This Worrisome Trend Could Influence Interest Rate Policy
The Federal Reserve (Fed)’s decision to leave its benchmark rate at its current level is a representation of the “wait-and-see” trend anticipated by the market.
Overall, economic data in the U.S. have marginally deteriorated since the central bank embarked on rate normalization last year, but the Fed’s mandated objectives of full employment and price stability are still largely on track for continued tightening this year, even if at a slower pace than anticipated.
That said, the Fed is in a difficult position regarding normalizing rates, since the economic cycle may be moderating just as the central bank seeks to raise rates.
Unlike some others, I don’t believe the U.S. economy will enter a recession anytime soon, and it’s not the U.S. consumer that concerns me. Consumer spending is likely to support the economy on the back of very strong employment growth over the past few years and potentially improved wage growth in the year ahead.
What does concern me: Corporate sector metrics have been disappointing of late, just one sign labor market growth will probably slow in the quarters ahead. Companies are scaling back expenditures of all kinds (capital expenditures, hiring, and inventory-builds, for example), as their top-line revenues and earnings decelerate. Though first-quarter numbers may come in better than beaten-down forecasts, firms are finding that top line revenues are still hard to grow significantly.
A closer look at corporate debt
Indeed, years of extraordinarily easy monetary policy have stoked corporate borrowing and financial engineering. As a result, some companies are now struggling with an increased debt load as revenues and profits begin to roll over. See the chart below.
This dynamic raises the troubling question of the extent to which corporations will pull back on growth initiatives, such as capital expenditures and hiring, as they cope with balance sheets that have been levered up to maintain decent returns-on-equity.
Without question, extraordinarily low interest rate levels have resulted in more reasonable interest-coverage ratios for many firms, but the aggregate amount of leverage added has begun to look concerning, particularly in the context of a possible “earnings recession.”
Indeed, when institutional investors were asked to identify the purpose to which they would most like to see corporations deploy cash flows (Bank of America Merrill Lynch survey, February 16, 2016), “debt repayment” recently superseded “returning cash to shareholders” for the first time in years.
As investors pressure corporate heads to focus on repaying debt, and profit expectations roll over further, it’s almost inevitable that we’ll see hiring slow significantly. In fact, as I recently noted, changes to headline payrolls have historically tended to lag corporate earnings/profits changes by a six-month time frame.
As such, I expect to see a worsening jobs picture by the back half of 2016.Slowing payrolls growth, in turn, is likely to keep the Fed’s rate normalization contained.
For more clues about future Fed moves and market price-action going forward, it’s a good idea to also keep an eye focused outside the U.S., and somewhat outside the Fed’s core dual mandates of employment and price stability. Indeed, the path of monetary policy change in the year ahead may be determined as much by what occurs outside the country’s borders than within them; more so than at any time in recent history.
Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is a regular contributor to The Blog.