Ever since the recession turned into a rout after September's financial meltdown, corporations have been in a cost-cutting frenzy, looking to protect profitability and bolster balance sheets. The bad news is that companies are still in survival mode and unlikely to make much of a contribution to any second-half recovery. The good news will have to wait until 2010. As the recovery picks up steam, companies will be extremely lean, financially fit, and ready to gear up their operations in a way that will benefit both themselves and the economy.
Right now all the frugality is hitting the economy hard. Businesses have slashed payrolls by 6.2 million workers through May, and through the first quarter they have pared capital spending by $248 billion and inventories by $294 billion. The cutting will most likely continue this year, although at a reduced rate. After recessions, companies begin to expand their operations only after they see demand picking up.
One sign of incipient recovery is coming from manufacturing. Businesses have liquidated inventories so rapidly that companies are beginning to reorder. Orders on manufacturers' books rose in both April and May after a steep slide, and industrial surveys through June show firmer factory production. This is the plus side of the steep inventory reductions, which will help stabilize the overall economy, but it will take faster growth in demand to sustain any factory-sector rebound.
That is a long way off. U.S. companies cut their outlays for equipment and software at a 30.9% annual rate in the fourth and first quarters, the largest two-quarter drop since the 1930s. Business construction, which plunged 42.9% in the first quarter, is in only the early stages of its contraction. Falling investment in new equipment and construction has subtracted an average of 3.6 percentage points per quarter from growth in real gross domestic product since the third quarter.
Despite its blow to the economy, cost control has helped to limit the damage to corporate health. Looking only at nonfinancial companies, which account for three-fourths of domestic profits, earnings since the recession began are down 14.9% through the first quarter, based on the Commerce Dept.'s tally. So far, however, the inflation-adjusted earnings decline has been less than in the comparably severe downturns of the 1970s and 1980s and similar to the drop during the relatively mild 2001 recession.
Although earnings are down, spending cuts mean nonfinancial businesses are able to finance all of their current capital outlays with the funds generated by their businesses without the need to tap the credit markets. Internal funds, which are similar to cash flow, are up 4.9% from a year ago, and in the first quarter they exceeded capital expenditures by $90 billion, a wide margin by historical standards.
That doesn't mean companies sat idly by as credit conditions in the corporate bond market eased. On the contrary, businesses raised funds via bond sales at a record annual rate of $570.3 billion in the first quarter, allowing them to lock in debt at a low fixed rate. In the first quarter, long-term debt as a share of all credit market obligations rose to 70.8%, close to the record levels seen from 2003 to 2006.
Instead of using their bond proceeds to buy new equipment, companies beefed up their balance sheets, raising their liquid assets as a share of short-term liabilities to a high 38.1%. They also repaid a lot of more expensive short-term debt, including $422 billion in commercial paper, bank loans, and other advances. And they bought back some of their stock. Overall, businesses lifted their net financial investment in the first quarter to a record $340.8 billion (chart), the highest in 37 years as a share of gross investment.
All this shows a major shift toward corporate caution that will be reversed only by a solid and sustained pickup in orders and sales. The upside: Companies will be in top condition to take advantage when a recovery arrives.