Brace for years of terrible stock returns as 2 key tailwinds fade, warns Fed economist

A trader at the CME.

US equities are expected to disappoint in the years to come.Scott Olson/Getty Images

  • US stock investors are heading for disappointment, a Federal Reserve researcher has warned.

  • Corporate tax and interest rate cuts have boosted stock returns for years, Michael Smolyansky said.

  • The Fed economist sees a bleak future for stocks as earnings growth slows and tailwinds fade.

Investors in US equities have enjoyed a tailwind for decades, but their luck is about to run out, a Federal Reserve researcher has warned.

Michael Smolyansky, Senior Economist at the Fed, recently released a working paper titled, “End of an Era: The Long-Term Slowdown in Corporate Earnings Growth and Stock Market Returns.”

His main finding is that the S&P 500 real return of 5.5% (excluding dividends) between 1989 and 2019 was driven primarily by falling interest rates and corporate tax rates, which are unlikely to recur. not in the years to come.

Stock prices generally rise because corporate earnings are rising or price-to-earnings (P/E) multiples are rising. Smolyansky found that corporate tax and interest rate cuts accounted for more than 40% of real growth in corporate profits between 1989 and 2019.

Additionally, lower interest rates translated into lower risk-free rates (the guaranteed return on assets such as US Treasuries), which explained all the expansion in P/E multiples. over the three-decade period.

“So investors got lucky,” Smolyansky wrote. “I contend that this good luck spell is most likely at an end.”

Interest rates hit historic lows even before the COVID-19 pandemic hit in early 2020. There is little room to bring them down further, especially given the renewed threat of inflation, Smolyansky said.

Meanwhile, the effective corporate tax rate for non-financial S&P 500 companies fell from 34% in 1989 to 15% in 2019. Further cuts seem unlikely given that the US debt-to-GDP ratio United is near an all time high and that the Biden administration imposed a minimum tax rate of 15% last year, the researcher said.

Even if corporate taxes and interest rates hover around their 2019 lows in the coming years, corporate profits will only grow at the same rate as earnings before interest and taxes (EBIT), Smolyansky said. EBIT growth lagged GDP growth in the United States between 1962 and 2019, so it is unlikely to grow more than 2% per year in the long term, he said. for follow-up. Nor can P/E multiples increase indefinitely, he added.

“This has serious implications for stock returns,” Smolyansky said. “If real earnings growth is not expected to exceed 2% per year in the long term, then the outlook for equities is bleak.”

“Equity returns and corporate earnings growth are very likely to be significantly lower going forward,” he added. The economist described decades of boosting earnings growth through tax cuts and interest rate cuts as “a trend that has reached its limits.”

Smolyansky warned that his bleak outlook is likely conservative. If the stock market doesn’t already price in weaker earnings growth, P/E multiples could contract sharply once it does, he said. Additionally, lower interest rates and lower corporate taxes may have spurred EBIT growth over the past few decades, paving the way for an even deeper slowdown than expected.

“Risks to this forecast, if any, are on the downside,” he said.

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