"The Buyback Party Is Over" - Albert Edwards Warns The "Market Is Now Running On Fumes"

by Tyler Durden

08/28/2014 12:51 -0400



While we have yet to do the actual math on the now-concluded second quarter earnings season, to find out if spending on buybacks surpassed the Q1 record, one thing is still quite clear: with the impact of Fed's QE fading, if only for the time being, buybacks remain the marginal driver, and according to some only driver, of stock market upside in 2014. This was shown explicitly in this chart we posted three months ago:





However one person who has decided not to wait in declaring the buyback party over, is SocGen's Albert Edwards, the same person who correctly forecast back in late 2012 the epic scramble by investment grade (and high yield) companies to lever up, incidentally, to record levels crushing all the endless blather that there is some massive corporate deleveraging going on.




This is what Edwards said in his latest note:
Much has happened over the summer, but two landmark firsts have occurred only recently, with the S&P500 breaking above 2,000 and the 10y bund yield breaking below 1%. Our Ice Age thesis has long called for sub-1% bond yields and I see this extending to the US and UK in due course. It is the equity markets where I have been consistently surprised. QE has been an essential driver for the equity market, providing the fuel for the heavy corporate bond issuance being used for share buybacks. Companies themselves have been the only substantive buyers of equity, but the most recent data suggests that this party is over and as profits also stall out, the equity market is now running on fumes

In other words, while QE has been the permissive factor enabling companies to engage in zero cost debt-funded stock repurchases, it was corporate CFOs and Treasurers who, in lieu of traditional retail and institutional buyers, have been the marginal buyers of stocks in the tail end of the most ridiculous, rigged, and as CNBC likes to call it, "unloved" rally of all time.

Here is the bad news:


It is widely accepted the Fed´S QE programme has inflated asset prices way above fundamental values (higher inequality being one unwelcome by-product). Andrew Lapthorne has identified the mechanism whereby QE, by shrinking the available stock of investable government bonds, has encouraged investors to instead gobble up other debt assets all along the risk spectrum.

Companies issuing at low yields into this buying frenzy are doing what they always like doing with debt in the final throes of an economic cycle ? they issue cheap debt to buy expensive equity. Decent profit (cashflow growth) may be more than sufficient to cover capital expenditure and dividends, but a gargantuan funding gap emerges as companies also undertake their corporate finance zaitech activities (see chart below, Andrew also calculates that currently almost a third of all buybacks are to cover the expense of maturing management share options ? QE is indeed making the rich richer!).


Of course, none of this is new: this particular cycle always mean reverts, as does the business cycle itself: the same business cycle which the Fed, with its infinite manipulation of all asset classes, and in its infinite stupidity, thinks it can control and delay the onset of the recession, when all it is really doing is making the drawdown that much more severe when it ultimately, and inevitably does hit:
... the elephant in the equity buying ring has been the US corporates themselves (see chart below), who have been hoovering up stock at a prolific pace from the household sector (mainly) financed by debt (see chart below). This is a normal cyclical event but made easier this time around by QE.




In retrospect there can be little doubt that QE has washed through the financial markets and elevated share prices via this route. The problem is that this pro-cyclical event has a habit of stopping suddenly for the usual reasons ? i.e. recession or a closure of the credit markets, etc. Andrew in his 18 Aug note shows that is exactly what seems to have happened in the latest Q2 data where share buybacks have actually declined dramatically on both a QOQ and YOY basis. He believes the end of QE may be directly responsible for this - see Bye-bye buybacks ? the end of QE is already being felt in the equity market.

The good news, if only for those sick of all the endless Fed manipulation of every asset class, something even Steve Liesman finally acknoledges, is that is if finally all ending...


This pro-cyclical process always ends in tears and is regarded in retrospect as typical end-of-cycle madness. For when the funding for corporate bond issuance stops (for whatever reason, i.e. QE ends), share buybacks also stop and one of the biggest drivers for the equity bull market is removed.





The equity bubble has disguised the mountain of net debt piling up on US corporate balance sheets (see charts below). This is hitting home now QE has ended. The end of the buyback bonanza may well prove to be decisive for this bubble. Indeed - is that a hissing I can hear?


... at which point the Fed will have no choice but to step in again, and the central-planning game can restart again from square 1, until finally the Fed's already tenuous credibility is lost, the abuse of the USD's reserve status will no longer be a possibility, and the final repricing of assets to their true levels can begin.


Global property markets

Frothy again

Easy money is inflating house prices across much of the globe

Aug 30th 2014





BEFORE the financial crisis of 2007-08 low long-term interest rates fuelled an extraordinary house-price boom around the world. That bubble was pricked in the crisis and subsequent recession. Since then, however, central banks’ attempts to crank up the recovery by pushing down long-term interest rates to new lows have had a predictable consequence in many property markets. House prices are now rising in 18 of the 23 economies that we track, in eight of them at a faster pace than three months ago (see table).

