The Federal Reserve Open Market Committee (FOMC) meets this coming Tuesday and Wednesday and the market is very divided on whether they will announce any changes to either their QE programme or their forward guidance policies. We too are extremely unsure about what may come about on Wednesday and so we will take a step back and discuss some of the bigger picture issues surrounding Fed policy.
First, we point out that the equity market seems to be behaving a little more bearishly in the run-up to this meeting compared to September. Counter intuitively, this seems to be down to the more benign position in Washington, a string of better economic data and a growing understanding that QE will have to end at some point. We would also point out that European equities have been under more pressure than the US. This may be simple profit taking after a strong run or perhaps the disappointing economic data of late (excluding Germany) is worrying investors who thought they were buying into a recovery story. Furthermore, US bond yields are near the 3% level (currently 2.86%); a level that seemed to concern the Fed in September when they noted the tightening in financial conditions. Who knows whether the poor bond and equity market performance so far this month will influence the Fed’s decision, but we do think that investors should take note of the deteriorating technical underpinnings of the equity markets, in particular in Europe, as the day of tapering draws ever nearer.
Back to Fed policy. It is certain that, as they begin to reduce QE, the Fed will be at pains to tell the market that they are not tightening policy (saying it and believing it are 2 different things). Furthermore, it also seems certain that they will want to replace QE with more forward guidance to convince the markets that interest rates will be kept at nearly zero for a very long period of time. They may even try and convince the market that forward guidance is more powerful than QE, which it most certainly is not.
If this all sounds a bit convoluted, well, frankly it is. The Fed has boxed itself into a corner. They realise that they have to end QE and start tapering very soon. They realise that QE is associated with a rising equity market and they are worried that an end to QE will coincide with lower equity markets. Will their forward guidance policies be effective in either propping up equity markets or reaching the high plateau of escape velocity in the economy? Possibly, but rates have been at zero for 5 years now and we have yet to reach escape velocity, and we doubt whether forward guidance will be that effective.
We have made the case for a long time now that US equities are expensive, and there is no need to cover all the reasons again today. However, what we worry about most is a sharp deterioration in corporate earnings. The consensus is plugging in near 10% earnings growth for the broad market in 2014. With revenue growth likely to be in the low single digits (as it was in 2013) then there has to be margin growth when margins (as measured by non-financial corporate profits to GDP) are already at record levels and significantly above the post WWII average. We actually look for profit margins to fall next year, not rise and perhaps there will be zero or even negative profits growth in 2014. This would be a negative surprise. Indeed, the lead into 2014 is already looking weak with Q4 2014 negative to positive pre-announcements at an off the scale new high, as shown in the chart above courtesy of SocGen.
If the corporate profits cycle is indeed turning down, then could this be a harbinger of US economic recession? Albert Edwards at SocGen makes a strong case for such an outcome. The argument goes that the corporate profits cycle.
leads the business investment cycle. Basically, company executives feel more confident about increasing business investment when current profitability is strong. Edwards also argues that business investment, being the most volatile component of GDP, gives a good heads up about future economic growth. So, the argument here is that the US could be at risk of recession next year if corporate profits fall.
Of course, the corporate profits cycle is not the only indicator that we need to understand, and it is not certain that profits will fall next year if margins remain elevated. What is also worrying at the moment is the continuing disinflation around the world. European inflation is well under 1% as we noted a few weeks ago and the periphery is in deflation. US inflation remains a little bit above 1%. This global whiff of deflation may be about to get worse with Japan and some emerging markets beginning to “export” deflation via weaker exchange rates.
So, what we potentially have on our hands in 2014 is a US economy suffering a slowdown as corporate profits slow or even contract, a deflationary whiff as growth in Europe remains sclerotic and Japan exporting deflation all at a time when the US Federal Reserve is about to reduce QE.