Recent economic data show the economy has regained a bit of momentum. A tighter labor market is pushing up hourly earnings at a faster rate, while the core personal consumption expenditures, or PCE, price index drifts higher. And, as previously discussed, Fed officials have been hinting at a possible increase in the federal funds target rate.
Together, these trends suggest that 10-year U.S. Treasury yields could come under further upward pressure. Since 1980, a simple model of the year-over-year percent change in the core PCE price index added to the effective federal funds rate shows a high correlation with the yield on the 10-year Treasury (Chart 5). While no model is perfect, this simple calculation suggests strong support for basic, widely accepted economic and investing principles.
Though the evidence suggests that yields may rise in the future, there are a number of potentially offsetting forces. First, though U.S. yields are at historically low levels, they are relatively high compared with many other developed economies. That makes them a good value on a relative basis and attractive to foreign investors. Furthermore, a potential federal funds target rate hike could push the dollar higher, and for foreign investors holding dollar-denominated assets, a stronger dollar could mean extra return on their investment. Finally, the U.S. Treasury market remains a safe haven in times of global financial or geopolitical uncertainty. Safe-haven buying could also offset upward pressure on yields from domestic fundamental forces.
In the short term it is nearly impossible to know which forces will win out, but in the longer term, fundamental forces tend to be more persistent.
Rising crude-oil prices combined with the development of new drilling technologies drove a fourfold increase in the number of U.S. oil rigs from early 1999 through 2008. New orders for mining and oilfield equipment rose in conjunction with the increase in rigs (Chart 6).
The plunge in crude-oil prices that began in mid-2014 has led to a drop in the number of operating oil rigs in the U.S. as well as plummeting oil-related capital investment. It’s amazing that U.S. oil production has only begun to fall over the past year, and output levels are still well above the production of just a few years ago (Chart 7).
Crude-oil prices were as low as the mid-$20s a barrel in early 2016, but have rebounded to around $50 a barrel. While that may still be too low a price to encourage a major new drilling surge, if prices continue to rise, capital spending on mining and oilfield equipment may stabilize, reducing the drag on overall capital spending.
U.S. equity markets have recovered from a significant sell-off early in 2016 and from a less severe pullback from mid-April through mid-May. The S&P 500 is currently only about 2 percent below its all-time high. In part the recoveries represent renewed confidence in the economic outlook. In order for markets to continue to post gains, investors will need assurance that businesses will benefit from sustainable topline growth, courtesy of healthy growth rates in overall economic activity. Investors will also need to feel confident that businesses will be able to maintain and protect profit margins in the face of potentially higher interest rates and labor costs.
Growth in earnings per share, or EPS, for the S&P 500 has been slowing since mid-2014, largely due to falling energy prices, though falling commodity prices have also hurt the materials sector, and weak exports have weighed on industrial companies. Despite the performance of S&P 500 earnings, S&P 500 profit margins, measured as operating income as a share of sales, have held up relatively well (Chart 8).
The two biggest threats to margins are likely to be higher labor costs and rising interest rates. Rising wages, however, may be offset by faster productivity growth. While that has been lacking in recent years, labor-cost pressures may be just the stimulus needed for cash-rich businesses to increase capital investment in order to boost productivity.
The second threat may be from rising interest rates. While it seems likely that the Fed will raise the federal funds target rate, policy makers have indicated that increases are likely to come at a very slow pace and in small increments. If that is true, the threat from rising interest rates remains minimal.
Overall, we expect businesses to be able to protect and maintain healthy margins over the next several quarters. If we are correct, then the combination of somewhat stronger topline growth and stable margins should allow for better EPS growth and continued price gains for U.S. equities.
Across the pond, the U.K. may be one of the closest economies to the U.S. in terms of recovery from recession and overall health. But despite the progress made by the Brits in boosting their economy, the U.K. equity market lags far behind the U.S. (Chart 9). One contributing factor to the poor performance may be manufacturing businesses that have had their profitability fall back to levels from the early-to-mid-2000s (Chart 10).
One final note on U.K. equities: The June 23 referendum on whether the U.K. should continue as a member of the European Union or whether it should exit (Brexit) will affect equity market performance. That issue will be put to rest soon. If the U.K. stays in the union, then investors will likely refocus on economic and business fundamentals. If it votes to leave, uncertainty surrounding the impact on both the economy and business fundamentals will likely linger for some time to come.