There remain some weak spots, especially in Europe. Prices in Spain, which had one of the biggest bubbles before the crisis, are still falling. They have also been declining in France and Italy, reflecting continuing economic weakness in the euro zone’s second- and third-largest economies. In contrast, housing markets are buoyant in some northern European countries, notably Britain.


Since some recovery was bound to occur after the housing slump, how worrying are the renewed signs of exuberance? To assess whether house prices are at sustainable levels, we use two yardsticks. One is affordability, measured by the ratio of prices to income per person after tax. The other is the case for investing in housing, based on the ratio of house prices to rents, much as stockmarket investors look at the ratio of equity prices to earnings. If these gauges are higher than their historical averages then property is deemed overvalued; if they are lower, it is undervalued.

Based on an average of these measures, houses are at least 25% overvalued in nine countries. Judged by rents, the most glaring examples are in Hong Kong, Canada and New Zealand. The overshoot in these economies and others bears an unhappy resemblance to that prevailing in America at the height of its boom before the crisis.

Following an agonising housing slump, America’s property market now looks in good shape. Prices are rising again, but there are few signs yet of history repeating itself. Although low borrowing rates are supporting the market, frothiness seems to be confined to some cities such as San Francisco where the supply of new homes is especially curtailed. This forms part of a broader tendency for property markets to be especially bubbly in big cities, particularly capitals such as London.






With global monetary conditions so loose, governments are using regulatory tools to cool overheated housing markets. In Canada, for example, the maximum term of the riskiest mortgages has been lowered from 40 to 25 years. Regulators in both Hong Kong and Singapore have repeatedly raised stamp duties and tightened lending restrictions. The measures seem finally to be working, especially in Singapore, where prices are now falling.

China’s market is on the turn. Though prices are still higher than a year ago they have edged down over the past three months. Developers are cutting back as a glut of newly-built homes has swamped the market. Since property and construction make up 13% of GDP, a big fall would pose trouble for the economy. But that may be contained since Chinese homebuyers have to chip in big deposits while the government has the fiscal capacity to prop up the market if things turn really nasty.


NATO’s summit

Mr Putin’s wake-up call

The Western alliance is responding better to Russian aggression in Ukraine. But there is more to do

Aug 30th 2014

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THE fighting in Ukraine, which Vladimir Putin further escalated this week by sending Russian forces over the border, provides a sombre backdrop to the NATO summit in Wales. But it ensures that the meeting on September 4th will not have to spend time agonising over what the 65-year-old alliance is for. The timing was originally meant to coincide with the end of combat operations in Afghanistan in January. Around 14,000 American and NATO troops may remain in the country to “train, advise and assistAfghan security forces for a few years more. But the summit’s main task, thanks to Mr Putin, is a return to NATO’s old business: ensuring that when it pledges to defend its members, it can do so.

The alliance was hesitant, at first, when Russia forcibly annexed Crimea in March. It took a few modest steps to reassure the new members closest to Russia that NATO stood by its obligation under Article 5: an attack on one is an attack on all. But despite the energetic leadership of the outgoing secretary-general, Anders Fogh Rasmussen, some members (notably the Germans, the Italians and the Dutch) were loth to be provocative” towards the Russians; a subsequent Polish request for 10,000 troops, including a sizeable American contingent, to be permanently based in that country was rejected, because it was too close to Russia’s borders.


Thankfully, appeasement of Mr Putin is no longer on the cards

Russia’s orchestration of the civil war in east Ukraine and the shooting down of MH17, with 193 Dutch nationals on board, by separatists recklessly armed by the Kremlin have hardened European opinion. It is clear that the alliance must prepare to deal with an antagonistic Russia for a long time to come. Yet, even now, the risk is that NATO will do too little.

The summit is likely to back a “readiness action planaimed at strengthening deterrence. It is good—but not good enough. A new high-readiness brigade will be formed, deployable within hours; heavy weapons will be pre-positioned in Poland which could be used later by “follow-onforces; and a new command-centre will be established. Yet NATO would send a stronger signal to Russia if it had followed the Polish suggestion and set up a base for 10,000 combat troops there.



One-way street


This would contravene the 1997 NATO-Russia Founding Act, which was intended to end the mutual suspicions of the cold war and pave the way for partnership between the alliance and Russia. However, Mr Putin has never treated NATO as anything but an enemy. So NATO members have no need to feel bound by a document that is not honoured by the other side.

