The decline in inflation over the past year has confirmed that the Fed went beyond neutral into restrictive territory with its four rate hikes in 2018. The Fed's preferred "core" personal consumption expenditure measure is expected to fall to about 1.5% on a year-over-year basis by the summer, forcing forecasters to revise down their estimates for 2019 inflation. It appears that this will be the 11th straight year that the Fed has fallen short of its 2% inflation mandate.
Significantly, the U.S. is not the only country where inflation has stayed below central bank targets. As Exhibit 1 shows, other major economies, including the euro area, Japan, the U.K., Canada and Australia have struggled to meet their inflation targets over the past five and 10 years. Recognition of this failure has caused the Fed and other central banks to redirect their attention to more aggressive efforts to accommodate economic growth until inflation rises and runs above target for a sustained period that lifts longrun inflation expectations back up to the 2% target.
Exhibit 1: Too Tight Policies Keep Inflation Below Target.
2 – 3
Source: BofA Merrill Lynch Global Research. Data as of April 18, 2019.
This shift to more accommodative policy has set the stage for a reacceleration in U.S. and global growth that is apparent in rising leading indicators like equity prices, which have recovered sharply around the world since the period of excessive Fed tightening ended.
The economy is entering a cyclical sweet spot where growth is currently rising and inflation is falling. This is typically the best time for equity returns because rising growth generally lifts earnings while falling inflation keeps the Fed at bay.
Fed tightening works with a lag in reducing inflation while having a more immediate impact on growth. While these lags can be "long and variable," empirical studies show that the lag between monetary policy moves and inflation is about a year longer than the lag between policy and economic growth.
Thus, in 2019, the Fed's tilt toward easier policy is already stimulating growth, while the restrictive impact of last year's tightening is still working its way through lowering inflation. Given the growing shortfall between actual inflation and the target and taking account of the need to push inflation above target for an extended period, this "sweet spot" for the markets appears likely to last at least a couple of years.
The Fed missed the pickup in productivity in 2018 as did the consensus of economists. That's why the inflation outlook is being revised lower. The consensus assumed that accelerating wage growth would translate into higher inflation. Instead, while wage growth picked up by about a half percentage point in 2018, productivity growth rose more, causing inflation to remain below target in 2018.
The consensus at the Fed and in the forecasting community is that supply-side effects are minimal and that wage pressures dominate inflation. Instead, tax cuts and deregulation have stimulated capital spending, which bolsters productivity. The 2017 Tax Cuts and Jobs Act (TCJA) was more stimulative than expected, and the supplyside effects were bigger than the Fed anticipated. In addition to the positive effect of increased capital spending on productivity, lower tax rates on labor income and higher wages induced more prime-age workers into the labor force, taking some of the pressure off of the tight labor market. As a result, gross domestic product (GDP) growth picked up to about 3% without a pickup in inflation.
Besides the positive impact of the TCJA on productivity and labor force participation, several other factors have worked to raise productivity growth out of its "secular stagnation" doldrums. Over time, weak labor supply growth, a strong dollar and high confidence are important determinants of solid productivity growth.
The demographic constraints on labor supply growth make workers a scarcer commodity and incentivize businesses to find more ways to raise the productivity of each worker. As a result, extended periods of low labor force growth are associated with higher productivity growth than periods where labor force growth is strong. This is one reason why productivity growth was stronger in the 1950s when the small Depression-era cohort was entering the labor force compared to the weak productivity 1970s era when the massive baby-boom cohort was entering the jobs market.
Similarly, a strong dollar incentivizes more productivity compared to a weak dollar. International competition forces strong currency countries to find ways to bolster productivity just as scarce labor does.
Finally, confidence about the longer-term growth of the economy stimulates investment and adds to worker productivity. The decade of secular stagnation was associated with recession levels of confidence among the small business community that creates most U.S. jobs. As the economy has recovered from the 2008 financial crisis confidence has returned to high levels and combined with a more pro-business policy mix has improved businesses willingness to invest for the longer term.
Taken together, these factors that raise productivity suggest that consensus economists and the Fed are still underestimating the economy's potential growth rate, which was a key factor behind the 2018 monetary policy mistake. Supporting this view is the evidence that the brief slowdown in late 2018 and early 2019 appears to have bottomed out around a 2% growth rate and seems to be accelerating from there. For example, the progressive improvement in U.S. economic data since January lifted first-quarter GDP growth to a much stronger than expected 3.2 percent.
