As discussed earlier, based on the FOMC’s forward guidance, we don’t expect the Fed to begin tightening monetary policy until sometime in the second half of 2015 at the earliest. For a different, more quantitative analysis, we use federal funds rate futures to estimate market expectations for the timing of potential rate increases. As of February 24, these data indicate an initial rate hike of 0.25 percentage points in either October or November 2015 and a second similar increase in January 2016. It should be noted that while these implied expectations have varied over the past few months with the ebb and flow of economic data, the implied dates have mostly tilted towards the second half of 2015.
Expected rate hikes combined with current low bond yields mean that investors in fixed-income securities may need to temper return expectations for the next several years as compared with historical norms. We base that assessment on an examination of four periods in recent history during which the Fed was regularly raising interest rate targets. These tightening cycles began in January 1987, February 1994, June 1999 and June 2004. We look at bond returns using three representative indices during each cycle and over subsequent three-year periods.
The data show medium-term government treasuries and corporate bonds tend to underperform short-term government treasuries during tightening cycles. Returns revert to long-term historical trends in the periods immediately following these cycles, with corporate bonds and five-year treasuries significantly outperforming short-term treasury bills over the subsequent three-year periods (Table 3).
So, while the Fed is tightening, short-term T-bills may offer better, albeit modest, returns as compared with longer-term counterparts or corporate debt. When the Fed stops tightening, the typical historical relationship may return. Therefore, investors may want to review the bond exposure in their portfolios as the potential start of tightening cycle approaches.
Commodities tend to be economically sensitive; however, industrial commodities are somewhat more tightly aligned to business cycles than other types of commodities such as energy, agricultural, or precious metals. Therefore, industrial metals commodities may provide some insights regarding current business conditions.
Commodity prices for the most part are determined by global market forces and recent weakness in commodity prices is reflecting weak global growth as well as a strong dollar. To get a more focused indication from industrial metals commodities, we look at U.S. production and new orders of primary metals, a group closely related to industrial metal commodities.
Since the current expansion began in mid-2009, U.S. production of primary metals had risen 64 percent through July 2014. Much of that gain came in the first year of the expansion as production recovered from a sharp 38 percent decline during the recession. Production continued to rise beyond the immediate snapback, gaining 16 percent from mid-2010 through mid-2014. Since hitting a peak in July 2014, U.S. production of primary metals has fallen about 7.6 percent through February 2015. That decline is broadly in-line with the fall in AIER’s leading indicators (Chart 5).
Similarly, new orders for primary metals posted a sharp rebound in the early part of the current expansion following a severe decline during the recession. New orders hit a peak in September 2014 and have fallen about 9.2 percent through January 2015. The weak performance of both production and new orders of primary metals support the view that the U.S. economy has hit a soft patch. However, like AIER’s leading indicators, the declines so far do not suggest a recession is imminent.
During the past four years, corporate sales and earnings have grown as a result of an improving economy. Since the end of 2010, earnings of the S&P 500 companies have grown 30.3 percent, or at an approximately 6.8 percent annual rate. Thanks primarily to share buybacks, earnings per share (EPS) have grown even faster, up 32.9 percent or 7.4 percent annually. These gains are more or less in line with the long-run average growth rate of about 7 percent. Strong earnings increases on the back of decent nominal GDP growth have laid a solid foundation for U.S. equity markets.
Equity investors, however, tend to be forward looking. So while recent historical earnings growth is important, it is expected earnings that really matter to investors. It is a positive sign therefore that projected long-term profit growth remains quite healthy, at 8.9 percent versus a long-term historical average growth rate of about 7 percent for the S&P 500 in aggregate (Chart 6). This suggests that equity analysts are not factoring any significant earnings slowdown or decline in their outlook. While equity analysts’ estimates may sometimes be overly optimistic, they do tend to reflect expectations for significant economic downturns, and currently, no such expectation is present.
Looking at earnings growth by sector (actuals and analysts’ expectations) can tell us something about the medium-term outlook for the economy. Of the ten sectors arrayed in Chart 5, the three most cyclically sensitive are consumer discretionary, information technology, and industrials. These three are also the sectors with the strongest long-term earnings outlook. If Wall Street analysts expected a turn in the economy, this would be reflected in lower earnings expectations for these highly cyclical sectors.
Although less impressive than in the U.S., stock markets have rallied globally. The underlying driver, however, is not necessarily earnings growth. For example, when we tabulate the earnings per share of corporations in the London-based FTSE 100 stock index, earnings have declined by an astounding 33 percent since the end of 2010. This suggests that gains in total returns in companies in the FTSE 100 index have been driven entirely by increases in price-to-earnings ratios. For the index as a whole, this ratio has jumped from below 11 at the end of 2010 to over 22 today.
Other markets have also experienced gains in total return while earnings growth lagged or fell. The Morgan Stanley Capital International (MSCI) Europe Index has gained 42 percent in the past four years while earnings have declined 22 percent. In Asia, Japanese markets returned 69 percent in the last four years while earnings rose a more modest 47 percent. Overall, when we look at global markets, the MSCI All Countries World Index excluding the U.S. (ACWI ex. US) notched a total return of 14 percent in the past four years as earnings have fallen 7 percent.
Only the MSCI Asia ex Japan index shows earnings growth that has exceeded total return gains (Chart 7). Investors will often bid up stock prices before earnings start growing, but if the earnings increase is delayed or is less than expected, these markets may be at risk.