One casualty from declining free cash flow in the US could be stock buybacks.
US businesses are no longer generating enough internal cash flow to fund operations. The corporate sector financing gap is historically wide, reflecting a heavy reliance on external funding. Corporate debt is growing faster than profits. The implication is that balance sheet flexibility is limited, which is a reliable indication of future repurchase activity.
To make matters worse, credit market risk appetite is drying up. Corporate bond yields are climbing steadily, and junk bond yields are well above earnings yields, eliminating the financial incentive to issue debt to retire stock. Even if that motivation still existed, the plunge in corporate bond issuance suggests there is little appetite for debt, which is needed to allow companies to repurchase shares.
The downside of this deterioration in corporate balance sheets is that a major support of overall EPS growth is likely to crumble. The NASDAQ Buyback Achievers Index is already underperforming, and overall shares outstanding are no longer falling, despite the plunge in new stock issuance.
A dwindling equity base has boosted return on equity (ROE) in recent years. Ergo, valuations could be at risk if ROE suffers over and above the negative impact from deteriorating profitability and flagging productivity.
Bottom Line: Poor earnings quality and deteriorating free cash flow are consistent with elevated stock market volatility and upward pressure on the equity risk premium. Stay defensive.
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