With 98% of companies in the S&P 500 having reported financial results, first quarter earnings season have effectively come to a close. The final report card showed an earnings decline of 6.6% on 0.7% revenue contraction. Fortunately, Wall Street grades companies on a curve. By that measure, over 70% of those companies succeeded in beating analysts’ consensus earnings expectation. Thanks to the relative game, stocks have generally trended upward during this reporting season. In the month of May, S&P 500 advanced by 1.8%. Year to date, it has now risen 3.57%. Not bad for a year that started with such negative expectation.
A common theme that have prevailed in the earnings reports of past several quarters had been the negative impact of the strength of the dollar. During the first quarter, it was a revenue headwind of 4% for Merck and 7% for Pfizer. Amazon was impacted by $210 million and Alphabet was dinged for only $169 million due to a timely hedging program that earned $593 million. The list of victims goes on and on covering nearly every industry. However, with the decline of the dollar in March and April, companies concern for currency impact in the future had been eased. Most expressed less headwind compared to their original expectation and some even expected favorable impact. As a result, the forward expectation for earnings did not decline as much as had been the pattern during the past several quarters.
For the second quarter of 2016, current Wall Street expectation of S&P 500 earnings stands at a decline of 6.1%. Then earnings growth would turn positive during the third and fourth quarter at 0.5% and 7.3% respectively. In Physics, it takes positive forces to thwart a negative velocity and eventually turn into positive velocity. Given the earnings expectations going forward, positive forces must be at work. Clearly, one of such forces is the dollar weakness in March and April. Alas, that did not last very long. The dollar had rallied in May and is threatening to undo one of the pleasant surprises that have given us a 3.57% return in the first five months of the year.
Enter the Fed
On May 18, The Federal Reserve released the minutes of its April FOMC meeting. It marked a stark contrast with the press release issued at the time of the meeting. It had been the market’s consensus that the Fed would not raise interest rate unless the economy strengthened further. Yet the minutes showed that a majority of Fed governors agreed that a June interest rate hike would be appropriate if the economy did not deteriorate. Of special interest to the Fed governors are second quarter GDP growth, strength of labor market and inflation making progress toward its 2% objective.
Of the three factors that concern the Fed the most, two are clearly strong enough for the Fed to act in June. The Atlanta Fed is currently forecasting a GDP growth of 2.9% and April’s report of core inflation came in at 2.1%. The only weak spot appeared to be April’s monthly employment report turned in early May. This makes the May employment report due out on June 3rd crucial. A healthy report all but guarantees an interest rate hike either in June or July.
Given the relative health of the US economy and the unhealthy risk taking and savings destruction of zero interest rate policy, it is understandable that the Federal Reserve would like to undo such emergency measure at the earliest convenience. But the global economy is more connected than ever. The Fed’s tightening policy is set amid an orgy of global easing. While Janet Yallen is contemplating raising interest rate, Mario Draghi is implementing the purchase of corporate bonds in Europe and Haruhiko Kuroda is thinking of purchasing ever greater amount of Japanese stocks.
The first US interest rate increase in December of 2015 was preceded by dramatic rally of the US dollar. With the likelihood of another rate hike soon, the dollar again rallied in May. Will the aftermath of the rate hike be similar as well? It does seem like a reasonable assumption to me.