After Friday’s strong employment report stocks fell as the likelihood of significant rate cuts later this year were diminished. But the losses were cut by half or more at the end of a very slow trading day.
This morning, however, the downward response continues if futures are any indicator. As we have noted numerous times, what drives equity markets are earnings and interest rates. The inverse of a P/E ratio, or E/P is an earnings yield. Since dividends are a direct function of earnings, an earnings yield is a reasonable proxy for a dividend yield which, in turn, competes with yields on other instruments such as bonds. If interest rates fall, E/P should adjust downward in sympathy. That means the inverse, or P/E will rise.
For the last five quarters, S&P 500 earnings have remained remarkably flat sequentially after a big jump in 2018 Q1 when the corporate tax cut took effect. What gains came from higher productivity and expansionary fiscal policy were offset by higher tariffs and foreign currency translation losses.
Now that the currency markets have flattened out since the spring of 2018, forex variations will have a much smaller impact on earnings going forward. Earnings could begin to rise once again, particularly if interest rates stay low and the Fed cuts rates, as still expected, at the end of July. But the rate of increase isn’t likely to be pronounced as most of the tariffs imposed by President Trump over the past year, and the retaliatory tariffs leveled by foreigners remain in place.
The number of Americans employed today is about 1.5% higher than a year ago. That suggests even a modest year-over-year gain in productivity of 1.0% would lead to an annualized rate of GDP growth of 2.5%. But with tariff and political uncertainty slowing the rate of capex growth, modest sustained gains in productivity may be as much as one can hope for. The semiconductor industry saw a sharp rise in inventory levels over the past three quarters, almost certainly a sign that prior optimism was excessive. Semis go into a wide swath of products from smartphones to machine tools. But a slowdown in demand, at least compared to prior expectations, suggests that tech spending growth has slowed. That is the part of investment spending that generates the greatest increase in productivity. Thus, while productivity continues to improve, one should question whether recent gains are sustainable.
With currency impacts muted, and earnings gains likely to be modest, that leaves interest rate changes as the primary short term driver for stock prices. Before going forward with this, let me suggest that if I have a choice between above average earnings growth accompanied by slightly elevated interest rates, or anemic earnings growth combined with low interest rates, I would take the former every time. Why? There are two reasons. First, over time, earnings rise persistently as our economy grows larger while interest rates move up and down around a center point for inflation which the Fed pegs at around 2%. Second, I have a much easier time sensing the forward path for earnings than I do for interest rates. Ask me to make an earnings forecast 12 months out and I can probably be accurate within 5-10% most of the time. Ask me six months from now whether the 10-year Treasury yield is more likely to be 1.5% than 2.5% and I can’t make a super strong case for either.
Before Friday, markets were pricing in 2-4 cuts in the Federal Funds rate by the end of 2020. Over the same span, earnings were likely to be up 5-8% according to forecasts. With that said, future analyst forecasts for earnings tend to shift lower over time. Therefore, a more accurate prediction may be for earnings growth of 5% allowing for a few percentage points in variance either way.
Thus, the major driver for stock prices is more likely to be changes in interest rates than it is major changes for projected earnings. Indeed, virtually all of this year’s gains to date have related to changes in interest rates. The 10-year Treasury yield at the start of the year was about 3.25%. Today, it is about 2.0%.
Let me give you a graphic reason how much that matters. Take company XYZ that traded at $100 per share at the start of the year with a $3.00 dividend, priced to yield 3%. XYZ, a blue chip company also is expected to increase earnings per share by about 5% to provide investors with a total return of 8%, very competitive with a 10-year yield of 3.25%. But with rates now lower by more than a percentage point, the total return for XYZ could be at least 100 basis points lower, maybe even the full 125 reflected in the decline in Treasury yields. Assuming no change in the forecast of 5% earnings growth, the full impact of changing interest rates would be reflected through a lower dividend yield. If XYZ were to be repriced to yield 1.75-2.00%, the stock price would rise to $150-170 per share. Startling!
Of course, if slower growth reduced future growth expectations, the full change wouldn’t be reflected via a change in dividend yield. So, let’s add in a reduction in forecasted earnings from $5.00 to $4.80 and a 5% increase in the dividend rate. If I do that, the math suggests a price of $120-130 per share. That is still a healthy gain, and one that is all due to a combination of lower rates and higher dividends. That is precisely what we have seen year-to-date. It also explains why stocks that pay healthy growing dividends have done so well. Witness utilities, REITs, and consumer staples. But can this continue?
Again, it all comes down to interest rate projects. Fed Chair Jerome Powell will testify before Congress this Wednesday and Thursday. Wednesday will be the big day. Is an interest rate decrease of at least 25 basis points a virtual certainty come the next FOMC meeting at the end of July? Probably, given the persistence of inflation to stay well below 2% and the negative rates overseas. But the more important question is what happens after July. Mr. Powell is likely to disappoint anyone who wants to see a clear path to lower rates beyond (and that would include President Trump). He will concede that inflation below 2% allows the Fed to be more expansionary and could set the table for further cuts. But, for a man who always claims to be data dependent, he will not want to corner himself. If he intends to set a message about September, the more likely forum would be the annual conclave of Fed leaders that the Kansas City Fed holds at the end of August. Without a strong statement committing the Fed to lower rates, markets might sell off, but any overreading of Mr. Powell’s reticence to set out a long term plan would probably be misguided.
Still, with so much good news priced in, stocks today carry some short term risk. Fed policy is only one risk. Any breakdown in US/China trade talks would be another. That risk is far greater than the likelihood of an all-encompassing new trade agreement. The Iranian situation also poses risks if it leads to any sharp jump in the price of oil. None of these will derail the economy growth glide path and none should lead to a major bear market. Short term adjustments are normal. Earnings season begins in earnest next week. After Mr. Powell’s comment this week, earnings will become the next big driver for stocks.
Today, Michael Weatherly is 51. Kevin Bacon turns 61. Anjelica Huston turns 68.
James M. Meyer, CFA 610-260-2220