Eran Peleg, CIO
The Shortage of Financial Assets
We often try to explain and to forecast changes in prices of financial assets, e.g. stocks and bonds, by analyzing broad macro-economic or company/sector-specific drivers: we will commonly hear or make statements such as “equity markets will go up on increased corporate earnings”… “bond prices should rise as central banks cut interest rates”… etc. However, sometimes things just boil down to plain and simple supply and demand.
In my very first session of Economics at university, the professor started off by explaining that the root of economics, or more accurately, economic forces lies in shortage. As we move away from equilibrium to a state of shortage of demand or of supply, economic dynamics will come into play.
Today, there is a shortage of financial assets, bonds and stocks, that is supporting their prices. Central banks, through their bond-buying programs (often labelled as ‘Quantitative Easing’ or ‘QE’), have created a shortage of government bonds. This shortage has pushed up bond prices – driving their yields down, often to zero or even into negative territory. But furthermore, low market rates have also enabled corporations to issue cheap debt. They are using this capital to conduct share buybacks and retire company stock. Retirement of shares benefits investors by reducing the total number of shares outstanding, hence boosting earnings-per-share. As an increasing number of companies buy back their stock, the overall number of shares outstanding in the market is reduced (see chart for S&P 500 below). To make things worse, in recent years, the retirement of stock has exceeded the amount of new stock coming into the market through IPOs – resulting in a shortage of shares as well.
S&P 500: The Shrinking Number of Total Shares Outstanding ($ Billions)
Equities: Gross Issuance Has Been Small Relative to Gross Retirement
(Through M&A and Share Buybacks)
So whether intentionally or not, central banks have engineered a shortage of financial assets. And as always in these situations, shrinking supply relative to steady demand has resulted in an increase in the price of the relevant asset – in our case, the prices of bonds and stocks.
It is difficult to say whether or not this situation will change anytime soon. Truthfully, for most of 2019, the US Fed has been unwinding some of the quantitative easing. However, very recently, we have witnessed a reversal and one of the fastest expansions in the size of the US Fed’s balance sheet (a reflection of the expansiveness of monetary policy) – see chart below. What is in store for 2020?