Giants of the S&P500 and the inequality backlash

Extreme inequality is set to be a big part of the US 2020 elections, and as if on cue the stock market is telling the same story. While breaching all-time highs, the S&P 500 index has increased its market cap by $5 trillion this year, more than the $3.7 trillion added during the whole of 2017, and more than the increase last year before the market plunged in September.

As we’ve noted in previous articles, the contributions to the latest increase are very skewed. The largest 32 companies in the index (at the start of the year) account for half of the increase, compared with 42 companies in 2017. The four biggest companies alone – Microsoft, Apple, Amazon and Alphabet – contributed a nearly quarter of the S&P’s added market cap.

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Understanding the chart

Click on the control below the chart to switch between different date ranges and market cap vs earnings changes for the S&P 500 index.

We can also look at the increase in corporate earnings. Here our chart shows the cumulative increase in trailing 12-month (TTM) earnings of the S&P components ranked by starting market cap. The companies currently earn $1.1 trillion per year in total, compared with $950 million two years ago. Compare this 20% overall increase with that of the five tech giants, which have seen their earnings increase by 40% over the same period.

Where does this money go? According to S&P Dow Jones Indices, the companies in the index are currently spending $1.2 trillion per year on dividends and buybacks, or more than their reported earnings. That is what helped add that $5 trillion of market cap.

Who are the beneficiaries of that increase? According to the San Francisco Fed’s triennial Survey of Consumer Finance, US households held $1.3 trillion of stocks in 2016, and $2.7 trillion of investment funds. But 60% of this wealth was held by the top 10% of households as measured by income.

A lot of research is being done on the higher percentiles of US wealth distribution (for example Saez and Zucman, who have developed alternative measures to the SCF, the excellent work by the Urban Institute, which has published visualisations based on the Fed’s raw data). Although the 2019 Fed survey won’t be published until next year, we be sure that the $5 trillion increase in S&P capitalisation will push the level of wealth inequality to greater extremes.

High-percentile beneficiaries don’t just include the founders of the biggest companies, such as Facebook’s Mark Zuckerberg or Amazon’s Jeff Bezos. Less obviously, they include their CEOs, such as JP Morgan’s Jamie Dimon or Google’s Sundar Pichai, both of whose stock holdings crossed the billion dollar mark recently. They include large swathes of the companies’ middle management, whose stock option exercise offsets the share buybacks.

Compare this with the decline in net wealth between 2010-2016 experienced by the lower 40% of the US income distribution. Compare that with four per cent wage growth in the US as a whole, or median real household income which is growing at about 0.8% annually (using end 2018 figures). Then you start to see why presidential candidates such as Elizabeth Warren have made so much progress with proposals whose effect would be to redistribute wealth.

Few would discount the ability of billionaires (self-styled or otherwise) to muscle into US presidential elections and win them. But whatever happens next year, the role that financial assets play in inequality will be at the forefront of the debate.

Labour’s local debt penalty

As we approach December’s general election, spending and borrowing promises by the main parties are at the centre of the debate. A key element is how spending and investment happens at local government level, and here too borrowing by councils can play a part.

Alongside the £13.5 billion of historic LOBO loans sitting on council balance sheets, the majority of this borrowing (£79 billion) is from central government, via the Public Works Loan Board, part of the Debt Management Office. This sounds like a bland civil service creation, but is in reality an arm of the Treasury, and therefore subject to direct government control.

And local debt is intensely political, as a Risky Finance analysis shows. Using DMO data, we can explore the borrowing of some 400-odd councils (excluding Northern Ireland) along with the party political control of these authorities. There are some interesting findings.

Understanding the chart

Click on the control below the chart to switch between different metrics for UK councils.
Data source: UK Debt Management Office, Ministry of Housing, Communities & Local Government.

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First let’s consider the political split by number of councils, which is what you normally see on political maps. Today, 114 are Conservative-controlled, but this number fell sharply from its previous level of 147 in local government elections in May, and almost the same number (111) have no single party in control. Labour comes next with 94 councils (down from its 2015 peak when it briefly overtook the Conservatives), and the Lib Dems are in the rear with 15 councils.

