Financial Conditions and the Market

The S&P 500 is flirting with an all-time high just as we’re about to enter what’s shaping up to be a lackluster earnings season. Analysts are anticipating the first quarterly profit contraction year-over-year since Q2/16. S&P 500 companies are expected to post quarterly profits that are collectively 4.3 per cent smaller than they were last year at this time, according to Standard & Poor’s. However, revenues are expected to expand – suggesting corporate profit margins are compressing.

The higher cost of financing is one factor pressuring profits: short-term interest rates are nearly 75bps higher thanks to Fed tightening last year. Labor costs represent another profit pinch, as wages over the last 12 months have grown by 3.3 per cent, with transportation and service jobs enjoying nearly 4 per cent wage gains.

Recognizing that the S&P 500 derives its value from earnings and dividends, some investors are wringing their hands over the contraction in earnings growth. Though investors may need to tighten their seatbelts over the next few weeks, we take comfort in the ineluctable strength of current financial conditions. The US Financial Conditions Index, compiled by Bloomberg, comprises credit spreads, the yield premium lenders require to extend credit to lower-quality borrowers, and market volatility, and compares where things stand now relative to their range over the last 5 years. Five of the 10 components are currently situated in the most quiescent quintile of their historical range, and none of the rest are in the most constricted quintile. We will continue to monitor financial conditions, but for now they’re confirming a “risk on” view.