Corporate Buybacks, Rising Rates, and Commodities

Tue, Mar 2, 2021 - 10:15am

Corporate buybacks have been a significant tailwind for higher stock prices in recent years; however, after Covid hit in early 2020, corporations largely put off buying back their own stock or issuing dividends with rising uncertainty over the outlook for earnings and growth.

Gina Martin Adams, Chief Equity Strategist at Bloomberg Intelligence, said with a large amount of cash now sitting on corporate balance sheets, we are likely to see a wave of repurchases and dividend payments in 2021.

Here's what Gina had to say in our recent interview with her on Financial Sense Newshour (see 2021 May See a Surge in Buybacks and Dividends, Says Gina Martin Adams for audio).

Buybacks Supporting Stock Prices

Right now, investors are focused on inflation pressures and whether rates will rise too much over the course of the year, Adams said. However, corporate earnings are recovering much more quickly than anyone anticipated, she added.

And, at the same time, companies are sitting on a record amount of cash at roughly 6 percent of total assets on the balance sheet, which is well above the longer term average.

corporate cash balances
US Census Bureau, Quarterly Financial Report: US Corporations: All Information: Total Cash on Hand and in US Banks [QFRTCASHINFUSNO], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/QFRTCASHINFUSNO, March 2, 2021

We’re likely going to see redeployment of dividends and a wave of repurchases to make up for the cuts to both of these programs during the Covid recession, Adams stated.

She expects to see roughly 15 percent dividend growth over the course of 2021 and close to 50 percent growth in repurchases. As of the first two months of this year, stock buybacks are already at the fastest pace in 15 years, according to the most recent EPFR data.

corporate stock buybacks
Source: Bloomberg, EPFR

Add corporate America to the growing army of buyers. Companies—a reliable ally of the last bull market—were forced to retreat and preserve cash during the 2020 pandemic, but are splurging on their own shares again. Their announced buybacks have averaged $6.9 billion a day this earnings season, the most since at least 2006, according to quarterly data compiled by EPFR. (Source)

Rising Rates Not a Worry...Yet

Many investors have been concerned about the recent increase in long-term rates. Though fiscal spending and debt continue to grow, it’s easy not to think about these things until servicing that debt becomes very expensive.

Looking at actual interest payments on the debt as a share of GDP, Adams stated, rates have bounced around between 2 and 3 percent for the last several years.

Even with the extraordinary growth in spending in 2020, interest payments are still not exploding higher, she noted. Typically, we would need to see interest rates head meaningfully higher for this to be a concern.

See Craig Johnson on 2021 Market Outlook, Rising Rates, and "Green" Metals

To the extent that some of this debt is funded at shorter-term rates, as rates head higher, interest payments will also start to head higher, Adams stated. At that point, questions of how we fund these obligations will become more pressing.

The primary concern revolves around how to pay for these increases without eating away at other government expenditures and government programs.

“That's the trigger point,” Adams said. “It does provide a good case for why you want to watch rates longer term. Obviously, real rates are still very far in negative territory. Even though longer-term interest rates are rising, they're still extremely low. So it's not a concern in the immediate term, but ultimately, rates will move up. And if rates move up faster than economic growth moves up, we suddenly have to contend with how we pay for all of this debt that we've taken on.”

From Reflation to Inflation

How all of this plays out certainly revolves around what happens with inflation, Adams noted, and we need to watch expectations and actual inflation metrics closely.

However, despite the monetary growth we’ve seen, and despite the Fed’s extraordinary efforts to support economic conditions throughout 2020, even though M2 is exploding, the actual velocity of money is not.

Until we see money velocity increase, a true outbreak of inflation is unlikely, Adams noted.

The most recent producer price print was still less than 1 percent year-over-year, and consumer prices are growing at about 1.5 percent year-over-year. These are very benign conditions, Adams stated, even compared to other time periods in which inflation conditions were accelerating over the last 10 years.

See Felix Zulauf Interview on Massive Stimulus vs. Deflationary Population Trends

Ultimately, the evidence for inflation is still subdued. It is still important to watch for policy errors that might create inflation, and this is the reason markets remain somewhat sensitive to the Fed.

Markets will continually ask if the Fed has it right as to whether any near-term reflation in the economy will be deemed transitory inflation, or if something more ominous is occurring. That is going to be a big part of the conversation over the course of the next year.

