Stocks gave ground yesterday amid a mixture of good and bad earnings reports. In the absolute, earnings were down across the Board. But the Q2 declines had been priced in. What matters always during earnings season is performance relative to expectations. Managements had been guiding analysts for the worst. As a result, bad earnings were better than sharply reduced expectations. Almost every earnings season, companies seem to beat expectations. The key, therefore, becomes forward looking guidance. While each month in Q2 was better than the previous month, the trends into July and beyond vary from company to company. The resurgence of new Covid-19 infections has impacted businesses in various ways.
Today, the Federal Reserve concludes a two-day meeting. Interest rates will remain unchanged. The Fed almost certainly will offer a gloomy economic outlook into next year. What Wall Street investors will focus on is the response. The Fed has already indicated that it intends to keep short term rates near zero for an extended period. The Board has been considering aggressively controlling rates further out on the curve through increased bond purchases of medium-to-long term maturities. The net result would be to keep interest rates near zero all the way out to 10 years.
Such a decision would be controversial. Obviously, low interest rates are positive for economic growth. If there is no cost to borrow, more people and businesses will borrow. Such actions would be stimulative to growth. But artificially holding rates near zero has unintended consequences. In a world that already has too much capacity, stimulating the production of more would create further economic imbalances. Deflation could be a consequence. Interest rates below natural levels may stimulate more investment. The key is whether it is stimulating good investment. In most cases, it is not. The world doesn’t need another office building or widget factory if there is already excess capacity.
The second problem the Fed must deal with as it examines its playbook for tools to support the economy, is determining under what conditions it will reverse course. What might be the future consequences of reversing that decision? There is little question that current 10-year interest rates on Treasuries of 0.6% or lower are largely responsible for the elevated P/E ratios we are experiencing in the current stock market. We know from recent history that in a world of 1.5-2.0% inflation, when the Fed simply maintains the level of its balance sheet, the interest rate on 10-year Treasuries vacillates between 1.5-3.0% most of the time. When that has occurred over the past decade, stocks have traded about 15-17 times forward estimated earnings. 16 times a robust S&P 500 earnings forecast of $180 is 2880, roughly 10% below current levels.
In other words, if the Fed allows market forces to determine rates once Covid-19 disappears and the economy becomes robust again, we could well find ourselves in a situation where earnings per share increase at near double-digit rates while stock prices fall due to a normalization of interest rates. Will the Fed let that happen? Since the Great Recession, any time the Fed has telegraphed a less aggressive monetary stance, financial markets have reacted negatively. It’s a virtual certainty that President Trump would react vociferously, should he be in office. Will the Fed allow rates to normalize without intervention, or will it become stuck in a Japanese style policy of endless support? In Japan, such a policy has led to stagnation, periodic bouts of deflation, and inefficient growth. In the 70s and 80s, Japan emerged as the second most powerful country in the world. It dominated semiconductor and steel production. Toyota and Honda emerged as world class car companies. But since the crash of 1987, Japan has lost its edge. Can you name me any new Japanese economic giant that has emerged over the past 30 years?
Obviously, near term, everyone seems to want lower rates. It is going to take a long time for our economy to heal even if a vaccine arrives tomorrow. I believe the Fed was properly criticized for being too supportive once the European debt crisis passed. I think if it goes too far in an effort to manipulate the economy, its ability to return to normal will become ever more difficult. Today, stocks are near record highs despite all the current woes. Without ongoing central bank support, no matter how fast earnings recover, further highs will be difficult. That is the quandary the Fed finds itself in. Furthermore, with governments taking on so much debt, the consequences of higher debt service costs associated with higher rates could be dire. Thus, the Fed could well find itself doing whatever it can to keep rates low for longer than needed. The net result would be an economy burdened with excess capacity for a very extended period. That is hardly a platform for efficient growth.
One quick note on earnings. After the market closes tomorrow, Apple, Facebook, Alphabet, and Amazon all report earnings. All are priced for near perfection. Friday should be an interesting trading session. It could well determine the near term course for markets.
Today, Dallas Cowboy quarterback Dak Prescott is 27.
James M. Meyer, CFA 610-260-2220