Last week saw a host of positive economic announcements, not least of which were the Fed’s comments surrounding rate increases. The U.S. economy is indeed humming along very nicely, fears of a trade war notwithstanding, and the companies making up the S&P 500 are doing exceptionally well. Average revenue growth for the 500 or so largest publically traded companies is expected to reach nearly 8% this year, while earnings are likely to grow 20%. But not all businesses are growing at such rates. Gross Domestic Product, or GDP, which measures the growth in total U.S. output, is expected to grow just 5% this year (including inflation). The contrast between S&P 500 revenue growth and that of the entire U.S. economy tells us something about the flattening yield curve, about which so many are worried, and also about the best strategies for investing in the current environment.
The contrast between GDP growth and S&P 500 companies’ revenue growth reveals that not all businesses in the U.S. are experiencing outsized expansion. Many companies in the U.S. see little growth, but this is a perfectly normal state of affairs, as a quick look at the history of GDP growth will confirm. Most enjoy some of the spillovers of technological progress, the main engine of growth, but are not the innovators themselves, and some are selling goods and services which never leave the country’s borders, and so miss out on the benefits of the ongoing economic expansion taking place in Europe and many emerging market economies. It is GDP growth, rather than S&P 500 companies’ sales growth, that underlies long-term interest rates and helps to explain the flattening of the yield curve. A flatter yield curve is not a cause for alarm, however, but rather a consequence of the current, lethargic state of technology growth.
Alarmist market watchers have been citing the flattening yield curve as a harbinger of economic recession. While recessions in the past have indeed been preceded by an inverted yield curve, many periods of flattening yield curves have coincided with lengthy periods of economic expansion. A flattening yield curve may eventually invert, but current economic conditions are not yet providing a hint of moving in that direction. Moreover, even when the curve has inverted, it can take years for a recession to develop. Unfortunately, recessions are devilishly hard to predict and the precise timing of the next one remains highly uncertain. A flatter yield curve simply means that long-term interest rates are not much higher than shorter term rates, and there is good reason for such a shift today.
Since interest rates compensate a lender for waiting to spend his or her own money today on a new car, a house, or whatever, the interest rate must be such that the lender gets to be able to buy the house or car in the future, plus a little extra for agreeing to wait. So the interest rate has to cover any increase in prices of those purchases in the future (inflation) plus the cost of waiting. The latter reflects the person’s degree of impatience. It also reflects, in a well-functioning economy like that of the U.S., the alternative bids to borrow the lender’s savings. Just as higher inflation means higher interest rates, more and better ideas for putting the lender’s savings to work by firms raises the interest rate the saver can get paid to wait to spend the money himself. These days, unfortunately, firms have been willing to offer precious little to borrow people’s money, and this reflects the sad fact that capital investment opportunities for most firms currently have relatively low returns by historical standards. While for many S&P 500 companies investment opportunities remain very exciting, in the broader economy, the story remains one of tepid investment and growth. And that is keeping the amount savers will get “paid to wait” unusually low and keeping the long-term real interest rate (the interest rate ex inflation) capped at low levels.
It is inflation that is driving interest rates higher and it is rising near-term inflation expectations that are causing the flattening of the yield curve. The Fed has been doing a good job in communicating its long-term inflation target of 2%, and the market’s confidence in the Fed hitting that target over the long term has been rising over the last few years. As it did, long-term rates increased, but the market was unsure how quickly that inflation would arrive, so short term rates moved higher only gradually. As the data started to confirm increases in inflation this year—not just in the distant future—short-term rates moved higher, but the long-term inflation expectation remained anchored around 2%, as it should have. This growing realization, and the Fed’s confirmation via last week’s Federal Funds rate increase, has led to a flattening of the yield curve.
This has not changed the prospects for returns on capital investments by firms, which remain tepid for most. Fortunately, as investors, we aren’t investing in the entire U.S. economy, but rather in a select subset of firms. The firms we select are the ones we expect to have the better prospects for growth through their access to growing markets and better technology. The yield curve may very well flatten or even invert, but we see many companies well-positioned to deliver above-market growth in revenues and earnings.