Rich council, poor council

Things really get interesting when we start looking at debt1)There are two databases we use – the PWLB loan exposure tables published by the DMO every March, and the Ministry of Housing, Communities & Local Government tables published every quarter, which includes other sources of borrowing such as LOBOs and loans to other councils.. Labour councils have the most, with £26 billion owed to the PWLB and £37 billion overall. Tory councils have about half the amount of PWLB loans, and a bit less than two thirds of the debt that Labour councils do. But the number of councils the parties control is different, so to improve the comparison we consider the debt owed per council.

On average, each Labour council owes £400 million, an increase from the £312 million they owed in 2012, according to the government’s figures. Meanwhile, Conservative councils owe just £194 million on average, a figure that has barely changed since 2012, even though the number of Tory-controlled boroughs has fluctuated significantly over the years. Lib Dem council debt is even smaller, at £159 million on average.

Of course that is only one side of the balance sheet – there are also investments to think about, including cash, money market funds, bonds and other assets like commercial property. Here the picture is reversed. Conservative councils are richest, with £13.4 in billion total investments in June 2019, while Labour councils had just £9.8 billion in total, according to data published by the Ministry of Housing, Communities and Local Government.

We can combine this data with borrowing figures and political control to produce a figure for average net debt per council (debt minus investments divided by number of councils controlled by each party). Now the differences are particularly striking: Average Labour net debt per council is £293 million, for Lib Dems it is £104 million, while for Tory boroughs it is just £77 million.

A constraint on front line services

As it is with individuals, debt is a constraint on councils. Those with larger debts – particularly if taken out when interest rates were higher – are constrained in their ability to spend. This spending is vital for councils because of the front line services many of them deliver. We can also track this with government data.

On average, Labour councils spend £362 million each per year on services such as education, social protection and housing benefit, compared with £239 million for Conservative-controlled councils. It’s easy to see why the Labour boroughs with their high net debt burden are more constrained than their Tory peers.

They are tightly constrained in terms of revenues they can raise, such as council taxes or business rates. If the economy worsens, they ought to spend more to alleviate their residents’ hardships, but their legacy debt burden prevents it.

Screenshot of interactive data visualisation available to subscribers

And our use of averages disguises the acute pressures some councils face. So although on average, Labour councils pay 0.25% higher interest than Conservative councils, a few such as Labour-controlled Bradford or Wakefield, pay interest rates of 5.5% and 6.1% respectively. Or consider Edinburgh, although not outright Labour but controlled by a Labour-dominated coalition, which pays 5.2% on a whopping £922 million of PWLB debt.

Unfortunately these councils can’t easily escape this debt burden because – as we discussed last year – the PWLB charges penalty rates for early repayment. Thus, while Labour councils’ PWLB loans have a notional value of £26 billion, when you include repayment penalties this goes up to almost £40 billion, according to the DMO’s figures at the end of March.

However, when PWLB rates are low it can sometimes be beneficial for high interest rate councils to take the hit and refinance into a lower rate, paying the penalty either with excess cash or additional borrowing. That’s exactly what some councils such as Newham or Cornwall have done with their LOBOs recently.

Javid’s surprise rate rise

But this came before the surprise decision last month by Sajid Javid’s Treasury to abruptly raise PWLB loan rates by 100 basis points. This was viewed by some commentators as a response to the recent trend by wealthier councils such as Spelthorne or Woking to borrow from the PWLB at recent low interest rates in order to invest in commercial property.

It’s true that this phenomenon is an abuse of the PWLB system: Spelthorne’s annual budget is less than a hundredth of Edinburgh’s, but it has borrowed more. However, the Treasury could have easily stopped this by banning the use of PWLB funds for such purposes. The rate rise is a blunt instrument that serves to punish Labour councils by keeping them chained to their debt portfolios.

This move shouldn’t be viewed in isolation though, because two thirds of council spending is funded directly by the government. In 2017, MHCLG began a consultation about changing its funding formula for councils, and asked whether legacy debt costs (the burden that mostly falls on Labour or Labour-leaning councils like Edinburgh) should be taken into account.

