At its 29th / 30th Open Markets Committee meeting Dr Bernanke’s US base rate setting committee opted, as has been copiously documented elsewhere, to raise the core Fed Funds rate for the seventeenth consecutive time, to 5.25%.
There was sufficient ambiguity in the accompanying statement to encourage the Fed Funds futures market to hold the probability of a further 0.25% point increase at the August 8th meeting well above 50%. At the same time, however, closer examination of what the communiqué actually said does provide some indication that US rate setters are, if not exactly heading for an early bath, trudging wearily towards the sidelines.
We use this note to get some kind of a feel for the outlook for corporate profit margins and earnings growth over the months ahead. To be sure, the US market’s forward multiple looks far from stretched and has underpinned continued investor enthusiasm for equities in the wake of the spring shake out. What concerns us here is the veracity of the earnings projections on which that forward multiple is predicated. Put simply, taking the knife to forward earnings expectations in the context of a slowing real economy could have a very dramatic effect on the market’s prospective multiple, making US equities look far less cheap as an asset class than they purport to be.
Whilst we too expect the Fed to push US base rates up again at its August meeting, we note three key extracts taken from the communiqué accompanying the June rate hike. Firstly, “Readings of core inflation have been high in recent months”. Secondly, “Recent indicators suggest economic growth is moderating” and thirdly, “The extent and timing of any additional firming that may be needed to address these risks”. Our
conclusion is that, taken in the round, these comments indicate a distinctly less hawkish tone than that propounded in the past. This is very significant.
US equities: earnings slowdown expected
US equities have risen into the most aggressive period of monetary tightening on record. US corporate profit margins are currently running at 13% (based on the US National Accounts definition as pre-tax profits relative to GDP) a fifty year high. The fairly obvious point we’re making is that it is as close to a guarantee that you’ll ever get in global economics that growth will slow over the next year or so as the impact of earlier rate hikes percolate through to the real economy. Taking that growth slow
down as read we can then speculate that, all things being equal, the rate of aggregate corporate earnings growth is likely to slow too.
There are plenty of reasons why 13% profit margins may prove a peak (historically margins tend to top out at closer to 10% but this cycle has proved far more longlasting than others of the post-WW2 past). The policy mistake the US authorities may be making this time is that monetary conditions are being tightened at a period in which the US Treasury bond yield curve is fully inverted. By increasing the gradient of the inversion, so policy makers increase the possibility of an economic “hard landing” down the road.
A riffle through financial market history reveals that nominal GDP growth has subsided a full eight times in the post-WW2 period following the point at which profit margins peak out. On every occasion earnings slowed over the ensuing twelve month period. In point of fact earnings did not just slow! On all but two occasions they actually went into reverse (and in 1978, the best year of the eight, annualised aggregate earnings growth shifted from +23% to just +1% the following year!). There was, inevitably, a price to be paid in terms of equity Market performance. The Dow averaged a gain of just 5% but importantly, against the current backdrop of risk-aversion, it was defensive counters which were in the vanguard on each occasion.
US equities: impact of share buy-backs
One important caveat to the above is that a difference exists between National Accounts earnings and S&P 500 earnings. Over longer time periods S&P earnings tend to rise faster and given the corporate sector’s predilection for share buy-backs one might expect the same to be true this time. Indeed the impact of share buy-backs has been to boost aggregate EPS growth by c3% per annum in each of the past three years. That being said, the share buy-back effect is likely only to mitigate the extent of the
earnings downturn, not nullify it altogether. Even assuming a very favourable outcome (i.e.- corporate earnings are held flat, hardly declining at all) the market’s forward multiple would actually be closer to 16x and not the 13x number so popular with market apologists.
The forthcoming corporate earnings season is likely to be watched closely. It will be watched not just for the earnings delivered but more particularly for what the corporate sector thinks about the outlook. Global developed equity markets are in no mood to take prisoners when companies forewarn yet this, to us, is a much more realistic assessment of prospects than those companies which continue to look forward to the future with confidence, only to come crashing back to earth, their wings melted having flown too close to the sun.
Recommended Further Reading:
For more on the record corporate earnings on Wall Street, read: US celebrates as profits soar. For a full list of articles, see our section in investing in stockmarkets.
by Jeremy Batstone of Charles Stanley Equity Research