Equity Outlook  |  Q3 2018

Several trends could boost equity returns

Shep Perkins, CFA, Chief Investment Officer, Equities

Shep Perkins, CFA, Chief Investment Officer, Equities
Co-Head of Equities, Portfolio Manager of Putnam Global Equity Fund and Putnam Sustainable Leaders Fund

Several trends could boost equity returns

Compared with the past two years, stock market returns have been underwhelming so far in 2018, but several trends could lend support to equities and help performance in the months ahead. The Tax Cuts and Jobs Act plays an important role, providing corporations with additional cash to buy back shares. Additionally, the vast sums raised by private equity investing and robust corporate M&A activity could also contribute to a more attractive supply/demand environment within equity markets.

Buybacks are surging

Businesses have been aggressively buying back their own shares for several years. This year is no exception, and tax breaks have provided extra cash to put toward buybacks. Based on guidance from S&P 500 company managements, market observers estimate that buybacks could surpass their record high and top $600 billion in 2018. If completed, this implies a 2.5% return to shareholders on top of the S&P 500's 1.8% dividend yield, for a combined 4.3% yield.

There is a tendency to assume that an increase in share buybacks means a decrease in capital expenditures. If company leaders are spending cash to pay shareholders, will they hold off on upgrades to facilities and equipment or other growth investments? I believe this is not an either/ or scenario, and strong year-over-year growth in capital spending suggests that companies are investing in their own businesses as well. For the past 15 years, data suggest that U.S. industrial companies have underinvested in capital equipment. Businesses recognize the need to update physical plants and that it is imperative to invest in new technologies to remain competitive.

There's plenty of dry powder at private equity firms

At private equity firms, high levels of "dry powder" could also play a key role in supporting valuations in the equity market. These firms have raised more than $1 trillion over the past three years, which implies a buying capacity of more than $4 trillion. They are likely eager to pounce on attractively valued companies and take them private.

Businesses are aggressively buying back shares

Corporate M&A activity is robust

Industry consolidation also tightens supply in the equity market. Acquisitions by private equity firms reduce the amount of publicly traded companies, as does robust corporate M&A activity. We believe both trends should continue. M&A is driven by high levels of confidence from management teams with more cash to deploy and a greater urgency to complete deals while interest rates are still relatively low but threatening to move higher.

Larger-scale M&A activity could also surge following the announcement in June that a federal judge approved the merger of AT&T and Time Warner. The U.S. Justice Department had filed a lawsuit to stop the merger late last year, and it also appealed the recent decision. However, we believe this outcome has encouraged more businesses to consider these types of vertical mergers. Of course, all three of these potential drivers — stock buybacks, private equity investments, and corporate M&A — could be put on hold if consumer or business confidence is shaken by unexpected macroeconomic events or if the economy tips into recession. But at this point in 2018, the environment remains conducive for all three, which should support equity prices, if not fuel further gains.

"At this point in 2018, the environment remains conducive for stock buybacks, private equity investments, and corporate M&A."

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