This past week, I have been focusing on the US economy and the Fed’s reaction function. I would summarize my view as positive about the cyclical trajectory of the US economy but concerned about so-called secular stagnation due to high private debt levels and low wage growth. I am also concerned that cyclical policy was so heavily geared toward monetary policy that it has caused a wide gulf between interest rates compatible with sustainable asset inflation and interest rates compatible with full employment and stable consumer price inflation. As the economic cycle could end soon, this dichotomy is coming to a head in the form of earnings weakness. Some brief comments follow below.
On the earnings front, EPS estimates for the S&P500 have steadily deteriorated for Q1 2015. The focus right now is on a strong US dollar and falling oil prices. But the importance concerns GDP growth in terms of weak business investment, production and inventories. Right now, according to Bloomberg estimates for Q1 are for a 5.8% contraction in Q1 EPS versus the year-ago period. This would be the first outright contraction since Q3 2009. And while oil prices are a boon for consumers, it will detract from sales for cyclically important companies due to a loss of industrial demand from the energy sector.
In the meantime, the S&P500 is trading around 17x forward earnings. And while the strong dollar is a draw for investors, many other regions of the globe have less rich multiples than the US. This is not 1999, but the signs of excess are all around. An example would be the big name IPOs coming to market without any earnings. GoDaddy did an IPO last week, pricing at around $4.5 billion. I use GoDaddy’s services and like the company’s products as a result. But the finances are a different story. This is a company that was founded in 1997, yet last year lost $143.3 million, down from a $279 million loss the previous year. It also has $1.3 billion in debt as it is controlled by private equity firms Silver Lake and KKR. It filed for an IPO in 2006 but withdrew the filing due to adverse conditions. But now it is trading at an enterprise value of $5.3 billion after a huge pop, post-IPO. Clearly the conditions now are better then.
How much will deals like GoDaddy hurt the US economy if they lose value over time? A lot less than the loss of value connected to home prices, since those are highly-levered investments. And that’s why the shale oil investment bust is more of a concern than excess in technology stocks like GoDaddy. Is energy comparable to the housing market? I say no. And as a result, I am less concerned about US domestic problems leading to a 2008-style meltdown. Neither energy or technology is going to result in the bust that housing did.
The reasonable worst case scenario is one in which earnings weakness leads to enough of a decline in production, investment and inventories that wages and job growth falter and then the Q1 slump in consumption continues and builds into something bigger. This is how garden-variety recessions unfold. It is not a crisis scenario.
Keeping this scenario in mind, we need to think about how policy adds to the mix. My sense is that the Fed wants to hike at least one time in order to test their tools for getting off the zero bound and being able to set and control the federal funds rates with the available tools it has developed. A March Reuters article gives the full details of the preparations being made. This is very important reading in my view. Here is how it begins:
The New York Federal Reserve officials tasked with prying interest rates off the floor have been meeting with bankers and traders to plot how best to do it, amid deep uncertainty over how much control they will really have over short-term lending markets.
With the U.S. central bank expected to raise rates later this year, Simon Potter and his team of market technicians have the tricky job of implementing higher rates using some new and lightly tested tools as well as some that may not work as well as in the past. They’ll be operating under intense global scrutiny that’s centered on the prospects for the world’s biggest economy.
Even while testing new methods meant to sweep up trillions of dollars of reserves from financial markets, Potter’s team is preparing for volatility and to make on-the-fly adjustments when the time comes, according to interviews with Fed officials and market participants.
The trouble is that the federal funds market, the intra-bank trading pool traditionally used by the Fed to meet its policy goals, has shrunk to about a quarter of its pre-crisis size after more than six years of unprecedented monetary stimulus.
“There is a lot more uncertainty in the mechanical features of the outlook than people admit to,” said Joseph Abate, a money-market strategist at Barclays Capital.
The Fed wants to avoid a scenario in which yields don’t rise enough after it lifts the fed funds rate because banks, flush with $2.5 trillion of reserves parked at the central bank, don’t need short-term funding.
The central bank also risks being drawn so deeply into money markets that it destabilizes things.
I will leave you to read the rest. But the bottom line here is that the Fed is uncertain how these tools will play out in the real world. It says it has the tools. But behind closed doors, it has acknowledged that it isn’t sure how well those tools will work. I believe this is so great a concern for the Fed that it is willing to err on the side of tightening for the first rate hike in order to put these tools to the test.
What the Fed is now doing is telling markets that the weak Q1 data are not enough to keep it from raising interest rates in the summer. It may delay raising rates. For example, June is still officially on the table for a rate hike and many Fed officials are still saying so explicitly. But they are also saying they are willing to look through the Q1 data and are simply waiting to see whether the Q2 data bounce back. This is what Atlanta Fed President Dennis Lockhart is saying. We know Yellen is saying this based on what I described last week. But St. Louis Fed President Bullard is saying this as well. San Francisco Fed President John Williams even thinks things are “looking downright good” in the US economy. So the stage is set for a rate hike. And I believe it will come sooner than the market expects if the data hold up. If the data sag, there will be no rate hike.
If the macro data perk up again, so will the market. And though we are no longer making new highs but we are still close to all-time highs. From a market perspective, the scenario to fear is the garden-variety recession one that is exacerbated by fiscal and monetary tightening, because markets are still at elevated price levels, wholly dependent on high profit margins, and corporate debt issuance coupled with share buybacks. The underlying top-line revenue growth has been weak and now EPS growth has come unstuck as well. This makes the market vulnerable, even in a garden-variety slowdown, especially given the overhang of private debt and poor wage growth.