“So far, it’s a story of reflation, not inflation, which is very supportive for stock prices and probably also keeps any sort of increase in rates generally at bay,” Adams said. “One of the things that we're going to contend with … is supply-based inflation, where supply chain disruptions in general resulted from COVID shutting down trade. … As a result, we've been left with limited supply of certain products globally. In an environment where demand advances and you have limited amount of supply, you can have temporary price increases. In the United States, the vast majority of what we spend is actually on services, and services don't seem to be tremendously constrained relative to demand right now. So we shouldn't see an absolute breakout in prices and inflation. But it certainly is something we want to watch for, and it would likely be one of the predominant reasons for an unforeseen move higher in rates.”

'Healthy Rotation'

So far in the recovery, we’ve seen a very healthy rotation, Adams noted. Notably, tech appears to have peaked relative to the S&P 500 in terms of performance back in September 2020.

Also, the market has moved toward a small-cap driven, broader performance, value-oriented recovery over the course of the last several months. Then small caps have only really started to take control since the November election, and this has been increasing since the beginning of 2021.

The market is broadening, Adams noted, where it had been highly concentrated in very defensive, high-quality strategies. Investors were hiding in investments they felt had the most defendable earnings stream in the S&P 500. Now, investors are starting to broaden their outlook and take on a degree of risk.

Rotation is also occurring into emerging markets relative to developed markets. Emerging markets are finally breaking out of the range they've been in since 2018.

“Generally, we’re seeing a broadening of performance in groups that were laggards in early 2020,” Adams said. “This has been a story for the last several months, and we think this will continue to be the story for much of 2021. As these groups play catch up, they tend to benefit more from economic reopening as opposed to economic shutdown. They benefit from a more risk-on, risk-tolerant investor base, as opposed to a risk-averse investor base.”

Sector Outlook

Action in the commodities space is consistent with reflation, Adams stated. Price increases in commodities are probably trading less on the expectation of inflation, and more on the idea that economies are returning to functionality.

Commodities are an immediate beneficiary of a cyclical recovery, Adams added, noting that Bloomberg's commodity index has surged over the course of the last several months. In fact, the index bottomed around the time stocks bottomed in spring 2020 and has recovered since. This further signals better performance and a risk-on attitude for equities.

See Cyclically-Important Commodities Are Signaling Economic Boom, Says Nick Reece

The story is not so clear cut with the Energy sector however, she said. Energy relative to the S&P 500 may be in a bottoming process, and it certainly hasn't broke higher. We are still below January relative to the S&P 500 level for the energy sector.

Alternatively, Financials have a more positive outlook, and benefit directly from an upward-sloping yield curve. This setup should see Financials outperform.

As a result, Financials may be a stronger driver than Commodities for an earnings recovery in the S&P 500. Overall, Adams favors cyclical plays over defensive plays, and we need to see much better earnings revision momentum emerge for groups like Energy, Materials and Industrials, for that long-only leg of value to perform better.

“Watch these plays and distinguish between them,” Adams said. “Rates are driving Financials. Reflation is certainly driving Energy and Materials. The question is, will reflation turn into inflation, because that's probably what's going to be required for the energy stocks to perform better. Longer term, Financials have more legs, because the yield curve is becoming more upward sloping, and we think the profitability of Financials will improve, and will prove to be the driver of performance of that space over the course of 2021.”

How to Invest for 2021

The recovery is just beginning, ultimately, and investors need to keep this in mind. We are clearly still in the early phase of the economic cycle, Adams noted, and it is necessary to have some tolerance for risk if you want to see something like high single-digit returns in your portfolio.

Of course, the caveat is that investors have to determine their own appetite for risk, their overall investment goals and where they are best positioned given their assessment of their portfolio, Adams noted.

With that in mind, investors who are prioritizing returns with some risk tolerance likely need at least some exposure to the equity market. We are likely to see equities outperform, and investors with an appropriate appetite for risk will not want to miss these potential gains.

For example, consider the last cycle coming out of the 2009 recession, where 2010 proved to be a relatively volatile year, but stock prices continued to rise and set off a decade-long outperformance for the equity market.

This is typical behavior coming out of economic recessions, Adams noted. Normally, following a recession, we see years of very strong gains in equities.

“We’re so early in an economic recovery cycle right now that you do want to have exposure to risky assets, and assets that are somewhat levered to improving economic conditions and economic expansion,” Adams said. “You want to have some exposure to the stock market, despite the fact that a lot of people are definitely still somewhat hesitant to do so. I think there's still plenty of value left in equities.”

To listen to our full-length interview with Gina Martin Adams at Bloomberg Intelligence, click here. If you're not already a subscriber to our FS Insider podcast where we interview book authors, strategists and industry experts from across the globe 3 days/week on all things economics, finance and markets...

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Written by Ethan D. Mizer

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