There are a few schools of thought on how to time interest rate hikes in keeping inflation under control. Some say wait until inflation rises before raising interest rates. Others say inflation should not be an indicator for hiking interest rates; different indicators should be used in order to stay one step ahead of inflation. Jerome Powell’s Federal Reserve is doing just that, currently raising the federal funds rate even though wage and price inflation have yet to materialize.
Deloitte’s research paper on share buybacks discusses the effect of interest rates on share buybacks. First they note,
“The gradual removal of monetary accommodation would subsequently raise real interest rates if low inflation persists. This can make savings more attractive while raising borrowing costs and slowing profit growth for companies.”
By raising interest rates prior to any material rise in inflation, the Federal Reserve has the ability to cool off the economy. This is because real savings rates rise when interest rates rise and inflation stays flat. It makes more sense to make risk free return on a savings accounts when the interest rates are higher, as opposed to when interest rates are near 0, where it makes complete sense to take risk in, for example, the stock market. Why might the Federal Reserve want to do this? One reason is because they may feel certain assets have started to get a bit inflated. Specifically, the Federal Reserve may feel that the stock market is priced a bit frothy. To encourage investors to move into less risky investments and move out of the stock market, they raise interest rates so that fixed income investments have a competitive yield.
Fixed income investments, by the way, is just another way of saying treasury bonds. The Federal Funds rate, which is the rate the Federal Reserve manipulates, is a very short term interest rate which influences bond yields. As you can see from the FRED chart below, the Federal Funds rate is very correlated with both the 2 Year treasury bond rate, and the 5 year treasury bond rate. Interest rates on savings accounts, money markets, and certificates of deposits, are also heavily influenced by the Federal Funds rate, going up when its goes up, and down when it goes down.
The Federal Funds rate currently sits at 2%. Two and Five year treasury rates sit at around 2.7%. The YTD return on the S&P 500 is close to 6.3%, while the dividend yield on the S&P 500 is 1.75%. The dividend yield tells us that if the S&P 500 was risk free, the yield on an investment in the S&P 500 would be 1.75%. Notice that currently, if we only compare yield, it makes more sense to be in fixed income investments. Of course, the S&P 500 is not risk-less; an investment in it has yielded +6.3% so far this year, but its important to note that it could have just as easily been -6.3%, since risk can work against investors. If a fixed income investment was yielding 3.7%, or 4.7%, it would make even less sense to be in the stock market, because a guaranteed 4-5% return is much better than a very risky 6% return. A good article on that thought process can be found here at the Financial Times.
Of course, there is a cost to higher interest rates; it becomes a burden for companies and people looking to borrow money. Again from Deloitte,
“Higher interest rates and persistently low inflation could [therefore] limit the share of profits spent on physical investment over the medium to long term.”
When monetary policy becomes less friendly (higher interest rates) for borrowers, it makes sense for the government to pick up the slack my conducting fiscal stimulus; government conducts fiscal stimulus by spending money on things like infrastructure, tax cuts, and welfare programs. A recent example of government fiscal stimulus was the Obama stimulus package known as the American Recovery and Reinvestment Act of 2009. That stimulus amounted to $800 Billion of government spending on everything from roads and schools to corporate tax cuts. There was also the 2009 Cash for Clunkers program, which transferred public funds to consumers to trade in old cars for new ones. These programs are government intervention in private economies; there is no reason in a free market economy that the government should transfer public funds to private business, unless in reality, the government has an ownership stake in private business, in which case, the economy is not a free market.
Continued from Deloitte,
“…a fiscal spending package to rebuild and expand existing infrastructure in the United States could spur an acceleration in corporate investment. Additionally, lower corporate tax rates, especially lower tax rates on repatriated profits, could also have a positive effect on corporate investment.”
The above is happening right now. The combination of the Trump Tax Cuts, and the one-time off-shore cash repatriation exception (repatriated cash will be taxed at a much lower rate than normal, but only one time), has elevated stock prices significantly. Corporations are having unprecedented success today making money. With that said, there are risks. Fiscal policy combined with easy monetary (interest rate) policy can overstimulate an economy. In the below FRED graph, we see that both Federal government spending ( as a percent of GDP) and Federal Reserve Quantitative Easing (buying mortgage and government debt in exchange for newly printed cash) have skyrocketed since the Great Recession of 2008. Both fiscal stimulus (government spending) and monetary stimulus (Federal Reserve monetary easing) happened in tandem! By any measure, interest rates today are still very stimulatory, as seen by the above FRED chart; rates today are much, much lower than they were in the 1980’s and 1990’s. These things combined can easily cause an inflation spike.
There is already evidence that the economy is overheating. The following FRED graph shows the stock market melt-up that’s occurred since President Trump’s election in November of 2016. The S&P 500 is up 45% since January 1st, 2015, and 40% of that is since the 2016 election, November 8th. In no way is it normal for stocks to return 40% in 2 years; this is what happens when the Federal Reserve sets rates at 0% (ZIRP) for an extended period of time. Money is forced into risky assets, like stocks.
