Low interest rates can be a great tool to get an economy in slow-down mode going again, but there always is an unwanted side effect. If credit becomes too cheap and available for just anyone, there’s bound to be ‘abuse’ in the system, as households (and companies) can spend the borrowed cash on anything they want.

We have already warned you before about the share buybacks on the financial markets, as the increasing profits (per share) are mainly inflated by lower interest expenses and a lower amount of outstanding shares, rather than really seeing a substantial improvement of the business and sector those companies are operating in.

Source: Factset Research

Even though there has been a lot of chatter of a rate hike (which will very likely be completely off the table after the Brexit-vote), S&P 500 companies still seem to be ‘addicted’ to borrowing cash to repurchase shares, and in the first quarter of this year, the 500 companies that are part of the S&P index have spent a stunning $161B on share repurchases, which is the second largest quarterly buyback rate since Q3 2007. And yes, we see the same sort of hubris in the markets today and we don’t think it’s a coincidence the record-high buyback rate was peaking right before the global financial crisis erupted in 2008.

Source: Factset Research

The same alarm bells are ringing now as well, as the world economy is slowing down and central banks are considering rate cuts and new rounds of quantitative easing to keep things going. Granted, this has been going on for a while, but the recent Brexit vote might be the long-awaited catalyst as it’s an indication things are changing in this world.

The massive buyback scheme (with almost $600B spent on buybacks from Q2 2015-Q1 2016) will simply HAVE to slow down as approximately 60% of the free cash flow of the S&P 500 is being spent on these buybacks. Sure, this means there’s an additional margin of 40% to make sure the S&P companies can keep this pace up, but then the next chart is showing there’s no way those companies can keep this thing going when (and not if) the economy will slowing down.

Source: Factset Research

Yes indeed, the dividend payout ratio on a trailing twelve month basis is approximately 40% for the S&P companies, and combined with the 60% spent on share buybacks, these companies have no fully allocated cash flow to fund share buybacks and dividends, rather than investing in growth. And that’s a worrisome conclusion.

After all, the central banks around the world are still playing with the idea to increase the interest rates as they think the world economy has been fixed, but if this indeed happens, the companies will have a serious problem to keep up the appearance as the impact of the higher interest rates on a company with an extensive net debt position could be devastating. Allow us to give you one example. McDonald’s Corp. (MCD) was one of the buyback champions in the past 12 months, having spent in excess of $9B on share buybacks. Its shareholders are obviously pretty happy as this allows McDonald's to continue to boost its EPS, even though the underlying business is clearly slowing down.

But there’s another, darker side as well. Right now, the $9B in additional debt will cost McDonald's just $75-150M per year (depending on the maturity dates of the debt), but if the average interest rate would increase by 3% to return to the normal historical levels, this $9B will start to cost McDonald's an additional $270M per year in interest expenses. Interest expenses that will cause more cash to flow to its financiers rather than its shareholders, as the operating cash flow per share of McDonald's will decrease by $0.31. And that’s just based on the past 4 quarters. Imagine what the impact would be if McDonalds would be on the hook for the additional interest expenses associated with three years of share buybacks; the total interest expense would increase by $750M or almost a dollar per share. Meanwhile, the additional $750M in interest expenses also means the free cash flow will fall by in excess of 15% (!).

Share buybacks can be a nice tool to create value for your shareholders, but the tool should be used in an efficient way. While it does make sense to repurchase shares at a free cash flow yield of 10%+, it makes absolutely no sense at all to buy back stock if you’re trading at a free cash flow yield of 4%.

Source: ibidem

The market seems to be addicted to cheap debt and associates the cash with spending it on share buybacks to reward its shareholders. That’s fine, but this capital allocation strategy will come back as a boomerang in the proverbial faces of the companies that are overspending on the buybacks and use borrowed cash to fund these repurchases. Right now, almost 30% of the S&P 500 companies are effectively ‘overspending’ on share buybacks.

It’s a ticking time bomb.