Spare the rod and spoil the child

With earnings season here, it looks as if the market is limbering up and stretching its shoulders in anticipation of another round of throwing its toys out of the pram.  Early returns have not been encouraging, and companies have retreated behind the excuse of the strong dollar to justify their poor performance.   Indeed, of the first 25 s&p 500 companies to report, 60% had a moan about the strong dollar.

Really?  While the DXY closed Wednesday at it highest level in seven months, it's hardly at unprecedented levels.   Indeed, the quarterly change in the Fed's broad dollar TWI was less a percent- quite a bit smaller than Q2's decline.  Obviously those with sterling receivables have been in a spot of bother, but come on: has no one heard of hedging?

While the dollar has of course generated substantial gains over the past couple of years, the vast bulk of that was a 2015 story.  Indeed, on a y/y basis the TWI was only up 2.4% in Q3...more or less the same magnitude of the forecast decline in earnings.   It's kind of hard to blame all that on the dollar, guys.

In a stunning coincidence, of course, productivity growth remains lousy on a macro level, which certainly isn't supportive of earnings growth on a micro level.   In 1990's Japan, yen strength forced exporters to think in terms of being a "100 yen company", i.e. a firm that was productive enough to remain profitable with USD/JPY at 100.   Instead of bleating about the dollar, perhaps US corporates should do more to focus on being 100 DXY companies by investing to enhance productivity.

Instead, what have we seen?   Huge investment in financial engineering and balance sheet leverage as firms issue debt to buy back stock.   If we look at the ratio of credit market liabilities of the nonfinancial corporate sector to fixed investment in equipment, we can see that we're at the highest level ever outside of a recession.  Indeed, the recent rise in this ratio over the last couple of quarters should be of concern to policymakers, because it implies a rise in leverage that often heralds and/or exacerbates a recession.

In this cycle, naturally, the ratio has been goosed by the enablers of the Fed itself and its ZIRP monetary policy.  The upshot has been an apparently inexorable decline in the ratio of wages to profits since the turn of the millennium.

Now that the reality of an impending rate hike and its implications are staring companies and the market in the face, the chances seem reasonable of a full on tantrum to discourage the Fed from doing a bit of prudent parenting.  However, as the old saying goes if you spare the rod you spoil the child; if a modest policy tightening forces companies to do the hard work of trying to improve productivity instead of screwing around with their balance sheets, well that's no bad thing now, is it.