grew by $1 trillion over the past year. However, using an alternative measure (with assets valued based on their historical cost instead of at market value), net worth climbed 2.0% in the fourth quarter to $14 trillion. Though this also marks a new high, it is considerably lower than the net worth of companies at market value. The primary difference between these two measures is that the market value of corporate real estate assets is considerably higher than the historical cost. As real estate assets can have an especially long life on a company's balance sheet, their market value shows their significant appreciation over time. While the market value of corporate real estate has increased sharply since 2009, the historical value of firms' real estate assets has increased more gradually. At $9.95 trillion in fourth-quarter 2013, the market value of corporate real estate has almost completely rebounded from the recession. Over this same period, net worth at market value has risen 43% while net worth at historical cost has risen 32%. While corporate assets have increased, liabilities, particularly in the form of credit market debt, have expanded as well.
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Outstanding credit market debt has increased by about 9% over the past year (and by 2% over the prior quarter) to $9.44 trillion (see table 1). Most of the growth in credit market debt is in the form of corporate bonds. The value of bonds outstanding increased 3% during the quarter, and 11% year-over-year, to $6.4 trillion. The share of debt relative to the net worth of companies (by net worth at market value) was nearly unchanged from the prior quarter at 47.1%. However, over the past year the ratio of debt to net worth has fallen by a full percentage point as the value of assets has risen more quickly than liabilities. The debt-to-equity measure of U.S. companies fell in the fourth quarter as the equity market continued to rise. Total market capitalization rose 9% in the fourth quarter to $21.4 trillion. With this increase in market capitalization, the debt-to-equity measure declined to 44% from 47%. At its current level, the debt-to-equity ratio remains near its average of 46% since 1990.
Table 1
Balance Sheet Trends For Nonfinancial Corporates

Nonfinancial corporate business trends (Bil. $) Total debt Corporate bonds Total financial assets Total liquid assets Net worth Market value Historical cost Market capitalization Financial ratios (%) Debt/net worth (market value) Debt/net worth (historical cost) Market cap/net worth (market value) Debt/equity (market cap) Liquid assets/short-term liabilities 47.7 65.5 93.4 51.1 46.7 47.8 65.4 89.2 53.6 46.1 47.4 65.6 91.9 51.6 46.8 48.1 66.5 89.2 53.9 47.4 48.0 66.1 98.6 48.7 47.5 47.6 66.5 96.8 49.2 47.1 47.3 66.5 99.9 47.3 48.7 47.1 66.4 106.6 44.2 50.7 16,996.0 17,252.4 17,806.8 18,060.5 18,413.2 18,999.9 19,582.5 20,034.0 12,386.2 12,612.3 12,868.9 13,054.9 13,359.2 13,603.7 13,937.0 14,216.1 15,873.6 15,387.1 16,366.8 16,107.0 18,149.1 18,383.0 19,569.1 21,363.1 2012Q1 2012Q2 2012Q3 2012Q4 2013Q1 2013Q2 2013Q3 2013Q4 8,113.4 5,346.4 8,247.2 5,452.9 8,440.9 5,599.7 8,685.9 5,795.2 8,832.5 5,940.0 9,052.6 6,082.7 9,263.9 6,269.0 9,441.5 6,435.5
14,787.0 15,008.2 15,277.1 15,500.8 15,765.6 16,026.6 16,380.8 16,731.5 1,646.5 1,655.2 1,719.2 1,764.0 1,788.7 1,811.3 1,905.9 1,984.0
Sources: The U.S. Federal Reserve and Standard & Poors Global Fixed Income Research.
Corporate Funding From The Financial Markets

