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Good morning. This week’s central bank meetings will hopefully give markets something new to sink their teeth into. Or not! Maybe everything will go as planned and nothing interesting will happen. Regardless, this newsletter will continue. Email us: [email protected] and [email protected].
Will higher rates dampen redemptions and cause the market to fall?
Our colleague Nick Megaw published an interesting article this weekend on the decline in stock buybacks in the United States. The big idea was that between regional banks hoarding capital following the Silicon Valley micro-crisis and rising interest rates, companies were buying back less of their stock. His painting:
Stock buybacks rise and fall cyclically, which is a persistent market irrationality (one would want companies to buy back their shares when the market is weak and stocks are cheap; but they do the opposite). What’s interesting about Megaw’s article is that it suggests that if we are in a new regime of higher interest rates, redemptions could be lower on a secular basis:
“Structural reasons as well as the interest rate environment contribute to this,” said Jill Carey Hall, equity and quantitative strategist at Bank of America. “We expect buybacks will not be as significant for the foreseeable future. . . When rates were zero, it made sense for companies to issue long-term, low-rate debt and use it to buy back stock. Now, not so much.
This question is important because, for a long time, corporations were the only consistent net buyers of U.S. stocks. This chart from Deutsche Bank from a few years ago tells the story well (I’ll try to find or create an updated one in the coming days):
This result is not surprising. Households (domestic and foreign) buy shares when they need to invest and sell them when they need to consume. It makes sense that over time there will be a rough match between their purchases and sales (subject to demographic trends). Companies make an initial offering and then generally avoid diluting investors with new issues, while carrying out buybacks when they can.
If the dominant net buyer of stocks is about to pull back due to rising debt costs, a negative price impact seems logical. That is, there could be a direct causal channel linking higher interest rates and lower stock prices.
Consider a company with a price-to-earnings ratio of 20 and a tax rate of 20 percent, which can borrow money over the medium term at 2.5 percent, such as a triple-B rated company probably could have done it two years ago. A fully debt-financed buyout of 5 percent of this company’s outstanding shares would be more than 3 percent accretive to its earnings per share. With a cost of debt of 6 percent, which a triple B company could pay today, such a buyback would have a dilutive effect on EPS (the accretive power of EPS, I must point out, is not really the final word on whether a buyout is a good idea, but it is a relevant and satisfactorily quantifiable consideration).
But the fact that rates affect the economics of debt-financed buyouts does not in itself imply that at significantly higher rates there will be significantly fewer buyouts. The sensitivity of buyout decisions to economic reality and the proportion of buyouts financed by debt could have a mitigating influence.
On the first point, while it is difficult to understand why a company would carry out a buyback that would have no accretive effect on earnings per share (except perhaps to compensate for the dilution of stock compensation), we know that buybacks are at least somewhat insensitive. to economic reality because we know that they are procyclical. More buybacks are made when stocks are more expensive. Companies are not perfectly economically rational when it comes to buybacks, so the impact of rising debt costs on buybacks may be less than one might expect.
On the second point, it’s important to note that many buybacks are done by companies that generate so much cash that the cost of debt doesn’t matter. In the last quarter, Microsoft, Apple, Alphabet, Exxon and Chevron – all huge cash distributors – accounted for more than a quarter of all S&P 500 buybacks, according to data from the S&P Dow Jones Indices.
Overall, I think we should temper our fears that rising rates would weigh on the market by discouraging redemptions. But to the extent you think buybacks support stock prices — and there’s a debate to be had about that — it may be that higher rates further divide the market between the haves and have-nots. The cash-rich will be able to maintain their buybacks, and potentially their stock prices, while the cash-poor who relied on debt financing will have to forgo them.
Normalization of the labor market
If the economy lands softly, will we know when it happens? Has this already happened? Growth has clearly held up; When it comes to inflation, however, it’s harder to say. Core inflation measures are lagged. Some are already saying that, after taking into account the slow pass-through of market rents to official indices, inflation is currently hovering around 2 percent and we are on the verge of a soft landing. We just can’t see it yet.
If inflation is too slow an indicator, we must then turn to the labor market. When labor demand exceeds supply, it irritates the Fed, keeping it focused on supposedly labor-sensitive inflation data, like basic non-housing services, which have resumed in August. With monthly payroll growth below 200,000 and unemployment rising, everyone agrees that the job market has cooled. The question is how much.
In two recent notes, economists at Goldman Sachs argue that we are basically back to normal. Labor market rebalancing is “now largely complete,” with many tightening measures returning to pre-pandemic levels (the red line below represents the average):
(The “labor market gap” is the number of people telling the Conference Board that jobs are plentiful, minus those who say they are hard to get. The “job-worker gap” is employment + (job openings – labor force, using Goldman’s estimate of employment openings.)
The continuing concern concerns wage growth, which is still far from normalizing. You can argue, as Goldman does, that it’s only a matter of time before wage growth slows. In theory, a reduction in labor market tightness – that is, in workers’ bargaining power – should occur before wage growth slows. One of the strongest measures of strain, the quit rate, tends to drive changes in wage growth, as shown in the chart below (let’s look, for example, at the mid-2010s):
Everything is clear, then? In his latest edition of The Overshoot, Matt Klein points out an important subtlety. Much of the wage disinflation we’ve seen so far comes from a reversal of the additional earnings enjoyed by job changers – people who got a raise by finding a new job – since the pandemic. Data from the Atlanta Fed’s salary tracker indicates that those who switch are now getting raises comparable to those who stay. Resident pay increases, meanwhile, are stubbornly high (pink line below):
One observation that might bring Klein’s point closer to Goldman’s is that when we talk about the labor market normalizing to 2019 levels, it is less often emphasized that the 2019 labor market was very strong. True, inflation was 2% at the time, but there may well be a difference in wage-price dynamics once inflation is already high. A return to 2019 may be necessary, but not sufficient, to bring down inflation. Until wage growth slows, declaring a soft landing seems premature to us. (Ethan Wu)
A good read
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