September 23, 2017 01:36 pm CDT
All About Earnings
By Briton Ryle, Wealth Daily

We talk a lot about interest rates and how they affect the stock market and our investments. The logic goes that cheaper money is good for corporations, as the less they spend on interest payments, the more income they can show on the bottom line.

Lower rates should also help spur the economy, making homes more affordable and encouraging Americans to take on debt.

And so the Fed has kept interest rates at zero since 2009 to help the American economy recover from the disastrous financial crisis.

The stock market has loved it. The S&P 500 is now in the sixth year of a record bull run.

As investors, we've made a lot of loot over the last few years. And perhaps it's even been enough to keep us from asking the all-important question: Has the Fed policy been effective?

If you simply judge the Fed by anecdotal evidence, the answer has to be yes — zero interest rates and quantitative easing have worked. The unemployment rate has been cut nearly in half.

In October 2009, the unemployment rate hit a mind-boggling 10%, and the numbers of uncounted people — those that had given up looking for work — made the real number closer to 18%.

In February, after a record-breaking streak of 200,000+ new jobs a month, the unemployment rate hit 5.5%.

Of course, there are still plenty of the "uncounted," people who, while out of work, don't fit the definition of unemployed.

Stock prices are higher. Anyone investing has done okay, and average household wealth in the U.S. hit a record in the fourth quarter of 2014 at $83 trillion.

You could certainly argue that the recovery has helped the wealthy more than the average American. The wealthiest 10% of Americans own 80% of the stock.

But we can also look at how much the average household is spending to pay down credit cards or home loans. That number, the Household Debt Service Ratio, is at 10% of disposable income, the lowest level since 1980.

Even if you missed the stock market rally, the average American has used the last few years to save a little more and spend a little less. 

Recent data from the housing market even shows that sector may be improving after many fits and starts.

The official measure of inflation shows that price gains have been muted. So all the fear of hyperinflation as a result of the Fed's easy money policy seems unfounded.

It's probably tempting to conclude that the Fed's radical action to keep rates at zero and buy trillions in bonds has been pretty risk free.

Unintended Consequences

I let that "buy trillions in bond" thing slip... because you can't address the zero interest rates without throwing in something about all those short-term Treasuries the Fed has bought.

In other words, the Fed lowered rates and then forced rates lower by purchasing trillions in bonds.

And what's more, the Fed has encouraged the federal government to continue to operate huge budget deficits by keeping funding costs low. Still, the U.S. paid around $235 billion in interest payments on its debt last year. But 10 years from now, those interest payments will be $900 billion.

That's a substantial amount of cash to spend just to service the country's outstanding debt. We have to wonder if there would be more resistance to racking up debt if interest rates were higher...

But still, we're not really getting to the heart of the matter. We still haven't asked the really big question: why? Why did interest rates go so low, and why have they stayed there without sparking inflation?

The answer points to something worse...

It's tempting to say that interest rates have stayed low because of weak demand. We could say that Americans are hesitant to take on new debt to buy stuff. We remember all too well what it was like to be over-leveraged when home prices started falling...

Throw in the last few years of high unemployment, and you can build a pretty strong anecdotal argument that Americans have lacked both the desire and the ability to spend like we did between 2004 and 2007.

While true, that thought still misses the real problem...

If You Build It, Will They Come?

The real problem we are faced with is too much supply.

We've got too much oil, too much steel, too much copper, too much iron ore, too many factories, too many clothing stores, too many restaurants, too many hedge funds, too many cargo ships, and so on...

The bottom line is that there is no pricing power because too many sellers are trying to sell stuff. They can't raise prices, which means they can't raise wages.

Interest rates can't fix that. Sure, interest rates may be able to cover it up for a while, as the decline in borrowing costs offsets the lack of pricing power. But that can't go on forever, especially with interest rates at zero.

Money can't get any cheaper than it is now... and we haven't seen demand return.

We could look at oil as a proxy for this oversupply. U.S. oil companies were able to issue plenty of debt ($500 billion over the last four years) at interest rates that fit nicely into a balance sheet. They were able to fund a massive expansion of production that we called the "shale boom."

America now produces more oil than it has in 20 years. And in fact, that investment led directly to the point where we are now: Markets are oversupplied with oil, prices fell, and there is a record amount of oil in storage. Oil workers are getting laid off, oil rigs are idle, and earnings have plummeted.

Of course, these oil companies still have to pay their debt...

And now, earnings for the energy space are so bad that they are expected to push the entire S&P 500 earnings down nearly 5% in the first quarter. Lower earnings mean valuation metrics like P/E ratios make the whole market look expensive, and we will likely see lower stock prices across the board.

That's a type of contagion, where a problem in one sector spreads to others. And analysts expect S&P 500 earnings to keep falling for the next two quarters. It might start to look like a recession before it's done...

Oil is just one example of where this has happened. We can also see it in retail, technology, and emerging markets in general.

Recessions are supposed to clean things out, kind of like how a forest fire takes out the biggest trees, allowing the entire forest to grow anew.

During the financial crisis, that didn't happen. Companies that should have failed didn't, and so we still have a situation where there is too much supply.

That's the big problem in the world right now. Interest rates aren't going to fix it.

Until next time,

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Briton Ryle

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