In light of the dramatic spike in interest rates since the Trump victory, where as we reported yesterday and as Bloomberg comments overnight, “yields on benchmark 10-year Treasuries posted their steepest back-to-back weekly increase since 2001” leading to the “the worst rout in the fixed-income universe in 15 years”…
… and which coupled with a surge in the 10-Year breakeven rate – a gauge of US consumer price expectations – to the highest in more than 18 months…
… has led to the biggest, and so far unanswered, question on Wall Street trader’s minds: at what level will rising interest rates pressure risk assets, and become “self-defeating”, leading to broader market selloff.
Yesterday, we presented out one argument from SocGen, shown in the table below, which tried to answer this question, and found that there is still some modest breathing room, of just under 30 basis points for US 10Y yield before bond yields start “hurting equities.”
However, as we also showed in light of yesterday’s market performance, this critical inflection point may have already arrived, because on Friday for the first time since the Trump election, stocks and bonds both fell at the same time:
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The move prompted Rick Rieder, CIO for global fixed income at BlackRock to tell Bloomberg in an interview that “the paradigm has shifted in terms of inflation. Long-end interest rates are dangerous. Make sure you are being really careful about the long-end exposure as we saw this week.“
To be sure, from a purely technical basis, the bond market may be on the verge of yet another major breakout higher in yields, one which could see the 10Y sliding from its current level of 2.35% all the way to 3%: assuming trendline stops are taken out, the move may be just as violent and rapid as the recent surge from 1.78% a mere two weeks ago.
The above likely means that – at a strictly macro level – the answer how much further bond yields can rise before shattering the eerie stock market calm, will likely be answered shortly.
However, in addition to macro, one should also consider the micro, and it is here that the ongoing bond rout may have more far-reaching consequences. Recall that one month ago we posted a warning from Barclays according to which “The Party Is Almost Over As Payouts Exceed Cash Flow By $115 Billion.” The implication was simple: with companies relying extensively on debt to fund stock repuchases, rising rates may soon put an end to corporate repuchases, which as Goldman recently said, were the biggest source of equity demand in recent years.
In fact, as we reported earlier today, according to Goldman, stock buybacks and dividend payments – a main reason for future S&P 500 upside – are now expected to account for a whopping 48% of total shareholder payouts in 2017, representing 48% of the total cash spent by S&P500 firms in the next year, and the most since 2007.
Buybacks alone are expected to amount to 30% of this $2.6 trllion in cash outlays (boosted by Trump’s “repatriation tax holiday”) or a massive $780 billion, an increase of 30% compared to 2016.
However, as Goldman’s David Hatzius warns that there may be a problem, namely record corporate debt: “Given that S&P 500 net debt/EBITDA is close to all-time highs, firms may choose to allocate a portion of repatriated cash towards debt reduction. S&P 500 leverage was significantly below average around the time of the 2004 tax holiday.“
A far troubling take comes courtesy of another recent report by Goldman’s Robert Boroujerdi, in which the strategist makes an outright call to “Avoid the Leverage and Payout Bubble.” Indeed, Goldman explicitly called the upcoming debt-funded stock repurchasing frenzy, one set to match the highet on record, a bubble.
Here is the warning:
While everyone is excited about the potential boost from fiscal stimulus and repatriation, the imbalances that have built up over the course of this cycle have not gone away. Low rates have contributed to an unprecedented corporate borrowing binge with debt levels more than doubling since 2007. However, this cash has not been used to fuel growth investments such as CapEx and R&D, but instead been simply returned to shareholders in the form of dividends and buybacks, which has not been productive, in our view. Furthermore, the slowing second derivative of a number of macro indicators suggests that we take a fresh look at the sustainability of these payouts. While not calling for an imminent cut, we see incremental risks for companies paying beyond their means on a normalized basis, particularly when the balance sheet has been extended to do so.
The problem in numbers:
- Aggregate leverage currently sits at 1.7x, but if we normalize EBITDA, it is closer to 2.0x (ex-energy), which is a level typically associated with high yield credit. With corporate borrowing costs still near the lowest levels on record (despite the recent move up in interest rates), we think the market has been relatively sanguine about the risks associated with the build-up of debt.
- Companies paid out 145% of their net income in 2015 (nearly double 2010’s levels) while asset age on a median basis has increased to over 7 years and leverage has nearly doubled.
However, the one bullet which in a time when rates are again expected to rise sharply, is the most critical of all, was the following:
- Corporate debt levels have more than doubled since 2007 and 2016 is on pace for another record year of Investment Grade issuance. Interest expense is up a more modest 40% as the cost of debt has fallen from near 6% to less than 5% at the end of 2015.
The chart above shows that – at the croporate level – the biggest risk is that interest expense payments, shown by the gray line which is a function of the average interest rate, jumps sharply as it catches up to the dark blue line, the relentless, record increase in total debt, which has been the biggest catalyst for both the historic increase in stock buybacks and, by implication, the record level in the S&P 500.
As a result, Goldman also notes that that as a result of the upcoming spike in rates, the “social contract” with shareholders (i.e. returns via dividend and buyback) is in danger of dying, and lays out some stocks that are most in danger as a result:
The Death of the once ubiquitous “Social Contract”
In Exhibit 25, we list companies in cyclical sectors with a “social contract” with shareholders (i.e. returns via dividend and buyback) and high leverage. Given many companies are currently over-earning and running close to peak margins, we see risks if things normalize. Indeed, when viewed on a normalized earnings basis (i.e. 2016 dividends and buybacks paid compared to median Net Income from 2007-2016), these payout ratios would be over 100%. Further, these names have leverage north of 2x, indicating limited potential of sustaining these payouts while also preserving their balance sheets.
These 10 companies are just the beginning: sadly over the past 7 years, most corporations that had the ability, levered up to levels that are simply unsustainable during times of renormalizing, i.e., rising interest rates. For now, neither the market nor for that matter, the Fed appear to be too worried about the risk of rising rates, chosing instead to focus on the favorable outcomes from rising inflation and higher rates. However, should last week’s bond rout continue at a similar pace in the near future, what was until recently smooth sailing for stocks as virtually every other asset class saw unprecedented bolatility, is about to turn quite violent.
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