The risk of the US economy overheating was highlighted months ago, but it was difficult to assess whether the market actually believed it was possible. Recent comments by US Treasury Secretary Janet Yellen have put the topic back in the spotlights as she raised the possibility of US interest rate increases.
US Treasury yields have been moving higher since last November, reflecting a rise both in inflation expectations and real (inflation-adjusted) yields. The increase in inflation expectations looked reasonable given by how much they had fallen during the lockdown recession. Much of the gain was centred on the next year as the US economy would likely be leaving the lockdown, while supply was still constrained. Inflation expectations further into the future (five year-five-year forecasts), however, were still below the levels seen in 2018.
The rise in US real yields, on the one hand, reflected forecasts for a pickup in economic growth thanks to the advancing vaccination drive and massive fiscal stimulus. On the other hand, it was an indication of market expectations for an eventual tightening of monetary policy. At one point, the market had priced in at least two 25bp policy rate rises within two years.
The US Federal Reserve has tried to signal that this expectation was misguided. The central bank has reiterated that it is comfortable with the inflation outlook and will not begin tapering its quantitative easing asset purchases, let alone begin to consider hiking rates, until the labour market has recovered and actual inflation is sustainably above 2%, which is the Fed’s policy goal.
Markets seemed to have finally received the message in April: Expectations for the expected future level of policy rates began do drop, and along with them nominal Treasury yields.
Recent comments by US Treasury Secretary Janet Yellen have partly reversed this trend. In contrast to Fed chair Powell, she has suggested that in fact, interest rates might need to rise ‘somewhat’ to keep the economy from overheating. This is consistent with her view when she was chair of the Fed between 2014 and 2018 and the central bank raised policy rates to offset the stimulative impact of the 2017 tax cuts by the Trump administration.
The market reacted in a predictable fashion to Yellen’s words: policy rate and inflation expectations rose (see Exhibit 1). On the equity market, value stocks outperformed growth.
We believe higher-than-expected inflation, if not exactly overheating, remains one of the key risks for equity markets in the near term. In contrast to earlier this year, when the increase in real rates was accompanied by higher growth expectations (and hence higher corporate profits), an increase in policy rates to contain inflation would solely increase the discount rate on profits without the offsetting benefit for earnings.
This Friday’s data on US non-farm payrolls should be a good indicator of how meaningful the overheating risk is becoming.
After three reporting seasons when company earnings came in significantly above analyst expectations, one would have thought that by now, equity analysts would have anticipated strong earnings growth and adjusted their forecasts accordingly.
Perhaps they did, but US S&P 500 companies have still handily beaten forecasts. Just 12% of companies did not surpass the estimates. Earnings exceeded what was expected by 23.4%. The sales beat was nowhere near as large, at just 3.8%, but compared to history, this is still impressive (see Exhibit 2).
What is perhaps more unusual about the latest quarter is the composition of the surprises and earnings beats.
As one has come to expect, information technology and communications services companies have shown strong year-on-year earnings growth and easily bettered analyst forecasts. Unexpectedly, companies in the ‘value’ segment have as well, notably banks (see Exhibit 3).
A year ago, during the lockdown recession, banks set aside large sums for expected losses from both corporate and personal loans. The massive amounts of government and central bank support since then have kept those losses from materialising to the degree expected and banks are now able to release some of those loan loss reserves.
Rising commodity prices and higher interest rates are other factors that should support earnings for companies in the value index in the quarters ahead.
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