Wednesday, November 14, 2018

Analysts Still (Too) High on S&P 500 Earnings

The latest earnings reporting season seemed to contribute to the sharp selloff in stocks during October, as some companies reported bullish earnings that were more than offset by bearish guidance about future earnings prospects. Collectively, however, the S&P 500 companies’ Q3 earnings results reported through the 11/8 week were 4.9% better than analysts had expected during the 9/28 week, i.e., just before the start of the latest earnings season (Fig. 1). As I’ve noted many times before, this pattern is par for the course. (The pattern shows up on our “earnings squiggles” data series as a hook at the end of the line—see our S&P 500 Earnings Squiggles Annual & Quarterly.)

In aggregate, the negative guidance corporate managements provided during earnings conference calls somewhat deflated analysts’ consensus earnings estimates for Q4-2018 and the quarters of 2019 (Fig. 2). However, the 2018 estimated earnings growth rate held steady during the 11/1 week from the week before at 23.6%, the highest reading ever for this data series (Fig. 3 and Fig. 4). The 2019 estimated growth rate edged down to 9.4%. The 2020 projected growth rate remained solid at 10.2%.

In other words, the Q3 results didn’t curb analysts’ enthusiasm for earnings growth this year and the coming two years. I, however, curbed my enthusiasm for the earnings outlook on October 30. Here’s more on why I did so:

(1) Me vs them. I lowered my estimates for earnings growth during 2019 and 2020 to 4.9% and 5.3% from 6.8% and 8.8%. I am predicting S&P 500 earnings per share will be $162 this year, $170 next year, and $179 in 2020 (Fig. 5). During the 11/8 week, the comparable analysts’ consensus estimates were $162.67, $177.69, and $194.55.

(2) Revenues slowdown ahead. The growth rate of S&P 500 revenues has been remarkably strong this year, which has contributed—along with the corporate tax rate cut at the end of last year—to the strength in earnings growth. Revenues per share rose 11.2% y/y during Q2, the highest growth rate since Q2-2011 (Fig. 6).

Industry analysts are expecting a slowdown in revenues-per-share growth from 8.5% this year to 5.5% in 2019 and 4.4% in 2020 (Fig. 7). That makes sense to me, since the trend growth rate of revenues has been roughly 4.0% (Fig. 8).

In addition, the global economic outlook is deteriorating, as evidenced by the weakening trends in recent months in both the OECD Leading Indicators and the Global Composite PMI (Fig. 9 and Fig. 10).

(3) Profit margin unlikely to set new records. What doesn’t make sense to me is the implication of analysts’ consensus earnings and revenues estimates that the S&P 500 operating profit margin will continue to rise to record highs. Their latest numbers imply that the profit margin will rise from 11.9% this year to 12.4% next year and 13.1% in 2020 (Fig. 11). For perspective, Thomson Reuters data show that the operating profit margin rose to a record-high 10.9% at the end of 2017 before the corporate tax cut. After the cut, it rose to fresh record highs of 11.9% during Q1 and 12.3% during Q2 (Fig. 12).

During the Q3 earnings season, many company managements warned that, in addition to their revenues growth being weighed down by the global economic slowdown, their profit margins were likely to be squeezed by higher labor costs as well as the impacts of tariffs, which were raising their materials costs and disrupting their supply chains. They didn’t say whether they expected to offset some of those higher costs with productivity gains.

So I don’t expect the S&P 500 profit margin to rise further from here. If it remains flat in record-high territory over the next two years, then earnings growth will match revenues growth. And if that happens, then industry analysts will be lowering their heady growth rates for earnings.

Thursday, November 1, 2018

Fed’s R-Star Is A Black Hole

President Donald Trump must regret that he didn’t renew Janet Yellen’s contract to head the Fed for another four years. She probably would have been more accommodating to his supply-side policies. They both are populist do-gooders at heart. They want as many people to get jobs as possible.

Instead, Trump appointed Jerome Powell to be the new Fed chairman at the start of this year. Powell had been the vice chairman under Yellen. Trump appointed Richard H. Clarida to fill Powell’s vacant position after he was promoted. Both Powell and Clarida are all for continuing to raise interest rates. Both see strong economic growth and a tight labor market as potentially inflationary. So they want to raise interest rates to avert this scenario, by slowing the economy down.

No wonder that the 10/23 WSJ reported that President Donald Trump directly accused Powell of endangering the US economy by raising interest rates: “I’m just saying this: I’m very unhappy with the Fed because Obama had zero interest rates.” He also complained that “[e]very time we do something great, [Powell] raises the interest rates.”

I am convinced that last month’s stock market rout started on October 3, when Fed Chairman Jerome Powell said in an interview with Judy Woodruff of PBS: “The really extremely accommodative low interest rates that we needed when the economy was quite weak, we don’t need those anymore. They’re not appropriate anymore.” CNBC also reported that Powell said: “Interest rates are still accommodative, but we’re gradually moving to a place where they will be neutral. We may go past neutral, but we’re a long way from neutral at this point, probably.” The CNBC article was alarmingly headlined as follows: “Powell says we’re a long way’ from neutral on interest rates, indicating more hikes are coming.”

The S&P 500 dropped 9.1% from the close on October 2 through last Friday’s close as Fed officials continued to hammer home Powell’s narrative (see top chart).

For example, in his first public speech as vice chairman last week on Thursday, Clarida explained why he thinks higher interest rates are in order. Sadly, it’s the same old party line that Fed officials have been spouting for a while to explain their gradual normalization of monetary policy. Here it is in brief:

(1) Star struck and star stuck. Clarida along with other Fed officials are star struck. They are stuck on the fanciful notion that the federal funds rate should be set relative to “the longer-run neutral real rate,” often referred to as “r-star,” or “r*.” Clarida acknowledges that it is an “unobservable and time varying” variable. However, fear not: It is “computed from the projections submitted by Board members and the Reserve Bank presidents.” The real rate is the nominal rate minus the inflation rate. Adjusting an overnight rate using a one-year inflation rate is just one of the many mind games Fed officials like to play.

