The Last Samurai

Here are some of the biggest stories from last week:

• The Bank of Japan maintained its negative interest rates.
• UK inflation slowed far more than expected in November.
• US corporate profit expectations for 2024 have barely changed this year.
• Shale oil production out of the US has significantly exceeded forecasts.

Dig deeper into these stories in this week’s review.

Macro

The Bank of Japan has long been clinging to its ultra-low interest rates, even when many of the world’s central banks were hiking borrowing costs. That’s because it’s trying to nudge consumer prices higher after battling with economy-crushing deflation for more than two decades. So it was perhaps not too surprising when the bank kept its rates at minus 0.1% on Tuesday – remaining the only major central bank to uphold negative interest rates.

However, with Japan’s inflation exceeding the BoJ’s 2% target since April 2022 and other major central banks starting to signal a change in their stances, investors were hoping that the BoJ would also alter its policy and offer some indication of when it’ll start lifting interest rates. But much to their disappointment, the central bank stuck to its tone, pledging to keep its negative interest rates for as long as it is necessary.

The BoJ’s ambiguity regarding the timing of rate hikes resonated through markets on Tuesday, sending Japanese bond yields and the yen lower. The currency’s movements in response to changing interest rates at home and overseas could be one complicating factor for the BoJ as it attempts to exit years of ultra-loose monetary policy. See, pulling the plug on negative interest rates when other central banks are cutting borrowing costs could trigger a much stronger yen. That would, in turn, slash the cost of imports into Japan, potentially reigniting deflation in the economy and undermining the BoJ's prolonged effort to combat declining prices.

Elsewhere, UK inflation slowed far more than expected in November, adding to pressure on the Bank of England to start cutting interest rates. Consumer prices rose by 3.9% in November from a year ago, marking the lowest inflation reading in over two years and a sharp slowdown from October’s 4.6% pace. The year-over-year gain was well below the 4.4% expected by economists, with food, fuel, and recreation prices driving the deceleration. But even core inflation, which excludes volatile energy and food costs, dipped by more than expected, from 5.7% in October to 5.1% last month. The good news didn’t stop there: services inflation, which the BoE has repeatedly cited as a persistent source of price-pressure concern, dropped to 6.3% – its lowest level since January.

The better-than-expected figures intensified speculation about when the BoE will start cutting borrowing costs, after it raised rates to a 15-year high in an effort to tame soaring inflation. Traders responded by betting that the central bank will deliver five quarter-point rate cuts next year, sending UK bond yields and the country’s pound lower. The FTSE 100, on the other hand, got a boost from the news, since cheaper borrowing costs and a weaker currency are good for big British companies that sell their goods overseas.

To be sure, even before this week’s inflation data, traders were already betting on four quarter-point rate cuts in 2024. And the BoE, at its most recent meeting earlier this month, was trying to push back against those expectations, warning that there is still some way to go in its fight against rising prices. It might have a point: inflation in the UK is still almost double the central bank’s 2% target, and is notably higher than in the US and eurozone.

Stocks

Despite all the wild developments in US financial markets and the economy this year, 2024 profit expectations have remained notably static. Analysts currently project that S&P 500 companies will earn around $247 per share in 2024 – a forecast that has barely changed from the start of May. The index has risen 14% since then, as the market overcame fears about a banking crisis, rising inflation, higher borrowing costs, and the possibility of an imminent recession. But during that entire time, analysts’ 2024 earnings projections for the S&P 500 stayed within a tight range, drifting between $243 and $248 a share.

A lot of those risks have now receded, sure, but as stocks rallied while earnings estimates remained steady, valuations went from reasonable to somewhat rich. The S&P 500, for example, is currently trading at 19.6x projected earnings – 24% above its 20-year average. The Nasdaq 100, full of tech stocks with lofty valuations, is even more expensive: it’s currently priced at about 25x projected profits. While that’s down from a peak of 30x in 2020, it’s well above the average of 19x over the past two decades.

The good news is that next year’s profit expectations look more realistic than they did back in May, after companies posted decent results last quarter and the Fed opened the door to a soft landing when it recently signaled 75 basis points worth of interest rate cuts next year. A soft landing is that dream scenario where the economy slows enough to tame inflation, but remains strong enough to avoid a recession.

Also let’s not forget that slowing economic growth has already led to an earnings decline for the S&P 500 firms. The dip was long but relatively shallow, with a 13% peak-to-trough contraction in trailing 12-month EPS in 2022 and 2023. That’s half the median 26% peak-to-trough earnings drop since the late 1960s, and that could suggest that profits will rebound by less than the stock bulls hope (if history is any guide, that is). See, a profit bottom since the late 1960s has preceded a nearly 16% median expansion in per-share earnings in the next 12 months, excluding the global financial crisis and the pandemic. Half of that would be 8%, which is below the 11% earnings growth expected in the S&P 500 for next year.

Commodities

After a period of relative quiet, the US shale oil industry has significantly increased its production, challenging OPEC's market dominance. This time last year, forecasters predicted US production would average 12.5 million barrels a day during the current quarter. In recent days, that estimate was bumped to 13.3 million – the difference comparable to adding a new Venezuela to the global oil market. The surge comes at a tough time for OPEC, which has voluntarily cut output by 2.2 million barrels a day to stabilize prices, only to find US supply growth undermining its efforts.

The US, riding a 17-year shale boom, is enjoying growing energy self-sufficiency. What’s more, the country’s increased production and reduced dependence on imports, coupled with its non-membership in OPEC, means the cartel’s production cuts have limited influence on the US oil industry's market actions. Case in point: despite OPEC's recent efforts to curb supply, oil prices carried on falling while American output continued to surge. What's surprising about the spike is that companies have increased production despite a roughly 20% decrease in active drilling rigs this year. This boost in productivity has baffled many analysts and researchers who had traditionally used the rig count as a reliable indicator of future crude output.

Making matters worse, soaring production from the US comes at a time when global oil demand growth is slowing down sharply as economic activity weakens in key countries. In fact, the International Energy Agency recently slashed its demand forecast for the fourth quarter of 2023 by nearly 400,000 barrels a day, and warned that demand growth will decelerate dramatically next year. According to the agency, global oil demand is set to rise by 2.3 million barrels per day this year to average a record 101.7 million barrels a day, driven by the lingering effects of the post-pandemic consumption surge. However, this growth is expected to halve to approximately 1.1 million barrels per day next year, as the pandemic-related rebound wanes and consumers increasingly shift to more efficient EVs.

Next week

• Monday: Christmas!
• Tuesday: Japan unemployment rate (November), US Case-Shiller home price index (October).
• Wednesday: China industrial profits (November).
• Thursday: Japan industrial production and retail sales (November), US pending home sales (November).
• Friday: Nothing major.