Quantitative easing (QE) has dominated debates among economists in recent years. Should the Fed use it as a tool? If it does use it, for how long should it do so? Does it create growth? Does it have pernicious effects? Does it redistribute wealth?
These are just some of the myriad questions that have arisen on the back of the Fed’s three QE packages. The Fed has done virtually anything and everything to keep interest rates at record lows and pump trillions of dollars into the economy in a bid to counter the economic crisis that threatened to push the world deep into the abyss 6 years ago. The low cost of borrowing would nurse the economy back to health, or so the theory goes…
Although the economic impact of QE is still hotly debated, what is certainly undeniable is the positive impact on share prices, with improved valuations being a natural response to lower interest rates. After a dismal 2008, when the S&P 500 lost 37%, the annualised rate of return for the market was as high as 17.9% at the end of 2013 for the period 2009-2013. The last year alone ended with an increase of 32.4% in equity prices (as measured by the S&P index, including dividends). But, while that was an excellent result for stockholders, we would humbly point out that the Fed isn’t mandated to increase the price of financial assets, but rather to assure the financial stability of the system while keeping prices under control and to contribute to the ultimate goal of any economic policy – that is, to deliver economic growth and prosperity.
Of course, we accept that higher stock prices are instrumental to a certain degree in driving the level of economic activity. Higher stock prices contribute towards an increase in consumption and investment due to the increase in household wealth imparted by higher equity prices. But, for all the trillions pumped into the economy through QE, US GDP is growing at just 2.4% per year (as of last June data). While such as pace is by no means sub-par, it certainly isn’t enough to justify the meteoric rise in financial asset prices.
Alas, it seems the Fed failed to realise that the people with the most propensity to consume wouldn’t be directly impacted by higher equity prices. Most people don’t own financial assets and rely on their job as the main source of income. With the unemployment rate recovering only very slightly, households have not significantly increased consumption levels. However, consumption only tells half the story. Eventually, it was hoped, higher equity prices and very low interest rates could induce companies to invest more and thus create the jobs that could ultimately increase household consumption. Such investment has not materialised. There are many examples: just think of Apple, which has been sitting on a very large cash pile for a very long time without investing. Instead, companies have simply used the spare cash to repurchase their own shares rather than to create any additional products or capacity. After all, to whom would they be selling? The domestic market looks mediocre and Europe continues to stagnate.
Instead of borrowing to invest, many companies are opting to borrow principally to change their capital structure instead. With the cost of money so low, companies are borrowing at near zero rates (by issuing new bonds) while repurchasing equity – that is replacing equity with debt as the main source of financing for their assets. This behaviour is commonplace, as we already reported in May. During the 1Q of 2014, companies in the S&P 500 index purchased a cumulative $160 billion of their own shares. If such a pace of buybacks continues, 2014 will set a record high in terms of share repurchases.
While a company may repurchase its shares from time to time to signal to the market a more optimistic view on the part of management, such a large scale of buybacks often has some drawbacks attached. It is therefore worth investigating the main reasons behind it and evaluating the consequences that can ultimately result from it.
Share buybacks are essentially management’s way of playing with the cost of capital. Corporates know debt is cheaper so want to borrow more but, instead of borrowing to buy assets, they borrow to repurchase equity. In doing so, they raise the share price (fewer shares in circulation, higher earnings per share), but they also increase leverage (i.e. finance risk). With companies having repurchased $160 billion of their own shares during 1Q alone, the debt position of corporate America is deteriorating, as the chart below shows. The other key point to be made here is the fact that the management team usually receives bonuses in share options, which obviously increase in value along with the increase in share prices.
The trillion dollar question thus is: To what extent are current record stock prices the result of an increase in share repurchases? We at least know their impact was significant and we also know that the music will stop sooner or later, at which time we will be approaching another collapse. This works like a Ponzi scheme. When the Fed ends its QE programme, money will stop flowing to the system and share repurchases will end. At that point, other investors will start selling their shares too. Simple herd instinct will do the rest. Make sure you are ahead of the pack!
Filipe R Costa