It gets even worse: Clarida admits that r* “must be inferred as a signal extracted from noisy macro and financial data. That said, and notwithstanding the imprecision with which r* is estimated, it remains to me a relevant consideration as I assess the current stance and best path forward for policy.”

He then goes on to quote a reputable authority on matters of economic astronomy (astrology, actually): “The reason for this is because, as Milton Friedman argued in his classic American Economic Association presidential address, a central bank that seeks to consistently keep real interest rates below r* will eventually face rising inflation and inflation expectations, while a central bank that seeks to keep real interest rates above r* will eventually face falling inflation and inflation expectations.” (Friedman, of course, was the father of monetarism, which has been mostly relegated to the dustbin of economic history.)

By the way, unobservable stars tend to be black holes!

All this suggests that the best measure of whether the real (and nominal) federal funds rate is too low or too high relative to the phantom r* is the actual inflation rate. So by Clarida’s own logic, if inflation remains subdued around the Fed’s 2.0% target, as it continues to do, why should the Fed raise interest rates at all?

(2) The new abnormal. That’s a good question. The Fed’s house view is that monetary policy has been set on a course of “normalization,” with the aim of raising the nominal federal funds rate to a more normal and neutral level of 3.00%, after interest rates were near zero from 2009 through 2015. The problem is that no one really knows if that’s the right level after so many years of abnormally easy monetary policy. What if the neutral federal funds rate is 2.00% rather than 3.00%? In that case, further rate hikes will be restrictive even though inflation remains subdued. (See our FOMC September 2018 Summary of Economic Projections, September 2018-2021 & Beyond tables.)

That’s why the stock market plunged in October. Instead of setting the course of normalization on autopilot with 25bps hikes following the March, June, September, and December meetings of the FOMC, why not try a more gradual pace of increases with longer pauses to assess whether the course of normalization needs to be recalibrated?

(3) Accommodative or not? Recall that the latest, 9/26 FOMC statement deleted the following language that had appeared in previous statements: “The stance of monetary policy remains accommodative.” This sentence had been in every FOMC statement since December 16, 2015, when the Fed started its latest rate-hiking program. In his press conference that same day, Powell minimized the import of this development, saying that the language simply had outlived its “useful life.” He contradicted that assessment on October 3, helping to set the stage for October’s stock market meltdown.

Furthermore, how does that square with Clarida saying that the federal funds rate needs to be raised some more because it is still below r*? There certainly is a big inconsistency between the change in the 9/26 statement and Clarida stating, “However, even after our September decision, I believe U.S. monetary policy remains accommodative.”

(4) Phillips’ disciples. Now that the unemployment rate is down to 3.7%, the lowest since December 1969, Fed officials seem most concerned that the tight labor market will boost inflation. They’ve mostly admitted that the Phillips curve trade-off between unemployment and inflation has flattened out. Yet they still fear that it will make a big comeback unless they continue to raise interest rates. Granted, wage inflation has risen recently to 3.0%, but it might very well be justified by a long-awaited rebound in productivity growth.

Nevertheless, Fed officials figure that by raising the nominal federal funds rate to a neutral rate of 3.00%, they will keep price inflation around their cherished 2.0%. However, their latest dot plot shows that the FOMC’s median estimate of the longer-run unemployment rate—a.k.a. “NAIRU,” the nonaccelerating inflation rate of unemployment—is 4.5%.

In other words, they are saying that to keep a lid on inflation, they have to raise the federal funds rate—up to a restrictive 3.40%, they currently reckon according to the latest dot plot—until the jobless rate rises back from 3.7% to 4.5%! That would imply a sharp economic slowdown indeed. So they figure that they could then lower the federal funds back down to their cherished 3.00%, i.e., the nominal version of r*.

Yet Clarida admits that NAIRU might be lower than 4.5%. So far, it certainly seems to be lower given that a 3.7% jobless rate isn’t boosting inflation much at all (see bottom chart). In his speech, Clarida said that NAIRU “may be somewhat lower than I would have thought several years ago.” He added: “With unemployment falling and wage gains thus far in line with productivity and expected inflation, the traditional indicators of cost-push price pressure are not flashing red right now.” You think?

(5) Raising rates to lower them. I believe that Powell is more of a pragmatist than Yellen. His unspoken game plan may simply be to raise the federal funds rate to 3.00% or even 3.50% so that when the next recession occurs, the Fed will have 300-350bps of leeway between the federal funds rate and zero. That’s fine, but longer pauses between rate hikes may increase the odds of raising the federal funds rate that high without triggering a financial crisis and a recession.

(6) Trump’s regrets. It’s no wonder that in the 10/23 WSJ interview linked above, Trump said: “To me the Fed is the biggest risk, because I think interest rates are being raised too quickly.” As for why he thought Powell was raising rates, Trump said: “He was supposed to be a low-interest-rate guy. It’s turned out that he’s not.” Does Trump regret nominating Powell? It’s “too early to say, but maybe,” the President said. Think of Powell and Clarida as Trump’s regrettables.

I was on CNBC last Friday. My message was: “We need the Fed to pause here and just take a breather. Let’s see how the economy plays out, and that will help the stock market a lot.” I concluded: “Fed officials have been talking like mission accomplished—that it’s the best economy that we’ve ever had. If it’s the best economy that we ever had, why raise interest rates? Why not leave it be if it’s growing with low inflation?”