Confidence can be a tricky thing to measure. You can lose it as quickly as you gain it, without really understanding why. It doesn’t follow any logic because it isn’t tangible. It’s a mindset. And, quite often, it doesn’t take much to sap the confidence out of something.
Business confidence works in much the same way. Companies are as sensitive to changes in the environment as people. The only difference is that when you’re struck by self-doubt, it might affect your mood, but there’s no real harm done. Yet when businesses get the yips, we all suffer for it.
If you’ve been following this story these past six months, you’ll have noticed something, well, odd. Business confidence in Australia is very healthy — stubbornly so in fact. Nothing can seem to shake its self-confidence. Not a housing slowdown. Not a commodity rout. Not lower corporate earnings. And certainly not stock market volatility.
You’d think something would’ve rubbed off during the tumultuous past few months. Not so, according to the latest NAB Quarterly Business Survey. Assessing the three months to December, the survey showed confidence rose 3 points to +4.
For a better idea of what this number means in real terms, we can look to the bank’s accompanying press release (emphasis mine):
‘[Business confidence] in large part is a reflection of business conditions (how firms feel about their own business), which also held up at elevated levels (+9 points) despite easing back slightly in the quarter. These outcomes are broadly consistent with what has been reported in the monthly NAB Survey, suggesting that the non-mining recovery has remained resilient.
‘The real insight from this survey is seeing how firms are feeling about the outlook for their business and the economy. It certainly seems like they are remaining quite upbeat about the outlook, which suggests good things for the labour market and future investment.
‘Leading indicators were relatively positive in Q4 2015. Forward orders remained at quite elevated levels, as did expectations for business conditions in 3 and 12 months’ time. A modest lift in capacity utilisation and [capital expenditure] plans for the next 12 months could be hinting at a much needed lift in non-mining business investment, although high ‘hurdle rates’ of return to investment will remain a challenge, while employment intentions have stayed elevated.
‘Finally, given the cross-winds facing the construction sector from a downturn in mining investment on the one hand, and booming residential construction on the other, this quarter we have broken down the responses from construction firms into residential, non-residential, engineering and services. “Unsurprisingly, engineering tends to lag behind in most indicators, while residential and non-residential building are outperforming.”’
In all, it was a positive quarter for businesses despite the odds facing the economy. We can only hope that positivity spurs businesses to invest in more people. Granted, we have evidence that it’s already rubbing off on the labour market.
The recent jobs figures may have confounded analysts, but the market is most definitely on the up. The 70,000 jobs created in between October and November raised eyebrows. But even if these figures don’t quite tell the whole story, the labour market is strong. Full time jobs numbers are still on the rise. And while low wage growth has some bearing on that, a job is still a job. And that can only be beneficial for the economy.
Why hurdle rates raise doubts about business confidence
The main point worth picking out from that quote above is where it mentions hurdle rates.
NAB acknowledges the importance hurdle rates will play in boosting business investment. For those of you not familiar with the term, it basically refers to the rate of return that companies expect on investment.
For instance, a business may have targeted hurdle rates of 10%. Any proposed investment gets matched up against internal hurdle rates. In other words, if a business doesn’t expect to receive, say, a 10% return on investment, they may not bother at all.
The amount of time it takes to achieve a return on investment matters too. The ‘payback period’ is commonly set at three years for many companies. Typically, projects that take longer than that fail to get approval. Yet the payback period is sometimes as short as one year, depending on the business. That could make it difficult to get new projects greenlit.
Of course, payback periods and hurdle rates vary from company to company. Not every investment opportunity will be matched against hurdle rates of 10%. Nonetheless, they’re crucial because they have a big say in what, and how much, businesses end up spending.
Most importantly is that investors do take hurdle rates very seriously. If shareholders see diminishing returns on their investments, they’ll go elsewhere. That leaves companies with a fairly straightforward decision. Either risk the wrath of investors, by investing in projects with low hurdle rates, or return cash straight back to them. Many companies, unsurprisingly, play it safe by returning cash to investors. It’s much better in the short term to pay out dividends if the hurdle rate doesn’t meet shareholder expectations.
That might explain the behaviour of a number of companies on the ASX. Growth opportunities are low, hurdle rates are high, and borrowing money is cheap. And the net effect of this? Buy backs and dividends galore!
One final thing on the NAB survey: these findings tell us little about what happened to business confidence last month in January. The rout in financial and commodity markets would’ve had the business sector second guessing itself a bit more than usual, you’d imagine.
We’ll have to wait a couple of months to see the fallout from it though. Until then, labour market figures will be our best gauge of where business confidence stands.
Junior Analyst, The Daily Reckoning
PS: Like hurdle rates, interest rates play a key role in determining whether a business invests. Unlike hurdle rates, which have been going up, interest rates are set to go down even lower in the future.
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