US Fiscal Outlook Starting to Play a Role for Long-Term Interest Rates

The two charts below show that US long rates are disconnecting from Fed expectations and oil prices. Despite the market still expecting five Fed cuts over the coming 12 months, long rates are moving higher.

And despite oil prices falling, long rates are moving higher. This suggests that long rates are rising because of emerging worries about fiscal sustainability.

This next chart shows the relationship between 10Y yields and nominal GDP growth:

The differential has been negative since the late 1990s except in recessions. Since 2003, outside of recessions and Covid, 10Y yields have ranged between 0.5 and 2.6pp below nominal GDP growth.

Probably uncoincidentally, inflation expectations have stabilized in the 2-3% range since 2000.

Nominal GDP growth has stabilized around 5%. At the current 10Y yields of 4.3%, the differential is only 0.7%.

Real yields are at the high end of their range since 2000.

Can the U.S. economy accelerate much beyond 5% nominal? Unlikely unless inflation re-accelerates, something the Fed will not allow.

Inflation components:

• PCE-Goods inflation remains negative, actually accelerating to –1.2% YoY in September and –1.6% a.r. in the last 2 months.
• “Beautiful tariffs” could boost goods inflation in 2025 (one-off impact).
• PCE-Services inflation was 3.7% YoY in September, down from 4.2% last March. Last 2 months annualized: +3.3%.
• Oil prices are down with low probabilities of flaring up.
• ECI-Wages were up 3.8% in Q3, down from 4.3% in Q1 and 4.0% in Q2.
• Productivity is helping meaningfully.
• Rentflation is the sole sore point. CPI-Rent is still rising about 0.4% per month as is the BLS All-Tenant-Rent Index (+3.9% YoY in Q3 but +5.7% QoQ).

Goldman Sachs expects October Core CPI at +0.3% MoM, +3.3% YoY.

EARNINGS WATCH

From LSEG IBES:

449 companies in the S&P 500 Index have reported earnings for Q3 2024. Of these companies, 76.2% reported earnings above analyst expectations and 19.2% reported earnings below analyst expectations. In a typical quarter (since 1994), 67% of companies beat estimates and 20% miss estimates. Over the past four quarters, 79% of companies beat the estimates and 16% missed estimates.

In aggregate, companies are reporting earnings that are 7.8% above estimates, which compares to a long-term (since 1994) average surprise factor of 4.2% and the average surprise factor over the prior four quarters of 6.5%.

Of these companies, 60.3% reported revenue above analyst expectations and 39.7% reported revenue below analyst expectations. In a typical quarter (since 2002), 62% of companies beat estimates and 38% miss estimates. Over the past four quarters, 62% of companies beat the estimates and 39% missed estimates.

In aggregate, companies are reporting revenues that are 1.6% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.3% and the average surprise factor over the prior four quarters of 1.1%.

The estimated earnings growth rate for the S&P 500 for 24Q3 is 8.6%. If the energy sector is excluded, the growth rate improves to 11.3%.

The estimated revenue growth rate for the S&P 500 for 24Q3 is 5.3%. If the energy sector is excluded, the growth rate improves to 6.3%.

The estimated earnings growth rate for the S&P 500 for 24Q4 is 10.0%. If the energy sector is excluded, the growth rate improves to 12.6

Trailing EPS are now $236.68. 2024e: $243.59. Forward EPS: $263.38e. 2025e: $274.63.

Revisions are positive:

Pre-announcements are somewhat more negative:

Share-weighted earnings of the Tech and Communication Services Indices are seen up 22.0% in 2024 and 18.6% in 2025 when they will account for 34.6% of all S&P 500 earnings, up from 30.0% in 2023.

The remaining 9 sectors earnings are expected to rise 4.4% in 2024 but a strong 12.1% next year. How?

Non-tech/CS revenues, up only 3.2% in 2024, are forecast to explode 11.7% next year (+12.4% ex-Energy after +3.9%).

In fact, every sector but Energy (+5.6%) are currently seen boosting their revenues by more than 10.0% next year, never mind inflation at ~3.0%. Looks like a tall order for me.

Goldman Sachs reckons that

the Magnificent 7 will have grown aggregate earnings by 30% year/year during 3Q 2024. This reflects a combination of 16% sales growth and 265 bp of margin expansion.

In contrast, 3Q profits for the S&P 493 grew by 3%, driven by 4% sales growth and 33 bp of margin contraction.

However, analysts expect the growth differential will narrow next year as S&P 500 sales and earnings growth broaden.

Of course, the growth premium is reflected in share performance. The Mag 7 stocks have collectively returned 45% YTD and comprise 32% of the market cap of the S&P 500. The 7 stocks account for 1251 bp (47%) of the S&P 500 return YTD.

