IN THIS ISSUE:
We continue to believe that "core" inflation is likely to generally remain below 2% this year in a lagged response to big deflationary effects from the pandemic shutdowns. However, the clear U.S. monetary and fiscal policy regime change is conducive to much higher inflation ahead, in our view. For one, there have only been three other comparable U.S. money-supply surges in the past 120 years, and all have been accompanied by high inflation. The most recent episode in the 1970s saw an entrenched inflation environment that couldn't be brought under control without major damage to the economy and labor market.
While the inflation outcome this time around remains to be seen, as we have expected since the $2.2 trillion Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") of March 2020 and aggressive Fed stimulus opened the floodgates of liquidity, assets that benefit from faster growth and inflation have outperformed. From crude oil to Treasury Inflation-Protected Securities (TIPS) and small-caps, and from real estate to base metals and commodity currencies, demand for reflation beneficiaries has surged. What's more, in our view, conditions remain favorable for reflation trades for a number of reasons, all tracing back to the unusually lax liquidity environment:
Exhibit 1: Rally In Base Metals Reflects Reflation Success And Is Unlikely To Stop Before New Highs.
Remarkably, many U.S. companies have built up a rather large cash mountain despite the pandemic. Rather than widespread solvency issues resulting from economic shutdowns, corporations on aggregate entered the New Year well supported. Total cash holdings and short-term investments sitting on corporate balance sheets for many S&P 500 companies, excluding Financials, grew to as high as $2.2 trillion recently (Exhibit 2), with the Technology and Industrial sectors holding the largest share of the cash pile.
In March and April of last year, economic shutdowns initially propelled companies to focus on building up cash as a precaution on economic uncertainty at that time. Liquidity dried up as capital market turmoil increased, and credit spreads widened out to levels not seen since the Great Financial Crisis (GFC). The Fed quickly moved to backstop funding markets by cutting interest rates to near zero last year and announcing large-scale bond buying programs that helped to shore up confidence in the markets. Credit spreads thereafter quickly recovered much of their widening, and investor confidence was restored before the Fed even made any asset purchases. Debt issuance briskly picked up as companies looked to take advantage of low borrowing costs and renewed investor demand to help replace lost earnings as a result of the shutdowns and to bolster their balance sheets.
Exhibit 2: Many U.S. Companies Quickly Increased Their Cash Holdings.
Companies have remained conservative with their cash deployment, keeping their balance sheets flush as they continue to monitor the economic recovery, but there are some signs of the purse strings loosening. With the distribution of coronavirus vaccines, additional fiscal stimulus, and accommodative monetary policy and pent-up consumer demand supporting profit margins and cash flows, and the time might be right for companies to normalize or increase the usages of their cash.
From an investor perspective, higher CapEx would signal better growth prospects at the company level and higher productivity at the macro level. Business investment for the S&P 500 wasn't spared from last year's pandemic fallout, and data from Bloomberg suggests an approximate 12% year-over-year decrease from 2019 expenditures of $765 billion. CapEx had been enjoying much stronger growth since 2018 as a result of favorable expensing policy within the Tax Cuts and Jobs Act (TCJA) so there's reason to believe that a continuation of those stronger trend levels could re-emerge as corporations gain solid footing. We find the endogenous factors that drive business spending to be mostly supportive going forward, with secular tailwinds from the continued transition to the new and more digitized economy. Financials, Energy and Real Estate sectors saw especially deep cuts last year but could be significant movers in a "CapEx catch-up phase," while the Technology and Communication Services sectors grew their investment last year. As suppliers of the investment, Technology and Industrial capital goods companies could benefit from corporate cash being put to work through capital expenditures.
While companies were quick to lever up during the pandemic in response to record low rates and the desire to bolster liquidity, they were also quick to taper their pace of buybacks (Exhibit 3). As opposed to dividends, which tend to be treated in a more programmatic manner, and CapEx, which generally is longer term in focus, buybacks are amongst the quickest programs for management to suspend, which they did in earnest. Buybacks for many S&P 500 companies hit their high-water mark in 2018 at $751 billion following the TCJA. However, net share repurchases plunged 41% from that level in 2020, to an estimated $444 billion, according to Evercore ISI Research. There are green shoots for renewed activity as the economy begins its journey toward normalization, and the pace of buybacks has recovered a bit from its bottom (2Q 2020). In fact, the number of announced buybacks over the past three months is more than double the average from last April through October, according to Strategas Research Partners. But this level is still below prepandemic levels. For context, third-quarter buybacks were about 50% less than average quarterly activity before the pandemic and even 10% less than levels prior to the TCJA. However, the same agility to cut buybacks can be used to ramp them back up. For example, many Financials voluntarily suspended buyback programs and may decide to restart them. As the sector with the second-largest repurchase footprint, that would be a significant kick-start back to a normal repurchase level which would be a support for equities.
Exhibit 3: Total "spend share" On Dividends, Buybacks, And CapEx Cratered And Could Indicate Capacity For A Bounce.
