U.S. Equities: Weak Fundamental Support

Despite a sketchy fundamental backdrop, an accommodative Fed is likely to support share prices for a while longer.

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The U.S. equity market capitalization is larger than total GDP, yet profits are steadily losing share relative to GDP. This is not a sustainable combination and a re-coupling is inevitable at some point. We doubt profits will close the gap. Profit margins are mean reverting and have already been well above average for a prolonged period of time. In fact, wage inflation has been handily outpacing pricing power and there is little volume expansion globally. Furthermore, the message from the latest BIS quarterly global credit flows update is that the credit impulse remains a substantial drag on economic activity, and by extension, earnings performance.

Bottom Line: A gradualist Fed, reduced threat of incremental near-term U.S. dollar strength and no imminent risk of a recession could keep U.S. stocks supported despite the questionable long-term fundamentals.

Will The Fed Be Trapped Like The BOJ?

The Fed wants to avoid, at all costs, entering the next recession with limited ammunition. Japan has been unable to sustainably lift rates since the turn of the century. Every time the BOJ has attempted to tighten monetary policy, the economy has endured recession. The highest it managed to lift rates was to 0.5% leading up to the Great Recession. The zero lower bound has served as a magnet, severely handicapping Japanese conventional monetary policy.

This is clearly a predicament the Fed wants to avoid, but the similarities with Japan are ee¬rie. The chart highlights that the Fed is closely following in the BOJ’s footsteps. Similarly, the lower bound of the 70% confidence interval of the Fed’s June median fed funds rate pro¬jection, as highlighted by Janet Yellen in her Jackson Hole speech, is flirting with the zero line. While we are not arguing that the U.S. is Japan, the odds are that the Fed will not have raised the Fed funds rate by enough in order to regain policy latitude for the next recession.

Our sense is that the Fed will likely wait until the economic dust settles before raising rates, as the risk/reward tradeoff favors a temporary 3-month deferral of the next rate hike.

For additional details, please access the report “Meltdown or Melt-up?” at gss.bcaresearch.com.

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