Tariffs represent potential downside risk to our estimates. Our economists expect the incoming administration to impose on average a 20 pp tariff increase on China imports. They assign a 40% chance of the 10%-20% blanket tariff proposed by Trump on the campaign trail.

During the 2018-2019 trade conflict, companies were generally able to pass the costs of tariffs through to customers. However, even if that dynamic were repeated, tariffs could potentially reduce earnings via weaker consumer spending, retaliatory tariffs on US exports, and increased uncertainty.

Based on our economists’ estimates of how tariffs would impact US GDP growth, each 5 pp increase in the effective US tariff rate would likely reduce S&P 500 EPS by about 1-2%.

But there’s also taxation:. A 6pp decline in tax rates would increase S&P 500 earnings by ~5%

Ed Yardeni:

Industry analysts are likely to up their earnings estimates. We are too. For the S&P 500, we are raising our 2025 and 2026 operating earnings per share from $275 to $290 and from $300 to $320. These estimates assume that Trump will quickly lower the corporate tax rate from 21% to 15%. As of the week of November 7, industry analysts were at $275 and $308 for the next two years. We expect that the S&P 500 profit margin will rise to new record highs of 13.9% and 14.9% over the next two years thanks to Trump’s corporate tax cut, deregulation, and faster productivity growth.

We are raising our S&P 500 year-end targets as follows: 6100 (2024), 7000 (2025), and 8000 (2026). We are now targeting 10,000 by the end of the decade. That’s a 66.6% increase from 6000 currently over the next five years.

We believe these forecasts are consistent with our Roaring 2020s scenario, which is receiving a boost from the animal spirits that should result from Trump 2.0’s economic policies. We also expect that the animal spirits will intensify as the wars between Russia and Ukraine and in the Middle East are resolved sooner rather than later.

Regarding the debt crisis: We expect that better economic growth will boost federal government revenues and that Elon Musk will succeed in slowing the growth in federal government spending. GDP growth might actually keep pace with mounting government debt.

So, we are changing the subjective probabilities of our three scenarios as follows: Roaring 2020s (55%, up from 50%), 1990s-style meltup (25%, up from 20%), and 1970s-style geopolitical and/or domestic debt crisis (20%, down from 30%).

Animal spirits can be associated with irrational exuberance causing a stock market meltup that could set the stage for a meltdown. Valuation multiples are historically high currently, especially for LargeCap growth stocks. However, we’ve recently observed that these multiples are likely to be elevated when investors believe that earnings can grow faster for longer because a recession is less likely in the foreseeable future.

We aren’t saying that a recession can’t occur over the rest of the decade. However, we note that despite the significant tightening of monetary policy during 2022 through 2024, there has been no recession. Why should there be one over the remainder of the Roaring 2020s?

Here’s the current snapshot:

China Price Growth Stays Near Zero as Deflation Persists

The consumer price index rose 0.3% from a year earlier, the National Bureau of Statistics said Saturday, compared with a 0.4% gain in the previous month. The median forecast of economists surveyed by Bloomberg was for the reading to stay unchanged from September.

Core CPI increased 0.2%. Producer inflation slid for a 25th straight month, with a 2.9% drop on year, more than the 2.5% decrease predicted by economists. (…)

The Fed’s Next Moves Are Now Anyone’s Guess Good economic data, and the coming Trump presidency, throw everything into doubt

The Fed cut rates by a quarter point on Thursday, as universally expected and following a half-point cut in September. Markets are already dialing back bets that another reduction will follow in December. Fed funds futures prices now imply a roughly 25% chance that the Fed will leave rates unchanged at that meeting rather than cutting again, up from 14% a month ago.

Further out, the uncertainty is even greater. Take for instance Fed policymakers’ longer-term economic projections released at their September meeting. These showed expectations on average that the target policy rate would be between 3.25% and 3.5% by the end of 2025, down from a range of 4.5% to 4.75% now. That represents a significant amount of easing still to come—perhaps one more quarter-point cut in December and then four next year.

But the chance that the Fed could cut rates by just a quarter point or less between now and June 2025, for instance, stood at a not insignificant 16.9% as of Wednesday on the CME Group FedWatch tool, compared with zero chance on the day of the September meeting.

When asked about the Fed’s September projections at Thursday’s press conference, Fed Chair Jerome Powell strongly suggested that economic conditions have improved since then. “In the main, the economic activity data have been stronger than expected,” he said, citing jobs growth (excluding the October jobs report, which was distorted by hurricane impacts), retail sales and some recent revisions to a series of Bureau of Economic Analysis data.

“I think you take away a sense of some of the downside risks to economic activity having been diminished,” he said. (…)

The Fed has taken some of the pressure off markets with a cumulative reduction in rates of three quarters of a point. How much more relief will be coming, and when, is now very hard to forecast.

