RBA says CFOs set the investment bar too high
In last week’s federal budget Treasurer Hockey announced a raft of measures to get Australian small businesses spending and investing again. It’s a necessary part of Australia’s economic transition and it’s a theme picked up by RBA deputy governor Phil Lowe in a speech today at the Corporate Finance Forum, titled Managing Two Transitions.
Lowe talked about the economic transition Australia is undertaking after the mining investment boom but he also mentioned a second transition — the step down in global interest rates and its impact on the investment decisions of business managers, CFOs in particular, in this new environment.
Lowe said companies are setting hurdle rates for new investments which are both inconsistent with the low level of interest rates globally and an apparent acceptance by business owners of a lower rate of return on existing assets.
In today’s environment, it seems that many investors have, reluctantly, come to accept that they will earn lower yields on their existing assets. An open question though is whether the same acceptance of lower returns is flowing through to firms’ decisions about the creation of new assets – that is, their own investment plans.
There is international evidence to suggest “the hurdle rates of return that firms use for new investment are quite sticky and that they are not very responsive to movements in interest rate,” Lowe said.
A recent survey by Deloitte in Australia showed hurdle rates in Australia “are typically above 10 per cent and sometimes considerably so,” Lowe said.
The question of what IS the appropriate rate of return in a low interest rate world is an interesting and open one according to Lowe, who noted that each “CFO will no doubt have a different answer to this.” But he added that, “in a world of persistently low interest rates, it may well turn out that the average answer is — or should be — lower than it used to be.”
The reason that’s important is recently companies have been returning cash to shareholders rather than reinvesting it in their business. That’s been rewarded by shareholders bidding the price of those shares up but Lowe’s summary of what this actually means is telling:
here, you manage the money, as we do not have investment opportunities that satisfy our internal rate of return
Are the globes business managers really bereft of investment ideas? Or, are they simply setting excessive hurdle rates for investment in a world of low interest rates?
It’s a point made by NY Times columnist Tyler Cowen over the weekend. Cowen wrote:
The recession was a learning experience that we haven’t fully absorbed. From this perspective, the radical and sudden changes of the financial crisis were early indicators of deep fragility and dysfunctionality.
Slowly but surely, we may be responding to these difficult revelations by scaling back our ambitions for the economy — reinforcing negative trends that were already underway.
He’s calling this period of transition a “Great Reset”.
It’s a stream of thought Lowe appears to share.
The difficulty is that if the majority of firms act in this way (returning cash via buybacks etc.), shareholders in aggregate get left holding the cash. And, on that cash, they earn very low rates of return – almost certainly lower than the rate of return that would, on average, be earned if that cash were invested by businesses in real assets. This is really just another way of saying that if the appetite for investment is low, savers, in the end, will get low returns on their savings.
Lowe’s message is clear.
It’s easy to buy back shares, return cash to investors and see your share price rise as a result. But, businesses in Australia, and around the world, need to look to a new hurdle rate for investment more appropriate to the economic and interest environment in which they operate in.
In doing this the Australian and global economies will benefit from a new wave of investment in productive assets, not the current wave of cash on the siedelines and on central bank balance sheets.