By WallStreetDaily.com

By Tim Maverick, Senior Correspondent

In an effort to ward off the deflation bogeyman, central banks around the world have adopted unprecedented monetary measures. In fact, more central bank insanity may be on the way.

Meanwhile, corporations have taken advantage of near-zero interest rates and gorged themselves on debt.

Since the financial crisis, U.S. companies have accumulated $9.3 trillion in new debt. And as of the second quarter 2015, high-quality firms tracked by JPMorgan Chase & Co. (JPM) had incurred $119 billion in interest expenses over the prior 12 months.

Unfortunately, this splurge was funded by a boatload of cheap debt, and that will turn into a major headache if deflation spreads further into the economy.

Even Goldman Sachs Group Inc. (GS) has noticed. It called the deterioration of corporate balance sheets “increasingly alarming.”

Bloomberg data shows that corporations now owe more in interest than ever in history. And their ability to service that debt – interest coverage – is at the lowest level since 2009.

Yet these same corporations continue sailing full speed ahead, shelling out record amounts for buybacks and dividends. Since 2009, U.S. corporations have bought back $2.4 trillion in shares. The top 30 S&P 500 firms alone have repurchased $700 billion worth of stock between 2010 and 2014.

So far, that strategy has worked well. Indeed, companies following the buyback strategy since 2007 have outperformed the S&P 500 Index, according to Bloomberg.

Credit Suisse Group AG (CS) analysts even called the buyback binge “the engine of the rally in the U.S. in recent years.”

But the party may be coming to an end – and the law of unintended consequences may be ready to bite investors where it hurts – in the wallet.

Today, analysts are questioning whether the whole buyback and dividend binge was really worth it.

Larry Fink, head of investment management firm BlackRock Inc. (BLK), wrote that companies are “underinvesting in innovation, skilled workforces, or essential capital expenditures.”

In other words, profits have been inflated on paper but haven’t actually produced anything tangible – no research and development, no new plants and equipment.

Recently, U.S. companies have spent more on buybacks and dividends than they have on capital expenditures, and the cash payout ratio (money to shareholders) continues to hover at 15-year highs. According to Standard & Poor’s, excluding the recession years of 2001 and 2008, dividends and stock buybacks represented an incredible 85% of corporate earnings since 1998.

Thus, corporations are straddling a fine line between rewarding shareholders and ignoring long-term investment in the core business.

What if Deflation Strikes?

But what happens to this strategy if the Fed and other central banks lose their battle with deflation?

Well, the ballgame changes drastically.

Corporate leverage (debt) is great in a period of inflation because companies can pay back their debt with cheaper dollars. But deflation is essentially the opposite of inflation – it makes money more valuable.

In other words, cash in hand will be worth more than anything else a corporation might do with it. And in a deflationary environment, corporations will be forced to pay back debt with dollars that are more valuable than the dollars they borrowed.

If deflation strikes, corporations will hoard cash. They won’t want to spend any money on items like dividends and buybacks, and cash will only be used to keep the business running.

Thus, for anyone who has enjoyed this era of ever-rising stock buybacks and dividends, keep your fingers (and toes) crossed that the Fed wins the deflation battle.

Otherwise, the big stock winners of recent years may hit the proverbial iceberg, and the corporate activist darlings will sink to the bottom of the stock performance tables.

Good investing,

Tim Maverick

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