It’s been no secret that the bid for equities in 2017 has been largely attributable to “mom and pop” coming late to the party and scrambling to catch the proverbial wave by piling into passive ETFs that track equity benchmarks. Here at HR, we call that the “Sharon” money.
Of course there’s been another perpetual bid for equities that’s persisted for years. The corporate bid. It’s actually beautiful in its simplicity. With the Fed having cultivated and perpetuated a relentless hunt for yield thus driving demand for corporate issuance, companies are able to issue debt on the cheap. They can then use the proceeds to fund share repurchases which boost corporate bottom lines and thereby inflate management’s equity-linked compensation.
The problem with this is that every dollar invested in financial engineering is a dollar not invested in innovation and/or productive capacity and eventually, leveraging the balance sheet to create make-believe bottom line growth will come back to haunt corporate America, but that’s a problem for another day – or at least that’s how management looks at things.
Well, with all of the above in mind, consider the following from Goldman who explains (again) the sources of equity “demand”…
Corporations and ETFs were the key drivers of US equity demand last year (Exhibit 1). Net equity purchases by corporations and ETFs equaled $584 billion and $188 billion, respectively, which offset net selling by mutual funds, households, and pension funds. Foreign investors also fled US equities during 2016, including $60 billion of net selling post-election amidst concerns of potential protectionist policies proposed by the Trump Administration.
In 2017, we expect history will repeat itself. Corporations and ETFs will continue to drive equity demand while mutual funds, households, and pension funds will remain net sellers of equities.
We lower our 2017 forecast of corporate equity demand by $100 billion, to $700 billion, given our Washington, D.C. economist’s expectation for a delay in corporate tax reform. However, corporations will remain the primary source of US equity demand this year. Our prior forecast assumed a one-time tax on untaxed foreign profits would occur in 2H 2017, resulting in an additional $150 billion of buybacks as firms repatriate overseas cash. However, we now expect corporate tax reform will not occur until in late 2017 or early 2018. Given this delay, we now estimate firms will only repatriate $60 to $70 billion of overseas cash this year and spend $50 billion (around 75%) on share buybacks.
ETF equity purchases will equal $200 billion given continued investor preference for passive vs. active management. Total inflows into equity ETFs equal $66 billion YTD vs. $23 billion of outflows from equity mutual funds. ETF ownership of the corporate equity market is at an all-time high (5%) while mutual fund ownership (24%) is at its lowest level since 1Q 2004.
We expect mutual funds will remain net sellers of equities ($50 billion) given investor outflows and low liquidity. Mutual fund liquid assets as share of total assets are near historical lows (3% as of Jan 2017). However, higher dispersion and improved fund returns YTD suggest that mutual fund demand in 2017 (-$50 billion) will be higher than in 2016 (-$117 billion).
Although we forecast a surge in corporate buybacks this year, managements should instead consider using their excess cash to grow dividends. The equity market is close to all-time highs and valuation is at historical extremes. In addition, pure yield strategies, such as buybacks, are at risk during periods of rising interest rates. We prefer firms that are growing dividends as they offer investors both yield and growth.