Another Reason for the Low VIX

Since the Great Financial Crisis and the unprecedented expansion of the balance sheet of many central banks, many investors think that officials are responsible for various distortions that they detect in the capital markets.  The compressed nature of equity market volatility is one of those distortions. 

However, the decline in the S&P 500 volatility (VIX) became most pronounced last year, when it frequently slipped below 10% and did not get above 20% even once.  After raising interest rates once in 2015 and once in 2106, the Fed's normalization accelerated last year with three rate hikes and the beginning of the unwinding of its balance sheet. 

Let's concede for the purpose of this argument, that the Federal Reserve's purchases of Treasuries and MBS, displaced investors and encouraged them to buy higher-risk assets.  Among these riskier assets are equities.  Hence the idea that the Fed's QE helped fuel the stock market rally. As equity prices rise, the volatility typically declines. 

While accepting this logic, another force seems at work and it cannot be simply reduced to the Fed's QE: corporate share buybacks.  From 2009 through 2017, the Federal Reserve's flow of funds shows corporates bought back $3.3 trillion of shares.  They are the most significant buyer of US shares. 

Households sold roughly $670 bln of US equities, and insurers and pension funds have sold about $1.2 trillion. of US shares.  Mutual funds and ETFs bought about $1.6 trillion worth of US shares, offsetting most of the selling.  The IMF noted last year that "large US corporations have experienced a negative net equity issuance of $3 trillion since 2009 through share buybacks." 

Why do corporations buy back their own stock?  The first and simplest answer is because they can.  Before 1980, the SEC prohibited such activity on grounds of potential manipulation of share prices.  The second answer is that they can in the sense that they have the means:  strong earnings growth and share buybacks, like dividend, return unwanted/unneeded capital back to shareholders.  

There is a role for low interest rates, which may be a function of the Fed's buying (which stopped in 2014).  That is partly because some large companies, especially with retained earnings offshore to avoid (minimize) taxes borrowed to buy back shares.  In 2013, S&P dubbed this "synthetic repatriation." However, with the new tax cuts and changes on how global earnings of US MNCs are treated, there will likely be less of a need to borrow, i.e., real repatriation can replace the "synthetic" approach.  

Indeed, early estimates quoted in the media suggest that through the middle of February, US companies have announced $177 bln in share buybacks this year.  That is more than twice the year ago period and contrasts with a 10-year average for this period of about $77 bln.  

The argument among some market participants makes another link.  The share buybacks are an important part of the equity market story and the low volatility.  Since 2009, the large equity pullbacks have coincided with the blackout period around earnings releases, for which share buybacks are still prohibited. Corporate buyers seem largely price insensitive but appear always ready to buy into weakness in what is perceived to be a bull market.  Share buybacks create a virtuous cycle.  The low volatility and low liquidity that result encourage additional corporate purchases.  

Three factors could potentially curb the corporate buybacks.  First, a ban could be legislated again, but it seems unlikely anytime soon.  The outrage does not appear great enough and no one wants to be blamed if the equity prices fall as a result.  Second, some have suggested that rising corporate debt levels or rising interest rates could constrain future purchases.  This may have been more likely before the corporate tax reform.  Third, a bear market for stocks could see corporate interest in buying back their own shares dry-up.  

It is a provocative thought experiment to consider what would happen if US companies could not buy back their own shares.  Mergers and acquisitions would likely increase.  Dividends would be boosted.  Cash would increase.  The capital structure of many corporations would improve as they stopped replacing equity with debt.  Ironically share prices may suffer as the largest buyer of US shares is sidelined.   It is possible that capital investment and employee compensation increase, but this does not seem like the most likely outcome or that it would be done in sufficient size to absorb the surplus savings of corporations. 

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