While stronger U.S. economic growth implies that a rising share of capital will be diverted to investment, our U.S. equity strategists doubt that the trend of a net contraction in shares outstanding is over.
Businesses are generating enough cash flow to finance capital spending through internally-generated funds, as measured by the corporate financing gap. Our Corporate Health Monitor reveals that businesses are in fine shape. Even if external financing demands continue to accelerate, as we expect, it still makes financial sense to retire stock.
There is still an historically wide gap between earnings yields and corporate bond yields in all ten S&P sectors. Real yields are low across the spectrum, with health care and materials actually enjoying negative real financing costs. On a broad basis, this means that businesses have the incentive and capability to shrink the number of shares outstanding.
While sales and productivity generate higher quality earnings growth than buybacks, history shows that buybacks can help the corporate sector maintain a healthy return on equity. Part of this positive correlation reflects the pro-cyclical nature of repurchase activity, but a lower equity base will boost returns on capital, all other things equal. By extension, a strong ROE is supportive of valuations.
Thus, while the economic soft patch will keep stocks locked in a corrective phase in the short run, the odds of a sustained equity downturn are low given that capital structure preference activity favors shareholders and the economy remains on a growth path.