Share buybacks to be continuing feature
John Greenwood, Chief Economist at Invesco, explains why he thinks the prospects of US-style share buybacks spreading to other economies and markets are highly credible.
Share buybacks have been a prominent feature of the US corporate financial scene since the early 1980s. Prior to this they were a relatively rare occurrence. Their emergence as a common device of corporate financial engineering roughly coincided with the rapid development of the junk bond or high yield market, also in the early 1980s.
There is a natural coincidence here: as CEOs and CFOs sought to raise returns to shareholders by issuing debt, it was logical to try to raise returns at the same time by buying back equity – in effect, increasing leverage from both sides of the balance sheet.
As reported by the US Federal Reserve Board’s Flow of Funds tables, equity buybacks averaged 2.0% of GDP during the period 1984-90, 1.0% of GDP in 1994-2000, and 3.1% of GDP in 2004-08. It will be observed that each of these periods coincided with extended business cycle expansions. Corporations were taking advantage of strong cash flows during business cycle expansions to buy back their own shares.
Not surprisingly, in the past five years (2010-14) since the US recovery got under way again, buybacks have increased, averaging 2.5% of GDP.
Conversely, during periods of recession or acute economic weakness equity buybacks typically decline. Corporate cash flows weaken with the result that corporate officers refrain from share buybacks. Consequently, over the entire period 1980-2014 buybacks have therefore averaged a much lower 1.3% of GDP (see figure 1).
This immediately raises the question: how long is US GDP likely to expand from here (2014) in the current business cycle, and will equity buybacks continue to be a prominent feature of the economic environment?
A second question is: to what extent will foreign companies follow the example of US companies in buying back equity? In other words, can the principles learned in the US corporate environment be applied to global financial markets?
On the first question my view is that the current business cycle expansion is likely to extend at least to the end of the current decade, i.e. around 2020. This means that the current expansion is only half way through its expected life, and there should be several more years of favourable economic performance ahead.
The reason for this is twofold. First, leading up to the economic downturn of 2008-09 balance sheets of financial corporations and households were seriously damaged, requiring extended periods of balance sheet repair. The balance sheet repair process is still on-going, and is the reason why growth in so many leading economies has been sub-par for several years.
Even so, thanks to lower-than-normal rates of investment companies have been able to build substantial cash reserves (see figure 2) with which to fund equity purchases for several years ahead. Moreover, this environment is not likely to disappear suddenly. Consequently a continuation of moderate growth with continuing share buy-backs is the most likely outcome.
Second, the damage to banks’ balance sheets in the US, the UK and the Eurozone was so extensive that it is taking many years to repair financial sector balance sheets. Added to this, regulatory pressures are requiring banks to strengthen balance sheets by increasing capital ratios and reducing trading or other risky activity.
All this is leading to very slow growth of money and credit in the major economies, which in turn will likely keep inflation very subdued for several years. Since it is inflation that typically compels central banks to raise interest rates to such a level as to terminate the business cycle expansion, the absence of inflation is the current upswing biases the prospects in favour of a prolonged expansion with only moderate levels of inflation and interest rates.
Moreover, from the view point of investors and shareholders, the current environment of low growth and low inflation means that nominal interest rates are likely to remain lower than in a normal business cycle expansion. This means some investors are likely to be seeking yields or returns in financial instruments other than deposits at financial institutions. In this respect, higher returns from equities generated by a continuing flow of corporate buybacks might appeal.
Finally, turning to the second question, the prospects for the application of these principles outside the United States seem at least as good as within the US. The reason is that the US is currently leading the developed world out of the recent recession, and other developed, western economies are lagging behind the US in terms of balance sheet repair and economic recovery. This means that the same general conditions – sub-par growth, low inflation, low interest rates and balance sheet repair – will probably prevail in the developed, non-US economies.
Accordingly, the prospects of US-style share buybacks spreading to other economies and markets are highly credible. The only question is whether the business cycle expansions – particularly in the Eurozone – will gain enough momentum to generate the cash flows needed to finance the buybacks. Only time will tell, but to the extent that the developed world typically follows in the footsteps of the United States not only in popular culture but in business practices also, the chances of buybacks being implemented over the next few years by foreign, non-US corporations must be considered good.