What Could Prompt A Rate Cut?
The Fed's shift of its attention toward a more proactive concern about reaching its inflation target instead of focusing on strong wage growth is evident in recent comments from officials. For example, in the April 22, 2019, edition of the Wall Street Journal, the following:
"Fed Vice Chairman Richard Clarida, speaking earlier this month on CNBC, appeared to be lowering the bar for such a move. He volunteered that a recession wasn't the only situation in which the Fed had cut rates in the past, pointing to instances in the 1990s in which the central bank "took out some insurance cuts."
"Over a 12-month period beginning in February 1994, the Fed raised its benchmark rate to 6% from 3.25%. It then cut rates at three meetings between July 1995 and January 1996 after inflation rose less than anticipated."
We believe this mid-90s example of a policy reversal is most closely associated with the 2018–2019 experience. In 1994, the Fed tightened too much, imparting a deflationary shock to the economy that it subsequently corrected. In both the recent and mid-90s examples, the Fed tightened too much in its initial normalization phase after a long period of unusually low rates. These interest rate overshoots forced a partial reversal in both cases. Whether the Fed needs to backtrack further on rates this time will depend on how low and for how long inflation stays below target.
Now that the U.S. corporate earnings season is past the halfway mark, investors have gotten a sense of how corporate fundamentals are shaping up in a moderating economic growth environment. Heading into the reporting season, clouds loomed overhead, dampening sentiment thanks to a suite of concerns ranging from margin pressures, commodity prices and a stronger dollar to broader economic concerns such as worries over Brexit and the unresolved trade spat between the world's top two economies.
In the face of what was forecast to be a year-over-year decline in S&P 500 first-quarter earnings, stocks topped new highs last week, capping a momentous 17-week 25% move to the upside from the lows of Christmas Eve. The trip in equities came courtesy of better-than-expected earnings, reducing, for now, the much-feared possibility of an earnings recession. So far, the majority of corporate earnings reports have topped expectations, with nearly 70% of the S&P 500 companies having beaten earnings estimates. With the rally in stocks this year attributable to expanding valuation multiples, first-quarter estimates were reset dramatically, lowering the bar for companies to clear. That said, a key challenge of this earning season remains the fading effects of corporate tax cuts, setting up a tough comparable quarter for S&P companies.
According to FactSet, on average over the past five years, actual earnings reported have mostly exceeded estimates from the end of the quarter through the end of earnings season. The spread between these two markers has typically increased by 3.7% on average, due to the number and magnitude of upside earnings surprises. As of Friday, 68% of companies are reporting actual EPS (earnings per share) above estimates, beating by 5.3%. This compares to 72% and 4.8% over the past five years. Factoring in the historical earnings growth rate plus the accelerated pace reported so far, could result in a positive year-over-year earnings growth for first-quarter (Exhibit 2).
Exhibit 2: S&P 500 Earnings Growth: End of Quarter Estimate vs. Actual.
U.S. global earnings (non-U.S. figures) have not been immune to the global slowdown impacting large swaths of American businesses and consumers. And key to this batch of earnings is to what extent industries have been, and will be, affected. Looking at revenue by geographic region shows that nearly 61% of S&P 500 revenues come from the U.S., with the remaining emanating from foreign markets. Internationally, the largest individual countries by total revenue percentage of the S&P are: China (5.9%), Japan (2.9%) and the United Kingdom (2.4%). (However, the European Union, on an aggregated basis, remains the largest foreign market for U.S. goods and services.)
On a sector basis, technology led the pack with the most foreign exposure, followed by materials and consumer staples (Exhibit 3). The sectors most exposed specifically to China are tech and energy, relevant to market observers who have been watching for developments in the trade talks between the U.S. and China.
Exhibit 3: Geography Matters: Revenue Exposure by Sector.
A number of companies cautioned that slowing global growth as well as international trade tensions could weigh on their bottom lines, bending earnings for those with higher international revenue exposure. According to the most recent Bureau of Economic Analysis data release (Q4 2018), gross corporate profits from the rest of the world hit a near-record high of $819.4 billion (seasonally adjusted annual rate (SAAR)) a figure up modestly from the prior quarter but some 3% higher than the same period a year ago. Rest-of-world gross corporate profits have marched steadily higher over the past few years, rising 20% between 2016 and 2018.
