Tuesday, June 7, 2016

Signs of the Next Financial Crisis? - Part 2

Yesterday, we discussed the recent weak employment numbers and took an in-depth look at the negative-yield bond bubble. Today, we're going to explore another alarming trend in the global--the massive growth in corporate debt.

First, let's look at the numbers. This chart from Bloomberg sums things up pretty well. Not quite a hockey stick shape, but we're getting there.

Since 2006, corporate debt has more than doubled to $6.64 trillion at the end of 2015. And as you likely know, economic growth over that same time period has not quite kept up with the growth in debt.

Of course, we should hasten to note that debt is not inherently a bad thing. On the contrary, the ability of individuals and businesses to take on debt improves our lives in innumerable ways. But as with any tool, it matters how you use it.

One of the major ways that corporations have been using debt is for share buybacks. And before we go further, it's worth explaining what exactly a share buyback is.

Share Buybacks Explained
Unlike the many opaque terms in finance, share buybacks are exactly what they sound like: it's when a public company buys back its shares from the people holding them. It has no practical impact on the company itself. As we have explained previously, changes in a company's share count or share price have essentially no direct impact on the company's actual operations. For example, a drop in the share price does not decrease the company's cash or resources, and a rise in the share price would not increase them.

However, since top managers typically own shares of the company and are ultimately responsible to the company's investors, they have a vested interest in seeing share prices go up as much as possible. Implementing a share buyback program is one strategy management uses to help achieve this goal of raising share prices.

Share buyback programs have a positive impact on the share prices in two ways. First, if the company is buying shares, there is an increase in the demand for the stock. As with any other market, this will have the effect of pushing prices upward. Second, a share buyback program decreases the number of shares outstanding. This in turn increases the ownership percentage for each outstanding share (any share held by someone or something besides the company entity itself). This also increases the closely watched earnings per share (EPS) figure.

Possibly obvious, but an example will clarify how this works. Say a company named Cat Co. has 2,000 shares outstanding and earned a net income of $2,500 in 2015. Let's also assume an initial share price of $20. In this situation, each individual share represents 0.05% (1 / 2,000) ownership of the company, and the EPS would be $1.25 ($2,500 / 2,000). With this EPS, we would calculate the price / earnings ratio (which is a common valuation metric) to be 16 ($20 share price / $1.25 EPS).

Now let's suppose the management at Cat Co. decides to implement a very aggressive share buyback program and decides to buy 750 shares. After the buyback is completed, there are just 1,250 shares outstanding, and let's assume the stock price went up to $32. Each share now represents 0.08% of the company, EPS has now risen to $2.00, and the P/E remains the same at 16. Nothing about the company's actual operations has changed, other than the fact that it had to spend cash to buy the shares. But management's decision was able to increase EPS and the share price by 60%. The figures used here are much larger (in percentage terms) than the share buyback programs that actually take place in the real world. But the underlying mechanics are the same. Management can directly influence the stock prices. And given that executive comp. is occasionally tied directly to share price, this is clearly an attractive option.

There's nothing necessarily wrong with share buyback programs. If a company has a lot of excess cash and has no attractive expansion opportunities to invest it in or debt to pay down, a share buyback might be a good option. It rewards investors directly, and will stop investors from complaining about idle assets sitting on the balance sheet. If the company still has enough cash on hand after the buyback, this should have no adverse consequences on the business itself.

That said, we should be more skeptical if a share buyback program is implemented using debt. Share buybacks do not generate new revenue and do not reduce expenses. At most, they can only slightly decrease future dividends payouts. Meanwhile debt must be repaid eventually and it adds interest expense. Thus, while a share buyback completed with excess cash has effectively no impact on the actual company, a share buyback completed on debt decreases the company's bottom line income and likely decreases net cash flow as well. In this way, it makes the company less stable than it otherwise would be, since it's effectively trading a short-term rise in the share price for a longer-term decline in profits.

