With Q3 earnings season in the rear-view mirror, we can now say that earnings growth is slowing. Over the last 4 quarters we have growth rates of: 2.1%, 6.5%, 6.5%, and 4.1%.

Federal Reserve rate hikes and quantitative tightening are causing earnings growth to slow as you can see in the chart below.

A chart of the Fed funds rate and how rate hikes are slowing down earnings growth.

The grey line is the Fed Funds Rate and the red line is S&P 500 earnings. You can see the big slowdown in earnings this last (Q3) earnings season. Even though the Fed has not raised rates since their June meeting, it takes time for the rate hikes to slow the economy. We can see that the Fed Funds Rate leads the economy and earnings by about 4 months.

Inflation is on the rise which is why the Federal Reserve is raising interest rates and reducing their balance sheet.

PPI and CPI chart shows inflation is on the rise.

The PPI (blue line) is up 4.2% and the CPI (red line) is up about 2.4% over the last 15 months.

Investment is sensitive to changes in the interest rate. When rates are lowered by the Fed, investment rises. This is precisely what we have seen for the last 8 years with low interest rates driving the stock market higher. In fact the Fed is now openly expressing that it may have created a bubble in the U.S. stock market because it had to keep interest rates so low for so long.

When the Fed raises interest rates, investment falls.

Keep in mind that it’s not ALL about interest rates. While the interest rate is important in determining the level of investment, that does not mean that rising interest rates and decreased investment will automatically lead to a recession. There is another factor to consider, animal spirits.

Keynes referred to expectations as animal spirits, and basically said that if businesses believe the economy was about to go bad, it could become a self-fulfilling prophecy.

President Trump has stirred animal spirits with promises of lower tax rates, less government regulation, less health care expenses for businesses, more government spending on infrastructure, and putting America first in international trade negotiations. As long as businesses believe the economy is about to get better when Republicans enact these things, it could become a self-fulfilling prophecy and the economy and stock market could continue doing well for some time even in a rising rates environment.


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