by John R. Goltermann, CFA, CPA, CGMA
February 27, 2019
Last month we wrote about some of the risks that have built up in the US financial system as a result of the government intervention to rescue financial markets post-2008. In the last ten years we have seen the Federal Reserve hold interest rates at 0% for seven years, implement “quantitative easing” for five years (buying almost $4 trillion dollars of bonds in order to bring long term interest rates and credit spreads down), a US government takeover of Fannie Mae and Freddie Mac, a $1 trillion emergency spending package in 2009 and Congressional intervention in the setting of accounting standards in 2009.
We needn’t look much further than Highgate’s office here in Cherry Creek where many new 8-story buildings have been or are being built for new hotels, offices and luxury apartments. Most now have ‘For Lease’ signs adorning the ground floor spaces indicating numerous vacancies in them. And most were/are financed with cheap debt in hopes that “If we build it they will come.” The problem is the exorbitant rent needed to cover the debt service is unappealing to businesses struggling to grow their cash flows. Cheap money has stretched the valuations of these properties to unsustainable levels. The stock market is not much different – high valuations of businesses fueled by debt-funded buybacks that are having trouble finding growth.
Since the selloff in the 4th quarter of 2018, the Fed has struck a more cautious tone on growth and inflation. In the process, it has signaled that it will pause on raising interest rates and has effectively greenlighted asset markets to resume their upward trajectory. At least for now. Corporate bonds will likely perform well relative to treasurys during this period, but the path of least resistance for yields on both is higher because economic demand is set to pick up, the labor markets remain tight and asset prices have bounced hard off the bottom on December 24.
1. The outlook for earnings may be too optimistic in today’s era of grievance politics that has arisen as labor’s share of total income bumps along all-time lows and income inequality notches all-time highs (see charts below).
2. Investment markets’ addiction to easy money and low interest rates (markets throwing tantrums at the first hint of tighter monetary conditions) may delay the normalization of rates and continue to encourage excessive risk taking until valuations become even more absurd.
3. The unprecedented rise in US deficits at a time of strong economic growth and full employment continues unabated. It is unforecastable to know how or when this will end, but as noted economist Herb Stein said, “if something cannot continue forever, it will stop.”
Challenges to profit growth
One of the factors that propelled US stock prices higher over the last ten years (besides low interest rates) is earnings. But how did earnings growth, in a slow economy with low pricing power (inflation) come about? Sales growth has been roughly in line with GDP growth. It was also not productivity growth (which was 1.1% for the last 10 years), and it was not low interest rates. Lower rates have been offset by growth in debt, so the interest payments (interest expense) line item made by corporations have been roughly the same over the next 10 years.
That leaves two major drivers of past earnings growth:
1) Falling corporate tax rates – the effective corporate tax rate was 21.7% between 2010 and 2017 down from 26.7% between 2000 and 2007. The marginal rate then dropped from 35% to 21% in 2018 which has provided significant profit growth through 2018. This was a one-time event.
2) As the two charts above indicate, the corporate sector’s ability to expand at the expense of labor is likely coming to an end. Wage growth has started to rise against the backdrop of a tight labor market, and populist political pressures are rising.
Moreover, share buybacks (financed through debt issuance) compounded earnings per share growth by itself over the last ten years (see chart below) and 2018 was another record year for buybacks. With total corporate debt now at its all-time high of $9.1 trillion, interest rates off their lows, and returns on cash increasing, the incentives to do buybacks is diminishing.
However, the ever-optimistic sell-side analyst community remains unfazed by the challenges to earnings growth. According to IBES data, individual company estimates imply long run earnings growth of 16% a year for the S&P 500 universe. That is more than double average historical earnings growth of 8%. There were similar assumptions priced into stocks in the late 1990s, early 2000s, and many of us remember how that ended.
Since we are arguably in the late stages of a record-long economic expansion, with buybacks diminishing, wages increasing, savings from tax cuts flat-lining and cost pressures building, it will be difficult for companies to increase their profits by 16% a year. So investors and market participants should not be surprised to see downward earnings revisions going forward. And that will be a challenge for stock prices that already trade at optimistic levels.
