In light of expectations that the Trump fiscal stimulus plan will unleash a new Golden Age for the US economy, driven in part by the repatriation of hundreds of billions in funds held offshore, yesterday we showed a disturbing analysis from Citigroup according to which the bank's share-shrinker portfolio has soared relative to the S&P following the US election. The implication was clear: as fas as the market is concerned, much if not all of the capital repatriated from overseas will be promptly returned to shareholders, and maybe much of the corporate tax cut as well. Citi's troubling conclusion: "This doesn’t bode especially well for those who hope policy changes will encourage a significant pick-up in US company capex."
Which means that far from being a boon to investment, the market's assessment - at least as of this moment - is that much of the $1 trillion fiscal boost, touted in Friday's Steve Bannon interview, will end up being returned to shareholders.
Overnight, Goldman chimed in with a similar forecast in which according to Goldman chief equity strategist David Kostin, in 2017, for only the second time in 20 years, stocks buybacks will account for the largest share of cash use by S&P 500 companies.
Specifically, Goldman expects that total capital usage will increase by 12% to $2.6 trillion with 52% allocated to investing for growth (capex, R&D, and cash M&A) and 48% to returning to shareholders. The only other time 48% of total cash was returned to investors was back in 2007 just ahead of the bursting of the credit bubble.
Where will the bulk of this buyback spending growth come from: Goldman, as Citi, predicts that tax reform legislation under the Trump administration will encourage firms to repatriate $200 billion of overseas cash next year and further forecast that a vast majority, or 75%, of the returning funds will be directed to buybacks based on the pattern of the tax holiday in 2004. Of the $200 billion to be repatriated in 2017, Goldman sees $150 billion being used toward repurchases, or 20% of total buybacks. Meanwhile, organic investment will grow far less: capex will grow by only 6%, R&D by 7%, and cash M&A by 5%.
To summarize: of the $2.6 trillion in total cash spent by companies, the largest bucket, or 30% of the total, will be on stock buybacks; this is the highest portion of corporate cash allocated to buybacks since 2007.
This cash distribution is summarized in the chart below:
Here are the full details from Goldman:
We expect firms will increase cash spending allocated to investing for growth (capex, R&D, and M&A) by 6% to $1.3 trillion while cash returned to shareholders (buybacks and dividends) will rise by 19% to $1.2 trillion. A stabilization in oil prices will moderate the collapse in Energy spending while ex-Energy capex will grow by 7%. We project cash M&A spending will grow by 5% in 2017 following a 20% drop in 2016. Modest US GDP growth of around 2% and ex- Energy earnings growth of 6% will sustain the popularity of buybacks and dividends. We expect tax legislation will pass in 2H 2017 that will include a one-time tax on previously untaxed foreign profits. S&P 500 repurchase activity will benefit from an incremental $150 billion (20% of total) of buybacks given firms will direct a substantial amount of repatriated funds towards share repurchases.
- Capex ($710 billion in 2017, +6% growth) and R&D ($290 1. billion, +7%) will increase in 2017. Downward pressure on Energy spending will be alleviated as oil prices stabilize. During the last 12 months, Energy has accounted for roughly 19% of total capex spending compared with 32% in 2014. Our commodities team expects Brent crude will remain above $50 per barrel and low domestic breakevens suggest modest 1% Energy capex growth in 2017 following a 20% plunge in 2016. In addition, Mr. Trump’s proposal to allow U.S. manufacturing companies to expense 100% of their capital investment in the first year would encourage additional capex, if passed. In contrast with capex, Energy only accounts for around 2% of total S&P 500 R&D spending, which has made aggregate R&D spending resilient to the sector’s downturn. Information Technology and Health Care have accounted for more than 70% of total R&D during the past 12 months.
- Cash M&A ($335 billion, +5%) will increase in 2017 following a 20% plunge this year from the record level in 2015. Although 2016 has witnessed a robust volume of announced M&A deals ($1.4 trillion), cash spending on M&A accounts for only 55% of the total. Uncertain anti-trust policy positions and tax inversion related regulation under President-elect Trump pose a risk to our forecast volume of cash M&A activity.
- Buybacks ($780 billion, +30%) will rise sharply in 2017. Our economists expect tax reform legislation will pass during 2H 2017. President-elect Trump and House Republicans have expressed support for a one-time tax on previously untaxed foreign profits as part of their tax reform proposals. We forecast that S&P 500 firms will repatriate $200 billion of their total $1 trillion of cash held overseas in 2017 and spend $150 billion of the repatriated funds on share repurchases. Managements generally remain committed to buybacks, which will benefit from 2% US GDP growth and ex-Energy earnings growth of 6%.
