U.S. Equities: Bye-Bye Buybacks

One casualty from declining free cash flow in the U.S. could be stock buybacks.


U.S. 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.

U.S. Equities: Burden Of Proof Lies With The Bulls

2100 has been a key resistance level for the U.S. S&P 500. We believe the market lacks a near-term catalyst for a breakout above that level. Conversely, several factors risk pulling the market down.


It is unlikely that economic data between now and the next FOMC meeting (on December 15-16) will be poor enough for the Fed to back off from raising rates; there remains one payroll report and inflation data. Equity prices have been steady over the past few weeks, i.e. since it has become apparent that the Fed’s default position is to raise rates at the next meeting.
But still, at nearly 16.5 times forward earnings, stocks are priced for a very good earnings/economic outcome. We have highlighted frequently in Daily Insights that we view most of the risks to the downside. Dollar strength represents monetary tightening and is a headwind for many S&P companies. Corporate selling prices are weakening, putting downward pressure on profit margins. EM risks remain elevated. We are on high alert for more severe corporate bond fallout, especially in the energy space.
In sum, it is not a recipe for broad market capital appreciation. The Fed may not be the trigger, but we nonetheless remain defensive and focused on minimizing risk.

The Renminbi’s Path Of Least Resistance

As the Chinese economy is still struggling with weak growth and heightened deflationary pressures, a weaker currency is certainly desirable in terms of aiding the authorities’ monetary easing campaign. However, it is not clear that will occur.


Some have argued that a large one-off devaluation of the renminbi, say in the magnitude of 20%, is in the best interests of China. The 33% devaluation of the currency in 1994 has been cited as a precedent. Granted, a quick and meaningful devaluation would not only help Chinese exporters but also minimize capital flight and reset market expectations for the exchange rate. However, this option, even if economically sensible, is technically and politically not feasible in the current environment:

  • The 1994 devaluation was a fundamental reform of China’s then “dual exchange rate” system. Prior to the devaluation, the “official” exchange rate deviated massively from the prevailing market rate. In this sense, the 33% devaluation was merely a move to eliminate the discrepancy. Unlike in 1994, there is no “market-determined” level that the official fixing rate can fall to now.
  • China’s share of the world economy is currently 14%, compared with just 2% in 1994 and its contribution to global growth is even bigger. With such a hefty weight, it is a lot more difficult for China to implement a “beggar-thy-neighbor” devaluation, especially considering the weak growth profile of other major economies. Furthermore, the latest numbers show that China’s trade surplus continues to make new highs, in stark contrast to chronic trade deficits in the 1980s and early 1990s. A sharp devaluation amid a record trade surplus would inevitably invite blames of currency manipulation and bode poorly for the renminbi’s bid for the SDR.

The second option for a weaker renminbi is a series of small devaluations over an extended period of time. Please see the next Insight, (Part II) The Renminbi’s Path Of Least Resistance.

EM Versus DM: Valuation Discount Is Not Large Yet

Relative to developed markets, EM stocks are not cheap.


EM equities appear “cheap” because the aggregate EM equity benchmark has larger weights than DM bourses in financials, energy, materials and autos, all sectors with low P/E ratios across the world.

When we control for sector weights, i.e., compare equal sector-weighted multiples between EM and developed markets, the EM discount is very small. The trailing P/E ratio for the equal-sector weighted index is 19 for EM, 21 for the U.S., 24 for the euro area and 16 for Japan.

Despite massive underperformance in recent years, EM stocks still do not yet trade at a large discount versus their DM counterparts. The valuation discount of 5%-25% (depending on the valuation ratio) is still very small given that EM credit and business cycles are in a full-fledged downturn – even while DM credit and domestic demand, though sluggish, are unlikely to contract.

Assessing The Impact Of The RMB’s SDR Ambition

There are growing odds that the IMF later this month will officially include the RMB in its SDR basket.


Some of the technical issues raised by the IMF on the RMB’s eligibility have been addressed by the Chinese authorities. For example, the RMB spot exchange rates on the onshore and offshore markets largely converged after the August shakeout, thanks in large part to heavy intervention by the Chinese central bank. The Chinese central bank has taken some bold steps to liberalize interest rates, and has improved transparency of its foreign reserve holdings.

Furthermore, the government has started the weekly issue of three-month Treasury bills to build the short end of the yield curve, and may soon extend onshore yuan trading hours to overlap with Europe, creating continuous pricing for the RMB. Meanwhile, major countries have all voiced support for the RMB’s SDR bid, at least conditionally on the IMF’s technical assessment. All of this has largely cleared the obstacles for the RMB to join the SDR currency “elite club”.

The inclusion in the SDR would certainly increase the RMB’s international status, but the near-term global impact will likely be muted, with or without the IMF’s stamp of approval later this month. Please see the next Insight, (Part II) Assessing The Impact Of The RMB’s SDR Ambition.