THE OVERWHELMING BUYER OF STOCKS ARE NON-FINANCIAL CORPORATIONS
In July, many were surprised to learn (even though we have shown this many times prior), that according to Credit Suisse analysts there has been just one buyer of stocks since the financial crisis: the corporate sector, also known as "stock buybacks."
Here's the summary from David Kostin: "Corporate buybacks and ETF inflows will drive US equity demand in 2018. We forecast corporate equity demand will rise by 3% to $590 billion next year. Increased authorizations and high cash balances should more than offset headwinds to buybacks from high valuations."
In addition to buybacks, Goldman is confident that the passive investing euphoria will continue, and expects expect investor purchases of ETFs to hit a record high of $400 billion in 2018. Investor preference for passive vs. active funds should continue to drive demand for ETFs
Meanwhile, Goldman predicts that active investors will continue to liquidate holdings, and mutual funds will remain net sellers of equities in 2018 while foreign investors will reduce net buying.
We forecast mutual funds will sell $125 billion of equities in 2018, in line with net equity demand during the past two years. We expect stable US GDP growth and a flat US dollar will support $100 billion of foreign investor demand for US equities next year.
CORPORATIONS: We forecast corporations will purchase $570 billion (-9%) of US equities in 2017 and $590 billion (+3%) in 2018 primarily through share buybacks (net of issuance). During 1H 2017 there was a considerable slowdown in repurchase activity given elevated policy uncertainty. Net buybacks are on pace to fall by 21% vs. 2016. Consequently, we lower our 2017 corporate demand forecast to $570 billion from $640 billion, implying a decline of 9% vs. 2016. However, our estimate still assumes an acceleration in net buybacks in 2H vs. 1H given a 60% expected increase in Financials buybacks due to CCAR results and buyback seasonality (2H usually comprises around 60% of annual buybacks). Net buybacks should rise by 3% in 2018 given an increase in repurchase authorizations including and excluding Financials, high cash balances, and solid earnings growth. However, extended valuation should limit substantial buyback growth. Rising interest rates and the underperformance of stocks focused on buybacks could pose additional headwinds to total corporate equity purchases.
So why the modest slowdown in buybacksin 2017? According to Goldman, "corporate equity demand plummeted in 1H 2017 in the face of fiscal and monetary policy uncertainty."
The pace of buyback executions in 2017 vs. 2016 has declined more sharply across all US companies (-21%) than the S&P 500 (-7%) because ex-SPX US equity demand has fallen by more than 60%. Policy uncertainty has also hurt other uses of cash. Annualized S&P 500 capital expenditures (-7%), R&D (-8%), and cash M&A (-13%) are all lower this year compared with 2016.
That is expected to change, and it's not only contingent on the fate of Trump's tax reform especially as it regards repatriation: an increase in buyback announcements and high cash balances is expected to drive repurchases next year.
- S&P 500 repurchase authorizations have increased by 18% YTD compared with the same time in 2016.
- Financials authorizations are 25% higher than the prior peak in 2015.
- Even excluding Financials, authorizations have risen by 4% so far this year.
- S&P 500 cash balances as a share of assets are near record highs (12%), indicating significant potential to deploy cash.
- The boost from the CCAR test results to Financials buybacks should also continue to support elevated buyback activity next year while positive earnings growth should benefit M&A.
We expect share issuance will remain at the 5-year average of $125 billion through year-end 2018.
Even so, there is one major reason why corporations will limits their buybacks - their stocks have never been more overvalued.
We expect the rise in corporate demand will only be modest in 2018.
- Total corporate repurchases next year should remain below 2016 levels.
- The equity market is at record highs and valuations are stretched, which will discourage firms from sharply boosting share repurchases.
- In addition, rising interest rates suggest that companies may refrain from issuing large amounts of additional debt to fund buybacks, especially when leverage for the median stock is at a record high.
