Markets

David Fickling is a Bloomberg Gadfly columnist covering commodities, as well as industrial and consumer companies. He has been a reporter for Bloomberg News, Dow Jones, the Wall Street Journal, the Financial Times and the Guardian.

It's when a party's been going on too long that it's most at risk of getting out of hand. The more interesting guests fade away, leaving the field dominated by a sketchier crowd. Behavior considered beyond the pale earlier in the evening is excused to inject more vigor into flagging spirits.

Financial markets, which former Federal Reserve Chairman William McChesney Martin once likened to a drunken debauch, exhibit similar dynamics. Seven years into the current global economic recovery, the punch bowl is almost drained. The remaining revelers are starting to raid the cupboards for stronger stuff.

Time for the Lights to Come On
The measure dropped below 12 percent last month, and the three occasions prior to that coincide closely with U.S. recessions
Source: Bloomberg

For evidence that the balloons are bursting and the dance-floor lights are coming up, take a look at the return on equity of the S&P 500 Index. The measure dropped below 12 percent on March 21 -- the first time it's crossed the line in that direction since June 2008. The occasions prior to that were May 2001 and April 1991, and all three instances coincided closely with U.S. recessions .

Party Crasher
When the U.S. economy is slowing, return on equity for the S&P 500 often falls first
Source: Bloomberg

You see a similar pattern in the FTSE 100 Index. Just 11 trading days during the 2009 nadir of global markets saw returns on equity slip below the current level of 5.5 percent. In Asia, the Hang Seng Index, Shanghai Composite and CSI 300 have all touched their lowest levels since 2009 this year, and remain just a sliver above their rock-bottom points.

Among major equity indexes, only the Nikkei, which is not far below its highest levels since 2008, and Europe's Stoxx 50, which has been bumping along at low levels since 2011, break the pattern.

Some of the more exotic activities from major corporations of late make much more sense when considered against a landscape of deteriorating returns.

Take inversions, where U.S. companies carry out reverse takeovers of foreign businesses in order to benefit from low corporate tax rates overseas.

Such deals, which activist investor Carl Icahn estimates have exceeded half a trillion dollars in recent years, don't come cheap. Pfizer, the global pharmaceutical giant that dropped its $160 billion attempt to hop into bed with Allergan after the U.S. Treasury promised to claw back the lost revenue, will pay a $400 million break fee to its spurned partner, people familiar with the matter said last week. There's also an estimated $120 million to $150 million Pfizer will have to shell out for the work its own bankers and lawyers have done.

Or consider buybacks. Companies in developed markets bought back $20.5 billion of shares in the 12 months to March 31, the highest trailing 12-month rate since the buyback binge that ended in May 2008.

Buyback Binge
Share buybacks in developed markets have reached their highest in eight years
Source: Bloomberg
Note: Data is for trailing 12-month buybacks.

One thing buybacks and inversions have in common is their tendency to flatter returns on equity. Inversions increase the return side of the equation by taking money that would otherwise go to the government and instead handing it to shareholders. Buybacks reduce the other side by draining cash and shrinking the size of net assets, otherwise known as shareholders' equity.

We've seen this movie before. In the mid-2000s, companies greeted declining profits by taking on debt, a neat way of flattering returns on equity since all the capital being consumed by the business is coming from creditors rather than shareholders. The net debt-to-Ebitda ratio of the S&P 500 peaked in August 2008, less than a month before the bankruptcy of Lehman Brothers sent the global economy into a tailspin.

It's understandable that boards should resort to such methods. Financial engineering is what you do when actual engineering -- the real driver of innovation and growth in a business -- has lost traction. Faced with sliding earnings and a mandate to deliver increasing shareholder returns, companies turn to their lawyers and bankers to stave off the inevitability of a business cycle that's on the turn.

With luck, we'll bounce off this low point and look back with complacency on the current returns dip -- which has, to be fair, pipped back up in recent weeks to 12.0391 percent. But analyst estimates of a 9.8 percent drop in profits in the upcoming first-quarter U.S. earnings season, the sharpest fall since 2009, suggest otherwise.

That's worrying. Economic policymakers have been hoping since 2008 that interest rates would be back in normal territory when the next downturn arrived, allowing them to deploy their conventional monetary policy tools to gin up the economy. If this party really is over, more than inversions and share buybacks will be needed to avoid a crashing hangover.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

  1. While declining profits don't look like a positive trend and coincide closely with recessions, the blessed scarcity of recessions means we're drawing from a rather small data set -- so you shouldn't take correlation to necessarily mean causation. And comparisons with previous downturns may exaggerate the similarities -- like unhappy Russian families, every slowdown is unhappy in its own way.

To contact the author of this story:
David Fickling in Sydney at dfickling@bloomberg.net

To contact the editor responsible for this story:
Katrina Nicholas at knicholas2@bloomberg.net