Dividends, like buybacks, are welcomed by shareholders as a return of capital and could be a use for excess cash on corporate balance sheets. However, unlike buybacks and other forms of capital deployment, dividends are typically more stable. From 2010 through 2019, S&P 500 dividends grew at a stable 10% annualized rate, until the pandemic-induced dip last year. As such, an economic recovery with strengthening corporate fundamentals doesn't necessarily mean that much higher levels of dividend growth are on the way. Rather, the actual proportion of shareholder yield that is attributable to dividends has been in decline relative to buybacks. Due to the sharp reduction in net buybacks, 2020 is expected to mark only the fourth year since 2005 in which dividends paid surpassed share repurchases. That being said, for dividends paid to recover back to the average annual growth trend of 10% from prepandemic levels, it would imply an additional $136 billion paid this year on top of expected 2020 dividends of $487 billion, according to Evercore ISI Research calculations. There is the potential for companies in the Financial, Real Estate, Energy, Materials, and Industrial sectors to boost dividends as cyclically-oriented pockets of the economy improve; however, the increased market share of sectors that traditionally offer lower payouts may limit aggregate dividends paid.
Some of the large corporate cash pile may be attributable to a dearth of M&A deals in 2020, as acquisition cash outlays were the second-lowest in 15 years for the S&P 500. Data from Evercore ISI Research illustrates that cash spend on acquisitions had averaged approximately $342 billion each year since 2015 and was accelerating, but last year's expenditures cratered to $151 billion. The intense freeze in M&A activity is further illustrated when viewed within the context of the broader equity market, as monthly deal value as a percentage of S&P 500 market cap was only 0.2% across the summer months.
This was the lowest proportion on record dating back to 1995, according to Strategas Research Partners. However, a recent pickup in activity has also been noted. Since September, the average number of deals and transaction values has rebounded to prepandemic levels and could even reflect nascent pent-up demand for deal making. A renewed focus on growth, the need for accelerated innovation, and more stable capital markets are likely to fuel M&A outlays going forward.
As interest rates have ground lower, the amount of corporate debt has risen, actually outpacing the cash buildup to a degree. Companies within the S&P 500 have borrowed at a historically brisk pace, with corporates issuing net debt of $549 billion in the four quarters through 2Q 2020, the most in 12 years, according to Ned Davis Research. Some investors have questioned whether the buildup in debt reflects overleveraging, but we don't view it as an acute risk. Coverage ratios have improved off from pandemic lows and are well within the post-GFC range. In addition, while the amount of nonfinancial corporate debt in the U.S. has grown by almost $1.7 trillion since 2015, the percentage relative to market cap has declined from 36.4% to 29.2%, according to the Federal Reserve Bank of St. Louis. For many companies, the impulse to add leverage was less about the immediate need for capital and more about the flexibility and extremely low servicing costs of it, and large aggregate cash balances support this view. We suspect that as interest rates rise and costs become a greater burden on coverage ratios, boardrooms will find the impetus to use cash buildup to pay down debt.
U.S. corporates should begin to deploy their cash hoards as economic growth accelerates in 2021 and 2022. In varying degrees, cash outlays could be deployed in shareholder friendly actions such as higher dividends and buybacks, paying down debt and investing for higher growth and productivity. These actions should be ultimately supportive of higher valuation levels and investor sentiment.
It was all downhill one year ago as the S&P 500 closed at its prepandemic high of 3,386 on February 19, 2020. What ensued was a devastating healthcare crisis, the fastest bear market in history and an epic decline in global output. One year on, the mood of the market is much different thanks to private sector innovation in coronavirus vaccine development and distribution, and generous government spending on finding a vaccine at "warp speed." With all hands on deck, pharmaceutical and biotechnology companies developed a number of vaccines to combat the coronavirus in as little as 11 months—a stunningly fast timeline. End to end, it can take years—if not decades—to develop effective vaccines, with the public-private partnership accelerating the cycle this time.
Case in point: The first two vaccines to be authorized by the Federal Drug Administration (FDA) for emergency use rely on discoveries that resulted from research funded by the U.S. government: The Messenger Ribonucleic acid (mRNA) viral protein design was developed by colleagues at the National Institutes of Health, and the RNA modification concept was first developed by researchers at the University of Pennsylvania. And to accelerate vaccine delivery, the government poured an additional $10.5 billion into vaccine companies since the onset of the pandemic. Evidently, the public-private sector partnership has been a key ingredient to vaccine development and afforded the U.S. a brighter outlook.
When it comes to research and development (R&D) spending, the U.S. business sector helps to drive investments in innovation, contributing almost three-fourths of total R&D. Some of the most innovative companies in the world, with the deepest pockets, are technology companies with R&D budgets that rival small countries. FAAMG2 as a technology aggregate ranks just above Germany in R&D spending, while healthcare companies spend an amount on par with Russia. With vaccine development epitomizing the importance of innovation, from an investment standpoint we continue to be overweight both the Technology and Healthcare sectors, which include many leaders in R&D.
Exhibit 4: R&D's Country And Company Big Spenders.
Technology big spenders = Facebook, Apple, Amazon, Microsoft, Alphabet (Google); Healthcare big spenders = Eli Lilly, Merck, Pfizer, Abbvie, Bristol Myers. Sources: UNESCO; Bloomberg; company reports. Data as of December 2020.