The US: As good as it gets?

For all the recent concerns about the global economic slowdown a lot of the data released in the last couple of weeks supports the view that the world economy is, for the most part, enjoying a decent run. Despite the government shutdown around the turn of the year and concerns over the ongoing trade dispute with China, the US posted an annualised GDP growth rate of 3.2% in Q1. Whilst inventories contributed almost 0.7 percentage points to this figure, the GDP outcome was still significantly better than expected at the start of the year. As Mohamed El-Erian pointed out in a Tweet, “the 2s-10s US yield curve has steepened quite a bit in the last two and a half weeks” which has received far less attention than the flattening which preceded it, which was viewed in many quarters as a harbinger of recession (chart).  

Just to show that the good news is not confined purely to the US, the Q1 euro zone GDP data out this morning pointed to a rise of 0.4% q-o-q (around 1.6% on an annualised basis). Whilst this was considerably slower than US growth rates, it was again rather stronger than might have been anticipated a few weeks ago. Next week’s Q1 UK figures are also likely to come in at 0.4% q-o-q with the possibility of an upside surprise on the back of pre-Brexit inventory accumulation.

With the US economy continuing to look solid, and no sign that the cycle is about to turn down as it is set to become the longest cyclical upswing on record, equity markets continue to power ahead. That said, Q1 earnings have been rather disappointing on the whole and earnings per share on the S&P500 are currently running around 6.5% lower than Q4 levels and 9.5% below the Q3 2018 peak. Based on consensus estimates, it thus looks likely that barring a miraculous surge US earnings in 2019 may only register a small positive gain of around 2.5% following a hefty 23.7% last year (the biggest gain since 2010). Naturally, this reflects the fact that the 2018 numbers were flattered by corporate tax cuts, and some weakness was always likely given that last year’s one-off boost could not be repeated.

Doubtless you will read newspaper headlines from equity bulls suggesting that around 80% of S&P500 companies have beaten earnings expectations of late. But we should not place so much emphasis on a metric which companies use to game the system in order to flatter their earnings profile. The simple truth is that despite the strength of the economy, corporate USA is unlikely to repeat last year’s stellar numbers. That is not necessarily a bad thing: If the market consensus proves to be right, US earnings growth over the period 2018-19 will still cumulate to 27% which translates into 12.6% per annum versus an annual average of 7.4% since the turn of the millennium.

But there are some indications that the dynamic that has driven the US market over the past couple of years may be fraying at the edges. First quarter earnings at Alphabet (the company formerly known as Google) undershot relative to expectations thanks to weak revenues whilst Netflix’s forecasts for subscriber numbers also trailed estimates during Q1. Admittedly Netflix has aggressive targets for the remainder of the year and a track record of delivering, so as a result the price has held up pretty well since the start of the year. But such has been the strength of the FAANG (Facebook, Apple, Amazon, Netflix and Google) sector that any downside surprises may catch the market unawares.

The Fed, which meets tomorrow, is likely to keep rates firmly on hold for a long time to come and reiterate that it is in wait-and-see mode. Whilst this has helped drive markets higher, I can’t help wondering whether the decision in March to announce a pause may have been a tad premature particularly given the strength of activity in Q1. Call me old-fashioned but it is not the job of central banks to support the markets, which after all have had a great run over the past decade. And given the extent to which equity markets and economic fundamentals have been running out of line, a further modest monetary tightening – or at least the impression that the Fed might do so – may be enough to take some of froth out of the markets without unduly derailing the economy.

Nonetheless, the macro data are probably as good as we are going to get – this is the ultimate Goldilocks scenario, with the US economy neither too hot nor too cold. The labour market data suggests that the job machine is running smoothly and consumer confidence has recently spiked to near all-time highs. Donald Trump’s recent exhortations to the Fed to cut interest rates and engage in more QE is thus completely the wrong advice right now. But if past experience is any guide, we should enjoy the current conjuncture while we can. It may not last.