Listen, SocGen’s Andrew Lapthorne is not a fan of financial engineering, ok?
In fact (and I hope I’m not mischaracterizing his views on this), I’d be willing to go out on a limb and say that when it comes to criticizing financial engineering gone wild in an era of easy money, Lapthorne is the most outspoken critic on the Street. He’s been railing against the folly inherent in leveraging the balance sheet in the pursuit of ill-timed buybacks for as long as I can remember and this is perhaps my favorite quote from him on that front:
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, it’s “clearly nonsense”, but the problem with being perpetually mad at this particular brand of nonsense is that in a world where artificially suppressed borrowing costs are commingled with investor myopia and commensurate short-sightedness on the part of corporate management teams whose compensation is in some cases equity-linked, everyone involved prefers “nonsense” to balance sheet discipline.
And because the same policies that pushed borrowing costs to levels that encourage financial engineering are helping to prolong the cycle, that lack of balance sheet discipline is the barking dog that never bites.
Eventually, this situation will “correct” itself, but in the meantime, buybacks are still serving as one of the last remaining pillars of support for a U.S. equity market that’s now managed to shrug off a veritable laundry list of mini-quakes and outright catastrophes, with the February VIX spike and the March tech selloff falling into the former category and the May meltdown in the BTP market and the ongoing turmoil in EM taking the top two slots in the latter.
(Ignore that bear market)
Two weeks ago, Goldman was out suggesting that markets were “asking the wrong $1 trillion question”. Far more important than Apple summiting the $1 trillion market cap mountain is this:
“Repurchase authorizations have surged by 80% YTD and now total $754 billion”, the bank wrote on August 3, before noting that their buyback desk has just upped its estimate for repurchase authorizations in 2018 to a record $1.0 trillion which, if it pans out, would amount to a 46% increase from 2017.
Well, if you were wondering what the above-mentioned Andrew Lapthorne has to say about that, suffice to say he’s not amused. Specifically, he thinks the numbers might be unrealistic, in terms of executions.
“We monitor net buybacks from the US report and accounts cashflow statements, and they have indeed risen a substantial 30% YoY following the US tax changes”, he writes, in a note dated August 13, adding that “the current quarterly run rate is around $190bn gross, or a net $160bn if you measure the actual reduction in shares.”
That, Lapthorne notes, is below the $200 billion in Q1 and yet here we are talking about $1 trillion in buybacks a figure that, if it proves accurate, “would require a 50% quarterly step-up in US buybacks – an extra $100bn per quarter.”
Long story short, he doesn’t think that’s likely to play out and even if it does, he’s characteristically skeptical about the assumed benefits:
We have written before on how announcing a buyback, but not actually carrying through with the buyback, has empirically been the best course of action for a company. So, seeing a high level of buyback announcements makes sense. What does not make sense is to assume that in the long-term this will be good for US equities. Yes, the overall pay-out ratio is high when you add buybacks to dividend payments, but a large chunk of this increase is being funded by cash from the balance sheet and the selling of liquid investment. Net Debt is therefore on the rise.
In any event, the reason I highlighted this is because Goldman’s contention that tech (and the U.S. equity market more generally, assuming there is a U.S. market without tech, an increasingly dubious assumption) won’t ultimately rollover is in part down the assumption that authorizations will be followed by executions. Recall this from the August 3 note mentioned above:
Investors take note: August is the most popular month for repurchase executions, accounting for 13% of annual activity. The buyback blackout period has now ended for most companies. More than 80% of firms in the S&P 500 have reported results and may resume repurchasing stock on a discretionary basis after being on hiatus for the past month. Buybacks represent the critical source of demand for shares given most other ownership categories are net sellers of stocks (households, mutual funds, pension funds).
Again, that’s one of the last remaining pillars of support for U.S. stocks in the face of myriad global headwinds and for his part, Lapthorne thinks it’s a “tall order” to expect executions to live up to the announcement hype.