Digesting the Fed, as tech knocks earnings out of the ballpark
US stocks may have tuned lower late on Wednesday but there is much to cheer about for financial markets. Q1 corporate earnings are much better than expected, with 25% of the S&P 500 having reported earnings so far, more than 84% of them have reported an EPS upside surprise, while so far S&P 500 companies are reporting their highest net profit margin since 2008. Ultimately it will be earnings data and strong economic growth that could drive stock markets across the world in the coming months. However, even an exceptionally good earnings season may be sowing the seeds of future trading woes as we shall see below.
Inflation rears its head
While the good news on the EPS and sales front have been flowing freely in the last couple of weeks, there is also a sting in the tail of these good earnings calls: inflation. FactSet have noted that more S&P companies have cited the word “inflation” for Q1 2021 than they have in the last 10 years. Consumer prices are rising – in the US CPI is up 2.6% YoY for March, whereas it was 1.7% in February. This jump is mostly down to producer prices, which are running hot, and well above Fed target rates, at 4.2% YoY for March, which was the largest annual increase since September 2011. US PLC and finance directors are worried about inflation, should retail and institutional investors be running scared too?
This is a tricky question. The Fed shifted its policy stance last year and announced that it would allow price pressures to rise above its 2% target for a period of time after an economic shock, for example in the months and years after the pandemic. The problem for financial markets is that we don’t know how long the Fed will tolerate above target inflation. Inflation concerns tend to send traders and financial markets into a spin, thus the unknown amount by which the Fed will allow inflation to rise is pushing the financial market’s anxiety buttons. This may lead to jittery markets, especially with so many global stock indices close to record highs. In the aftermath of today’s Fed meeting, US stock indices are lower and the benchmark US 10- year Treasury yield is back above 1.6%, however, it has backed away from its earlier high at 1.65%. These may sound like small moves, but for the Treasury yield every basis point counts and can have big implications for the broader markets.
Why the Fed is steadfast in its dovish position
The fall in yields came on the back of the Fed meeting, after the central bank once again committed to sticking to ultra-loose monetary policy. The Fed said that it would keep interest rates at record low levels and continue with its asset purchase programme. Fed chair Powell once again stated that recent gains in inflation, particularly those in March, would be transitory and that the US economy would need to make “substantial further progress” before the Fed would consider asset purchase tapering. Thus, Fed chair Powell seemed to give stock bulls another incentive to buy the market, as Fed support is likely to remain in place for some time.
Covid fears lurk at the edges
So why the sell-off in stocks on the back of this dovish meeting? We do not think that all of it is down to calling the Fed’s bluff, there are other major events going on that could negate some of the impact of strong corporate earnings and a dovish Fed. These include concern about the strength and deadliness of the latest variant of Coronavirus that is tearing through India and shows no sign of slowing down. This is a warning sign that Covid is very much still alive and well and remains a risk to those countries who have only vaccinated a small fraction of their populations, like India. It is also a warning sign to countries that have had successful vaccine roll outs like the US and the UK, the virus could still mutate and pose a threat to our economic recoveries.
Taxes – time for financial markets to get concerned?
President Biden may also stir up some jitters, he has been in office for 100 days, and some elements of the financial community are concerned about his plans for “big government” in America, and the taxes that will come with it. The President’s American Families Plan, announced on Wednesday, included free college tuition for community college students. More tax plans are expected to be announced this evening, however, he has guaranteed that no one earning less than $400,000 will see their taxes rise. The problem with that, say some analysts, is that the US economy is hyper connected, so a tax increase on a wealthy individual will trickle down the food chain. Essentially, tax increases are hard to contain, and thus, any increase in taxes could neutralise the boost to growth from a surge in government spending. An expected hike in capital gains taxes has already caused jitters in the markets in recent weeks, however, the key piece of information to watch out for will be when a capital gains tax hike will be implemented. Will it be later this year, next year or further down the line? Of course, the more Biden and co. push out the hike in capital gains taxes the more moderate the impact on the financial markets will be. It is also worth noting that to get any proposed changes to the US tax code passed into law, all democrats in the Senate would have to support the changes, that could be a tough call for some of the new Democratic senators from the South. However, if there is a party line on tax rises, this could trigger the largest increase in US taxes for a generation, so no wonder the market is nervous.
Right now, it’s all about taking the rough with the smooth. The smooth is earnings data. So far, the earnings reports have beaten expectations, as we mention above, which is helping to justify sky-high valuations for some companies. Apple joined Google’s parent company Alphabet by announcing mega earnings for Q1 on Wednesday. Apple profits doubled from a year ago, and Facebook also posted bumper earnings. The prospect of share buybacks on both sides of the Atlantic could be enough to see stocks continue to rise in the coming days, however inflation and taxes are like kryptonite for equity markets, so watch out for any adverse surprises from both fronts as we await to hear the details of Biden’s tax plan.