SocGen’s Andrew Lapthorne has been waiting on everyone to wake up to the buyback scheme for a long ass time.
At this point, I certainly hope you’re aware of what I mean when I say “scheme.” The buyback bonanza that’s accounted for the majority of U.S. equity demand over the past several years is simply financial engineering at its worst. You issue debt at artificially suppressed rates to investors who are still engaged in a frantic hunt for yield and then you use the proceeds to buy back your own shares and inflate your bottom line.
Simple. Elegant. And yet simultaneously revolting and abhorrent for those of us who are sane.
Here’s how the above-mentioned Lapthorne put it earlier this year:
As we have long pointed out, the reason for [the] increase in debt is largely down to financial engineering – aka share buybacks. Borrowing money to buy back your elevated shares is clearly nonsense.
Yes, “clearly nonsense” and as it turns out, the equity market has started to punish that “nonsense” even if the credit market hasn’t.
Well Andrew is back this week with a rather disconcerting revelation. Read below as he explains that “over-leveraged companies have finally reached a limit on being able to borrow simply to support their own shares”…
Last week in the US, the S&P 500 fell 1.4%, but the smaller cap Russell 2000 dropped 2.7%, leaving this index up just 1.3% for the year and down 5% over the last couple of weeks. VIX leapt by over 60% from its lows and High Yield Credit also fell sharply. Along with the Russell 2000, HYG has also unwound most of this year’s positive performance in a matter of weeks. In our view, high yield credit and the Russell 2000 are all the same trade with different wrappers. Their continued success is highly dependent on asset volatility remaining as subdued and debt markets as generous as they have been, both of which we think is highly unlikely.
This apparent aversion to balance sheet risk is not restricted to US small caps or HYG, indeed within the S&P 500 ex financials such a strategy remains the most profitable of our US investment styles this year. What might be contributing to this performance trend? Well we note that share buybacks have slumped by over 20% YoY. Perhaps over-leveraged US companies have finally reached a limit on being able to borrow simply to support their own shares.