“The main goal of tax reform is to boost job creation and capital expenditure/research & development spending, potentially creating a positive ripple effect on US economic growth”, SocGen’s Sophie Huynh innocently writes, in a sweeping equity strategy piece dedicated to buybacks.
It’s a nice thought – that cutting corporate taxes will incentivize benevolent management teams to spend the windfall raising wages, hiring people and investing in productive capacity. Of course, it doesn’t usually work out that way, and Huynh admits as much.
“Unfortunately, for now, as was also the case following the 2004 American Jobs Creation Act, the use of cash and repatriated cash has been more a boon for US share buybacks”, she writes.
The buyback debate is as tired as it is critical. Repurchases are paramount from the perspective of buoying equity prices (for years, the corporate bid has been the dominant source of equity demand) and bolstering bottom lines (BofA estimates that around 30% of total EPS growth over the last five years was derived from buybacks), but the discussion is also a scorching-hot potato going into an election year.
Donald Trump has variously tried to pitch his tax cuts as a godsend for the middle class, but the reality of the situation is that the benefits have accrued disproportionately to the rich, not least because the windfall for corporations has been passed along to shareholders, and most financial assets are concentrated in the hands of the wealthy.
Obviously, it’s not as simple as all that. Post-crisis monetary policy has also played a massive role in incentivizing financial engineering, as the hunt for yield creates demand for corporate issuance, the proceeds from which are then plowed into EPS-inflating buybacks.
Additionally, it’s an oversimplification to suggest that corporate management teams haven’t spent on capex, R&D and wages – they have. Here’s the actual breakdown:
The overarching point, though, is that gross buybacks have exploded in recent years and there are two key questions going into 2020: 1) How large will the corporate bid be?, and 2) To what extent will politics influence corporate cash usage going forward?
Goldman sees buybacks decelerating to $675 billion in 2020, while SocGen’s estimate is $570 billion, which the bank notes would “still be double the long-term average”.
Remember, buybacks are a kind of real-life plunge protection, especially during acute selloffs. So it matters that the overall size of that bid is set to fall.
But as SocGen goes on to write, you can rest easy knowing that management still has your back.
“We think corporate buying will remain at double the long-term average, which would act as a cushion for equity price action in our US mild-recession scenario”, the bank says, adding that “the buyback cushion comes on top of our expectation of resilient P/E expansion in a search for yield environment and limits on the depth of an earnings recession”.
The bank’s derivatives strategists expect volatility will likely trend higher, at least through the end of this year, but if you ask Huynh, the persistence of the global hunt for yield (reinvigorated by central banks’ renewed push down the accommodation rabbit hole) may limit any upside in US equity vol.
“In a $13 trillion negative-yielding debt environment, and a mild recession likely ahead of us, the search for yield could continue to drive investment decisions”, she says, on the way to noting that “with this yield-harvesting mindset, investors would continue to appreciate the combined yield the S&P 500 provides, but would still find short VIX strategies attractive”.
In closing, she offers the following visual, which speaks for itself.
Clearly, all of this goes out the window if a full-on, deep recession comes calling, and you’re reminded that “certain” politicians have called for a total rethink of the way buybacks are treated on Capitol Hill.