The new tax law is expected to result in a sharp increase in corporate buybacks in which companies purchase and cancel some of their own shares in order to drive up the value of the remaining shares in circulation. That might give some TSP funds a lift in the short term. In fact, 2018 could be a record year for buybacks, although this activity may well taper off in 2019 with interest rates continuing to rise, among other factors. (Whether stock prices themselves rise is another matter.)
Interest Rates Up
The Federal Reserve Open Market Committee, under the new leadership of Fed Chairman Jerome Powell, raised interest rates by another 0.25% last week. This marks the sixth increase since they began raising rates in late 2015, and the rate now stands at 1.50%-1.75%.
The Fed expects two more increases in 2018, which would bring the rate up to 2.00-2.25% by the end of the year. And they expect to continue gradual rate increases in 2019.
In addition to keeping inflation in check, rising Fed interest rates have the eventual effect of increasing rates on bank savings accounts, corporate bonds, U.S. treasuries, mortgages, other consumer loans, as well as the G Fund and F Fund. However, it also puts some downward pressure on equity valuations because it increases the cost of capital for businesses and makes bonds a more competitive alternative for investors.
The Rise of Corporate Buybacks
One of the key things that interest rates can influence is the use of corporate share buybacks.
Companies can buy back their own shares and cancel them, which reduces the number of shares in existence and therefore increases the ownership percentage of the company that each share represents. This helps accelerate earnings-per-share growth, dividends-per-share growth, book-value-per-share-growth, and other per-share metrics.
For example, imagine a company earns $1 billion in annual net profit and grows its profit by 5% per year. After five years, its net profit would be about $1.27 billion. If the company consists of 100 million shares held by investors, the earnings-per-share each year starts at $10 and increases to $12.70 by year 5.
Now, suppose that the company also used some of its earnings to buy back and reduce its number of existing shares by 5% per year, from 100 million shares down to 77 million shares by year 5. If $1.27 billion in net profit is divided over 77 million shares, the earnings-per-share would be $16.50, a massive 65% gain compared to the starting year.
Unfortunately, companies on average tend to buy back a ton of shares when their stock prices are high (like in 1998, 2007, and now), and far fewer shares when their stock prices are cheap:
Source: JP Morgan Guide to the Markets
This makes share buybacks a lot less efficient in practice than they could be in theory. Only the most disciplined companies make optimal use of share buybacks.
Over the past several years, companies have increasingly taken advantage of low interest rates to issue cheap bonds and use the proceeds to buy back large numbers of their own shares and pay higher dividends. This has resulted in corporate debt levels reaching about where they were during prior late-cycle debt peaks:
Source: JP Morgan Guide to the Markets
Due to these higher levels of existing leverage and higher borrowing costs on their bonds due to rising Federal Reserve interest rates, many companies began mildly reducing their share repurchases in 2017 compared to 2016.
The corporate tax cuts, however, have given companies the ability to make a large uptick in share repurchases for 2018. JP Morgan estimates that companies will spend over $800 billion on share buybacks in 2018, taking advantage of repatriation of cash from overseas holdings and other aspects of the tax bill. This will be a record buyback year by far for corporate America if the announced and projected share buybacks come to fruition.
However, share buybacks might taper off in 2019, because companies will have higher levels of leverage, higher interest rates on any debt they issue, and likely no new catalysts for another wave of buybacks.
Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.
