Tags: buybacks | market | performance | sector

Buybacks, Dividends Fueled Market Surge in First Quarter

Buybacks, Dividends Fueled Market Surge in First Quarter
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Monday, 02 July 2018 07:32 AM Current | Bio | Archive

Strategy I: Buybacks by Sectors. Last Wednesday, Joe and I reviewed S&P 500 share buybacks with data just released for Q1-2018.

Today, let’s drill down into the buyback data for the individual S&P 500 sectors:

(1) S&P 500. For the overall composite, buybacks totaled $189.1 billion during Q1, the best quarterly rate on record (Fig. 1). The previous record high was $171.9 billion during Q3-2007. The grand total since the start of the bull market during Q1-2009 is $4.1 trillion.

(2) Sectors Q1-2018: Here is the Q1 buybacks derby from highest to lowest for the sectors: Information Technology ($63.4 billion), Health Care (35.6), Financials (33.8), Consumer Discretionary (18.7), Industrials (16.6), Energy (10.1), Consumer Staples (7.3), Materials (2.3), Real Estate (0.8), Telecom Services (0.2), and Utilities (0.2).

(3) Sectors’ price performance. The buybacks help to explain the outperformance of the S&P 500 Information Technology sector so far this year. Explaining other sectors’ performance with the buybacks data is harder to do. For example, although Health Care had record buybacks during Q1, the sector is up only 1.0% ytd, slightly underperforming the S&P 500 (Fig. 2).

Here is the performance derby of the S&P 500 sectors’ stock price indexes ytd: Consumer Discretionary (10.8%), Information Technology (10.2), Energy (5.3), S&P 500 (1.7), Health Care (1.0), Real Estate (-1.0), Utilities (-1.5), Materials (-4.0), Financials (-4.9), Industrials (-5.6), Consumer Staples (-9.9), and Telecom Services (-10.8). The outperformers have been the cyclical sectors, while the underperformers have been the defensive sectors that tend to be inversely correlated with the bond yield and weighed down by a flattening yield curve.

In other words, the buybacks along with dividends may have driven the overall market more than they have impacted the sectors’ relative performance (Fig. 3).

Strategy II: Performance Derbies Since March 2009. Perhaps a longer-term perspective might find a better correlation between buybacks and sector performance. Here is the buybacks derby for the sectors since start of the bull market during Q1-2009: Information Technology ($1,007 billion), Consumer Discretionary ($632), Financials ($619), Health Care ($578), Industrials ($450), Consumer Staples ($405), Energy ($248), Materials ($89), Telecom Services ($39), and Utilities ($15) (Fig. 4).

Let’s see if these flows might explain the relative performance of the S&P 500 sectors over the same period: Consumer Discretionary (592%), Information Technology (511), Financials (427), Industrials (353), S&P 500 (302), Health Care (281), Materials (234), Consumer Staples (165), Utilities (131), Energy (81), and Telecom Services (68.1) (Fig. 5). The four sectors that outperformed by the most have also had the most buybacks.

While we are on the subject of performance derbies, let’s compare Stay Home vs Go Global since March 9, 2009:

(1) Stay Home vs Go Global in dollars. Here it is in dollars for the major MSCI stock price indexes: United States (302), Emerging Markets (120), Japan (110), EMU (106), and the United Kingdom (102) (Fig. 6).

(2) Stay Home vs Go Global in local currencies. Here it is for the same indexes in local currencies: United States (302), Japan (135), Emerging Markets (134), EMU (123), and the United Kingdom (111) (Fig. 7).

It’s no contest: The US remains well ahead of the pack. Joe and I expect this will continue to be the case at least through year-end and maybe beyond. We don’t foresee the trade-weighted dollar getting much stronger, nor do we see much dollar weakness up ahead (Fig. 8). What we do see currently are ongoing tensions within the European Union (EU) resulting from unchecked immigration, notwithstanding last week’s voluntary agreement among EU leaders about how to handle the problem.

Trump’s tariffs are another major issue for the EU, as well as for China and Mexico. We see pressure on Chinese financial markets resulting from Trump’s protectionist campaign, as evidenced by the recent drop in the yuan’s value (Fig. 9). On Sunday, the Mexicans elected a left-wing version of Trump as President. More broadly, the strong dollar (attributable to the Fed’s rate hikes and Trump’s America First campaign) is weighing on most emerging market economies.

The Fed & ECB: Bullseye. Fed officials must be celebrating with high fives. On January 25, 2012, the FOMC issued a statement explicitly setting an official 2.0% target for the y/y PCED inflation rate, particularly the core rate. The latter has been below that target ever since, but finally hit the mark in May, according to data released on Friday (Fig. 10). The headline rate was 2.3%, while the core rate was 2.0%, a perfect bullseye.

The folks governing monetary policy at the ECB must also be doing a celebration dance. The Eurozone’s CPI inflation rate jumped to 2.0% during June, according to the flash estimate, thanks to rapidly rising oil prices. The core rate remained weak at 1.0% (Fig. 11). Now the bad news:

(1) ECB. Trump’s protectionism may be starting to weigh on the Eurozone’s economy. The immigration crisis may also be doing so. Early last month, the ECB said it expected to end its QE program in December. But the narrowness of the rebound in inflation and the slowing pace of economic growth might convince the ECB to hold off on exiting QE for a while longer.

