Or is it that the bond markets know something the Fed doesn’t know? Like maybe, aside from the ‘strains in financial markets’ noted by the FOMC in its statement, there is a fundamental case for an assertive policy response (as described in A Case for a Half Point off the Funds Rate! 11th December 2007).
The chart shows how the earnings growth reported by companies in the S&P 500 has either exceeded expectations - the positive bars - or fallen short of them - the negative bars. The data is from Thomson Financial and I have used the expectations that were held by the consensus at the start of each quarter since the end of 1996.
With a few exceptions, earnings growth exceeded expectations from the second quarter of 2003 to the second quarter of this year. It fell short of expectations in the third quarter and, although companies have yet to report for the final quarter of this year, the likelihood is that earnings growth will fall short of expectations again (the negative bar for the final quarter of the year approximates the likely outcome).
It is well known that earnings revisions or surprises tend to persist. When earnings fall short of expectations there is usually more of the same to come and the chart clearly illustrates this. Earnings growth fell short of expectations during the Asian currency crisis (1997), the Russian debt default and the subsequent collapse of Long Term Capital Management (1998), and more recently, during the dot com bust (2000 to 2002). And it is happening now.
Earnings growth is slowing a lot faster than expected and, on past form, earnings could continue to disappoint for several more quarters. This can’t be good for investment, jobs, personal income and spending. Also, without much personal income growth the capacity to service any and all kinds of debt will greatly diminish. That raises the risk of default and, if the credit squeeze is intensified as a result, the strain in the money markets won’t be easily alleviated. All this has been driving the bond markets - both the Treasury market and the market for corporate debt.
The Fed’s reluctance to take a lead from the bond markets is understandable. Long ago Paul Samuelson, one of the earliest Nobel Prize winners for economics, made memorable the point about markets as lead indicators in his taunting remark about Wall Street predicting nine out of the last five recessions. That brilliant comment has always struck a chord with me but my guess is that, if you tallied it up, that 9 out 5 would still a better record than most forecasters.
The bond markets are telling us that the risks for growth and inflation are on the downside and I’d prefer to take a lead from them. The FOMC meet again at the end of next month. If the money markets are still malfunctioning and the economic and corporate news flow disappoints, the Fed will have to pull out all the stops and cut the funds rate by at least 50 basis points.
Bond markets have made their point and equity markets have discounted plenty of bad news. Relative to bond markets, equity markets offer long term value, as the chart below shows.
