For the first time in five years, corporate debt is growing at an above-average rate. It was up 8.9% year-over-year in the first quarter vs. a 53-year average of 8.5%. Meanwhile, capital spending is exceeding corporate cash flow, as indicated by the “corporate financing gap,” which dipped into negative territory in the first quarter of this year. True, profit margins and return on capital continue to increase. But any further deterioration in corporate balance sheets could begin to affect earnings growth. We believe analysts’ forward-looking forecasts could be a bit too optimistic. Also, let’s not forget the connection between consumer and corporate spending. If consumers pull back sharply, companies are apt to get stingy.

The Fed: rate hikes may not be over

Two years have passed since the Federal Reserve began raising interest rates. In late June, the Federal Open Market Committee raised rates by 25 basis points for the 17th consecutive meeting, bringing the federal funds rate to 5.25%. The language that the Fed used, however, gave the market some hope that the rate hikes may be over, as the Fed said the “extent and timing of any additional firming” will depend on incoming data, dropping the reference to the likelihood that more firming may be necessary. The committee also acknowledged that economic growth is moderating, while indicating that “some inflation risks remain.”

Though the language led many investors to believe a near-term pause is possible, the risk remains that new information about the economy and inflation could prompt more rate hikes. What’s more, even if there is a pause, that doesn’t necessarily mean an end to the tightening cycle overall.

The U.S. economy: signs of weakening

While most major economic indicators point to a strong economy at present, forward-looking indicators point to slower growth and possibly a recession. The two wild cards right now are housing and energy prices. If the slowdown in the housing market gains traction and if energy prices remain high, both consumers and corporations would be impacted. That could lead to an especially troubling scenario: a slowing economy with rising inflation. The Federal Reserve, while it has already hinted that a pause may be in the offing, might be forced to continue to raise short-term interest rates in the face of a slowing economy.

Economic data released during the second quarter revealed continued strength in manufacturing, a healthy labor market and a surprisingly resilient consumer. Nonetheless, some signs of deterioration are evident, especially in the housing market. Historically, low rates have led to mortgage refinancing and home equity booms, preventing the economy from going into a major slump. But over the past two years, the Fed has been busy taking that extra liquidity out of the economy.

The consumer, who rode the now-subsiding swell of easy money, could face shoals ahead. Home builders are already starting to feel pain. One of the more popular affordability indexes, the National Association of Home Builders/Wells Fargo Housing Opportunity Index, recently posted its largest eight-month drop in history. The index measures the percentage of homes sold that are affordable to families earning the median income during a specific quarter.

The share of our income now devoted to spending on “essentials” is at an all-time high of 55%.1 There has also been a sizable swell in the inventories of both existing and new homes. While other factors such as the labor market remain positive for consumers, the slowdown in housing will indeed be something to monitor going into the second half of the year, as a severe pullback in housing prices could seriously dampen consumer spending and potentially worsen the outlook for the U.S. economy.

Inflation and interest rates: mounting concerns

While signs of slower economic growth may begin to dominate investor sentiment in the coming months, inflation continues to be a worry. The core consumer price index, which excludes the volatile food and energy components, rose 0.3% for the third consecutive month in May, putting the annual rate at 2.4%, its highest level since March 2005. Market volatility has risen in part because of this uncertainty. Higher inflation generally leads to lower price/earnings ratios. Even if earnings remain strong, investors tend not to want to pay as much for the underlying stocks.

Interest rates were on the rise for much of the second quarter. If the 10-year Treasury yield continues to climb, we could see a breakdown in the long-term downtrend in rates that began in the 1980s. Even more worrisome for stocks: the risk of a sustained yield curve inversion (long-term rates lower than short-term rates), especially if the markets perceive the Fed has gone too far and the economy is headed for a slowdown.

Yet another risk is that the global economy could soften, as demand from China and other emerging economies may be slowing. Without China and the U.S. running on all cylinders, investors may be more concerned about global growth.

In the face of such rising risks, we think it’s wise to be cautious.

Gillian Parrillo
The Sacramento Executive