Anticipating a cut in U.S. corporate tax rates, Wall Street analysts late last year ratcheted up earnings estimates for 2018, forecasting an 18% increase in profits, but declining cash-flow growth remains problematic for markets, according to Société Générale’s Andrew Lapthorne.
In a note to investors, he pointed out that despite continued economic growth and a tax windfall, U.S. equities have underperformed the rest of the world since Dec. 15.
The S&P 500 SPX, +0.81% the large-cap U.S. equity benchmark, is up 5.6% year to date. The iShares MSCI U.S. ETF ACWX, +0.53% is up 5.9% since the start of the year.
Lapthorne is not convinced about the bullish posture of U.S. equity investors, however, citing messages coming from a flattening yield curve and a weaker dollar, both of which normally reflect weaker growth in future.
Read: The bond market hit a 3-year milestone — so where does it go from here?
The yield curve — the difference between the short-dated and long-dated yields — has been flattening steadily since 2013, when it was at about 265 basis points. The spread between two- TMUBMUSD02Y, +0.01% nd 10-year Treasury yields TMUBMUSD10Y, -0.69% is currently at 60 basis points.
An inverted yield curve preceded all of the past seven recessions, but a flattening yield curve does not always mean it will invert. In fact, the yield curve steepened over the past few weeks after narrowing to 48 basis points.
The weakness in the dollar over the past 12 months came despite the Federal Reserve hiking interest rates three times last year, and promising another three in 2018, with some analysts suggesting that it a reflection of weaker long-term growth prospects.
Read: Why a weak dollar may be a sign of long-term pessimism
But Lapthorne’s main concern centers on cash flow. In the chart below, Lapthorne shows that net operating cash-flow growth in the U.S., once the energy sector is excluded, decelerated from around 7% annually to just below 3% now, “a rate of growth normally associated with a period of weak economic growth.”
Lapthorne sees a clear relationship between the decline in cash-flow growth and the yield curve, as well as the dollar.
Lapthorne quotes an old saying, “Revenue is vanity, profit is sanity, cash is reality,” and suggests investors take note of the slowdown in cash flows.
“If the cash-flow growth signal is correct, and that reinforces the yield-curve view of U.S. economic prosperity, then equity markets could be in for a nasty surprise,” Lapthorne wrote in a note Monday.