The Addiction to Easy Money
The Fed’s retreat from its hyper-stimulative monetary policy (suppression of interest rates) unsettled markets in the 4th quarter of 2018. This perfectly highlighted the stock market’s dependency/addiction to low rates. That is the problem with addiction – the withdrawal period is difficult. That puts the Fed in a difficult position because it must balance the need to prevent an overheated economy with the need to maintain financial stability. Its recent revelation on January 4 that it will “listen to markets” signals to us that the Fed is willing to risk falling behind the curve on inflation and will continue to encourage financial speculation and imbalances.
The Fed also took this stance in the late 1990s and again in the early to mid-2000s when it held the fed funds rate far below the growth of nominal GDP. Prolonged periods of abnormally low rates inevitably gave rise to financial excesses and speculation. Too-low-for-too-long interest rates led directly to the tech bubble in 2000 and the housing bubble through 2008. Once again, we have interest rates far below the growth in GDP, and not surprisingly, we have seen speculation through the pervasive use of index investments, and over-allocation to FAANG stocks (Facebook, Apple, Amazon, Netflix and Google).
The Fed has raised interest rates by 225 basis points (2.25%) through nine increases over the last three years. The four increases in 2018 were blamed for stock market volatility in the 4th quarter. Yet all the Fed has done is bring the real fed funds rate out of negative territory. If a real funds rate of 0.5% is enough to trigger extreme market volatility and threaten the economy, then the system is much more vulnerable than generally assumed.
The federal deficit is expected to reach $1 trillion this year, or around 5% of GDP. This is a record peacetime deficit and unprecedented for the later stage of an economic expansion. And the deficit is likely to increased given the aging population’s impact on entitlement programs.
There is no strong support for fiscal discipline in Congress because politicians always prefer profligacy over austerity because elections rarely go to those who advocate for spending cuts and tax increases. The burden of imposing fiscal discipline will then fall to markets.
Currently markets do not seem fazed by fiscal trends. The 10-year treasury bond yield remains below 3% and the gap between 10-year and 30-year treasuries remains low. Typically, when there is concern about government finances, that gap widens. While a crisis may be years away, the concern is that the lack of fiscal discipline poses a threat to markets because it could limit authorities’ room to enact stimulus in the next recession.
Rarely is there a time with few economic, political or financial issues to worry about. And if people are not worried, that all by itself is worrisome. Even in the best of times, there are problems and potential threats to any outlook, so it pays to always approach investments with skepticism and caution.
On average, the stock market is more likely to rise than to fall as it has recorded monthly gains 60% of the time since 1950. This was particularly true between 1982 and the end of 2018 with the S&P 500 delivering compound annual returns of 11% a year despite two 50%+ market declines during the period. This was the greatest 36-year period for financial assets in history driven by falling inflation, falling interest rates, corporate restructurings that boosted profit margins, rising equity multiples and a massive expansion in credit growth through Wall Street “innovations” and vast increases in lending through capital markets.
Going forward, the investment environment is likely to be quite different in that inflation and interest rates are more likely to rise than to fall, profit growth will come under pressure without more corporate tax cuts and with labor demanding more share of income. Valuation multiples (such as the price-to-earnings ratio) will have a hard time continuing to expand from their already record high levels, and credit growth will be more difficult given the current record levels of debt. These concerns are for the long run, not the short run, which is currently enjoying the tailwinds from Fed euphoria.
The obvious question from all of this is how should one invest in a world of real challenges and low prospective returns? At the risk of sounding dismissive, the answer is very carefully. The first concern should be investing with an eye toward safety and capital preservation – not by buying bonds, but by owning equities that have been well-researched for value, where the footnotes have been analyzed, corporate governance assessed and the hard work of understanding the business has been done.
When the prospective return environment is low, like it is now, it takes longer and takes more risk to recover from market losses, so loss avoidance is critical. Therefore, a conservative approach toward equities is warranted, ownership of some diversifiers such as gold, foreign stocks and energy to hedge against the real possibility of inflation (which is not expected at all at the moment), and higher than normal levels of cash to lower portfolio volatility and maintain financial flexibility makes the most sense. We recommend being cautious in the event that today’s optimism and euphoria and the perfection for which stocks are currently priced, turns out to be misplaced.
 Source: BCA Research