Business World

Sunday 27 May 2018

Growing corporate earnings and positive US jobs figures could see Fed pull the plug

Traders work on the floor at the New York Stock Exchange. The Dow Jones Industrial Average continues to reach record highs, breaking through levels last seen in 2007.
Traders work on the floor at the New York Stock Exchange. The Dow Jones Industrial Average continues to reach record highs, breaking through levels last seen in 2007.

James Saft

Equity markets, especially in the US, are being held aloft by two historical anomalies – quantitative easing and high corporate profits – either of which could start to go away in 2013.

Last Friday's surprisingly good update on the state of the US jobs market raised the chances that soon the Federal Reserve will be more actively – and publicly – mulling how and when it will slow or end its purchases of assets.

At the same time, US corporate profits are at vertiginous levels and climbing, arguing at the very least for caution about their future path.

Combination

That combination, of very good and growing corporate earnings and monetary policy that pushes investors to take risks in equities, has helped lift the Dow Jones Industrial Average to an all-time record.

What happens, however, if progress in the jobs market continues? That might reverse the wage suppression that has been a feature of the anaemic recovery of the past few years, crimping profits, while giving the Fed reason to begin pulling its support for the economy.

If payrolls continue to grow at their improved pace, and if labour force participation doesn't rebound, unemployment will have reached 6.5pc, the Fed's threshold for rolling back QE, by the summer of 2014.

That is a lot earlier than markets are forecasting. Interest rate markets are discounting little or no tightening in real interest rates, meaning taking into account inflation, until 2018.

A quicker-than-expected normalisation of monetary policy could be very destabilising for markets; equities would suffer as support is removed and the knee-jerk rise in interest rates involved would undoubtedly catch out many who have loaded up on government bonds.

To be sure, it may well be that the Fed's spotless track record of meeting financial market distress with easier money is itself underpinning markets.

Who cares if the Fed is going to withdraw QE if they will only put it back on again when the Dow tumbles 500 points some fine Friday?

QE withdrawal

One reason to expect an early withdrawal of QE is the fact that it may soon be attacked on two fronts.

A small but vocal minority of Fed officials, notably Richard Fisher of the Dallas Fed and Charles Plosser of the Philadelphia branch, worry about its unintended effects and effectiveness and are calling for bond purchases to be tapered. Then, if job growth is sustained, the QE doubters may well soon be joined by Fed officials from the middle ground, bringing forward the timetable for tapering or ending bond purchases.

With this as a possibility, it is important to realise exactly how remarkable the growth of corporate profits in the US has been, especially given the economic backdrop.

Corporate profits after tax now account for about 11pc of GDP, having oscillated between 4pc and 6pc between 1950 and 2000.

A simple return, over several years, to the historic mean implies really poor future returns for stocks in the absence of some other extraordinary support.

But why might profits drop? Firstly, profits have expanded in part because wages in the US have taken a smaller and smaller piece of the pie; now below 44pc of GDP and dropping, down several percentage points since 1999.

That is in part the fruit of globalisation and the offshoring of jobs. However, that which can be offshored largely has been and the likely trend is for new manufacturing technologies to start pushing jobs back into the US

As well, a rebound in housing markets is the kind of growth that can only happen onshore. Secondly, there is the issue of the potential for declining government spending. A dollar spent by the government is a dollar that supports household income, and consumption, and corporate profits.

Whatever the right policy should be, the debate now is about the extent to which government spending is curtailed, in real inflation adjusted terms, over time.

When governments cut back on deficit spending, the only hope for profits is a cutback in household savings, which would run against both the trend and, given the pitiful state of Americans' retirement accounts, logic.

Punch line

"Here is the punch line. Any normalisation in the sum of government and household savings is likely to be associated with a remarkably deep decline in corporate earnings," John Hussman of the Hussman Funds wrote in a note to clients.

That decline in earnings is going to hurt stocks, especially if companies are caught in a vice between a rise in earnings and a gentle decline in revenue from government spending.

If profits fall just as the Fed is withdrawing support, either because employment has recovered or because it has lost faith in its own magic – then watch out.

Equities' best hope might be a cut in government spending deep enough to kill job growth – and extend QE.

That is neither likely nor desirable.

Irish Independent

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