With the Federal Reserve indicating that a rate rise next month is likely, but not yet a certainty, most market observers and participants will be keenly focused on the jobs report released by the Bureau of Labor Statistics (BLS) this morning. Yellen et al have made it clear that, as their mandate requires, inflation and unemployment are the main metrics that will influence their eventual decision. There were murmurs after Yellen’s last press conference when she referred to the effects of global conditions but ultimately it will be the domestic situation regarding jobs and prices that shape policy.
That is as it should be, but if indications from the last couple of weeks of earnings reports are to be believed, a rate rise now, following a great jobs number, could be a dangerous move.
I have, up until now, been of the mind that the Fed should just bite the bullet and raise rates as soon as possible. We know it has to happen at some point and the delay with the accompanying chatter is increasing the distortion of markets to such an extent that the stock market’s role as an indicator of corporate health is becoming lost. That is still the case, but if a rate hike, or rather a series of them, risks completely derailing the economy then some distortion in pricing is a small price to pay. I now believe we may be facing that scenario.
My mind has been changed by a few noticeable trends in earnings this quarter. If you have felt that this season has been marked by a slew of companies beating on the bottom line but missing on the top, then you are correct. The numbers, according to Factset, back that up. 76 percent of companies reporting so far have beaten earnings expectations, which exceeds the 5 year average, while only 47 percent have reported revenue beats, which is below the average. Put simply, corporations are making more money despite sales not growing, or at least not as much as anticipated.
From the perspective of economic growth, this is worrying in two ways. Firstly the lower revenue suggests that economic activity is not as strong as some data suggests and some people believe. In a capitalist system, corporate revenue and profitability are the number one indicator of economic growth and when revenues are slowing, it is a worrying sign. The most popular excuse for that trend has once again been the strength of the dollar, but if you think that will get better if the Fed raises rates while the ECB is making increasingly dovish pronouncements then you need to go back to Economics 101.
Secondly, the fact that so many companies are still making more money than widely anticipated despite those disappointing sales points to the potential for even more problems in the future. The only way that a company can do that is by increasing margins, and there are, in turn, only two ways to do that; raising prices or cutting costs. If they do so by increasing prices then it is an indicator of economic health. The problem here is that with core inflation remaining stubbornly below 2 percent and revenues generally missing the mark there is no evidence that that is how margins are being increased. That increase, therefore, must come from cost cutting.
That phrase “cost cutting” sounds so benign but when you consider what it actually means the fragility of the ongoing recovery becomes clear. There is undoubtedly some degree of good here, with companies trimming fat to become leaner, meaner money making machines, but after around eight years of doing that there cannot be too much fat left to trim. That leads us to the other ways in which costs can be cut; cutting jobs in preparation for scaled down production, or reducing capital spending. It doesn’t take a genius to see that if either of those things is the cause it is worrying for the short term future.
That is why the backwards looking jobs report that, on the surface, looks like such a fantastic indicator may not be telling the true story. There is a problem lurking, and if the Fed does simply what it is mandated to do and reacts to unemployment and price data there may be a heavy price to pay in the first half of next year.
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