In other words, if the DMO and the Treasury wouldn’t budge on PWLB repayment penalties, MHCLG might sling the most indebted councils some extra funding in compensation. Affected councils welcomed this idea, but this summer, DHCLG announced that the funding review would be postponed to 2021. Until then – or sooner if the government changes – councils remain subject to the whims of the Treasury.

References   [ + ]

1. There are two databases we use – the PWLB loan exposure tables published by the DMO every March, and the Ministry of Housing, Communities & Local Government tables published every quarter, which includes other sources of borrowing such as LOBOs and loans to other councils.

Corporate bonds dance to the central banks’ tune

Credit investing is hard enough without having to read presidential tweets and central bank transcripts. But that has been the story this year, as bond markets ebbed and flowed around perceptions of rising and falling rates. And we mean everything about the bonds – their issuance, yields and spreads.

BNP Paribas piles on the senior tranches

Bank pillar 3 disclosures show that the French banking giant more than doubled its securitisation exposure over the last 12 months.

‘Securitisation is back’ was our sub-headline when we last reviewed bank pillar 3 filings from the end of 2018, observing that total exposures had increased by $48 billion during the year. Half a year on, the trend has accelerated, with $120 billion of new exposures added in the last twelve months to the balance sheets of the 11 systemically important banks we monitor.

Europe’s negative yield explosion

Investing in Europe’s bond markets is costly these days. Like oil, you have to pay a storage fee to buy and own this debt, in the form of a negative yield. And the costs may be about to skyrocket.

The year that transformed Britain’s LOBO landscape

The last 12 months have been remarkable for changes at UK councils hobbled by lender option borrower option (LOBO) loans.

After years of denying the problem, attitudes at councils are changing, typified by the toppling of Newham’s long-standing mayor last year in favour of a transformative candidate, Rokhsana Fiaz. Multiple lawsuits have been filed by councils against the biggest LOBO lender, Barclays.

The Sharpe Ratio Ratio

Portfolio optimisers often give results that are extreme and unstable. With so many variables involved, it can be hard to decipher why. This article presents a simplifi ed formula for a two-asset optimisation which will bolster your intuitive understanding of how a portfolio optimiser behaves and why it may behave badly.

Download the paper here

About Thomas Smith

Thomas Smith specialises in quantitative investing. He currently works in the Quantitative Analytics division of Barclays plc. Previously, he was Lead Quant Researcher and partner at Brooksbridge Capital LLP, and a member of the fixed income research team at AHL, a division of Man Group plc. Thomas holds degrees in economics from the University of Toronto and the University of Oxford.

Smart Beta and Dumb Optimisation

Over the past 60 years, a rich history of quantitative research has emerged aimed at the investing community. None has had as much influence as the concept of portfolio optimisation.

According to research, portfolios do better when optimised for low risk and high returns. This has prompted the growth of passive index funds, because the idiosyncratic risks of individual stocks aren’t compensated enough, limiting the alpha that stock pickers can generate.

More recently, the idea of smart beta has become fashionable. If you divide the universe of stocks by factors such as size, momentum or value and optimise your exposure, you can outperform the index and demonstrate this using a backtest. Analytics provided by MSCI Barra or Bloomberg make this as easy as pushing a button. Today, hundreds of billions of investment dollars are being allocated to smart beta products.

In reality, the theory behind this fashion is shakier than many investors realise. When applied naively to input data, optimisation models can lead to extreme or unstable trading strategies.

Inside China’s real estate bond boom

Rising trade tensions with the US haven’t dampened the pace of dollar-denominated bond issuance by Chinese companies, particularly in the highly-leveraged property sector. In the last 12 months, real estate issuers in China have increased their outstanding debt by $38 billion, half of that in this year alone.

Screenshot of interactive data visualisation.

The biggest names here include Evergrande Group, Sunac and Country Garden, with most issuance done via Caribbean tax havens. Let’s look at them in more detail.

According to Evergrande’s annual report, it owns property inventory with floor area covering about 50 square kilometres in mainland China, an area the size of Chicago, as well as land held in reserve. Country Garden has about 24 square km, while Sunac boasts 150 square km of floor area, the size of Liechtenstein.

