Soft-landing enthusiasts (and who isn't one?) have had much to feel good about since June 2004, when the Federal Reserve began tightening the reins on monetary policy following a historic series of easings that took short-term rates to 1%. No doubt, there are serious long-term challenges ahead for the U.S. economy–starting with worker health care and retirement planning for an aging population and the federal government's renewed dependence on deficit spending. But economic growth has remained resilient, despite two years of steadily climbing short-term rates. Real gross domestic production rose 4.2% in 2004, 3.5% in 2005 and a stunning 5.6% in the first quarter of 2006.
This growth surge has helped generate substantial profits for most companies, and despite a sharp rise in stock buybacks and cash-led merger-and-acquisition activity last year, much of the windfall sits today in cash and cash equivalents. In fact, corporate cash hordes have expanded 50% since 1999, according to a study by Chicago-based treasury consultants Treasury Strategies Inc., with cash and short-term investments carrying maturities of three years or less rising 7.5% this year alone, to $5.4 trillion.
TIME TO GO LONGER
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The factors driving this disproportionate buildup in short-term holdings–a combination of preoccupation with Sarbanes-Oxley compliance, fear of a sudden downturn and a generally more conservative outlook spawned by a series of unexpected disasters like 9/11, the demise of Enron Corp. and even the threat of pandemics–remain a subject for debate. In hindsight, given that long-term yields still haven't moved up that much, the conservative stance would appear to have been a reasonable strategy. The question today: Can it and should it continue? But despite the extended period of rising rates, the answer is far from obvious–to treasurers or the experts advising them. "With interest rates rising, we expected that there would be a slowdown in short-term holdings, but it hasn't happened," says Chrystal Pozen, a principal at Treasury Strategies. "When we were in a much lower interest rate environment, it made sense to hoard cash because there weren't a lot of options and companies didn't know when rates would go up. The opportunity cost of holding cash is greater now, and it may be worth more if it were redeployed."
Therein lies the tricky part for cash managers: When to go long? "How corporate investors got caught during the last year was in extending their maturities on the belief that the Fed was finished raising rates," says Lynn Evans, a director of investment management group BlackRock Inc.'s cash management business. That happened to some late last year following the Hurricane Katrina disaster, when expectations rose that the end of the tightening cycle had been reached and the time was right to move into longer-dated maturities. Those who did were unpleasantly surprised to see the Fed continue hiking short rates after they were locked into what would become underperforming instruments. That can be a dangerous position to be in should a company get hit at the same time by a sudden decline in assets, which could end up exacerbating such mistakes.
Consequently, companies in recent years have shifted even deeper into the most liquid instruments, according to Treasury Strategies: Among all short-term holdings with maturities of three years or less, 65% were held in very short-term instruments, maturing in 30 days or less, in 2006, up from 51% in 2004. At the same time, holdings in longer-term instruments with maturities of between one and three years fell to 9% in 2006, down from 23% in 2004. When the group of 650 corporate treasurers was asked by Treasury Strategies about their liquidity plans for the year ahead, 41% said they expected short-term liquidity will remain the same and 32% said it will increase. Of those who expected increases, 65% said the main source will be cash from operations. Others expected the primary liquidity drivers to be sales of assets and proceeds from debt issuance.
That head-in-the-shell period may be coming to an end. Recently, Federal Reserve Chairman Ben Bernanke signaled that the Fed may have done as much rate hiking for the moment as it needs to. Although most still expect a hike at the August board meeting, a consensus is developing that the summer increase will be the last until mid-2007, when the Fed might actually feel the necessity to cut. That would suggest that treasurers should begin to more earnestly attempt to capitalize on current rates. One way some treasuries are diversifying, according to Paul Audet, head of cash management at BlackRock, is by moving a portion of their holdings away from institutional mutual funds and into more structured products or separate accounts with slightly more extended durations. "Now, companies are seeing the opportunity of earning 5%-plus yields with little to no risk and are starting to look for other alternatives for that corporate cash," he adds.
MORE CASH MEANS MORE CONTROLS
Christopher Martin, vice president of client solutions at JPMorgan Chase Treasury Security Services, agrees. "The biggest trend for corporate treasurers is a focus on the investment management side and enhancing the management of their cash surpluses," he says. "These portfolios are looking much more like complex securities portfolios than ever before, almost like pension accounts."
But Sarbanes-Oxley has complicated portfolio management. As a result, Martin says more corporates are turning to custodial arrangements that have traditionally been more common for pension management. "They're forced to focus on whether they have sufficient control over internal and external management."
Of course, there are many factors at play for large companies when they adjust their portfolios. "We look all the time to see whether we can get a better yield, but a lot of the decision is based on credit and access to credit," says Joel Broussard, deputy assistant treasurer at Chicago-based insurance brokerage Aon Corp. Broussard oversees the company's $250 million liquidity pool consisting of cash positions across the company and fiduciary investments held for its insurance brokerage clients. "Yield is great, but I'm not going to make a move and leave one of my relationship banks over minor fluctuations in basis points."
A BUFFER FOR THE NEXT DOWNTURN
Most economists expect growth to ease in the coming quarters, although most don't look for a recession in the coming year. The Blue Chip Consensus of 54 economists found expectations of real GDP growth of 3.5% for 2006 and 2.8% in 2007. Nearly 72% expect a quarter-point rise in the Fed Funds rate at the August meeting, with a high likelihood that that will be the final move until the middle of 2007, when the Fed could move to cut rates. "It's typical to see the Fed cut interest rates six to seven months after the end of a tightening cycle," says Randall Moore, editor of Blue Chip Economic Indicators. "If the economy has slowed enough and inflation pressures recede enough, the Fed could feel comfortable cutting rates. So much depends on where oil prices go from here. So far, there hasn't been a big pass through of energy costs to core inflation."
And the fact that companies haven't dramatically put their cash into capital investment spending or longer-term investments could provide a much-needed cushion for the economy should economic growth slow in the coming quarters. "It has been a more moderate upturn than normal in capital expenditures, but still good," says Peter Hooper, managing director and chief economist at Deutsche Bank Securities Inc. Even if there is a slowdown in the economy, "it will be a gentler one than if there were a lot of excess capacity and inventory overbuilding like we had in the 1990s. Corporate balance sheets look very good."
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