Wednesday 29 March 2017

While conventional models focus on interest rates, the reality appears to be far more complex – with expectations playing a core role.


Economic theory traditionally suggests that interest rates are a core lever in determining corporate investment; the lower the rate, the higher the investment because of cheap funding and a higher discounted value of future cash-flows.

Reflecting this is central bankers' use of historically low interest rates to boost corporate investment against a challenging economic backdrop.  However, as the Eurozone shows, economic reality has not followed economic theory; cutting the lending rate did not have the expected effect on corporate investment. 
 
Instead, a set of three interconnected indirect drivers are at play, which investors must grasp if they are to understand what determines the level of corporate investment and indirectly the capacity of companies to generate attractive long-term returns going forward: economic activity vs. productive capacity; funding considerations vs. financial frictions; and confidence vs. uncertainty.

Corporate investment matters for returns

Understanding the drivers of corporate investment is critical for institutional investors. Lower corporate investment reduces productivity and leads to a fall in potential GDP, ultimately depressing the neutral rate of interest and lowering returns. 

Taking economic activity first, corporate investment depends on lagged changes in growth. Traditionally, a weakness of corporate investment has coincided with a slow recovery in economic activity. As consistently highlighted by ECB President Mario Draghi, the structural health of the economy is also important, as productivity stagnation lowers the potential growth rate. This in turn will weigh on realised GDP growth and the willingness to invest. What follows is a self-reinforcing circular dynamic of slow growth, limited investment, slow productivity gains. Second, access to funding has not been an issue for corporates in advanced economies.  The internal funding capacity was supported by the increase in earnings whereas external funding has simultaneously benefited from both the low interest rate environment and well-functioning capital markets on the back of investors' quest for yield.  But, financial frictions did act as a headwind to corporate investment during the period of the European sovereign debt crisis.  The high borrowing spreads in countries such as Spain, Greece and Portugal added a constraint to the investment model. 

Expectations and uncertainty play a role

Future expectations about the environment are crucial, as corporate investment is heavily influenced by confidence.  Uncertainty can create a significantly lower response of investment to sales growth for example.  Similarly when there is a cyclical downturn, as occurred during the recent global financial crisis, the policy rate falls, and investment falls on the back of soft confidence, minimal expected sales growth and stagnating capacity utilisation.

Management is also susceptible to a horizon bias. Empirical research shows the expected earnings for the next 12 months have a big impact on investment plans.  Uncertainty and lack of confidence can explain why hurdle rates (the required internal rate of return on investments) have remained high despite the decline in the weighted average cost of capital, thereby acting as an obstacle for corporate investment. This can also explain the popularity of share buybacks which in the short run support share prices but in the long run may hamper the ability of companies to grow their earnings on a sustained basis.

Finally political uncertainty may also play a role, as research has highlighted that firms can reduce investment expenditures by over 4% during election years relative to non-election years.
 
The only way to address the challenge of weak corporate investment from a policy perspective is to acknowledge that low interest rates alone cannot bolster investment.  They should instead be considered alongside the factors of confidence, financial frictions, funding, and uncertainty. Policies aimed at boosting productivity would in turn raise the growth potential of advanced economies. This would increase the willingness of corporates to invest and create an attractive environment for institutional investors with a long-term horizon.


William De Vijlder has been Group Chief Economist of BNP Paribas since September 2014, and previously held senior roles at BNP Paribas Investment Partners.
William De Vijlder – Group Chief Economist of BNP Paribas
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