For years, the main source of demand for US equities has emanated from corporate management teams.
It was a simple, yet highly effective scheme. The hunt for yield occasioned by central banks driving risk free rates into the ground (and below) created insatiable demand for corporate debt. Management obliged. After all, why not borrow when rates are low and demand is high? Proceeds from that debt were funneled into EPS-inflating buybacks. That drove stocks higher, which in turn was great for management’s equity-linked compensation packages.
Of course the problem with this scheme is that it’s financial engineering – you’re just myopically leveraging the balance sheet with little regard for what the long-term consequences might be. In the mean time, you’re helping to embed an unhealthy amount of leverage in the system.
Well as SocGen’s Andrew Lapthorne has variously noted, the market is starting to punish poor discipline:
And besides, it looks like the credit cycle might be turning. Additionally, the whole “repatriated cash will fund a buyback bonanza” thesis has taken a hit now that tax reform has been delayed (seemingly indefinitely).
So the question is: who’s going to step in and take the equity demand baton from corporate management teams?
The answer isn’t surprising: ETF investors, who now own the largest percentage of the equity market on record.
The Federal Reserve Board recently published its quarterly Financial Accounts of the United States report, which analyzes $41 trillion of corporate equity assets. These include $25 trillion of domestic public corporate equity, $8 trillion of foreign equity holdings, $5 trillion of private equity, and $3 trillion of ETFs and closed-end mutual funds.
As US stocks rallied by 6% in 1Q, ETFs and international investors increased their share of total corporate equity ownership (Exhibit 1). ETFs own almost 6% of the equity market, the highest ETF share on record. In contrast, mutual fund ownership fell to its lowest level since 2004 (24%).
ETF demand in 2017 is on pace to exceed total net purchases during 2015 and 2016 combined. In contrast, mutual funds were net sellers of equities for the sixth consecutive quarter. ETFs purchased $98 billion of equities during 1Q 2017 ($390 billion annualized) compared with total annual purchases of $174 billion and $188 billion in 2015 and 2016, respectively. Although mutual funds sold $31 billion of stocks in 1Q, net demand was around $15 billion higher than 3Q 2016 ($49 billion) and 4Q 2016 ($46 billion).
US corporate demand (buybacks minus issuance) equaled $136 billion in 1Q 2017, lower than each of the last six quarters. However, buybacks was still the biggest driver of US equity demand. Financials accounted for 22% of S&P 500 buybacks, above its five-year average contribution of 15%.
We expect US corporate demand will rise by 2% to $640 billion in 2017. Adjusted EPS growth of 3%, near-record levels of cash-to-assets, and below average capacity utilization will drive positive buyback growth this year. We had previously forecast that buybacks would rise by 11% to $700 billion. Our revised estimate reflects a delay in our economists’ expectation for the timing of tax reform that would prompt firms to repatriate overseas cash. We had assumed companies would repatriate $60-$70 billion in 4Q 2017 and spend $50 billion on buybacks. Our new estimate excludes any boost from tax reform in 2017 and also accounts for weaker activity in 1Q.