Also:

Powell said it was too soon to say how the next administration’s policies would reshape the economic outlook.

“We don’t guess, we don’t speculate, we don’t assume” what policies will get put into place, Powell said.

Really? Remember “transitory”, “the long and varying lags”, rentflation, “the neutral rate”.

Ed Yardeni’s smart assessment:

[Powell] stated a few times that he and his colleagues on the FOMC believe that monetary policy remains restrictive since the FFR is still above its mystical “neutral” level. He did not explain, nor did any reporter ask him to explain, how they know that monetary policy is restrictive if the economy is doing so well, when he also said that economic growth could be even stronger next year!

In his opening remarks, he said, “We know that reducing policy restraint too quickly could hinder progress on inflation. At the same time, reducing policy restraint too slowly could unduly weaken economic activity and employment.”

Notice that he is implying that the FOMC is committed to lowering rates, the only question is how fast. He did say that given the strength of the economy, there’s no rush to lower the FFR. So at his latest presser, Powell stuck to his ultra dovish pivot which he first signaled in his August 23 Jackson Hole speech: The Fed will be cutting interest rates for the foreseeable future.

Powell said the Fed is trying to find the middle path between the risk of cutting the FFR too quickly thus undermining progress on inflation, or cutting too slowly and allowing the labor market to weaken too much. In either case, rates are being lowered. The only question is how quickly. (…)

Powell acknowledged that the economic numbers since then have been stronger than expected. One might question why an additional rate cut was needed if the economy is in fact in better shape today than it was at the Fed’s last meeting? What’s the rush, if there is supposed to be no rush? (…)

Ignore the Headline Miss—Productivity Firming This Cycle

Nonfarm labor productivity, defined as output per hour worked, increased at a 2.2% annualized rate in the third quarter. The outturn was a bit less than expected and comes on the heels of a downward revision to the prior quarter (2.1% from 2.5% previously) that was largely driven by a lower measure of output during the quarter. Incorporating the revisions, nonfarm labor productivity was 2.0% year-over-year in Q3.

Despite the third quarter’s miss and downward revision to the prior quarter, the trend in worker efficiency continues to look solid. Recent benchmark revisions to GDP showed stronger nonfarm output in recent years, which has led labor productivity to grow at an average annualized rate of 1.8% since the pandemic, up from a prior estimate of 1.6% and the past business cycle’s 1.5% average (2007–2019).

Relative to Q4-2019, real output of the nonfarm business sector has expanded 12% while hours worked have increased a more modest 4%. The differential suggests that workers are finding a way to produce more with less, and early evidence from the Bureau of Labor Statistics points to the broader adoption of remote work as one key factor.

Source: U.S. Department of Labor and Wells Fargo Economics

Firming labor productivity growth is important in quelling the labor market’s inflationary impulse. Compensation per hour worked increased at a 4.2% annualized rate in Q3. This measure tends be more volatile than other measures of compensation, such as the Employment Cost Index, which showed a more benign pace of labor cost growth in Q3. Nominal labor costs are a significant input to production, yet from the perspective of inflation pressures, compensation per unit out output is what matters. In that regard, unit labor costs (ULCs) were running at a 1.9% annualized pace in Q3.

The choppiness in labor productivity growth can make discerning a trend in unit labor costs difficult. When we smooth annual growth with a four-quarter moving average, ULCs were 3.0% in Q3, a notable pickup from the prior published reading of 1.2% that preceded the Bureau of Economic Analysis’ upward revisions to income and thus compensation.

Unit labor cost growth will likely be revised back down at least somewhat once benchmark revisions to the Current Establishment Survey are finalized (the preliminary estimates show 818K fewer workers on the payrolls in March 2024, pointing to lower aggregate hours worked). However, piecing together the upwardly revised pace of labor productivity growth and still strong ULCs, we suspect the FOMC will ease monetary policy at a more gradual pace in the coming months.

Source: U.S. Department of Labor, U.S. Department of Commerce and Wells Fargo Economics

Wage Growth Tracker Was 4.6 Percent in October

The Atlanta Fed’s Wage Growth Tracker was 4.6 percent in October, down slightly from 4.7 percent in September.  For people who changed jobs, the Tracker in October was 4.7 percent, down from 4.9 percent in September. For those not changing jobs, the Tracker was unchanged at 4.6 percent in October.

FYI, services wages were up 4.8%, up from 4.6% in August.

China Extends Lifeline to Local Governments but Holds Off on Big Stimulus Investors had been hoping for a large-scale effort to revive the country’s economy

China’s top legislative body gave its green light for local governments to swap some of their mounting off-balance-sheet debts but stopped short of new fiscal stimulus measures to revive the struggling economy.

