No, Markets Are Not Signaling a Policy Mistake

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No, Markets Are Not Signaling a Policy Mistake

Our customary Sunday evening items:

#1: The latest on US corporate earnings expectations.

Let’s start with an old Wall Street saying: “If you’re running money, never listen to Wall Street analysts. In bull market you don’t need them. In a bear market, they’ll kill you.” The idea here is that price action is the only thing that matters. In an uptrending market, it is easy enough to see the leadership names and own them. When stock prices weaken, however, analysts are typically slow to catch on. They’ll just keep thinking the near future will resemble the recent past in terms of market sentiment.

With that cautionary tale in mind, let’s look at the latest trends in Wall Street analysts’ S&P 500 earnings expectations for 2021 (bottom line) and 2022 (top line). (Chart courtesy of FactSet).

On the plus side, you can see that earnings expectations are continuing to rise. That’s what should be happening given Q1’s strong numbers and generally better than expected US economic growth.

Also on the plus side, we can easily make an argument for why these estimates are still low. Q1 came in at $49/share, but even with the revisions you see in the chart Wall Street is still expecting Q2 and Q3 to print lower earnings than that ($45/share and $47/share, respectively). That means 2021 is more likely to come in around $200/share, or 5 percent ahead of the Street’s estimates.

The bad news: investors know these numbers are too low. They can do the math we just showed you. What they want to see is not just earnings beats in Q2, but also a clear runway which turns that $211/share estimate for 2022 into at least $230 (10 pct above 2021).

Takeaway: this is the simplest explanation for why US stocks are having a tough time with last week’s change in Fed policy stance. Investors know the Fed must do something in the face of a robust US economic recovery. But they also need to hang their hats on a pretty optimistic earnings number for 2022 to stay bullish. The $230/share estimate that underpins a vaguely attractive S&P valuation (18x) is fully 40 percent higher than the prior peak for US corporate earnings (2019’s $163/share). We can get that sort of result, but only with a hot domestic economy and (ironically) inflationary pricing power.

#2: Both slices of the US corporate bond market – investment grade (IG) and high yield (HY) – held in remarkably well on Friday. Yes, the drop in longer-dated Treasury yields helped IG; the weighted average maturity for that index is 14 years. But the increase in shorter term Treasury yields was a headwind for HY (3.8-year average maturity) and yet the HYG ETF was only off 0.05 pct on Friday. LQD (IG ETF) was up 0.5 pct.

All that speaks to the resilience of both IG and HY spreads over Treasuries, which as of Thursday were at 10-year record lows.

Here is the IG spread chart, with the old February 2018 low noted:

And here is the HY spread chart, with the low in September 2018:

Takeaway: this data supports the idea we introduced in the prior point, namely that markets are struggling to forecast corporate earnings upside in a new rate regime but (importantly) are not worried about a Fed policy mistake. Both charts actually show what these markets do in a policy mistake scenario: it is that sudden increase in spreads in 2018. IG spreads went from 113 basis points at the start of Q4 2019 to 158 bp. HY went from 322 basis points to 533 bp. Once Fed Chair Powell reversed course on future rate hikes in early January 2019, spreads came right back down. The current trends in IG/HY spreads show none of this action at present.

#3: Fed Funds Futures’ predictions for rate “liftoff”. Fed president Bullard’s Friday comments about a possible 2022 rate increase pushed Fed Funds Futures’ (FFF) pricing almost as much as the FOMC’s revised dot plots did on Wednesday:

  • At the start of last week, December 2022’s FFF contract was at 99.79. That implies a Fed Funds rate of 21 basis points (100 minus 99.79), or about 24 percent odds of a rate increase between now and then.
  • After the FOMC meeting on Wednesday, pricing fell to 99.75. That works about to about 50 percent odds of a rate hike.
  • Friday’s close for this contract was 99.68. That implies Fed Funds of 32 basis points, very close to the 0.375 midpoint of a 0.25 – 0.50 range. Using the same math as the prior odd calculations, we’d estimate that at 78 percent odds of a rate increase by December 2022.

Takeaway: The Fed should be happy that its communications have reset market expectations on rate policy so quickly and with apparently little collateral damage to asset prices. Also, Fed Funds Futures have been much more accurate over the years than human economists, and markets know that. This means that stock prices now discount a rate increase by the end of 2022.

Sources:

FactSet Earnings Insight Report: https://www.factset.com/hubfs/Website/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_061721A.pdf

Fed Funds Futures: https://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund_quotes_globex.html