I generally try to write the weekly commentary with a single theme in mind. However, this week, I’m going to jump around a bit and hit different topics of interest including: Yellen, US inflation, S&P earnings, South Africa, and expectations.
Reflecting on Yellen’s remarks during her testimony last week my understanding of the situation has not changed. The Fed’s policy and guidance continues to signal to the markets that an eventual rate hike is coming.
One of her statements sums the entire testimony up nicely, "If economic conditions continue to improve, as the Committee anticipates, the Committee will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis.
Before th, the Committee will change its forward guidance...the modification should be understood as reflecting the Committee's judgment that conditions have improved to the point where it will soon be the case that a change in the target range could be warranted at any meeting." Yellen went on to say that the Fed would not likely raise rates at either the March or April meetings.
This statement was interpreted by the markets to mean that there would be no rate hike in 2015. Asset prices began to reflect this incorrect interpretation of her comments. I have been saying, as have many others, that the June meeting is the most likely scenario for the first rate hike. Nothing about last week’s testimony has changed my opinion about that timeline.
The pundits who are arguing strongest against the mid year hike are emphasizing the low US inflation readings. The problem for those people is that the Fed focuses on the core inflation rate, the rate without energy and food, rather than the headline rate.
So, while the headline rate has certainly been impacted by the crash in energy prices, the core rate has barely moved over the last 6 months. In her testimony, Yellen spoke to low inflation by recognizing that the decline in energy prices weighs on the headline rate and has some spillover to the core rate. She also went on to say that after some additional near-term weakness in inflation, the Fed expects core inflation to begin to move back towards the 2% threshold.
On top of Yellen’s testimony, we also received the latest US inflation readings last week. Headline inflation fell year-over-year for the first time since 2009.
The last time CPI went negative, the US economy was just starting to recover from the Financial Crisis. Obviously the headline inflation is being adversely impacted by crashing energy prices.
The energy index fell 10% from December to January and the gasoline index fell 20%. But remember, as I stated earlier, the Fed focuses on the core rate, not the headline rate. The core rate was unchanged from December, staying at 1.6%. Its also important to remember that this is the same core rate we had last March, before energy prices came crashing down.
There are a couple of solid reasons why the Fed focuses on core inflation rather than headline.
First, headline inflation generally catches up to core inflation and not the other way around. The Fed is betting that the dramatic decline in headline inflation will eventually be pulled back up to the level of core inflation once energy prices stabilize and begin to rebound.
Second, as consumers, you and I have to pay for food, gas, and utilities. But when the Fed is setting policy, it's attempting to set policy for long periods of time. It isn't trying to market time and change policy every time itmeets.
In order to accomplish this goal, they need to focus as much as possible on the signal (core rate) rather than the noise (headline rate). The media will focus on the headline, cause well, it makes headlines. However, the real information is in the core rate. And even if you disagree with the Fed’s focus, if it's using it to drive policy, you better be paying attention to it.
At The Margin
Rather than get caught up in the latest headline number of a particular data point, I’m always focused on whats happening at the margin. The slope of a line is much more important than the individual data points. At the margin, some very interesting things have been happening.
S&P 500 Earnings
On December 31, the consensus estimate for the full year 2015 earnings growth of the companies in the S&P 500 was 8.2% and the consensus estimate for revenue growth was 2.8%. As of the end of February, just 8 weeks later, the earnings estimate has fallen to 2.8% and revenue growth estimates have fallen to a -0.3%.
That's a 65% decline in earnings estimates in 8 weeks. This is only the third time since 2000 that revenue growth is expected to decline year over year. The last two times was during the tech bubble bursting and the Financial Crisis.
While South Africa’s annual GDP growth rate is still running at about half its long-run average, focusing on the margin gives us more information. South Africa released its Q4 2014 GDP numbers last week, and it showed acceleration from Q3’s 2.1% growth rate up to 4.1% in Q4.
Q4 also marked the third consecutive quarter of acceleration higher since GDP bottomed out in Q1 2014. Equity markets have confirmed this acceleration higher by gaining 26% over the last 12 months, while South Africa’s GDP growth rates have been improving.
South frica has received zero press over the last year both on an absolute basis as well as when compared to the S&P 500, which incidentally returned 23% over that same time period.
There is a similar trend occurring in a number of other emerging markets. No economies are growing like they did pre-Crisis. And some are performing better than others. If you pay attention to the margin, it generally signals shifts well before the mainstream begins to pay attention.
At soe point, I’m going to write a more in depth piece on forecasts and expectations. But for now, let me some up how I feel about analysts expectations by saying who gives a shit.
Forecasts are notoriously wrong, yet markets rise and fall based on whether the latest data point or central bank commentary exceeded, met or disappointed the consensus expectations. I’ve already said that the headline number for any economic data point isn’t nearly as valuable as the slope of entire data series.
So, what value is there in comparing the headline number to what 30 economists polled by Bloomberg thought it was going to be? None. But the fact that most of the world disagrees with my line of thinking is actually good for me.
It allows me to take advantage when the opportunity presents itself to enter a trade at an ideal entry point because the market is over-reacting to a headline number and how that number stacks up against expectations. This type of market movement based on headlines occurs all the time. People can’t help themselves.
There is real money to be made and focusing on what's occurring at the margin will put you several steps in front of most other investors and it will also give you a much clearer picture of whats really happening.