Australian business is prepared to stuff the economy to protect short-term profit

Grumpy cat. Photo: Getty Images

After years of strong profit growth amid falling interest rates, the environment for Australian business has turned a corner. Companies are sitting on their hands watching the economy deteriorate.

The cat’s out of the bag. They’re not going to sacrifice profit margins by investing.

Last year it became clear economic growth was slowing, as home owners were saving and consumers were feeling wary about the future.

As margins got squeezed, “cost-out” became a widespread strategy in the corporate world. For many businesses, “cost-out” really means sacking staff, usually the highest cost component of a company.

In October last year the Commonwealth Bank equity strategy team noted that “about half the listed companies that we cover are in the middle of aggressive cost-cutting campaigns”.

Deutsche Bank also noted that while corporate Australia had benefited from relatively strong revenue growth, labour productivity didn’t rise in line. So with earnings starting to deteriorate, the cost-cutting seen in the US economy that saw unemployment remain stubbornly high in the years after the GFC started to bite in Australia.

So when the mining party wound down and other sectors could not fill the gap, unemployment unavoidably ticked up from having a 4 in front of it to a high of 6.4% earlier this year.

Yesterday’s private capex data showed as clear as day that investment intentions in the business sector are collapsing. UBS called the spade a spade and said the outlook moved “from bleak to recessionary”.

The simple reality now is that even if consumers are feeling a bit more confident, without investment from business the Australian economy is set for a period of lower economic growth.

The question for companies — and their shareholders — will be whether they expect the strong profit growth and dividend returns to continue.

The RBA has been warning that corporate Australia has been setting too high a bar for investment projects, and that continuing cuts to interest rates can no longer be relied on to have the stimulatory impact they traditionally deliver.

So like Joe Hockey has been begging companies to do, the RBA wants businesses to spend. But for many large or even mid-size companies, investments won’t be cleared without showing an internal rate of return of around 10%, with some margin for error based on different scenarios.

The trouble is once you lower that investment hurdle, the margins of error start to make those projects look very unappealing.

This has led to share buybacks and high dividend payout ratios and low investment in the business, which ultimately lowers the expected returns a business can generate in the future, without strong new revenue lines.

But as companies and national economies around the world have been finding in this era of lowering returns, there is real meaning in the adage that you can’t shrink your way to greatness.

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