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Why A Rate Hike Might Result In A 'Double Whammy' For Mainstream Investors

After publishing ‘better than expected’ job numbers, the market interpreted the results as a sign Yellen will now most definitely increase the interest rates within the next few months. These mood swings seem to be the flavor of the day and now the futures of the 30 day Federal Reserve Funds rate are also showing an increased possibility the Federal Reserve will increase the benchmark interest rate.

We already discussed whether or not a rate hike would be a good thing for the American economy, and we were unsure about this as the recovery of the domestic economy is going extremely slow. Additionally, an increased interest rate would increase the pressure on the US budget as the interest expenses would increase by almost $200B per year per one percent increase in the interest rate.

A higher interest rate generally also means the stock market will see some cash outflows as the increased yields on bonds and savings accounts will attract the investors with a relatively low risk appetite. After a prolonged period of zero interest rate policy, there will most definitely be a repercussion for the stock markets if the interest rates will indeed increase, that's just basic economics. But there’s more.

Back in May, we reported on the extremely high level of share buybacks executed by several large companies. In the first quarter of the current financial year, approximately $400B was earmarked for share repurchases and it looks like the real number for this year will be higher. According to research from FactSet, the initial $400B has already been fully used in the first quarter of this year.

Source: factset.com

And that’s quite a worrisome picture. Everything is pointing in the direction share buybacks will be responsible for $500B+ in trading volume (the TTM volume was $555B for the four quarters ending in June) and that’s quite a lot of money!

Why is this problematic?

Because for the first time since 2009, the average buyback ratio to free cash flow of the S&P 500 has increased to in excess of 100%. As most companies are also paying a dividend on top of the share buybacks, this basically means a lot of companies out there are borrowing cash to fund the buybacks. Why? Because (until now) the ability to borrow money at a low interest rate resulted in a positive tradeoff between paying more interest expenses versus boosting the per-share results.

Source: factset.com

In some cases, the importance of the share buybacks cannot be underestimated. Boeing was one of those ‘overspenders’, and after generating a free cash flow of $4.4B and paying out $1.9B in dividends, the company would have had $2.5B at its disposition for share buybacks in the first nine months of this year. Not bad at all, but Boeing shifted into the ‘overdrive’ mode and spent in exess of $5.6B to repurchase in excess of 36 million shares. A part of that was funded by ‘excess’ cash, another part by increasing the company’s total liabilities.

Source: Wall Street Journal

So what will happen when Boeing decides it no longer makes sense to buy back shares because the economics aren’t appealing anymore as additional share repurchases would have to be funded by (increasingly expensive) debt? Its share price would no longer be supported by the buybacks, and that will indeed make a substantial difference. Buying 36 million shares for its own account in approximately 180 trading days results in Boeing having bought an average of 200,000 shares per day, or in excess of 6% of the average trading volume.

So on top of a natural shift from stocks towards fixed income assets on the back of a rate hike, a higher cost of debt will also reduce the amount of cash spent on share repurchases. As the buyback rate of the trailing twelve months is in excess of $500B, it’s increasingly likely some of the ‘heavy spenders’ (Boeing, General Motors,…)  will have to scale back their repurchase rate and the main markets would lose one of the main drivers of the recent excellent performance.

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