Any money that the government is using to conduct stimulus, is being issued on credit. The US government is $21.4 Trillion in debt. The government does not have cash laying around, waiting for an opportunity to be transferred back to corporations, or individuals. Every type of stimulus program, whether conducted by the Federal Reserve (Quantitative Easing) or the government (Cash for Clunkers, the Obama stimulus, 2008 Bank Bail Outs), is government debt being taken out to fund corporate equity. The government has no equity; it has run a Current Account Deficit for decades, as seen from FRED graph below.
This means that all spending is debt fueled, and furthermore, the amount of money the government is spending to service that debt (make interest payments) is skyrocketing. The point is that the money that corporations now control as assets, in cash or equity (shares) and perform share buybacks with, is stimulus money from the government, which is ultimately government debt, and taxpayer liabilities. Just to put an exclamation point on the craziness, the transfer of government assets to corporate balance sheets has gotten so overdone that the most profitable companies are turning into creditors of the US government! It may not be long before cash cow companies like Apple and Amazon are bailing out the US government.
According to an article from CNBC, share buybacks can keep stock markets price very elevated. According to David Kostin, chief US equity strategist at Goldman Sachs,
“Corporate repurchases remain the largest source of demand for shares.”
Corporate repurchases create demand, and reduce supply. It’s no wonder prices are surging! Mr. Kostin’s next statement reflects exactly what we just discussed; corporate assets are nothing more than government liabilities, and there will be a day of reckoning that will effect both parties:
“… the swelling U.S. budget deficit presents an obstacle for investors, particularly if it causes government bond yields and interest rates otherwise to rise, putting pressure on market valuation.”
The following excerpt, continued from Deloitte, is interesting, and worth addressing:
Repatriated profits, however, may also be used to repurchase shares. But a rising price-to-earnings ratio across equities will probably continue to make share buybacks increasingly more expensive. This is probably the reason behind the decline in buybacks over the last two quarters. Nonetheless, the practice of buying back shares will not reduce the savings available for investment, but may shift the investment decision away from corporations to institutional and individual shareholders.”
A price-to-earnings ratio is a measure of the price of a share of stock, divided by the earnings per share of said stock. If a stock is trading at $10 per share, and the earnings are $1 per share, then the PE ratio is 10. The historical average of the S&P 500 P/E ratio is in about 16. That means a stock with a PE ratio of 10 is potentially cheap. A company that see’s its shares trading at a 10 P/E may very well engage in a share buyback program, buying shares while they’re cheap. Investors and traders may do the same thing. Let’s say all that buying drives the price of the stock up to $20 per share. Unless earnings increase, the P/E is now 20. This means the stock is now expensive relative to the long term average of 16. Today, as of the EOD September 7th, 2018, the market P/E ratio of the S&P500, according to multpl.com, is 24.88. That is far higher than the long term average of 16.
Another measure of P/E, which averages out earnings over 10 years, is known as the Schiller P/E. Its long term average is also ~16. It puts the value much higher, as shown in below chart:
At current P/E ratios, some say share buybacks are no longer worth it. Stocks as a whole are far too expensive for them to make sense. But according to CNBC, Goldman Sachs notes that,
“…corporate buybacks appear poised to reach the $1 trillion mark this year.”
John Blank, chief equity startegist at Zacks Investment Research, makes an ominous observation:
“In fact, the last time there was a big surge in buybacks was in 2007. The financial crisis hit in 2008.”
In 2007, S&P 500 P/E ratio hit a high of 22. It turns out P/E ratios are not that great in predicting market movements. P/E ratios actually spiked in January of 2009, when stock prices had bottomed. But that didn’t mean the market was expensive. Why? Because the market was seriously pricing in the end of the world; it was pricing the end of earnings, and mass company bankruptcies. When the government stepped in and bailed the economy out, earnings stabilized, and eventually rose, bringing the P/E back down to earth. This type of event of extreme volatility is why the Schiller P/E is sometimes preferred when earnings are very volatile, around times of dramatic inflation/deflation. Notice in the Schiller P/E chart, there was no spike and retracement in 2009; its a much smoother chart due to the 10 year averaging out of earnings. The Schiller P/E did a much better job of predicting Black Tuesday and the Tech Bubble of 2000. Today, the Schiller P/E is higher than it ever was, higher than 2008, and higher than Black Tuesday. It’s approaching the value of the last tech bubble. Is it coincidence that today’s market is also being driven by technology? We shall see.
One last thing to note from CNBC,
“Share repurchases will help provide demand for stocks as many retail investors pull away from the market. Mutual funds have seen a net outflow of $57.1 billion this year from retail investors.”
I find this to be important because again, it reinforces that the buyers in the market today are not necessarily who we want them to be. Ideally, buyers should be investors on all levels, eager to participate in our greatest accomplishment as a capitalist society: the stock market. Share buybacks remove shares from the public market; they privatize companies, and shrink public participation. Privatization is the new trend in corporate America. Companies are sick of dealing with all the requirements that go with being a public company. When companies buyback their shares, they’re basically taking control of the company away from the public, essentially making themselves less answerable to the public. When Elon Musk announced his intention to take Tesla private, he did it because he was sick of the “short-sellers”, the scrutinizers of his company. So who has the money to take entire companies private? The answer to that is an exploding class of finance companies known known as private equity. That is a different discussion for a different time, but if you’d like to read ahead, check out the following articles from The Economist: you can find those here and here.