Is Inflation Or Deflation Coming? Part 2

The $64 trillion dollar question is which of these two scenarios is likely to occur. We hinted at it, in the previous paragraph, with that bit about if the interest rate ticks up.

Ahah! The demand for credit (or in this example equity capital) depends on a falling rate (earnings yield). It evaporates if the rate ticks up! There’s little demand at higher rates! Only at ever-lower rates.

When Does Raising Capital Cease Being Profitable?

There is a connection—arbitrage—between the rate of interest and the return on capital. Businesses will raise capital to grow revenues or cut costs, and keep raising more capital until it’s not profitable any more. Since this profit equals return-rate, then there are two ways raising capital could cease being profitable. One is that return falls. This occurs because each uptick in hamburger supply causes a downtick in the return on capital on hamburger stores. Note that this is not a downtick only on the marginal return on capital. It’s a downtick on all hamburger capital extant. All hamburger restaurants are penalized, not just the ones who borrow to build new stores.

Or two, the borrowing could push up the rate. But in the case of a falling interest rate, the borrowing is from bargain-hunters. They borrow because the rate dropped. They cannot ever drive the rate up, because their business case to open a new store only works at ever-lower rates. They make an ever-lower bid on the interest rate, they do not take the offered rate.

Compare to the environment when rates were rising after WWII through 1981. The profit on carrying more and more inventory for longer and longer periods drove more and more borrowing. That borrowing, was not dependent on ever-lower rates. It was perversely more and more borrowing at higher and higher rates, as those corporations borrowed to chase ever-higher profits in commodity hoarding.

Is there any manufacturer alive today, who would want to increase its holdings of inventory? Much less borrow to finance such hoarding?

Today, we have now seen 40 years of the falling cycle. Companies have all but eliminated inventories, using Lean (aka the Toyota Way) and Just-in-Time delivery. They constantly find ways to become more efficient, to cut costs, to substitute capital for labor, and to expand capacity. It is an environment of falling prices and falling interest rates.

The root cause is when interest is above marginal return on capital.

How else can we interpret the fact that so-called “zombie” corporations (a term used by the Bank for International Settlements) represent over 15% of total corporate debt outstanding? A zombie is a company characterized (by the BIS) as having profits < interest expense. These companies have X amount of capital. A subset of that capital, X-Y, is financed with debt. And the firm’s cost to service this debt is below its return on the total capital of X! The way we formulated it, interest > return on total capital. Which would be X.

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Disclaimer: The content in this article is provided as general information and for educational purposes only and should not be taken as investment advice. We do not guarantee the accuracy ...

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