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“Credit positive activities,” A Short-lived Phenomenon

According to a Moody’s analysis of 100 large companies, after an initial round of “credit positive activities,” notably debt reduction, following the corporate tax cuts in the 2017 overhaul, firms have shifted their attention to stock buybacks. The tax cuts increased corporate cash flow by almost $400 billion in 2018. Of that increment, 37% went to debt reduction in the first half; that fell to 14% in the second half. Just over a third, or 36% went to share repurchases in the first half; in the second half, that soared to 60%. Capital spending’s share went from 22% in H1 to 20% in H2.

The first half’s gross debt paydown exceeded gross borrowing, making for a net reduction in debt outstanding. In the second half, however, firms returned to net borrowing (though at a rate considerably below 2016 and 2017).

Shifting the focus from the uses of the tax cut gusher alone, firms devoted 49% of their total cash outflow to capex in 2016–2017; that fell to 41% in 2018. But the share devoted to buybacks went from 25% to 31%.

Moody’s report pairs nicely with a new NBER working paper by Daniel Greenwald of MIT, Martin Lettau of Berkeley, and Sydney Ludvigson of NYU, “How the Wealth Was Won: Factors Shares as Market Fundamentals.” They find that between 1989 and 2017, $23 trillion in real equity wealth was created by the nonfinancial corporate sector. More than half, 54%, of that increase “was attributable to a reallocation of rents to shareholders in a decelerating economy.” (To be specific, those rents were reallocated away from labor.) Economic growth accounted for 24% of those gains, lower interest rates for 11%, and a lower risk premium, also for 11%. By contrast, between 1952 and 1988, less than half as much wealth was created, but almost all of it, 92%, can be attributed to economic growth. Conventional estimates of the equity risk premium are, by their work, overstated by 50%.

Unlike many models of stock returns, rather than imagining a single representative agent, Greenwald et al. divide the population into shareholders and workers—in line with a world where the top 5% of stock wealth distribution owns 76% of total stock market value. Shareholders earn relatively little of their income from labor, and workers earn almost all of theirs that way. In this model, shifts in income from labor to capital, which play no role in the traditional valuation literature, have a significant explanatory power over stock market returns. A reminder that two of the three authors of the paper are business school professors and not freelancing Bolsheviks.

What about the low interest rates of recent years? The authors find they explain little of the stock market’s rise since the financial crisis. While real rates are low by the standards of the 1984–2000 period, they’re not by the standards of the 1950s through the 1970s.

Greenwald et al. do not address buybacks specifically, but they certainly fit in with the distributional shift towards shareholders in their model.

Philippa Dunne & Doug Henwood

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IPOs Underperforming the Broad Market

The unicorns are finally going public in size after a long delay. Lyft did its IPO at the end of March, and Uber will be coming any day now. And more as the year goes on, flooding the San Francisco Bay Area with billions, and separating techno-optimists from large quantities money. It’s almost like 1999 again, minus the productivity acceleration (and pervasive euphoria).

Perhaps we’re being spoilsports, but this is all looking rather frothy. We’ve been worrying for some time about stock market high valuations, but an exuberance has been missing. Wacky IPOs might be a sign that the long bull market is finally entering its blowoff phase (though these can take some time).

Here are some stats from the leading academic authority on IPOs, Jay Ritter of the University of Florida. As the top graph below shows, there’s been a long-term decline in the share of firms making their market debut that were profitable. In the 1980s, 81% of tech firms going public were profitable; that fell to 14% in 1999–2000 but rose back to 38% from 2001–2007 (though obviously many fewer floated stock in the early 2000s than the late 1990s). But we got back to 16% in 2018. The profitable share of firms classed as “other” has almost always been higher, but it follows a similar path. Biotech firms are the least profitable, but they’re often swinging for the fences with a single product rather than trying to build a broad business.

As the lower graph shows, today’s market debutantes are generally much older than those of the era—an average of twelve years in 2018 compared to less than eight at the end of the 1990s. Uber, which lost $3 billion on revenues of $11 billion last year, and which shows no signs of becoming profitable any time soon, is ten years old. (As the company confesses in its prospectus, “we may not be able to achieve or maintain profitability in the near term or at all.”) You might think a firm that’s not making money after a decade or more of life and survives only on constant infusions of cash from venture capitalists might not have the best prospects for the future. But, as conceded above, perhaps we’re being spoilsports.

But maybe not. Ritter shows that since 1980, using a three-year buy-and-hold strategy, IPOs have underperformed the broad market by over 18 percentage points. Which makes one want to ask a VC, if this firm is such a great investment, why are you selling it?

