Last Tuesday, the FT asked the question “Where will corporate America’s overseas cash pile go?” An excellent question indeed.
Until Trump proposed a repatriation tax and lower overseas corporate taxes, the share buyback binge which has propelled the US equity market for the past seven years was set to peak. Goldman Sachs estimates that the tax holiday will result in 200 billion USD of repatriations. US businesses have some 2.6 trillion USD cash held abroad. The expectation is that most of this cash will be directed at share buybacks and dividends, although share buybacks will likely dominate as the more tax efficient means of shareholder reward.
Let’s try to argue against this consensus scenario. There are basically three things you can do with corporate cash, you can:
- buy back shares,
- buy other companies,
- invest in capacity, or
- retire debt.
Interest rates are rising which implies that, one, indebtedness is expensive, and two, investment in capacity faces a higher hurdle rate of return. Buying back shares raises the leverage of the company making it relatively more indebted. Buying other companies raises leverage far faster than share buybacks. Investment in capacity may be justified if final demand picks up but, ceteris paribus, higher interest rates means less investment. How about retiring debt either through buy backs or simply attrition.
Net debt to EBITDA for S&P 500 companies rose from 1.1X in 2013 to 1.7X while total debt to EBITDA rose from 3.6X to 4.6X. This is a considerable increase in leverage in a short time. The scope for a deleveraging cycle is ample. If US companies embark on strengthening their balance sheets, by eschewing share buybacks and reducing indebtedness, the impact on credit spreads could be significant.
From 2002 to 2007, credit spreads tightened as leverage fell. From 2007 to 2008, leverage rose and credit spreads surged, although the catalyst to be fair was not in the corporate credit market but in the housing market. The credit rally from 2010 to 2014 coincided with balance sheet deleveraging. What is remarkable about the credit market has been the rally from February 2016 to date which has occurred while corporate leverage is still increasing. If corporates start reducing their leverage, we could be seeing a more sustained rally in credit and spreads reaching for the lows of the 2004 -2006 period.
Further signs of strength and stabilization are recorded in China and Japan and US economic data were robust, especially the NAPM PMI. Global growth, a few months ago in doubt now appear to be in a synchronized recovery.
This week, the Fed will convene its last FOMC of the year and is almost certain to raise rates by 0.25%. Failure to do so would raise uncertainty. The market implied probability for such a move hit 100% a couple of weeks ago and is now at 94%.
Equities had a very good week. European equities surged on a weak EUR, an extension of QE (albeit in third gear) to the end of 2017. Japanese equities were also very strong on a weak JPY and improving economic data. Now, US equities were also strong, driving the S&P500 and Dow Industrials to new highs. Momentum from the Trump trade rocks on.
Duration sold off in USD, EUR, JPY. However, credit spreads tightened further, offsetting some duration losses in IG and certainly dominating duration in HY.
Non agencies were slightly weaker last week but loans and bank capital rallied significantly. To put things in context, leveraged loans are now +9.45% YTD on a sub 2% volatility, and non agencies are up over 16% on vols of 4%.
The headlines read bond rout, bear market in bonds, and trillions wiped out in bond markets, but the main stream newswires don’t differentiate between credit and duration. Duration has sold off significantly but credit has had a bumper year, better than equities in raw terms and far, far better on a risk adjusted basis.
It was a volatile week for EUR with the Italian referendum having little final impact and the ECB’s lower, and less, for longer whipsawing the markets for an intraday range of [1.0598 – 1.0874]. Otherwise USD has been consistently strong to the point of boredom.
OPEC secured production cuts of 558,000 bp/d from non-OPEC producers including Russia (300kbp/d), Mexico (100 kbp/d), Azerbaijan (35 kbp/d), and Oman (40 kbp/.d)
It is clear that as the Saudis were determined to push up inventory to sweat US shale, so they are determined to raise and maintain prices. The question is how high and how long? The answer is dependent on answering the question, why? We think it’s the Aramco IPO which is in 2018, so we’ve answered how long. How high? Not more than 85 USD for that would imply the long term viability of the entire US shale industry. Still, a 70-75 USD target is a decent return away from the current 55 USD.
Remember the consensus outlook for 2016 which investors held at the end of 2015?
- Equities: Europe and Japan would outperform US and Emerging Markets. Wrong, wrong, wrong and wrong.
- Overweight equities and high yield. Right, and right.
- Underweight government bonds. Wrong all the way up to July.
- Oil would continue to be weak. Would have been right twice and wrong once this year. Right from Jan to Jun then wrong. Right again last month.
- Weak base metals. Wrong.
- USD strong, EUR, JPY weak. EM currencies weak. Wrong from Jan to Jun. Right from Aug to date.
The consensus trades of the year 2016 seen from 2015 were mostly confounded in the first 3 months of the year. Watch out.
- Meeting of European Parliament
- India CPI, IP
- IEA oil report
- Germany HICP, CPI, ZEW
- UK CPI
- China IP, retail sales
- Eurozone Economic Sentiment
- OPEC oil report
- European HICP, CPI, IP
- US retail sales
- FOMC meeting
- Japan IP
- UK wages and claimants
- BoE MPC
- BoK base rate
- SNB rate decision
- European manufacturing, service and composite PMI
- UK retail sales
- US CPI, PPI, capacity utilization, Empire State, Philly Fed, Claims
- Eurozone HICP
- Singapore exports
- US building starts and permits