The US subprime crisis ended one of the biggest bull markets to date but will it cause corporates to revert back to cash? Frances Maguire reports.

The recent US sub-prime crisis has, it seems, put an end to the bull run of the past four years, which was fuelled by the availability of cheap credit and buoyant market conditions. The cut in interest rates by the US Federal Reserve (Fed) brought a welcome respite to the world’s stock markets, though, enabling the FTSE index to recover after suffering its biggest slump since the bull market started in 2003.

Despite the action taken by the European Central Bank in August, the markets are expecting further short-term volatility and many hedge funds are understood to be sitting with as much as 40% of their funds in cash.

Watching cash positions

Lisa Rossi, head of liquidity management and US product management, global transaction banking – cash management at Deutsche Bank, says: “Since the end of July, we have been watching closely to see if our corporate clients would start to leave additional balances on account but, while we have seen a slight uptick, it has not been dramatic.” While liquidity is tight in the market, most of Deutsche Bank’s major clients in the US still are maintaining their cash position, she says, but they may not be utilising it in the same way.

“On the investment side of the business, Deutsche Bank offers end-of-day investment sweeps in the US and we are being asked extensively about our portfolio mix for our mutual fund offerings,” says Ms Rossi. “However, for the most part, our investment options are on the conservative side, which aligns with our clients’ requirements. Our clients’ funds are primarily associated with their operating cash position and that requires a more conservative investment strategy. The bank will continue to monitor the market. If the Fed lowers rates, we may see some further impact.”

Speaking at the Federal Reserve Bank of San Francisco Conference on the Asian Financial Crisis Revisited last month, governor Randall S Kroszner said: “The performance of firms heavily dependent upon external sources of funding is disproportionately negatively affected in deep financial systems during periods of banking crisis.” He said that the impact was more keenly felt on younger firms, with shorter histories, and firms with “a large fraction of hard-to-measure intangible assets” that may have particular difficulties raising funds from the market due to information problems.

Historic levels

Tim Scholefield, head of equity at Baring Asset Management (Barings), says that cash levels are already at historic high levels, dating back to the dot-com crash in 2000 and 2001, and they are unlikely to go higher. “Since the IT bubble burst, there has been a sustained move towards deleverage. For example, in the European corporate sector, certainly among larger companies, net debt to equity was about 60% on average in 2001-02. This has come down steadily to about 40% due to very strong economic growth.”

Also, after the dot-com bubble burst, there was quite a significant behavioural change among corporates, says Mr Scholefield. Corporates became much more disciplined in their use of cash.

“In simplistic terms, there was always a tendency to rush to invest and to acquire. Now, partly because of the experience of the IT bubble and also because of the rise of shareholder activism and more influence of shareholders, there is much more discipline in how cash is being put to work within the quoted sector. There is evidence of this in the overall structure of balance sheets,” he says.

So, according to Mr Scholefield, cash levels, and using balance sheet leverage as a proxy for that, are at very high levels by historic standards. There are good reasons for that, and ones that are likely to persist, he believes.

Two sectors where there are particularly high levels of cash are healthcare and IT, where it is common to find companies with no debt at all and significant cash sitting on their balance sheets, says Mr Scholefield. An example of this is Cisco, the US hardware company, which has about $20bn-$23bn of cash on its balance sheet, up from about $17bn last year.

“Cash levels are already very high and if you have a reasonably benign or constructed view of the outlook for global growth over the next 12 to 18 months, then it is hard to see why cash over the long term should go significantly higher,” he says.

One consequence of the subprime issue could be that central banks will ease monetary policy and, going by the money markets’ pricing for the next 12 months, it looks likely that the returns on cash will be less and so the cost of holding cash will start to rise.

“This suggests a downward pressure in terms of cash being on balance sheets. In Japan, interest rates are persistently low anyway, so cash is not the most productive of assets to have on the balance sheet,” says Mr Scholefield.

Shareholder concerns

Corporates with persistently large amounts of cash on their balance sheet are likely to prompt questions among shareholders because it is very visible and they are investing in companies to turn assets into earnings, and not to bank them indirectly through a company, says Mr Scholefield. “There is a need to have cash for all sorts of reasons – zero cash is not ideal – but having large amounts of cash sitting long-term on your balance sheet is certainly questionable.”

Research has shown a direct correlation between high levels of cash held by companies where shareholder protection is low, and that cash-rich firms tend to overpay for acquisitions and not perform as well post-acquisition as other acquirers (according to International Corporate Governance and Corporate Cash Holdings by Amy Dittmar, Jan Mahrt-Smith and Henri Servaes, 2003)

Another reason that Mr Scholefield gives for companies being unlikely to hold on to cash is that they are more conscious of the interests of shareholders than perhaps they would have been five to 10 years ago and, although cash levels have gone up, there has also been a lot of redistribution of cash to shareholders through share buy-backs.

“Share buy-backs and bid activity in the US market were typically running at around $1bn per month in the 2002; it is now at about $20bn,” says Mr Scholefield. “So we have seen a noticeable trend towards companies generating cash, not finding an attractive investment opportunity for it, and deciding the best use of it is to pay it back to shareholders.”

He emphasises the contrast between the US economy and the rest of the world and says that, although there are areas of the global economy where there is more bad news to come, in terms of earnings, large parts of the world that are not directly affected or associated with the subprime issue in the US have significant financial strength in terms of cash and are probably being unduly punished by the recent uncertainty and flight to quality.

Market confidence falls

According to Barings, the rapid losses in market confidence are creating opportunities in Asia and emerging Europe, with well-capitalised companies whose revenue is driven by rapid economic growth in the developing world. “There is no obvious reason why such companies should have seen their share price dragged sharply lower by signs of distress in the mature, over-extended US subprime housing market. Nevertheless, there are plenty of recent examples of this phenomenon to be found in stock markets in Asia and emerging Europe,” says Mr Scholefield.

If the 2000 crash is anything to go by, it is worth noting that corporates had already begun lowering cash reserves. Speaking at the American Enterprise Institute in Washington on July 18, 2006, on the subject of corporate cash balances and economic activity, governor Kevin Warsh said that cash had started to decline and borrowing had picked up.

He cited the reason for the unwinding of cash balances by firms as being partly “a renewed focus on capital spending and other business expansion efforts by executives”.

He said: “This renewal has been spurred, notably, by growing external pressures to boost shareholder value. To be sure, such developments may cause the liquidity and credit quality of some corporations to recede a bit from their very high levels but will not, in my view, put at risk their strong balance sheets or impede the solid expansion of business spending.”

Drawing down balances

Mr Warsh noted that firms were likely to continue to draw down their cash balances through the acceleration of shareholder buybacks, raising dividends, increasing business spending and becoming more acquisitive.

“Notwithstanding these very recent developments, I would expect firms to hold more cash than has been the norm over the previous few decades due to changes in the economic and geopolitical environment, and a more rigorous legal and regulatory setting,” he said.

Post-subprime crisis, the question will be: have many of these factors changed? It is perhaps too early to tell whether there will be the same focus on capital spending but the shareholder scrutiny is still in place and, while corporate cash holdings may remain high in the short-term, they are unlikely to go much higher.GRAPH: CASH TO ASSETS RATIO

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