The impact of deflation on capital…..

I have commented on a number of occasions about the risks to returns on equity capital, as an offset to nominally attractive valuations, in a deflationary/deleveraging environment: reduced investment, existing capital depreciated and or written off, resulting in lower potential growth and lower returns on equity capital.  An excerpt from a recent ITEM Club Winter 2011/2012 forecast highlights the real world dynamics of this risk in situ:

“Fortunately, British business remains in a strong position to ride these challenges. Large Plcs cut back heavily on investment and other spending during the last recession and now enjoy remarkably strong cash flows and balance sheets as well as a very low cost of capital. They have been holding back from investment because of uncertainties about home demand. They now face even bigger imponderables overseas, and surveys of investment intentions suggest that the recovery in business investment is faltering.M&A activity and advertising have also been hit by uncertainty.

..but uncertainty has killed investment and job cuts are likely to follow.   Companies ramped up dividends and share buy-backs in 2012 as a way of getting surplus cash back to shareholders. However, finance directors are now likely to keep a tight grip on their cash as an insurance against adverse developments.  More of a worry for the consumer, recruitment is weakening, at the time when the government most hoped private sector recruitment would offset public sector redundancies. In earlier quarters, the former easily outweighed the latter, but in the third quarter of 2011private payrolls increased by just 5,000, while government employment shrank by 67,000. Employment levels remain exceptionally high in relation to output, and employers may shed staff if prospects deteriorate further.”

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