After a five-day meeting, the Standing Committee of the National People’s Congress on Friday approved the issuance of 6 trillion Chinese yuan worth of local government special-purpose bonds, equivalent to about $837 billion, to replace off-the-books debt that had piled up over the years to levels that have worried many economists.

The newly-approved debt, to be issued over the course of three years, will bring the upper limit of outstanding local-government special-purpose bonds to 35.52 trillion yuan by the end of 2024, Xu Hongcai, a deputy director of the NPC Financial and Economic Affairs Committee, said during a briefing on Friday.

Separately, Chinese Finance Minister Lan Fo’an said at Friday’s briefing that, over the next five years, local governments will be able to tap an additional 4 trillion yuan worth of special-purpose bonds—originally mainly issued for infrastructure projects—to replace off-the-book debts.

Collectively, officials say that the measures would replace 10 trillion yuan worth of so-called “hidden debt” at the local government level, which Lan said stood at 14.3 trillion yuan at the end of 2023—though many private economists put the real figure at somewhere between the equivalent of 50 trillion yuan and 79 trillion yuan.

The debt was raised over many years by China’s local governments, primarily through affiliated financing vehicles, to fund infrastructure spending. Friday’s measures would put some of these hidden debts explicitly onto government balance sheets.

The long-awaited press conference was conspicuously silent, however, on expected measures to issue special treasury bonds to replenish capital levels at Chinese banks, as well as special-purpose bonds to support the country’s struggling property sector. Investors and economists had been expecting such measures in the weekslong run-up to Friday’s press conference. (…)

• Companies Are Already Exiting China to Escape Trump’s Tariffs

Steven Madden Ltd. is accelerating plans to shift production out of China after Donald Trump’s victory in the US presidential election raised the odds of increased tariffs on imported goods.

The shoe retailer now aims to reduce goods manufactured in China by 40% within the next year, up from its prior target of a 10% reduction.

“As of yesterday morning, we are putting that plan into motion,” Chief Executive Officer Edward Rosenfeld told analysts on an earnings call Thursday.

Yesterday, I posted about Breville and a few other companies also planning such moves.

And BTW, Rosenfeld said Steve Madden is exploring a move to “countries like Cambodia, Vietnam, Mexico, Brazil.” He didn’t mention the U.S. as a possible place of production.

• Top China Hedge Fund Urges Clients to Pull Cash on Trump Risks

One of China’s largest hedge funds advised some clients to pocket gains as Donald Trump’s return to the White House increases risks to the Asian nation’s economy and markets.

Shanghai-based Perseverance Asset Management, which manages more than 100 billion yuan ($14 billion), suggested that investors in a range of products run by its star fund manager Deng Xiaofeng should consider redeeming, according to a notice sent to distributors seen by Bloomberg. (…)

Perseverance Asset’s holdings in 35 mainland-listed companies where it was among the largest 10 shareholders of circulating stocks totaled 40.6 billion yuan as of June 30, according to filings data compiled by Shenzhen PaiPaiWang Investment & Management Co. (…)

China Wants a Deal With Trump, Foreign Ministry Adviser Says

“For the Chinese side a deal is desirable,” said Wu Xinbo, director at Fudan University’s Center for American Studies in Shanghai, who led a group of experts in China’s Foreign Ministry to meet politicians and business executives in the US earlier this year. “We don’t want to have a trade war.”

“We all understand Trump’s style — he will try to utilize his leverage to keep pushing China,” Wu told Bloomberg on the sidelines of the Caixin summit in Beijing. “It takes time, and it takes wrestling between the two sides.” (…)

He said a face-to-face meeting between the two leaders should be arranged as soon as possible, preferably before Trump’s inauguration on Jan. 20, 2025.

“We need to get a sense of what’s on his mind,” Wu said, adding that the two sides need to start addressing each other’s concerns. (…)

Since Chinese officials rarely veer off the official script, the comments from Wu — an influential voice on relations between the world’s biggest economies — offer a glimpse into how Beijing is viewing Trump’s comeback. Foreign Ministry spokeswoman Mao Ning told reporters on Wednesday that China’s policy toward the US is consistent and will continue to be handled “with the principles of mutual respect” and cooperation. (…)

Trump’s victory represents more of a challenge than an opportunity, Wu said. That’s not just because of his style, but also because some of the names mentioned for his administration can’t be considered “rational hawks,” making for more difficult negotiations this time around.

If a trade war does erupt, Beijing would have no choice but to respond and retaliate, Wu said.

“I hope this time our approach will be more effective,” he added.

WORTH LISTENING

Stan Druckenmiller is always worth one’s time:

https://open.spotify.com/episode/54MvqynUyejRkRsFDIvdHg?si=awlMBFXCSMSpLUpju1JEPA