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Just around the Corner? Maybe Not.

A very smart analyst joked yesterday that the Consumer Price Index is the new Nonfarm Payroll. Since the FOMC has made it clear that they are waiting for 2% inflationor perhaps Godotall eyes are searching for signs we might be getting there, so all price indexes are good fodder, especially the PCE, the Fed’s favored index.

The FOMC’s models have continually demonstrated a “just around the corner,” feature where, despite currently weak PCE measures, the expectation is that higher inflation would occur in the near future.
Unfortunately, a historical look at the broad components of this inflation measure belies their optimistic projections:


Above is a logarithmic graph of the three components of the PCE price index: durable goods prices (in blue), non-durable goods prices (in red) and service prices (in green). Two key visual elements are apparent: durable goods prices have been consistently declining since the mid-1990s. Non-durable goods prices have been stagnant to slightly lower for the last 5 years. That leaves services as the only PCE price index component that can exert upward pressure.

Let’s look at the same data from a Y/Y percentage change perspective:


Durable goods prices (in blue) have been subtracting from price growth for the last 20 years. Non-durable goods prices (in read) have been declining since 2011-2012; they subtracted from PCE price growth for most of 2015 and only recently turned positive. Only service prices (in green) have increased PCE price pressures on a consistent basis.

There are several important lessons to draw from this data. First, the PCE price index looks at prices from a business perspective. According to the Cleveland Fed, “the PCE is based on surveys of what businesses are selling.” The above charts indicate that neither durable goods nor non-durable goods companies have any pricing power. Second, the Y/Y percentage change in service prices has been declining. Third, price growth for 31% of PCEs are either negative or very weak. That means the remaining 70% of prices would have to increase at a faster Y/Y rate to hit the Fed’s 2% PCE Y/Y inflation target. This runs counter to the second conclusion regarding service prices, that the y/y rate of change is narrowing.

Those trends mean the Fed cannot hit its 2% y/y target under the current circumstances.

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Risky Balance Sheets: IMF Confirms TLR Worries

For some time now, TLR has been pointing to risks in rising nonfinancial corporate debt levels – a sharp contrast with the deleveraging that has been going on in the household and financial sectors. In its latest Global Financial Stability Report, out this morning, the IMF confirms our worries, offering considerable detail on the nature and risks of increasing corporate leverage.

The IMF makes several points, among them:

• Even with a cut in corporate tax rates, many firms would be too cash-constrained to increase capital spending – which is the economic rationale for such a policy change. Three sectors in particular – energy, utilities, and real estate – which together have contributed almost half the capital spending among S&P 500 firms in recent years, would find it difficult to boost investment. “Perhaps more important,” writes the IMF, “cash flow from tax reforms may accrue mainly to sectors that have engaged in substantial financial risk taking,” like purchases of financial assets, M&A, and dividends/buybacks. Such spending, the Fund notes, has accounted for more than half of free corporate cash flow since 2012 (another risky practice we’ve been highlighting in our quarterly reviews of the Fed’s financial accounts).

• Despite high equity valuations, firms have chosen to buy their own stock rather than floating fresh shares, and have often been using debt to finance the buybacks.

• Corporate credit quality, as measured by weakening covenants and rating downgrades, has been deteriorating – and not just in the energy sector. Capital goods and health care are looking dodgier as well.

• Leverage ratios are rising as credit quality deteriorates. (See graph below. All graphs from the IMF report.) Median debt of S&P 500 companies is close to a historic high of over 1.5 times earnings – and it’s not just energy. A broader universe of 4,000 companies, accounting for about half of all U.S. corporate assets, is approaching levels last seen just before the global financial crisis.


• Despite low interest rates, debt service ratios have fallen dramatically, as shown on graph below. Interest coverage is less than six times earnings, a ratio below what we saw before the financial crisis, and on a par with what we saw in 1999, just before the bust. Should tax cuts lead to wider budget deficits (which are not terribly high right now) and higher interest rates, interest coverage ratios could decline further.


• You might think that a cut in corporate taxes and moves that would allow the repatriation of funds stashed in tax havens abroad might ease the situation, but the IMF warns against those comforting thoughts. As shown on the final graph, the 1986 corporate tax cut and the 2004 repatriation led not to a reduction in debt or an increase in capital spending, but an increase in financial adventuring. Were such measures accompanied by a weakening of financial regulation and oversight, things could get very bumpy.


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