(2) The Fed. Fed officials have said that their current gradual course of monetary normalization will be maintained even if inflation rises moderately above their 2.0% target for a short period of time. However, like their colleagues at the ECB, they must have some concerns that the uncertainty unleashed by protectionist saber-rattling might weigh on business expansion decisions. They are also likely to explain inflation rates above 2.0% as being transitory—resulting from the tariffs that have already been imposed.

Credit: Concerning CLOs. Complex structured finance products were not the root cause of the 2008 financial crisis. In our opinion, the primary cause of the crisis was too much credit extended to unqualified borrowers in the mortgage market. Nevertheless, structured finance products did greatly exacerbate the crisis. Leading up to the crisis, investors in products like residential mortgage-backed securities (RMBS) did not fully comprehend the risks. Many RMBS investors didn’t see the housing market bubble until it burst. They all assumed that home prices would never fall. So deadbeats would lose their homes, which would be sold to recover the funds they borrowed. Instead, home prices plunged as delinquencies soared.

Significant concerns are now building around another type of structured finance product: collateralized loan obligations (CLOs). “Managers of the vehicles have already raised $66 billion this year. If they continue apace the market will surpass the full-year record of about $120 billion set in 2014, according to data from S&P Global Ratings. CLOs now comprise about 60% of the $1 trillion leveraged loan market,” reported the 6/26 WSJ.

The worrisome growth trend in CLO issuance was flagged last year in a FT opinion piece titled “The sequel to the global financial crisis is here.” It’s true that no financial product is without risk, and growing debt is usually not a comforting sign. But does it make sense to equate the recent rise in CLO issuance to the rise in RMBS-related products that preceded the crisis? Melissa and I don’t think so. That’s because while the products are similarly structured, they are composed of different types of credit. Leveraged corporate loans underlie CLOs, while RMBS-related products are composed of consumer mortgage loans.

Further, CLOs generally performed well during the crisis compared to the horror show put on by RMBS-related products at that time. Currently, corporate credit continues to expand, but fears of a corporate credit bubble may be allayed for the reasons discussed in our 6/19 Morning Briefing. Let’s have a closer look at CLOs:

(1) C&I bank loans at record high. Commercial and industrial (C&I) loans held by all US commercial banks rose to a record $2.23 trillion during the 6/20 week (Fig. 12). This category is up $116 billion y/y. It is up $1.05 trillion since its cyclical low in mid-2010. That accounts for the C&I loans held by the banks. Lots of their loans are also packaged as CLOs.

(2) CLO 101. CLOs purchase a diversified pool of senior secured bank loans made to companies, which are typically rated below investment grade. CLO debt is divided into tranches, each of which has a unique risk/return profile. Many investors perceive that all structured credit comes with greater risk than more straightforward, plain-vanilla fixed-income products.

(3) Lower default rate. That’s because CLOs are often associated with other forms of structured credit, such as RMBS-related products, that were at the epicenter of the financial crisis. Historical data discredits the negative perception of CLOs. CLOs experienced significantly lower default rates than corporate bonds between 1994 and 2013, according to a 4/5/17 analysis by Guggenheim, a global asset management firm. We should note that the firm has structured finance products in its offerings. However, the data in the analysis are sourced from Standard & Poor’s. Guggenheim notes: “In fact, AAA and AA-rated CLO tranches have never experienced a default or loss of principal, even during the depths of the financial crisis.”

(4) Skin in the game. Nevertheless, CLOs were hit with additional regulatory requirements following the crisis. CLO funds were subject to Dodd-Frank Act rules, requiring investment managers to hold some of the risk of their deals. Earlier this year, those requirements were reversed, as discussed in a 2/13 Reuters article. Reuters noted that “CLO funds performed well during the financial crisis and saw the application of risk-retention rules as unfairly maligning the asset class by lumping [it] in with similar funds that were blamed for” the crisis.

So the Loan Syndications and Trading Association (LSTA) sued the Fed and the SEC in 2014 on the basis that the rules imposed on CLOs were unfounded. An initially unfavorable ruling for the LSTA was ultimately appealed and overturned during early February in a win for the roughly $500 billion asset class, according to Reuters.

(5) Win for CLO funds. In a 3/29 post, PIMCO’s CLO team wrote they expect that repeal of the risk retention rules will lead to greater CLO volatility as funds sell existing positions that were held to meet the rule. Further, PIMCO also expects CLO issuance to rise along with the repeal of the regulatory requirement. PIMCO didn’t say anything about the potential for increased risk associated with CLOs given the rollback of the rule. That outcome seems appropriately excluded from PIMCO’s points because CLOs weren’t behind the risk that led to the rule in the first place.

(6) Now isn’t then. In response to the alarming FT article (cited above), Dechert, a global law firm, wrote a note titled “The Sequel to the Global Financial Crisis Is Not the CLO! (Ok, Not Yet).” It stated: “I think [the author of the article] is looking under the wrong rock for the next global financial crisis.” The note explains that CLOs today are a lot more plain-vanilla and conservative than such products were preceding the crisis. It continues: “The underlying loans largely have full covenants, recourse and structure which is highly coincident with any portfolio lender product and in some ways more rigorous than some.” In fairness, the law firm may be biased, as its bread and butter seems to come from the CLO market. However, at the 1/11 CREFC 2018 conference, the panelists corroborated the legal firm’s claims.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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Buybacks along with dividends may have driven the overall market more than they have impacted the sectors’ relative performance
buybacks, market, performance, sector
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2018-32-02
Monday, 02 July 2018 07:32 AM
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