US economy still has momentum
Here are two seemingly counter intuitive opinions: the Fed will raise interest rates again this year, even though global stock market will likely endure further weakness.
In my opinion, despite all the negative risks floating around, chances are good that the US economy will retain sufficient momentum this year to keep the jobs market ticking over and wage growth moving higher. Against that background, it will be very hard for the Fed under Janet Yellen to justify keeping interest rates at current near-zero levels.
That said, reasonable US economic growth may well not be enough to keep US profits moving higher also. Weak productivity growth, slow global demand, a higher US dollar and rising wages could all combine to keep profits on the back foot, which in turn may well see Wall Street struggle for a second year in a row.
In a sense, it’s probably time for US profits to underperform economic growth, which would be consistent with America’s record high profit margin continuing to fall back toward more normal levels.
Of course, Wall Street likes to think that if it squeals loudly by enough, the Fed will obediently sit up and take notice – and quickly kill any thought of raising interest rates. Under than chairmanship of Alan Greenspan, this type of thinking became known as the “Greenspan put”, namely if stocks do badly enough the Fed will save the day by slashing interest rates.
Belief in the put is alive and well, with the smarties on Wall Street quickly pricing out any risk of US interest rates this year in the wake of recent stock market volatility.
There are several problems, however, with this benign view.
For starters, US interest rates are typically a lot higher than they are now when the Fed tries to save Wall Street and the economy – such as after a long expansion which is slowly turning into a downturn, if not outright recession. But despite America’s gradual six-year expansion since the financial crisis – which dragged down the unemployment rate from 10% to only 4.9% - the Fed only began raising interest rates late last year. The Fed simply does not have much ammunition to help, and at best the market can look forward to steady interest rates this year – or at most a token cut in rates back the practically zero levels prior to December. It’s the price to be paid for the Fed starting the tightening process so late in the cycle.
Secondly, as noted by Janet Yellen in Congressional testimony last week, the economy still appears to retain good momentum. There are negative forces to be sure, with weak global demand and a higher US dollar hurting exports. The decline in oil price is also causing energy companies to “slash jobs and sharply cut capital outlays”. Unseasonably warm weather and an inventory correction also particularly hurt growth in the December quarter, but these seem temporary factors.
Against this, US consumer spending is humming along thanks to solid employment growth, accelerating wage growth and lower petrol prices. Home building is also continuing to rise, with Yellen noting the “level of new construction remains well below the longer-run levels implied by demographic trends.” Outside of the energy sector, business investment is also rising.
Despite the very low level of unemployment, Yellen also thinks the labour market can strengthen even further given that broader measures of labour tightness – such as the number of discouraged and underemployed workers – remains above pre-financial crisis levels.
All up, the strong impression I gained from Yellen’s testimony is she’s not yet moved by recent financial market volatility to temper her views about the need to raise interest rates further. Indeed, while acknowledging both upside and downside risks, her base case view remained that “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”
Indeed, we could be entering one of those perverse periods in which Wall Street tanks on good US economic news - as this would reinforce the view that the US dollar and US interest rates would likely rise further. Equally perverse, a stronger US dollar might then also help push down commodity prices (especially oil) even though this would be associated with ongoing strength in the world’s largest economy.
Wall Street should be careful what it wishes for: the Fed will only stop raising interest rates if the economy is teetering near recession, which would be a much greater negative for corporate profits. That said, while a growing US economy is better than an stagnant US economy for corporate profits, my concern is that profits growth still won’t be strong enough this year to satisfy Wall Street.
1. A put option is the right to sell stocks at a pre-determined price, so it like having insurance in place against declines in your share portfolio.
Published: Monday, February 15, 2016
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