NATO’s European members should show their serious intent in another way, too. Fiscal austerity and a false sense of security have resulted in years of defence-budget cuts, whereas Russia has doubled its military spending (in nominal terms) since 2007. The complacent assumption in European capitals has always been that America would fill any capability gaps. Mr Rasmussen says that Mr Putin’swake-up call” has jolted half of NATO’s members into promising not to cut further, but that is not enough. In 2006 all member countries pledged to spend 2% of their GDP on defence. In Europe only Britain, France, Greece and Estonia come even close (although Poland is getting there). What NATO needs above all is more deployable and better-equipped forces—and European leaders prepared to tell their voters why they should pay for them.


Washington Recaptured

Simon Johnson

AUG 28, 2014
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Burning of Washington 1814




WASHINGTON, DC Two hundred years ago, Washington DC was captured by the British – who then proceeded to set fire to official buildings, including the White House, Treasury Department, and Congress. Today, it is a domestic interest groupvery large banks – that has captured Washington. The costs are likely to be far higher than they were in 1814.

America’s largest bank holding companies receive an implicit government subsidy, because they are perceived to be too big to fail.” The authorities will not allow the biggest banks to default on their debts, through bankruptcy or in any other fashion, owing to the need to prevent the financial system from collapsing. This doctrine became starkly apparent in late 2008 and early 2009; it remains in force today.

This effective exemption from the risk of bankruptcy means that anyone who lends to the largest half-dozen banks receives a government guaranteefree insurance against the risk of a catastrophe. This allows these banks to obtain more debt financing on better terms (from their perspective). In particular, their executives operate highly opaque firms, with risks effectively masked from outsiders and very little in the way of loss-absorbing shareholder equity. Simply put, without their government backstop, these murky empires could not exist.

Democratic Senator Sherrod Brown of Ohio and Republican Senator David Vitter of Louisiana, along with some important colleagues, have long sought to phase out this implicit subsidy. And independent analysts, such as Anat Admati of Stanford University, have explained all of the relevant details of how – and why this should be done. Those details – for example, in Admati’s recent testimony to the Senate subcommittee chaired by Brown – are not in doubt. Thanks to Admati and her colleagues, we have a clear rendering of them in straightforward, non-technical language.

Unfortunately, the leading federal government officials remain in denial. The most spectacular recent example of this is a report issued this summer by the Government Accountability Office. The GAO had a simple task: At the request of Brown and Vitter, it was charged with assessing the scale and impact of the implicit guarantees provided by the government to large bank holding companies.

The GAO responded by producing a deeply muddled report that followed the financial industry’s suggestion of focusing almost exclusively on the difference in bond spreads (interest rates on various forms of financing) between the largest banks and some of their competitors. Such spreads are only a small component of the funding advantage for big banks, and they are also highly cyclical meaning that the advantage for the biggest banks manifests itself the most when markets are under pressure, as they were in the fall of 2008.

The GAO concluded that these spreads had indeed been high in 2008, and that now they have fallen. But, as Admati pointed out in her testimony, if the authors had included 2006 and earlier years in their analysis, they would have seen low spreads using their own methodologydespite the obvious fact that massive implicit subsidies were already in place. All that the GAO established is that the macroeconomy was previously in bad shape and it is now doing somewhat betterhardly a profound finding.

The GAO report also refers to the Dodd-Frank financial reforms of 2010, including the requirement that large bank holding companies createliving wills.” The industry contends that the existence of these living willsshowing how a big bank’s collapse could be handled without causing global financial panic means that “too big to fail” is over.

Sadly for the GAO, shortly after their report appeared, the Federal Reserve and the Federal Deposit Insurance Corporation rejected the most recent living wills as completely inadequate meaning that there is still no road map for handling the failure of a very large bank. Either such a firm would be allowed to fail, with dire consequences for global finance, or there would be some sort of backdoor bailout.

The GAO’s failure to see and state this problem clearly is a major disappointment. As FDIC Vice Chairman Tom Hoenig put it, “Despite the thousands of pages of material these firms submitted, the plans provide no credible or clear path through bankruptcy that doesn’t require unrealistic assumptions and direct or indirect public support.”

To be fair, the GAO is not the only part of official Washington seemingly beguiled by large banks. While the Fed now recognizes that living wills are inadequate, it has taken an extraordinarily long time to reach this rather obvious conclusion – and the Fed’s Board of Governors is still dragging its feet on forcing the banks to simplify their operations.

American forces performed disastrously at the Battle of Bladensburg in August 1814, allowing the British to capture and burn the capital. Two hundred years later, we may well be witnessing that battle’s intellectual and policymaking analogue.



Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with James Kwak, of White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.