Economic growth shrinking in the Land of the Rising Sun.  While much attention is being paid to the potential move in U.S. interest rates, it’s interesting to look at the results of massive easing outside of North America.  Japan’s economy grew much less than expected in the second quarter, adding to pressure on policymakers to encourage both companies and households to increase spending.  GDP grew at an annualized rate of just 0.2% in the June quarter, missing estimates of 0.7%.  The weak data suggest a combination of monetary and fiscal stimulus under prime minister’s Abenomics program since the end of 2012 has not been sufficient to boost domestic demand.   Maybe central banks across the globe should be taking note of this failure of an extremely aggressive monetary policy.  The Bank of Japan (BOJ) stunned markets in January when it set a minus 0.1 percent rate on some deposits that banks place at the central bank, with the move taking effect from February.  While the BOJ hoped the shift to negative rates would encourage banks to lend more, spurring higher spending and inflation, none of that has happened as yet.  Asset purchases are a key plank of the central bank’s “quantitative and qualitative easing” program.  The BOJ had doubled their purchases of ETFs from 3 trillion yen to 6 trillion yen, but all it did was turn the BOJ into the largest holder of stocks and other financial assets.  The BOJ was already a top-five owner of 81 companies in Japan’s Nikkei 225 Stock Average and it is now on course to become the No. 1 shareholder in 55 of those firms.  While stock market bulls have cheered the tailwind from BOJ purchases, opponents say the central bank is artificially inflating equity valuations and undercutting efforts to make public companies more efficient.  More importantly, though, the recent economic results show that all of this buying is doing nothing to actually improve economic growth.  Clearly the ‘trickle down’ strategy, where the extra wealth created is turned into actual spending, is not happening.   When will central banks finally start to throw in the towel on these failed policies, which are only building up massive debts on their balance sheets which will ultimately have to be repaid?

The stock market rally has continued during the summer despite the fact that corporate earnings suffered their 5th straight quarter of declines.  While the numbers did come in slightly ahead of expectations on an overall basis, the ‘bar had been set very low’ in terms of those expectations.  Energy was the biggest year-on-year loser as lower oil prices impacted producers.  Financials were also down as lower interest rates and slow loan growth lead to weak results.  The chart below shows S&P500 Composite operating earnings over the past 15 years.  While the recent decline pales in comparison to the collapse in earnings in 2008, the trend in earnings is clearly going to be a problem for a stock market trading at all-time highs.  Stocks can rise for 2 reasons; rising earnings or a rising multiple on those earnings.  With earnings multiples well above historical levels and earnings growth looking weak, we can’t see where there is an impetus for higher stock prices?U.S. profits face weakness from energy & financials

The bond market should be concerned about stock buybacks, but not because of their bullish effect on share prices.  Instead, bondholders should be anxious about where the cash to pay for them comes from. It isn’t widely appreciated that the money has been borrowed in the credit markets, and that the borrowers have taken on a large amount of debt to support the buybacks. That’s cause for worry on several fronts.

The first is simply that outstanding corporate debt is now at a record high. Many people argue that the debt was issued when rates were low and corporate borrowing was cheaper than usual, but that really just ‘glosses over’ the issue.  Unless interest rates are going to stay at these ‘crisis levels’ in perpetuity, debt service costs will start to rise at some point and balance sheets will become more strained.  According to the Federal Reserve’s flow of funds data, outstanding non-financial corporate debt is 45.3% of GDP.  That nearly matches the level seen in the first quarter of 2009 (45.4%) and exceeds the prior peak of 44.9% achieved in the third quarter of 2001 (see chart below.) Stock buybacks push corporate debt close to highs

While the buybacks do increase earnings per share in the short term, the companies have fewer reserves left to support them in any economic downturns.  The current level of buybacks bears a striking resemblance to the period leading up to the 2008 financial crisis.  A Deutsche Bank report notes that S&P500 companies paid out two-thirds of their earnings through buybacks and dividends over the past five years.  FactSet further notes that those same companies spent $166.3 billion on share buybacks in the first quarter, a post-recession high and one only surpassed by $178.5 billion in the third quarter of 2007, just prior to the last stock market peak.  Companies need to be putting more money into real investments such as expansion and increased employment in order to sustain economic growth.   Just feeding the ongoing demand for share buybacks is the type of market behaviour that creates market ‘bubbles’; and it can’t last!

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