Now that we’re well into the new year and the first quarter earnings season is almost fully behind us, it makes sense to pause and try to understand where we are in the economic cycle and what we should expect in the near term future.
The most notable recent change is the stock market. Compared to February, volatility has diminished markedly. However, the “buy the dip” mentality that drove stock indices to ever higher levels since 2009 seems to have vanished. Indeed, since reaching an all-time high in January, the S&P has basically moved sideways, with a few scary price drops followed by “melt up” rallies. Going into earnings season, we had expected that stock prices would be at or above the previous high by now if earnings came in anywhere near our expectations. In fact, earnings came in much better. Through May 5, year-over-year sales are up 9.5% and of those that have reported, 77% have beaten expectations while only 17% have disappointed. Operating margin during the quarter expanded to 11.56% from 9.84% prompting Standard and Poor’s to boost their 2018 earnings forecast to $157.65, a 26% rise over the $124 earned last year. S&P forecasts that earnings will rise another 10% to $173 in 2019. By all measures, this earnings season has been stellar. What’s perplexing though is that a number of analyst’s have discussed the concept of peak earnings; the idea that this is as good as it gets. The concept came about on the Caterpillar Corporation’s quarterly conference call. Several days after the call the CEO clarified the comment to imply that he meant the company had a stellar quarter not that it is likely to be the best quarter of this year or this cycle. Nonetheless, the media focused on the concept for the better part of a week.
At the other end of the spectrum is the bond market. The Federal Reserve has raised the Fed Fund interest rate 5 times and has indicated that they’ll probably hike three more times this year. What’s not received much focus is that the bond market is starting to feel like it’s entering a bear market. The Barclays Aggregate index has been down 6 of the last 11 months and year-to-date is down -2.19%, while the 10-year Treasury Note briefly traded above 3% recently. Making the case for higher interest rates, headline inflation registered 2.5% year-over-year in April. With inflation now trading above the Fed’s stated target, the FOMC has changed the tone of it language, indicating that they’ll tolerate inflation that runs at 2% plus or minus some unspecified amount. That should be an unmitigated bearish signal to the bond market that inflation is at risk of moving materially higher. Despite the rising specter of inflation, the interest rate differential between the 2-year notes and the 30-year bond, known as the yield curve, has fallen below 0.60% for the first time since the financial crisis. As discussed in previous updates we don’t consider the flattening of the yield curve as a leading indicator of a recession. Instead, we believe it’s just another side effect of the flawed monetary policy.
With regard to employment, the jobs market simply could not be better. The number of unfilled jobs has risen to an all-time high of 6.5 million positions while the unemployment rate stands at 3.9%, just 0.1% above the all-time low. Goldman Sachs has forecast that they expect that given current dynamics in the economy, the unemployment rate will fall to 3.25% by the end of 2019. To put that into perspective, unemployment reached a low of 4.4% during the pre-crisis housing boom. If Goldman’s forecast comes to pass average hourly earnings and inflation are likely to continue to climb. With that, we expect inflation will continue to climb, providing a tailwind for the Fed’s interest rate normalization.