Philosophy, Earnings, and Cake

Topics - Macroeconomics

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Philosophy, Earnings, and Cake

Stock investors get plenty of criticism. We are told they are myopic, that they can’t see beyond the next quarter’s numbers. As of late, however, they seem to be asking some big existential questions. Have we been wrong about the potential growth of the economy? Can earnings growth perpetually outpace economic growth? Is the economy headed for recession or is there something different in this cycle? And as we pointed out last week, they haven’t always had the same answers as investors in other markets. OK, maybe this isn’t Sartre pondering eternity, but for data crunchers this is philosophical. 1 1 Close Someone once said “Well Camus can do, but Sartre is smartre.”

In theory, higher long-term growth should be good for risky assets like stocks and bad for safe ones like bonds. But when estimates of long-term growth go up, stocks sometimes react negatively. This may be because investors fear higher yields more than they like the additional growth. Stocks tend to focus more on earnings than economic growth. Earnings are correlated with economic growth, but there are differences.

If you look at pre-tax earnings, as reported in national accounts, you’ll see earnings are very cyclical – they may be even more sensitive to the economic cycle than GDP itself. 2 2 Close The National Income and Product Account earnings reports are far less volatile than GAAP earnings and more difficult to manipulate so they are useful in evaluating things from a macro perspective. This is one reason stock investors fear recessions. (Stocks may also perform poorly during recessions because of risk aversion.) But it may create a peculiar relationship with growth, where stock investors aren’t overly concerned about the economy unless it enters a recession. It may explain why stocks can be so resilient in the face of seemingly bad political news if it doesn’t materially affect the economic cycle and the earnings outlook.

In addition to the cyclicality in earnings, there are some longer-term trends. From a little after the end of World War II until the early 1980s, nominal GDP outpaced corporate earnings. 3 3 Close There are a lot of ways to break up the data, but that point seemed like the most instructive. Another interesting fact is that over the whole post war period, nominal GDP has grown faster than earnings. Around 1982, this trend started to reverse, and since then earnings have grown faster than GDP. It probably isn’t a coincidence that we had a long-term bull market in stocks.

Sources: Bloomberg, Bureau of Economic Analysis, Federal Reserve. Date for the first chart from 12/31/1951 to 12/31/1981. Date for the second chart from 12/31/1981 to 6/30/2018.


There are several factors that have provided tailwinds to corporate earnings in the past four decades. Regulation has become more corporate friendly. Companies may have more power in wage negotiations, which enables them to take a greater share of the national income than workers. Some economists have pointed to technological change as structurally benefiting corporate earnings at the expense of other areas of the economy. The debate as to why margins and corporate earnings have been growing is well beyond the scope of weekly market commentary (though others at this firm may or may not have weighed in), but there are some takeaways for those of us with short attention spans who follow markets rather than political debates.

Since the early 1980s, stocks have been able to have their cake and eat it too; then have another cake and probably a few doughnuts. Earnings have increased as a share of GDP while interest rates have fallen. And this has happened while growth has been fairly good. Stocks have had an environment in which they can have both a lower discount rate and more earnings to discount. It’s a very friendly environment.

However, the recent earnings numbers, as measured by national accounts, give some reasons for concern. First, it appears that earnings only just recently breached the previous peak set in 2014. We have also seen that the more commonly reported post-tax GAAP earnings have been growing much faster than these NIPA earnings in recent quarters. There are numerous differences between the two measures. 4 4 Close For example, GAAP earnings are after tax and treat depreciation differently. However, in this case, the difference is probably mostly the result of the recently lowered effective tax rate. This is another reminder of what many market participants already seem to know – that much of this year’s earnings growth is coming directly from the tax bill passed last December. It makes sense that lower taxes would increase earnings as a percentage of GDP as it is a transfer from the government to the corporate sector. 5 5 Close It is more accurately less of a transfer from corporations to the government. But you know what I mean.

Back in 2015, when NIPA earnings were falling, some economists expected a future slowdown in economic growth, which as we know did not come. Looking back, part of that decline was sectoral, in that energy and related companies’ earnings were decimated by lower oil prices. Now some folks are worried because we haven’t seen new highs in earnings even after a recovery in oil prices. This may resolve itself with higher future NIPA earnings numbers, which are compiled with a lag. Most investors pay more attention to the GAAP earnings than to the NIPA ones partly because they are released in a more timely fashion and of course are company specific.

Other measures of economic growth remain strong. There is good reason to think that many of the positive equity conditions will continue. But if you think about the two main drivers of the incredible run we’ve had – lower rates and higher earnings – the next few years may not be as friendly. Fed members have signaled that rates may move to a higher neutral level and possibly beyond. The political climate could become less favorable to companies which have been taking a greater share of national income. In other words, there is still plenty of cake out there, but you can understand why investors in the past few weeks have become a little nervous that their piece may be a little smaller than they had thought. 6 6 Close Or you could just blame buybacks. And remember eating cake is a sin, just like market timing.

What We Are Watching 

Canada Central Bank Meeting (Wednesday) The Bank of Canada (BoC) began to tighten policy last summer, and has so far increased its interest rate target from 0.5% to 1.5%. The Canadian economy may already be showing some of the tell-tale signs of tighter monetary policy, with weaker growth in housing and autos, two of the more interest rate sensitive sectors. 7 7 Close Housing starts and auto sales were both below year earlier levels in September, according to data from Canada Mortgage and Housing Corporation and Desrosiers Automotive Consultants. Nonetheless, overall growth has remained fairly strong with GDP up 2.4% YoY in July. 8 8 Close Statistics Canada. Following the last policy meeting in September, the BoC statement noted that “recent data reinforce Governing Council’s assessment that higher interest rates will be warranted to achieve the inflation target,” while noting downside risks from trade tensions with the United States. 9 9 Close Bank of Canada Statement, 9/5/18. Since that time, data has broadly conformed to expectations, while trade concerns have lessened significantly after the U.S., Canada, and Mexico reached a deal on changes to NAFTA. A rate hike appears quite likely at this month’s meeting, and indeed markets are pricing some chance of back-to-back hikes at the next two meetings. Recent BoC statements have assured markets that the central bank “will continue to take a gradual approach,” so the removal of this phrase would be a fairly clear signal that the pace of hikes could speed up.

U.S. GDP (Friday) U.S. GDP growth was robust in the second quarter at 4.2% QoQ annualized, the fastest quarterly figure since 2014. 10 10 Close Bureau of Economic Analysis. Second quarter results likely received a boost from a few transitory factors, including a bounce-back in some consumer spending categories after weather-induced weakness in the first quarter and a surge in agricultural exports ahead of expected tariffs. Nonetheless, underlying trends in consumer spending, government spending, and investment (the largest components of GDP) continue to look quite healthy. As is often the case, volatile components of GDP such as net exports and change in inventories are likely the biggest source of uncertainty around the upcoming initial estimate of third quarter growth. Unless these components break in a very negative direction, however, headline GDP is likely to remain well above current estimates of potential.

Italy Bond Rating Review (Friday) This is set to be a busy week for Italy, where the recent announcement of plans for a larger 2019 budget deficit has put pressure on Italian government bonds (BTPs) and local equities. The European Commission has criticized the budget for noncompliance with E.U. rules, and has asked for a response to its concerns by Monday. On Friday, S&P Global Ratings is scheduled to publish an update of Italy’s sovereign credit rating. Should Italy eventually lose its investment grade rating from S&P and other ratings agencies, it could lead to forced selling by some investors. Lower ratings could also eventually jeopardize the eligibility of BTPs for ECB asset purchases and collateral operations, although such an outcome still appears remote.