What to Watch: Interest Rates, Inflation, and Earnings
Earlier this year I authored a blog post series modeled after the game “20 Questions” in which I presented 20 issues, and their relevant probabilities, that I believed were likely to prove the most germane to the markets over the course of 2019. Throughout the year, I will revisit several of the questions and evaluate if my initial probability and thesis are still on track.
Question number two on the original list was “Will the Federal Reserve raise interest rates the 2-3 times that it expects in 2019?” I gave this scenario a 5% likelihood. My conclusion can be read here.
Suffice it to say that three months later, 5% still seems about right. The most recent Fed meeting on March 20, 2019, all but took a Fed rate increase off the table for the balance of the year. The Open Market Committee officially moved from an expectation of two hikes by year-end to none, with just a single hike targeted for 2020 and none in 2021. The Fed has also indicated that it will cease its balance sheet run off in September, considerably earlier than first envisioned.
Of course, the Fed’s current intentions are by no means set in stone and the outlook will likely change somewhat as economic conditions ebb and flow. The recent consensus projection implied by the futures market is for a 60% or so probability of a Fed interest rate cut by year-end—something we think the economy is still strong enough to avoid. One can question the wisdom of following the FOMC’s interest rate guidance—their forecasting track record is no better over time than the Wall Street consensus (which itself is not all that impressive). But a dovish Fed has been the cornerstone of the ten-year bull market and it would surely be unwise to ignore their intentions. As highlighted in spades by December’s market meltdown, investors are well-aware that economic expansions almost always end with an overly restrictive Fed.
The Fed’s current dilemma is to weigh the increasing signs of global economic deceleration (Chairman Powell specifically cited Europe and China in his recent comments) versus generally more positive US economic trends (e.g., strong employment data, moderate inflation, solid consumer confidence, expansionary ISM survey data, a February uptick in the Conference Board Leading Economic Index). The equity market has spent almost all of this year in the glass half full camp. The bond market, however, seems to have decided in recent weeks that global economic weakness may be poised to shatter the glass completely. German and Japanese bond yields have returned to negative territory and the level of negative yielding debt globally is back toward record levels at ~$11 trillion—up over 50% since September. The US bond market, with its recently inverted 3-month and 10-year yields, appears to be sending a similarly cautious message. As previously discussed, sustained yield curve inversions have traditionally been a reliable—albeit not perfect—indicator that a recession is 6-18 months away. The “it’s different this time” counter-argument is that the entire global fixed income universe has been set off-kilter by global quantitative easing, distorting traditional market mechanisms. Along those lines, the spreads between government and corporate bond yields remain at generally benign levels. Still, the March yield curve inversion is a clear reminder that we are much closer to the end of the economic cycle than the beginning.
We did our best impression of President Truman’s reviled one-handed economists in the prior paragraph (“All my economists say, ‘on the one hand…on the other hand’”). At a basic level, that’s because the prevailing global economic backdrop is more “meh” (that’s a non-technical adjective that your millennial friends can explain in greater depth) than say 2008 bad or 2017 good. Indeed, it probably has a similar connotation as the “not too hot, not too cold” Goldilocks view that was a hallmark of the post-crisis bull market. While global contagion remains a risk, the Fed’s halt to the tightening cycle should significantly reduce the odds of a US recession next year.
There are two other key market drivers that appear to be approaching key inflection points: inflation and earnings. Inflation is never far from the market’s (and the Fed’s) consciousness and outside of the recent rebound in energy prices I’ve seen little evidence of inflationary pressures building in the economy. Almost all inflation surprise indicators have rolled over in recent months, consistent with global economic deceleration. Indeed, the prices paid elements of the ISM and regional Fed surveys have fallen toward two-year lows. The proverbial “fly in the ointment” for inflation hawks has been wage inflation, but even that has been decelerating for the past few months. Moreover, to the extent wage inflation remains somewhat elevated by recent standards, productivity growth is (finally) increasing at an even faster rate. Combine all this with the deflationary impact of technology, deficits, and demographics, and a near-term inflation spike appears unlikely.
The recent global economic slowdown and decline in bond yields is causing the recent inflation fears to morph back toward the deflation fears that lingered throughout much of the 2008-2016 period. A bona fide deflation threat is not a present concern, but it is more worrisome than surging inflation. The inflation/deflation saga is clearly something we will be monitoring closely.
As for earnings, the 4Q18 market sell-off was accompanied by an increasing number of Wall Street strategists predicting a so-called earnings recession. Consecutive declines in quarterly earnings last occurred during the 2015-2016 period when oil and other commodity prices tumbled, and the broader equity markets struggled to remain flattish.
Last year’s nearly 25% GAAP earnings growth bonanza was never going to be sustained given the one-time boost provided by the late 2017 corporate tax cuts. The market was ruthlessly efficient in reducing the lofty earnings multiples that prevailed early in 2018 to account for the fact that earnings growth was peaking. The 2019 earnings outlook has always been cloudier though given lackluster global growth, trade fears, and rising input costs. The current consensus expectation is for US S&P 1Q19 operating earnings to decline by about 3% in 1Q19 before rising slowly but steadily toward nearly 7% growth in 4Q19. With the earnings warning season all but over, history would suggest that 1Q numbers will come in a bit higher than expected but that lower guidance (exacerbated by continued strength in the US dollar) will reduce growth expectations somewhat in the outer quarters. As such, a legitimate two quarter-plus earnings recession remains quite possible. While the market’s momentum is undeniably strong at present, the current one year forward multiple of 16x, essentially the average of the past 25 years, strikes us as about as good as it will likely get until the global economic outlook stabilizes. The recent stronger than expected Chinese and US March manufacturing survey data are a small step in that direction.