Interest rates are normalizing, and as a result equity markets are under pressure. For nearly a decade, overnight rates have been held below the rate of inflation thanks to global central bank largesse. Facing a financial crisis, the Federal Reserve, the European Central Bank and the Bank of Japan pushed their overnight rates to zero and bought $14 trillion financial assets. Eighteen months ago, the Fed reversed course and embarked on a tightening program by lifting overnight interest rates and closing the book on quantitative easing. The ECB recently announced the end of its QE program and will likely raise overnight rates next summer. The BoJ will likely not be far behind.
Generously low rates fueled a corporate debt boom: between 2009 and 2017, non-financial corporate debt outstanding expanded $2.7 trillion to $6.2 trillion. A portion of the proceeds was used to fund share buybacks. According to DataTrek Research, for the 12-month period ending in June 2018, S&P 500 companies spent $646 billion buying back their own shares. Share buybacks drive earnings per share growth, a key metric in S&P 500, by reducing the number of shares outstanding. The buyback frenzy reached a crescendo when Berkshire Hathaway Chairman Warren Buffet reported $928 million in share buybacks in Q3/18, his first repurchase since 2012.
The S&P 500’s EPS expanded more than 20% this last earnings season, due in large part to share buybacks. Since the end of 2016, total net income of the Dow 30 stocks has expanded 23%, from $71 billion to $87 billion through Q3/18. The Dow’s EPS, meanwhile, mushroomed 40% – nearly double the rate of growth of net income – thanks to share buyback activity.
While stocks may be fully valued, bonds are downright expensive thanks to artificially low yields due to central bank interference. Interest rate normalization has the potential to tip the bond-stock valuation balance enough to pull the rug out from under what has been one of the key drivers of EPS growth – share buybacks.
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