- If policy uncertainty persists, management teams may continue to curb cash spending as they did during 1H 2017.
- Investors have rewarded firms investing for growth over those returning cash to shareholders. Our sector-neutral basket of 50 stocks that have spent the most on capex and R&D (GSTHCAPX) has returned 25% YTD vs. 16% for the S&P 500. In contrast, a similar basket of stocks with the highest trailing 4-quarter buyback yields (GSTHREPO) has lagged the S&P 500 by 470 bp this year (12% vs. 16%).
Still, should Trump tax reform pass, it is a key upside risk to Goldman's forecast: "In the event tax reform passes, we expect corporate demand could rise by an incremental $75 billion relative to our baseline estimate of $590 billion to reach $665 billion in 2018, implying 17% growth vs. 2017."
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Ok, buybacks will once again determine the fate of the market in 2018; what about other sources of stock buying, and selling? Here is the full breakdown:
- ETFs: We estimate investor flows into ETFs will rise to a record of $400 billion in 2018, a 33% jump from our 2017 estimate of $300 billion. The vast majority of ETFs are owned by retail investors. ETF assets as a share of the total corporate equity market (public and private) have doubled since 2009 and now stand at a record high (6% of total). The magnitude of passive fund influence is greater when looking only at public equities. ETF AUM, including index objective funds, is equal to 14% of S&P 500 market cap and 9% of the total US public equity market. US equity ETFs have witnessed inflows during each of the past seven years and inflows of $132 billion YTD. Investor preference for passive over active and strong household balance sheets should support strong ETF inflows next year.
- MUTUAL FUNDS: We expect mutual funds will be net sellers of equities in 2017 ($100 billion) and 2018 ($125 billion). Mutual funds have sold equities for seven consecutive quarters since the end of 2015. Equity mutual fund outflows ($98 billion YTD), coupled with a declining liquid asset ratio, have been key drivers of negative equity demand among active funds during the past two years. We reduce our 2017 estimate of mutual fund equity demand to -$100 billion from -$50 billion given greater-than-expected net selling during the first half of the year. The combination of passive fund popularity and weak active fund returns will continue to hurt mutual fund equity demand in 2018.
- FOREIGN INVESTORS: We expect foreign investors will remain net buyers of US equities but reduce purchases from $150 billion in 2017 to $100 billion in 2018. Foreign investors were net sellers of US equities during the past two years. However, a weak US dollar during 1H 2017 helped reverse the trend of net selling. We raise our 2017 estimate of foreign investor equity demand to $150 billion from $25 billion. Demand should remain positive in 2018 given stable US GDP growth of around 2%. However, a flat trajectory for the USD suggests lower purchases in 2018 compared with this year. We expect US investor purchases of foreign equities will equal $300 billion in 2017 and $250 billion in 2018 given solid global economic growth.
- PENSION FUNDS: Pension funds will sell $300 billion and $250 billion of equities in 2017 and 2018, respectively. We lower our 2017 estimate of pension fund equity demand to -$300 billion from -$175 billion given elevated net selling (-$273 billion annualized) in 1H 2017. We expect pension funds will continue to sell equities in 2018 as the 10-year US Treasury yield rises by 100 bp to 3.3%. Net selling of equities by pension funds has averaged $200 billion annually since 2012.
Finally, what if rising rates blow up the corporate buyback machine, and make it prohibitively expensive to sell debt and buy stock with the proceeds, leading to the loss of the marginal buyer? Well, just to cover itself for that contingency, Goldman left the following footnote:
BEAR MARKETS: Investors continue to worry about the timing of the next bear market. Although we think an imminent correction is unlikely, we analyzed flows around bear markets during the past 70 years. In general, corporations, foreign investors, and mutual funds reduce equity demand during a downturn while pension funds increase net buying. Households have been net sellers 100% of the time.
Yes thank you, what we'd like to know is if households will also be "100%" net sellers in 2018...