These three are just the tip of the iceberg – there are dozens more of Chinese developers whose bonds feature in iBoxx’s emerging markets corporate bond index. According to Chinese government statistics, there are about 1,200 square km of uncompleted properties in China – a floor area that if laid out flat would be almost the size of Greater London.

To pay coupons on their bonds, the property developers have to complete these buildings and then sell these properties at high prices to China’s growing middle class. While rating agencies categorise most of this as junk debt, investors such as Pimco’s emerging markets bond fund have snapped it up.

Total outstanding Chinese corporate borrowing tracked by iBoxx is now approaching the half trillion dollar mark, with $120bn in real estate alone. Shanghai property prices, measured in dollars per square foot, are now similar to London and New York. Even so, average credit spreads for the sector have tightened by 145 basis points this year. Things worked out well for Evergrande chairman Hui Ka Yan, who spent $1 billion of his own money buying his company’s bonds last October.

In June 2007, then-Citigroup CEO Chuck Prince famously talked about having to “keep dancing until the music stops”. That remark came just before the global financial crisis. In June 2019, the music may be still playing, but the notes are growing more discordant by the day.


Leveraging the Powell put in US M&A markets

Warning signals multiplied in the first half of June – the US treasury curve inverted, the US-China trade war intensified, and the prospect of a very real war in the Persian Gulf pushed up oil prices. Central banks have reversed the tightening rhetoric of a few months ago, and markets are now anticipating a rate cut later this year.

That sparked a remarkable rally in stocks as investors bet that Fed chairman Jerome Powell will bail them out.

Screenshot of interactive data visualisation tool

The picture of S&P 500 cumulative performance this year is almost identical to a year ago, with the difference that Microsoft has replaced Amazon as the ‘tentpole’ holding up the index. Once again, holding the four biggest market cap stocks at the start of the year outperform the index itself, with a 23% return vs 16% 1)note that our capitalisation weighting is different to the free-float weighting used by S&P.

The $420bn increase in Microsoft and Facebook’s market caps this year is equal to the entire market cap of the smallest 60 S&P 500 members (the world of Mattel, Harley-Davidson and Foot Locker). The gigantism arguments we have written about before seem truer than ever: the incumbent power of tech giants makes them unstoppable, their huge R&D budgets goose their shares with option value, and regulatory threats are perceived as impotent.

For companies that lack the same dominance or R&D optionality, the alternative is to buy it in, using cheap borrowed money. In the long term, the strategy is rife with execution risks, but in the short term, investors love it.

It pays to be acquisitive in 2019

To see how, let’s filter our cumulative return chart for stocks that at the beginning of the year were in the midst of the process of acquiring others. These 76 M&A acquirers in the S&P 500, when ordered by cumulative cap-weighted return, converge on 21%, five percentage points more than the entire index.

Screenshot of interactive data visualisation tool

Acquiring R&D expertise or market dominance seems to increase stock returns whether you are a media giant like Walt Disney, or a tech company like IBM or Fiserv. The only sector where investors are sceptical of M&A is healthcare, where companies such as Eli Lilly or Bristol Myers Squibb have lost ground this year.

If the market is so kind to the idea of M&A, then it makes sense to use leverage to do it. Indeed, two thirds of the $460bn of M&A deals in progress at the start of this year used cash, or a mixture of stock and cash.

Paying for M&A deals is what drove US corporates to increase their total bonds outstanding by $170 billion in the first five months of 2019 according to iBoxx data. This increase was led by the technology sector which contributed $34 bn, followed by health care and industrial goods at $24 bn and $21 bn respectively.

Screenshot of interactive data visualisation. Corporate bond data provided by Markit iBoxx.

Although things were less frenzied than in the equity market, by their own sober standard, credit investors were fine about the new borrowing. Credit spreads for US corporates declined across the board. It’s telling that spreads of companies that borrowed the most, such as IBM or Bristol Myers Squibb, declined more than companies that didn’t increase debt.

As with equities, perhaps the M&A deals that drove the borrowing seduced investors, offering them a more compelling growth narrative than the alternative of sitting on the sidelines doing nothing. And they can ignore all the worrying recessionary and geopolitical signals because they know that the Fed has their back.


References   [ + ]

1. note that our capitalisation weighting is different to the free-float weighting used by S&P