- Dividends ($460 billion, +6%) should grow roughly in line with EPS for the next few years. Consensus forecasts imply that Financials and Health Care will grow dividends by 9% in 2017, the highest across all sectors. Our top-down earnings model forecasts S&P 500 dividends will grow at a compound annual rate of 3.6% during the next ten years, above the dividend swap market-implied growth rate of 2.3% (see Global Dividend Swap Monitor, October 26, 2016).
A breakdown of buybacks by sector:
It goes without saying, that as more cash is allocated to shareholder payouts (buybacks, dividends), less goes to CapEx, and economic growth.
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Why is Goldman convinced that most of the repatriated foreign cash will be used to fund buybacks? The answer: tax reform as well ashistorical precedent.
We estimate that $150 billion out of $780 billion of S&P 500 buybacks in 2017 will be driven by repatriated overseas cash. Corporate tax reform will likely be a top priority for the Trump Administration. Our economists expect that tax legislation in 2017 will include a one-time tax on previously untaxed foreign profits. We forecast that S&P 500 companies will repatriate close to $200 billion of their $1 trillion of total overseas cash in 2017, which will be directed primarily towards share repurchases.
Under current policy, US-based firms may defer US taxes on profits earned by foreign subsidiaries until they are repatriated. Once repatriated, foreign earnings are taxed at the US federal tax rate of 35% minus a credit for foreign taxes paid. Rates in other OECD countries range from a low of 12.5% in Ireland to a high of 34% in France. The deferral of tax on foreign profits combined with the high US statutory tax rate incentivize firms to shift as much income as possible to low-tax jurisdictions and to avoid repatriating income generated in those countries to the US.
President-elect Trump and House Republicans have both expressed support for a one-time tax on untaxed foreign profits. In their “blueprint” of potential tax reform, House Republicans proposed an 8.75% tax on permanently reinvested overseas cash and a 3.5% tax on other untaxed foreign earnings. Mr. Trump also proposed similar tax reform during his Presidential election campaign.
Our Washington, D.C. economist Alec Phillips expects that tax legislation will likely pass in 2H 2017. The probability of significant legislative activity has increased as a result of single-party control for the first time since 2010, and Republican singleparty control since 2006. In addition, tax reform appears to be prominent on the policy agenda in 2017. We expect to see initial tax reform proposals around March or April and possible enactment during the second-half of the year.
The reason Goldman expect S&P 500 firms to repatriate $200 billion of their $1 trillion total overseas cash in 2017, is because it complies with historical precedent: US firms repatriated 10% and 20% of their total estimated overseas cash during the 3-month and 6-month periods, respectively, following the enactment of the Homeland Investment Act (HIA) of 2004. Given the firms' forecast of tax legislation during 2H 2017, Goldman predict that S&P 500 firms will repatriate 20% of total overseas cash next year.
And, furthermore, since buybacks were the biggest beneficiary of the repatriation tax holiday in 2004, Goldman expects more of the same this time:
We forecast $150 billion of the total $200 billion of repatriated overseas cash will be allocated to share repurchases in 2017. Share buybacks were the biggest beneficiary of the repatriation tax holiday in 2004. One study estimated that between $0.60 and $0.92 of every $1 repatriated was spent on share purchases (“Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act” (2011), The Journal of Finance 66(3): 753-787). S&P 500 buyback executions rose by 84% in 2004 and 58% in 2005. There was also a jump in dividends in 2004 and sharp M&A growth in 2005, but the rise in buybacks following the tax holiday far exceeded any other increase in cash use
There is one big risk however, to Goldman's estimate, as the bank itself admits: "Increased debt levels, policy uncertainty, and stricter enforcement of rules regulating the use of repatriated cash pose risks to our estimate." Given that S&P 500 net debt/EBITDA is close to all-time highs, firms may choose to allocate a portion of repatriated cash towards debt reduction.
Just like comparisons of the Trump and Reagan ignore that debt/GDP under Reagan was 30% (compared to nearly 100% now), S&P 500 leverage was also significantly below average around the time of the 2004 tax holiday.
To be sure, the HIA of 2004 prohibited firms from using repatriated cash on buybacks in an effort to increase domestic investment but, as Goldman notes, "money is fungible." Still, if a tax reform package passes in 2017 with a similar goal of boosting domestic investment but has stricter regulation of cash use, then capital spending may experience significant increases rather than buybacks.
Incidentally, over the past week, the market has shown little worry that Trump may limit what the repatriated funds will be used for, and has already priced in much of the expected repatriation-funded buyback bonanza, as the following portfolio baskets show.
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In short, absent a formal directive from the Trump administration on explicit "use of repatriation proceeds", which curbs or outright limits the $200 billion or so in estimated repatriated proceeds, from being spent on buybacks (according to Goldman roughly 75% of the total amount will be used to pay shareholders) there will be virtually no benefit to the broader economy, and instead corporate shareholders will once again reap the benefits as they have for the past 7 years, a time in which they levered up their companies to all-time highs, with the vast majority of the newly raised debt used to fund, drumroll, buybacks.