Steven Pearlstein, a Pulitzer Prize winning columnist on business and the economy for the Washington Post, suggests that we time travel back to 2006. Home prices were rising 10%, 15%, 20%; homeowners were collectively taking out $300B in cash from their increasingly valuable residential properties so they could buy any and every thing they wanted; and households and markets crashed when everyone figured out that houses and stocks were overly priced by debt-fueled markets.
Fast-forward to today, 12 years later and the whole thing is happening all over again. This time, or at least for the moment, it’s not households but giant corporations using cheap debt to get any and every thing they want such as increased dividends and stock buybacks. And just like the households before them 10 years ago, corporations are using cash-outs to help drive corporate debt to record levels. Like before, corporations are adding short-term high returns to drive an already booming economy. And just like before, corporations are diverting capital from productive long-term investment to further inflate financial bubbles…this time in corporate stocks and bonds.
Today’s buyback economy is driven by financial engineering, not innovation (improved facilities and equipment, services, products, etc.) or productivity growth. Today’s buyback economy is fueled by borrowing equity and then converted into debt. Today’s buyback economy does not lower prices for consumers or raise the wages and skills of employees. This buyback economy, according to Pearlstein, “returns” money to shareholders to the tune of $1.2T this year, according to estimates from Goldman Sachs, thanks to the cash freed up buy the 2017 Republican tax bill.
Pearlstein looks to INSEAD, Europe’s top business school, to determine the wisdom or folly of corporate buybacks. INSEAD’s Robert Ayres and Michael Denick determined that the more corporations spent on buybacks from 2010-2015, the less good those buybacks did for stock prices.
Just as in the housing market, the pool of stocks available to buy, like the pool of houses available to buy, is shrinking. Ayres and Denick concluded that this reduction of stock supply has resulted in $3T of corporate debt, an all time high for corporate debt and still rising. Couple this historic low supply of stock with huge global demand and voila, you get stocks priced at 25 times historic earnings.
Sound familiar? Like in 2007-2008 when analysts began noticing a decline in loan quality for late-cycle home mortgages, Daniel Arbess of Xerion Investments calculated in a February 2018 Fortune Magazine article that 1/3 of the largest global corporate loans have at least $5 of debt for every $1 in earnings. In this same Fortune article, Arbess said, “A new cycle of distressed corporate credit looks to the just around the corner.”
Household debt mortgage debt, credit card debt, car loan debt and student loan debt are, likewise, at record highs. 38% of people with credit card debt have an average of nearly $11,000 debt on their cards, according to Value Penguin. And subprime borrowers, according to the Consumer Financial Protection Bureau, have increased their debt by +26% in just two years.
That the Federal Reserve is raising interest rates at this time of record household and corporate debt is, according to Pearlstein, “nothing short of corporate malpractice.”
Pearlstein concludes his thoughts in the Washington Post in June 2018 that banks are in better shape today than they were in 2008 but not by much. “Banks are still the most highly leverage financial institutions in the economy. They remain vulnerable to recession-driven increases, delinquencies, and defaults in corporate, real estate and household loan books. And because of all that, every entity remains vulnerable to rising interest rates.”