Bonds have risen as a share of total credit market borrowing by nonfinancial companies since fourth-quarter 2008 as falling interest rates and quantitative easing have lowered the long-term cost of funding. As corporate bond yields have remained low, companies have actively refinanced and issued new debt to lock-in relatively low-cost financing. In contrast to bonds, loan financing is much more likely to have floating interest rates, and thus we've seen companies shift more of their financing to bonds. During this time, depository institution loans and other loans have fallen as a share of total nonfinancial corporate debt outstanding to 18.1% from 28.6%, while bonds have grown to 68% from 52% (see chart 6).
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Chart 6
Investor demand for leveraged loans has increased this year, but during the fourth quarter companies repaid more loans than they issued. Debt outstanding from other loans and advances contracted by $8.7 billion in the fourth quarter. In contrast, depository loans outstanding grew by $26.3 billion in the fourth quarter. Over the past year, debt outstanding from depository loans and other loans and advances to nonfinancial corporates has grown by 4% or $65.7 billion, considerably less than the 11% ($640 billion) growth in corporate bonds outstanding. Credit market borrowing was positive for the year at $782.5 billion. Though companies have increased their funding from the credit market, they returned more money to the equity markets than they raised. Equity funding was negative for the year at -$383.7 billion as buybacks and acquisitions outpaced new issuance (see chart 7). Net equity issuance has been negative each quarter since third-quarter 2009.
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Chart 7
Who's Buying Corporate Bonds?

In 2013 U.S. companies issued $1.08 trillion in new bonds (including rated and unrated issuance). Adjusting for debt that was refinanced or otherwise retired, corporate bond debt grew by $666.8 billion from nonfinancial and financial companies, and from foreign issues purchased by U.S. residents. Most of the new bond debt ($640.3 billion) came from nonfinancial corporate issuers, while the financial sector retired $103.1 billion more than they issued (see table 2). Mutual funds, foreign buyers, and households purchased most the new issuance in 2013. U.S. households were net sellers of corporate and foreign bonds in the first half of the year, though their purchases increased substantially in the fourth quarter. At an annualized rate, U.S. households purchased the equivalent of $418 billion in corporate and foreign bonds in fourth-quarter 2013, even surpassing mutual fund purchases. For the year as a whole, mutual funds were the biggest buyers of corporate bonds at $318.2 billion, or nearly half of the net amount issued by nonfinancial corporates.
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Table 2
Who's Buying Corporate And Foreign Bonds?

(Bil. $) Net purchases Households Government Rest of world Banks (including credit unions) Insurance cos. Pension and retirement funds (public and private) Mutual funds (including MMF and ETF) Other financial institutions Net purchases Net issues Financial sectors Rest of world Nonfinancial corporate business Total net issues (281.9) (158.8) 225.4 (215.3) (586.0) 163.3 411.7 (11.0) (575.2) 59.9 438.6 (76.7) (325.8) 137.7 410.8 222.7 (209.6) 62.2 579.6 432.2 (103.1) 129.6 640.3 666.8 (162.7) (5.6) (21.8) (39.3) (60.9) 24.4 (90.0) 140.7 (215.3) 75.1 3.9 (127.3) (137.8) 128.4 (116.8) 119.4 44.1 (11.0) (319.2) 7.7 (36.8) (124.7) 127.3 89.3 129.5 50.3 (76.7) 132.3 (4.1) (109.9) 4.3 127.5 21.2 152.5 (101.1) 222.7 98.2 (9.6) (16.9) (6.2) 50.0 (105.7) 358.1 64.2 432.2 104.3 1.2 191.5 (16.3) 57.9 (4.5) 318.2 14.5 666.8 2008 2009 2010 2011 2012 2013
Notes: Seasonally adjusted annual rates. MMF--Money market mutual funds. Sources: The U.S. Federal Reserve and Standard & Poors Global Fixed Income Research.
Related Research
After Several Years Of Steady Decline, U.S. Household Leverage Is Showing Signs Of Increasing Again, April 10, 2014 Credit Trends: Global Corporate New Bond Issuance Slowed In February, Totaling $222 Billion, March 20, 2014
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U.S. Corporate Flow of Funds in Fourth-Quarter 2013: Equity Valuations Surge As Capital Expenditures Lag

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Balance Sheet Trends For Nonfinancial Corporates

Corporate Funding From The Financial Markets

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Who's Buying Corporate Bonds?

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Who's Buying Corporate And Foreign Bonds?

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