If you look at the cost of equity versus the cost of debt, the incentive to issue debt and buy back equity has never been higher. We are at a point in the markets where there is an exceptionally wide gap between the yield on investment grade European and US companies' 12-month forward earnings and the average yield on their bonds.
What is ‘cost of equity’?
Cost of equity is what shareholders demand as returns, while cost of debt is what a company pays to borrow. To source capital where it is cheapest, companies tend to arbitrage between equity and debt.
The US
With not enough shares issued to offset those withdrawn from circulation, equity supply has shrunk steadily, one reason for record share gains in recent years - especially in the United States, where 80% of firms are estimated to conduct buybacks.
However, US buybacks have lost some momentum, perhaps as the impact of massive tax cuts fades. New stock buybacks averaged just $2.8 billion daily in the last three weeks, the second-lowest volume in the past eight earnings seasons.
Europe starts to look interesting
Europe looks particularly interesting. Morgan Stanley advised European firms to cut dividends and conduct buybacks instead.
European share buybacks last year equated to just 1% of market capitalisation versus around 4% in the United States. With German benchmark bond yields, the main reference rate for euro debt - crumbling more than 70 basis points this year to around minus 0.5% - corporate borrowing costs have collapsed by two-thirds, offering companies a unique opportunity to embrace the buyback culture.
It is attractive for European companies to issue debt or take out bank loans for buybacks and they could have been doing it for years. It's similar in Japan, they have been enjoying zero interest rates for even longer. In fact, net European buybacks amounted to $100 billion in the past year, a record high run-rate, even if dwarfed by last year's roughly $800 billion US tally.
Why has Europe lagged the US in share buybacks?
The reason buybacks have been historically less popular in Europe and Japan is that shareholders have tended to prefer dividend income. Despite last year's buyback surge in Europe shareholders earned 80% of their cash returns from dividends.
Japan
There are also signs that Japanese firms, notoriously stingy with buybacks, are joining the party: Buybacks hit a record 6.5 trillion yen-plus ($59.8 billion) in the fiscal year to April 1 2019 and Goldman Sachs predicts a further 20 percent increase in the year to April 2020.
Goldman predicts a strong equity market in 2019
Last week, Goldman Sachs raised its 2019 target for the US benchmark S&P 500 index by 3% to 3,100, implying a 24% gain for the year, but has lowered its earnings estimates citing weakness in economic activity and margin outlook.
Conclusion
With not enough shares issued to offset those withdrawn from circulation, equity supply has shrunk steadily, one reason for record share gains in recent years - especially in the United States, where 80% of firms are estimated to conduct buybacks.
The buyback boom is one side-effect of rock-bottom interest rates. And with central banks again in rate-cutting mode, the trend could get a fresh lease of life.
This article was issued by Kristian Camenzuli, investment manager at Calamatta Cuschieri. For more information visit, https://cc.com.mt/ . The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.