Why Aren't Australian Businesses Investing

With the Federal Budget set to dominate the news this week, we thought we’d pen a note regarding the outlook for business investment in Australia, and why, despite the lowest cash rates in history, it is still so subdued.

Perhaps worse than the current malaise is the fact that the outlook for business investment in the coming years is hardly encouraging either. Whilst the whole country has ‘priced in’ the end of the capital investment boom in the mining sector, it isn’t looking much better elsewhere, outside of property construction perhaps.

That it is a problem is hardly debatable, with even the RBA acknowledged the issue in their latest statement of monetary policy, where they noted that “indicators of non-mining business investment intentions suggest that a significant pick-up is not in prospect over the next year or so.”

The RBA’s observations are hardly surprising in light of a number of business related surveys, including those from NAB, Roy Morgan, and Dun and Bradstreet, all of which are tepid (at best).

So what is the problem? Why won’t businesses open their wallets?

A disclaimer first! One, obviously specific companies, and even sectors face drastically different circumstances, so the perspective offered below is of course generalized.

Secondly, I don’t run a business. Apart from some shares in listed companies I have essentially no control or influence over, I’m not an owner, a director, or a CFO, so I can’t say for sure what is going through those peoples collective minds right now.

With that in mind, I can only tell you what would be going through my mind if I were being forced to make major decisions regarding capital investment, and the ‘playing field’ I would be trying to assess, as it were.

Amongst other things, I’d be looking at the Australian consumer, the local economic situation, the global economic situation, what the government was up too, current and expected monetary settings, as well as hurdle rates for investment opportunities.

Lets take a look at each of these items one at a time.

Australian Consumer

This would be my primary concern, for on balance, I would be very worried about the Australian consumer, the people I need to purchase my product.

On the surface that might seem a strangely negative position to adopt. After all, we have the highest median net worth on the planet (by some margin), record high house prices, and even our superannuation funds have largely recovered their GFC induced losses. How can one be negative about the outlook for the citizens of the wealthiest country on earth?

Well, there are actually a number of reasons to reach this conclusion.

Firstly, the Aussie consumers wealth is overwhelmingly concentrated in housing, which owner-occupiers are either unable or reluctant to ‘tap’, for obvious reasons. Secondly, the wealth Aussies have in superannuation also can’t be spent either, at least until they hit retirement.

Australian’s also don’t have much in the way of disposable savings. Yes the savings rate is circa 10%, but that includes the superannuation contributions people are mandated to invest.

This lack of spendable savings (for want of a better term) is evident in a number of surveys, include one by ME Bank last year which showed that just 46% of households save anything on a monthly basis. If it weren’t bad enough that more than half the country can’t save at all, for those that can, the amount they saved had fallen by 12% in the previous year.

I’d also note that private debt levels (especially housing debt) are at the extreme end of the scale, both in historic terms and relative to other countries. Indeed the private debt burden is so large down under today that many Australians now spend a greater percentage of their income servicing their mortgage than what they did when mortgage rates were more than 10% higher a couple of decades ago.

Indeed a recent Wesley Report: Facing Financial Stress noted that, despite the lowest interest rates on record, many households were in a worse financial position than what they were a few years back. The number of technically insolvent households had risen 33% (to 4 in 10 households), whilst there had been a near 20% rise in the number of households who were financially stressed.

With the outlook for employment clouded at best, and wage growth the lowest on record (and essentially negative after inflation and taxes), it’s hard to be anything other than pessimistic on the outlook for the Aussie consumer in the coming years.

Australian Economy

I’d be cautious at best regarding the outlook for the Australian economy too. The pick-up in housing construction has been pleasing to see, but I’d be worried about the full flow-through effects of the decline in commodity prices, I’d also be concerned about the still yet to be fully felt unwind in mining capital investment, and the soon to be shuttered Australian car industry.

At a higher level, I’d also be conscious of the fact that we’ve now gone over two decades without a recession. In business terms, I’d be thinking that was an incredible run, and that it wouldn’t be so surprising if we were in for some tougher times ahead, and that adopting a more cautious stance was appropriate.

Coupled with the negative outlook for the Australian consumer, I wouldn’t be giving the local economy the benefit of the doubt per se, and I’d be expecting either a continued deterioration, or at best a long period of stagnation.

Global Economy

I’d be lukewarm on this as well. I’d have noticed improvements in some headline economic statistics (most notably unemployment in the USA), but I’d also know we are still in the midst of the most extreme monetary policy experiment the world had ever seen, the unintended consequences of which are impossible to know right now.

I’d also be aware that debt levels the world over (both in terms of aggregate money owed as well as a percentage of output) are substantially worse than what they were when the GFC hit.

Clearly, the developed world still has a number of unresolved challenges it needs to overcome, one way or the other.

Local Politics and the Budget

This would be a real source of concern. If I were looking at the current government, I’d be confused how on the one hand they could describe interest rates of 3% several years ago an ‘emergency low’, yet today encourage us to go out and spend and invest with interest rates at 2%.

