There’s been no shortage of digital ink spilled in these pages about what central banks hath wrought in terms of the incentive for corporates to borrow to fund buybacks.
With policymakers driving everyone down the quality ladder in search of yield, investors clamor for corporate debt. And where there’s insatiable demand, there will be someone who’s more than happy to meet it with supply. Of course the temptation is to use the proceeds from record issuance to fund share repurchases and that creates perverse incentives. Here’s how we described the situation last week:
The main worry here is that corporates have leveraged themselves to the hilt in an environment characterized by an insatiable hunt for yield among investors. In order to keep the ravenous hordes sated, corporate management teams have simply met demand with more supply and in many cases used the proceeds to buy back shares in a “virtuous” loop that not only inflates the bottom line, but also boosts management’s equity-linked compensation. See? Everyone’s a winner!
Well, everyone except the people who care about the balance sheet and the extent to which it’s being leveraged in pursuit of a myopic, greed-driven agenda.
So there’s that. And if you want to look at some scary corporate leverage charts, you can find them in the piece that’s excerpted from.
Of course if you’re engaged in financial engineering, you’re by definition not spending on productive capacity and that has obvious implications for the economy. Have a look at the trend in this chart from Goldman:
You could argue that we don’t need any more capacity so why would you want to go out and help spend us all into a deflationary spiral, but that’s a kind of chicken-egg scenario. Because as Bloomberg’s Cameron Crise reminds you on Thursday, “investment creates jobs and economic growth.”
Read below as Crise explains that when you compare the S&P 500 dividend yield with net-of-tax corporate borrowing rates,” you find that “over the last couple of years it has never been as attractive to borrow to pay shareholders, using data since 1990.”
When taken with everything said above, the implication is that we have a bubble in financial engineering.
There’s an old song from a century ago called “I’m Forever Blowing Bubbles” that’s been kept alive by supporters of West Ham United, an English soccer team. Cynics might suggest that global central banks have also adopted it as their theme song given the lofty valuation of many asset markets. Unsurprisingly monetary authorities have played down this notion, with both the Fed and ECB suggesting that commercial real estate is the only real source of concern at the moment. Yet bubbles can take many forms, and it’s possible that central bank policies are contributing to a bubble in corporate behavior — one that’s contributing to the low level of nominal GDP growth.
- Central banks are famously averse to identifying bubbles in real time, preferring to conduct postmortems as they pick up the pieces afterward. On the face of it, U.S. equities may seem to have bubble-like valuations — though in the context of interest rate levels, prices are a bit less troubling
- Yet low interest rate levels have not merely boosted stock prices, they have underwritten a mode of corporate behavior that is not conducive to nominal and real GDP growth — at least in the U.S. Greased by the lubricant of low interest rates, these days American corporations often find it easier to engage in financial engineering than investment in organic growth to boost their earnings per share
- Returning capital to shareholders has taken on a paramount importance, aided and abetted by easy policy settings. Comparing the S&P 500 dividend yield with net-of-tax corporate borrowing rates suggests that over the last couple of years it has never been as attractive to borrow to pay shareholders, using data since 1990
- Why does this matter? Over the last three decades there has been a pretty strong negative correlation between the attraction of financial engineering and the share of capex in GDP. Investment creates jobs and economic growth — financial engineering rewards shareholders with a low marginal propensity to consume
- An obvious exception to this phenomenon is of course Amazon, but even there the benefits are hardly unalloyed. The retailing behemoth has been able to invest in winning market share without bothering to turn a profit. While low prices have benefited consumers, they make it hard for the Fed to meet its mandate — and its arguable that it’s been a net benefit, given the distress among other retailers
- The level of the stock market isn’t necessarily a bubble…but the behavior that’s driven it there might be. That nonfinancial debt is near all-time highs as the capex share of GDP approaches 45- year lows suggests that the “Bubbles” music is playing, even if the Fed and other central banks cannot hear it