When comparing performance within the S&P 500 of those most exposed to foreign or domestic revenues, the top quartile of those ranked with the most exposure to foreign markets versus the bottom quartile of those with limited foreign exposure in the S&P, the former are outshining their more domestically focused counterparts year-to-date. To note, S&P companies in the Focused Foreign Revenue Exposure Index are up 20.3% this year, following a drop of -7.6% in 2018. In contrast, the S&P companies that comprise the Focused U.S. Revenue Exposure Index are up a more modest 13.1% in 2019, after last year's drop of -8.3% (Exhibit 4). This echoes our sentiment regarding multinationals well positioned in foreign markets with a reliance on foreign revenues.
Exhibit 4: It's Not a Small World, Afterall.
This earning seasons' price reaction for companies that have beat EPS and sales estimates outperformed the S&P by 1.1 percentage points the following day, below the long-term average of 1.6 percentage points. Conversely, companies reporting EPS and sales misses have underperformed by 3.8 percentage points, more than the historical average decline of 2.4 percentage points. Thus, shares of companies in the S&P 500 that miss earnings estimates are being punished more than average this quarter and those beating aren't feeling too loved either.
We view earnings season as an attractive time to take advantage of increased volumes and elevated volatility around a stock's earnings event, as we remain overweight largecap equities and would be buyers on any weakness. We expect EPS growth to slow from the torrid pace of 20% in 2018 and settle toward 5% in 2019, contingent upon improving economic and trade progress. We prefer exposure to industries that offer earnings streams from secular trends within technology (digital revolution, artificial intelligence, robotics, cloud computing etc.) and those offering cyclical value such as financials and industrials (capital expenditures beneficiaries, defense, infrastructure).
Another key component of earnings seasons remains to be fully seen—guidance. The S&P 500 could benefit from any improvement in the management guidance ratio, which had deteriorated in the first quarter as it typically does. It being only half way into firstquarter earnings season, company guidance is generally neutral, and this sets up realistic expectations and a lower bar for upside surprises for the remainder of 2019. A recovery in guidance this earnings season is likely in our view and would be a positive catalyst driving new highs for the market.
The U.S. surprised the market last Monday by announcing its plan to eliminate waivers on the purchase of Iranian oil, and essentially cutting global oil supply by squeezing Iran. Oil prices were already moving higher in recent weeks as disruptions in Libya and Nigeria, combined with increased tensions in Venezuela, helped drive Brent oil prices from $50-55 range to start 2019 up to the $70-75 range as of April 25, 2019. To offset the anticipated decline in Iranian supply, the U.S. will largely depend on Saudi Arabia to increase its production in the second half of 2019.
At the behest of the U.S., Saudi Arabia is likely to increase its production once again in coming months, albeit gradually, until Saudi can see the actual impact of sanctions on Iranian and Venezuelan oil production and exports. The structure of unconventional oil production means the U.S. cannot turn on and off its space capacity in real time, leaving Saudi Arabia as the main provider of short term global spare capacity (estimated Saudi spare capacity is slightly over 1M barrels per day). This dynamic could support oil prices at the upper end of the $50-70 range in the near term. BofA Merrill Lynch1 Global Research forecast for 2019 remains at $70.
Exhibit 5: Brent Futures Price vs S&P 500 Energy.
Brent oil prices rallied around 40% year-to-date and although energy equity prices also rallied since the start of the year, energy stocks as measured by the S&P 500 Energy sector index are up only ~18% year-to-date on a total return basis. We believe the energy sector is likely to remain a volatile sector that is traded by investors given complex geopolitical dynamics, tensions in the Middle East, production disruptions around the globe, and the decline in the power of OPEC given equally powerful oil and gas production from both Russia and the U.S. Nevertheless, with investor sentiment for the energy sector currently extremely negative, underweight positioning in energy stocks, and the high correlation between oil prices and energy stock prices, there could be a compression of the aforementioned performance gap between oil prices and energy stocks (Exhibit 5). Not all energy companies will be good investments, in our view. Therefore, we recommend investors consider investing in energy companies with strong balance sheets, the ability to generate free cash flow at $40-50 oil prices, maintain disciplined capital investment plans, are committed to returning more cash to shareholders and offer attractive dividends.