What I am hearing from the Federal Opposition would be equally troubling. And whilst that’s not to blame the current government or opposition for the malaise that we face, and whilst I would be cognizant of the almost impossible job they face supporting growth and balancing the books, that doesn’t mean there isn’t anything to be concerned about.

That brings us to the deficit. People can say we’ve got one of the lower government debt to GDP ratios in the world, but that wouldn’t alleviate my concern. “Not being Greece or Japan” when it comes to your government debt to GDP ratio is nothing to celebrate.

I’d also be very concerned at a deficit of $40bn plus. Pretty quick math would tell me that that is close to 13% of government revenue. If my company was bleeding cash like that, and was set to continue bleeding for years to come, I’d know we needed to slash costs or raise revenue. I can’t imagine there are many CFO’s, company directors or business owners who can’t work out that when we talk about government slashing costs or raising revenue, it either means huge cuts to public spending, or an increase in taxes.

Either of those means less money in the pockets of everyday Australians, the very people I need buying my products, and who, as discussed earlier, are already facing plenty of headwinds.

Monetary Settings

I don’t think you’d need to be an economist or financial market commentator to know that years of zero interest rates around the world, plus trillions of dollars of printed money isn’t exactly normal.

In fact, it would probably be an advantage if you aren’t an economist, for as a business owner you’d more readily accept how extreme a policy setting it is, especially when you correctly hear it described as “life support”.

If you told me (as the Fed and the like are) that you were about to take a patient off life support, I’d be happy to hear it, but I’d also be cautious against betting that that person would make a full recovery to robust health. I’d wish them the very best, and sit back and wait to see what happens.

I’d also face a real problem committing capital to business investment right now for another reason (this one predominantly limited to listed companies), and that is the demand from shareholders for dividends. In a ZIRP world, paying dividends has been priority one, though buy-backs have been pretty popular too.

Spending money on either higher dividends or more buy-backs leaves less money for investing in the business itself.

Hurdle Rates

Finally, I’d be asking myself what kind of return is required to justify risking capital. On this note, I wouldn’t be using current 10-year bond yields or other government ‘risk free’ rates, which are at the lowest level in recorded human history. Instead, I’d be asking myself, “will this investment still make economic sense in more normalized monetary and economic environment,” something both government and central banks the world over swear we are returning too.

This was something even RBA Governor Glenn Stevens discussed, in an address to The American Australian Association luncheon, in April 2015 in New York. Discussing the low rate of capital investment spending by businesses, Stevens observed that one potential reason why it had been so sorely lacking was that there was perhaps a;

“stickiness in the sorts of ‘hurdle rates’ that decision makers expect investments to clear. I cannot speak about US corporates, but this would seem to be consistent with the observation that we tend to hear from Australian liaison contacts that the hurdle rates of return that boards of directors apply to investment propositions have not shifted, despite the exceptionally low returns available on low-risk assets. The possibility that, de facto, the risk premium being required by those who make decisions about real capital investment has risen by the same amount that the riskless rates affected by central banks have fallen may help to explain why we observe a pick-up in financial risk-taking, but considerably less effect, so far, on ‘real economy’ risk-taking.”

I think Stevens is right. As I stated above, I wouldn’t be using today’s extraordinarily low interest rate environment as a justification for risking capital, and I can’t imagine I’d find myself all alone in that assessment.

Summary

Without looking at company or sector specifics, we are left with the following scoreboard when it comes to assessing the outlook for business investment.

Perhaps I’m being too pessimistic, but looking at all of these factors, there isn’t one I’d be confident about, and a couple I’d be very nervous about.

As such, unless any proposed capital investment was to increase operational efficiencies and lower costs over the medium-term (and let’s be honest, that sadly means job cuts), I’d be very cautious to green light any large-scale capital investment.

There is one final factor worth considering here too, and that is the ‘barbecue test’. Now for most people in Australia, the chat with friends and family around the barbecue probably revolves around how work is going, the mortgage, work around the house, how the kids are doing in school, and how your footy team is going.

There is no reason to believe that the conversation between business owners, directors and executives would be much different, except for one major difference. Instead of the ‘how’s work’ question, it will be ‘how’s business going?’

And I have no doubt there’d be a lot of caution (not necessarily outright pessimism) expressed in the answer to that question. And no matter who we are, and what we do for a living, all of us are influenced by our peers, and what we see and hear around us. That kind of caution can be self-reinforcing.

After all, if you know other companies are holding onto their cash and playing it safe, it can’t help but influence your own thinking, even if only at a subconscious level.

Add all these things together and I for one don’t find it particularly difficult to understand why business owners and directors are so reticent to invest right now.

As such, I don’t expect this critical cylinder for a sustained economic pick to fire for some time, and no amount of budget tinkering or monetary easing from the RBA will change that.

Warm Regards

Jordan Eliseo

Disclaimer

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