Patrick Watson of Mauldin Economics suggests alongside the yield curve, rising corporate hubris is another sign recession is coming

By Patrick Watson*

The yield curve isn’t the only sign recession is coming. Rising corporate hubris says the same thing.

Business scandals seem to peak at the end of every growth cycle. I suspect that’s because CEOs are human, and humans get overconfident when everything is going well.

• In the late 1980s, we had the savings & loan crisis, followed by recession in 1990–91.

• The early 2000s brought both a deep recession and scandals at Enron, Tyco, WorldCom, and others.

• The Great Recession exposed Bernie Madoff’s fraud scheme, and a couple of years earlier, commodity broker Refco went bankrupt after its CEO had concealed millions in bad debts.

Note these weren’t just poor judgment. Business leaders committed crimes, and some went to prison.

Nowadays we let once-criminal acts go uninvestigated, much less punished. But they still tell us something economically important: when the smartest people in the room think they’re bulletproof, it’s a good bet they aren’t.

And the proof is probably not far away.

Photo: FBI

Fake success

In American culture, we often celebrate entrepreneurs and business leaders. They must be doing something right or they wouldn’t have succeeded, we think.

That’s not always true, though. Sometimes people take illegal or unethical shortcuts to success—and the rest of us may not see it until much later, if ever.

The problem with such shortcuts is they are fake success, and companies that follow them eventually fail. Which is bad for both employees and stockholders, as well as customers.

Allegations of negligence and/or misconduct at public companies seem to be growing. A few examples…

Boeing (BA) is reportedly under federal criminal investigation for the safety certification of its best-selling 737 MAX airliner. Two fatal crashes appear related to software features that either didn’t work right or weren’t revealed to airlines or pilots.

The Federal Trade Commission may fine Facebook (FB) up to $5 billion for violating promises it made in a 2011 investigation for mishandling user data. Other investigations are underway too.

Goldman Sachs (GS) and two of its former employees face criminal charges in Malaysia over corruption and money laundering with the country’s sovereign wealth fund, called 1MDB. Top executives may have approved some of the illegal transactions.

Managers of Insys Therapeutics (INSY), including the company’s founder, were convicted last week of paying doctors to prescribe the company’s opioid drugs to patients who didn’t need them. Insys also misled insurance companies to get higher payments.

Tesla (TSLA) founder Elon Musk faced contempt charges for tweeting non-public and possibly misleading information about the company. He reached a settlement with the SEC and escaped criminal liability, for now.

Wells Fargo (WFC) is… where to begin? Two consecutive CEOs have now resigned after a fake-account scheme that surfaced in 2016. Assorted other offenses ranging from mortgages to foreign currency trading have the bank in hot water.

This isn’t just a US trend. Former Renault-Nissan-Mitsubishi chairman Carlos Ghosn faces Japanese charges for underreporting his pay and diverting company assets for personal use. The once-celebrated executive’s reputation is now in tatters, and he may face prison time.

I could go on, but you get the idea.

Photo: AP

C-level incompetence

Are evil people running all these companies? Maybe, but probably not. Remember the old saying: “Never attribute to malice that which can be explained by stupidity.”

But that shouldn’t be an excuse. Shareholders pay CEOs big bucks to make well-considered, quality decisions that benefit the company. A lot of that money is apparently not buying the results it was supposed to.

So go up the food chain. The boards who hired these CEOs seem not to have made good choices, either—compounded by not ousting executives who don’t perform as expected.

Why anyone would own shares in such companies, I don’t know. For many, it’s probably because they only care about a rising stock price, which they’ve been getting.

But if the stock is rising not because the business is well-run but because it is borrowing money to buy back its own shares, the gains won’t last. And that’s exactly what has happened.

According to Goldman Sachs (among the offenders listed above, so savor the irony), repurchases were the largest source of equity demand over the last decade.

All this brings us to a really awkward, uncomfortable macro question.

Photo: United Soybean Board via Flickr

Economic lubricant

When we read in the news that Company X is making some kind of big change, we make certain assumptions.

Maybe we think it’s a bad idea, but we figure the company’s leadership has considered all the data, examined the alternatives, and choosing as wisely as possible.

That isn’t necessarily true if the company faces little or no competition. Maybe the executives don’t care because they’re getting paid regardless.

This is a growing problem, as John Mauldin has been writing. A small handful of companies now dominate entire sectors of the economy.

Here’s what John wrote last month in Capitalism Gone Wild.

Competition is an economic lubricant. The machine works more efficiently when all the parts move freely. We get more output from the same input, or the same output with less input. Take away competition and it all begins to grind together. Eventually friction brings it to a halt… sometimes a fiery one.

The normal course of events, when politicians and central banks don’t intervene, is for companies to grow their profits by delivering better products at lower prices than their competitors. It is a dynamic process with competitors constantly dropping out and new ones appearing. Joseph Schumpeter called this “creative destruction,” which sounds harsh but it’s absolutely necessary for economic growth.

With creative destruction now scarce as zombie companies refuse to die and monopolies refuse to improve, we also struggle to generate even mild economic growth. I think those facts are connected.

Indeed, they are connected. And that makes corporate corruption and incompetence a problem for everyone.

I think some of this is a consequence of size as well. Today’s largest companies are so huge, and involved in so many different things, that no one is really in charge. So it’s no wonder they do crazy things.

Such conditions haven’t ended well in the past. We’d best hope for better luck this time.

*Patrick Watson is senior economic analyst at Mauldin Economics. This article is from a regular Mauldin Economics series called Connecting the Dots. It first appeared here and is used by interest.co.nz with permission.