Buybacks Will Remain Supportive For U.S. Stocks

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.

Buybacks Will Remain Supportive For U.S. Stocks

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.

Update On U.S. Small Caps

Overall equity market volatility, poor breadth and a poor performance from the retail sector all warn of tactical trouble ahead for U.S. small cap stocks. Longer-term measures of risk are also flashing red.

Small Caps

In the chart above we show the difference between our proxies for the small and large cap equity risk premiums, defined as the earnings yield less the long-term Treasury yield for each asset class. This measure is still historically high, signaling that investors are poorly compensated for taking risk in small cap equities. Thus, the onus is on small cap profits to grow at a more robust pace than large cap earnings to justify such thin risk premia. While the latest NFIB survey of the small business sector showed that expected sales have jumped, this may be coming at the expense of profitability. The number of firms reporting profit improvement is sinking anew, and our relative small/large cap profit margin proxy has dropped sharply. The implication of sagging profits is that investors are likely to demand a higher risk premium for investing in small caps, a scenario consistent with additional share price underperformance.

Bottom Line? Our U.S. equity strategists recommend a large cap bias.

What Supports The Euro?

According to our FX strategists, the ECB on the sidelines and the ballooning current account surplus are bullish forces for the euro.

What Supports The Euro

The European economic recovery is proceeding and the ECB kept policy on hold last week. Unless Europe relapses into a recession (resulting in pronounced deflationary pressures), the ECB will remain on the sidelines. Therefore, with the Fed’s balance sheet still expanding, relative monetary policies will continue to exert upward pressure on the euro. It will take a renewed expansion in the ECB’s balance sheet or a re-escalation of sovereign debt concerns to weaken the euro materially.

Our FX strategists believe that the most under-appreciated bullish development for the euro is the ballooning current account surplus. At nearly $300 bn, the eurozone is the largest current account surplus economy in the world, surpassing even China. Also, the eurozone’s surplus compares to a current account deficit of near $400 bn in the U.S. There is a huge $700 bn difference between the U.S. and eurozone’s external balances. This means that the U.S. needs to attract $700 bn of capital inflows just to be on par with the eurozone’s current account surplus.

Moreover, Europe’s current account surplus could see the euro strengthen should risk aversion rise. In the past, the Japanese yen tended to appreciate during periods of stress in global financial markets. This was not because foreigners were buying the Japanese yen and JGBs as a safe haven. It was because Japanese investors refused to recycle their current account surplus into “risky” overseas assets. Japan’s excess savings got trapped within the country, causing the yen to strengthen. The euro may begin to display similar characteristics to the yen now that it is running an enormous current account surplus.

For these reasons our FX strategists remain bullish on EUR/USD.


Global Asset Allocation: High Yield Versus Equities

Junk bonds have outperformed equities by a wide margin since their inception in the late 1980s. However, our Global Asset Allocation service anticipates a change for the following reasons:

Stocks versus High Yield

  • Highly attractive relative valuations: The spread between the yield on equities and junk bonds is near record levels. In fact, the ‘search for yield’ has pushed the spread into positive territory, an extremely rare occurrence prior to the Great Recession. Though valuations tend to be poor indicators of short-term performance, extreme levels such as these, limit downside risk and lend support to a longer term change in relative performance.
  • Corporate Activity: Companies have every incentive to continue financing stock buybacks with debt. Corporate balance sheets are strong and financing costs after taxes and inflation are negligible. This directly undermines high yield returns compared to equities.
  • A supportive growth backdrop: The relationship between relative equity/high yield performance and real global growth is straightforward. Positive growth is highly correlated with equity outperformance. Conversely, high yield tends to outperform stocks in recessionary environments. Our base case is that growth continues to edge upwards in 2014. But even if growth does slow, none of our recession indicators are flashing red, and it is very difficult to envision a scenario where growth is negative.
  • Interest rate normalization should be relatively equity friendly, assuming no ‘policy mistake’.

Bottom line: After several years of relative underperformance, the risk/reward profile is leaning in favor of stocks vs. high yield.

Continue To Overweight U.S. Tech Stocks

The U.S. tech sector has a healthy pulse, signaling solid earnings support and high odds of a continued uptrend in relative performance.

Continue To Overweight U.S. Tech Stocks

The Federal Reserve Bank of San Francisco’s Tech Pulse Index (TPI) is a coincident indicator that gauges the health of the IT sector. The TPI comprises tech investment, consumption, employment, production and shipments. The TPI is currently making fresh recovery highs, consistent with other measures of tech sector activity such as new order growth, hours worked and firming in our pricing power gauge, as shown in previous research.

Following years of under-investment after the bursting of the tech bubble, pent-up tech demand is slowly being realized. Importantly, the government is finally shifting away from being a major drag on tech spending, providing an offset to the anticipated moderation in emerging markets demand. While any sustained strength in the U.S. dollar could eventually become problematic for this globally-exposed sector, cost structures are lean, reflecting the adoption of a profit margin preservation mindset in recent years.

Bottom Line: The S&P tech sector remains a core overweight.