‘Fed put’ stops working when earnings begin to decline: UBS
Investors treating bad news like good news—and vice versa—is the narrative shorthand of the moment when it comes to explaining daily stock-market moves, but the looming second-quarter U.S. earnings reporting season could soon change the equation, one analyst warned Tuesday.
The good-news-is-bad-news version of the phenomenon was on display last Friday after a stronger-than-expected U.S. June jobs report triggered a modest stock-market pullback as investors scaled back the scope of expected interest-rate cuts by the Federal Reserve.
Ahead of the data, investors had pushed all three major U.S. stock indexes — the S&P 500 SPX, +0.45% the Dow Jones Industrial DJIA, +0.29% and the Nasdaq Composite COMP, +0.75% — to record finishes last Wednesday, with buying enthusiasm attributed to enthusiasm for aggressive Fed monetary easing after recent weak economic data.
On Wednesday, the S&P 500 topped 3,000 for the first time after Fed Chairman Jerome Powell appeared to signal that a July rate cut remained likely amid uncertainty over the economic outlook.
Echoes of 2001 and 2007
The counter-intuitive dynamic, which has investors expressing disappointment over strong economic data and joy over weak numbers, has exasperated some market observers, but it’s hardly a new phenomenon, noted François Trahan, a strategist at UBS, in a note to clients.
“The excitement investors are currently showing over impending Fed easing is fairly typical,” Trahan wrote. “Indeed, there were similar short-lived periods of enthusiasm in both 2001 and 2007 as investors began to focus on coming rate cuts.”
But, as investors might recall, neither of those episodes panned out like market bulls had anticipated, Trahan observed. While extended “rate-cut rallies” were a feature of the 1990s, they’ve proven to be short-lived over the last 20 years as market valuation measures, like the price-to-earnings ratio, expanded temporarily but then began to compress in the face of weaker leading indicators, he said.
Earnings in the spotlight
That puts the second quarter earnings reporting season, which gets under way early next week with results from some banking heavyweights, in the spotlight. Trahan noted that unlike the 1990s, the so-called “Fed put” was of little use in 2001 and 2007 when S&P 500 index earnings growth fell to 0%.
A put option gives the holder the right but not the obligation to sell an underlying asset at a set price by a certain time, providing insurance against loss. The metaphorical Fed put is a reference to the belief that the central bank will take action to bolster asset prices in the event of an economic downturn.
Moreover, earnings growth has been slowing more rapidly than economic data suggests, Trahan said. That’s due in part to import tariffs imposed by President Trump, but is explained largely by the 2018 corporate tax cuts rolling out of year-ago comparisons.
Companies in the S&P 500 index are expected to see an earnings decline of 2.6% in the second quarter, according to FactSet.
Questioning the premise
But not everyone agrees with the premise that investors are treating bad news as good news. Krishna Memani, vice chairman of investments at Invesco, argued in a Tuesday blog post that the popular narrative suffers from a “framing problem.”
The premise is that the Fed’s decision earlier this year to pivot from its policy of gradual but steady interest rate increases to a stance that now has investors anticipating rate cuts as soon as the end of this month was driven by fears that the rate increases of the past three years had left the U.S. economy on the verge of catastrophe.
Room to run
Memani argues that the Fed “got way ahead of itself” by hewing to policy-making driven by the Philips Curve—the theoretical inverse relationship between inflation and unemployment. By last December though, the Fed concluded that the U.S. economy was slowing sharply while inflation remained absent, warranting a decision to “get off the tightening bandwagon”.
Memani contends the Fed simply did the prudent thing and halted tightening before driving the economy into the ditch. He looks for the Fed to gradually unwind “its last few rate increases in a prudent and methodical way,” with financial conditions easing into the second half of 2019. Memani expects the economy to pick up steam in the second half after a second-quarter soft patch and resume annualized growth of around 2%, allowing stocks to rise despite a modest rise in long-term U.S. interest rates.