Consumer Sentiment High, Business Confidence Low by Filipe R. Costa

While equity markets have gathered some speed over the last week, as central banks continue to boost the global growth of money stock, it seems that not everyone is happy with the world’s future prospects. While the Michigan Consumer Sentiment indicator is increasing to record levels, global business confidence measures are decreasing to their lowest post-crisis levels. The central bank intervention is creating a good mood but that isn’t effectively translating into global demand, which in turn is preventing businesses from investing and hiring.

Every time equity markets stop rising, some central banker comes to the rescue through promises of increased asset purchases and of stable long-term low interest rates. In last week’s case, we got a surprise rate cut from the People’s Bank of China, along with Mario Draghi’s comments on the possibility of the European Central Bank buying sovereign debt. We also had an update on the easing prospects for the Bank of Japan, as Shinzo Abe dissolved parliament, expecting to extend its mandate. We could say that the equity markets currently gravitate around monetary policy and that they are more or less disconnected from the real economy.

But while central banks’ actions seem to impart an effect on investor and consumer sentiment, the same isn’t true about business sentiment.

The numbers just released by Markit regarding global business confidence are at a five-year low, which clearly contrasts with the mood in the equity market. But that should not be a surprise to readers as we have been pointing out many flaws in the path the global economy is taking. Just look at the latest GDP numbers in Europe. Germany barely avoided a recession while the Eurozone growth is minimal. In the US, GDP is growing but at a slower rate than during previous recovery periods. And while the Bureau of Labor Statistics (BLS) just announced that the latest unemployment figure was down to 5.8% we cast many doubts on the real quality of that employment.

“Of greatest concern is the slide in business optimism and expansion plans in the U.S. to the weakest seen over the past five years. U.S. growth therefore looks likely to have peaked over the summer months, with a slowing trend signalled for coming months”, commented Markit’s chief economist.

Over the last few years, central banks around the world have been pumping money into the system through unconventional measures, purchasing every kind of asset in an attempt to reduce interest rates and induce higher consumption and investment.

But the equation is broken. The central banks’ moves were welcomed by investors who got a second chance on their impaired investments. They got a free lunch, as the equity market fully reverted the financial crisis’ losses. Businesses also applauded the move. They got an excellent opportunity to reallocate capital between equity and debt. They issued debt, increased borrowing and used the proceeds to buy equity.

But what about the transmission mechanism?

Mainstream economics tells us that a decrease in interest rates should induce more investment and consumption and, if prices don’t rise accordingly, we can achieve real growth.

If asset prices rise and interest rates decrease, aren’t businesses expected to invest more and to hire more?
According to the severely flawed unemployment rate, which points to 5.8% in the US, it seems so. But according to the rise in share repurchases for S&P 500 companies, which grew from near $20 billion in June 2009 to $160 billion in March 2014, it seems not.

Corporate America has been paying a massive dividend to shareholders, which is a signal that firms are lacking investment opportunities. Companies are delaying investment decisions because aggregate demand isn’t increasing. If there’s no extra demand and companies still have capacity, why would they invest more? The following chart published by FT’s John Authers is shocking and complements this idea very well. Companies are returning 90% of their profits to shareholders, as they don’t see any investment opportunities. They do this through dividends and repurchases (which are nothing more than a special form of dividends).

No matter how much money a central bank pumps into the economy or how cheap that money is, if demand isn’t increasing, companies don’t want to invest. The same reasoning applies to consumer credit. No matter how cheap it is, people won’t pick it up if their living conditions are deteriorating.

On that part you could argue that, with the current low unemployment rate and high consumer sentiment, aggregate demand should be picking up. But it isn’t. There are many people just marginally attached to the workforce and many others with part-time jobs. Globally, household income is not rising to the point people can really increase spending. The Federal Reserve creates the idea that economic conditions will improve, pushing consumer sentiment higher, but this is artificially inflated.

Monetary policy proves ineffective here, as the transmission mechanism is failing. At the first stage, it creates the illusion that economic conditions will improve and thus the equity market starts rising fast. But then, when the economy doesn’t really improve you will be left with impaired equity prices, which will have to come down to earth – usually via a crash!