In small doses, debt-fueled buybacks would not be a big story. If they are occurring en masse however, that could be cause for concern. The latter is what we've been seeing over the past few years.

Debt-fueled Buybacks
This chart from Society Generale, via Zero Hedge, compares the change in debt with the amount of net buyback activity.

This doesn't tell us that all new debt goes into buybacks, and it doesn't mean that all share buybacks are debt financed. But it does suggest a very strong connection between the two.

And it's not hard to see why companies would choose to go this route. The economy is not growing as fast as it normally does during an economic expansion, which limits the amount of profitable investments a company can make. But management still wants to raise EPS and the share price, even if the business isn't actually growing. Add in the historically low interest rates, and debt-backed share buyback programs suddenly make sense.

According to Bloomberg's calculations, share buybacks have amounted to $2 trillion since 2009. Not all of it is backed by debt, but the chart above indicates a significant portion is.

Of course, this doesn't mean that the companies involved are going to go bankrupt tomorrow. As long as interest rates remain relatively low, the debt may not prove to be a significant burden. But if corporate earnings continue to trend downward, as they did in Q1, and the economy slows down, many more corporations may be unable to weather the storm.

This rapid rise in debt-fueled share buybacks also suggests a degree of skepticism is necessary when considering the near record highs that stocks have reached. Share buybacks inherently increase stock prices. They can also make the underlying companies weaker in the process. If Q1 earnings are any guide, that appears to be what happened.

The Folly of Central Bank Policy
In a recent article, we showed how the artificially low-interest rate policies of the Federal Reserve and other central banks had effectively doomed pension funds and other investors to choose between a rock and a hard place. Either they own safe assets (bonds) with insufficient returns, or they choose riskier assets (stocks) that still only offer what used to be a regular return. This will speed up the collapse of many pension funds and wreak untold havoc for other retirees.

We've also previously explained how low and, even worse, negative interest rate policies around the world squeeze the profit margins for banks, among other maladies. This puts banks and the broader financial system at greater risk for failure.

Yesterday, we explained the significant asset bubble building with respect to negative-yielding bonds, which are also a direct by-product of central bank monetary policy (in addition to bank capital requirements).

Now, we can add debt-fueled share buybacks and exuberant corporate borrowing to the list as well. Few investors would stomach a company borrowing money at a high interest rate just to manage their short-term share price and EPS. But in a low interest rate environment, this activity becomes commonplace.

The cruel irony in all of this is that central banks have chosen their monetary policy with the alleged goals of stimulating and stabilizing the economy. In reality, their policies have dramatically increased the systemic risks in the global economic system. The next recession,* like the last one, will certainly be blamed on capitalism and the free market. But central banks are not a creature of the free market. They are just another arm of the government, and the blame for the next recession, when it does come, should lie squarely on them.

*As we noted yesterday, economics can't really tell us the timing of the next recession. Another recession always comes eventually, and that's about all we can say for sure. Based purely on time elapsed if nothing else, we appear to be about due though. It is also worth noting that talk of a new recession became a mainstream subject after the most recent jobs data. For example, JP Morgan recently released a report featured on Yahoo Finance suggesting the risk of a recession has not been this high since the recovery started. But again, none of this is remotely conclusive.

*(Cont.) Personally, and this is strictly my speculation, I think the next recession could happen as soon as this year. There are many major events that could prove to be the spark needed to set things in motion. Most significantly, there's the British vote on remaining in the EU, the yet-unresolved Puerto Rico debt problems, and perhaps most significant of all, the US presidential election. I think this last event will seal the deal if the others don't. In my view, the US appears poised to elect Donald Trump, a candidate who wants to start trade wars and has spoken openly a defaulting on the traditionally "risk-free" US Government debt. If that uncertainty is not enough to spook investors in this environment, I'm not sure what is. But again, that's just my speculation, and as you can see, it has more to do with politics and psychology than economics.

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