US stock investors may need to brace for potential letdowns, as indicated by recent warnings from a Federal Reserve researcher.

Corporate tax reductions and interest-rate cuts have facilitated stock returns for an extended period, as pointed out by Federal Reserve economist Michael Smolyansky.

Smolyansky anticipates a rather grim future for stocks, with slowing earnings growth and fading tailwinds.

US stock investors have thrived on vigorous tailwinds for years, but now, it seems their fortune is about to take a downturn, warns the Federal Reserve researcher.

Recently, Smolyansky published a research paper titled, “End of an Era: The coming long-run Slowdown in corporate profit growth and stock returns.”

He concludes that the S&P 500’s real return of 5.5% (excluding dividends) from 1989 to 2019 was predominantly due to declines in interest rates and corporate tax, a trend unlikely to persist in future years.

Stock prices usually elevate when corporate profits grow, or P/E multiples expand. Through his research, Smolyansky discovered that over 40% of the real corporate profit growth between 1989 and 2019 could be accredited to reductions in corporate tax and interest rates.

Furthermore, the lowered interest rates led to decreased risk-free rates (the assured return from assets such as US Treasuries), accounting for the P/E multiples expansion over this period.

Commenting on these findings, Smolyansky articulates, “Investors, therefore, got lucky. I argue that this bout of good luck is likely over.”

Even before the 2020 onslaught of the COVID-19 pandemic, interest rates were at historically low levels—diminishing any chance to reduce them further, specifically given the reemerging inflation risks.

At the same time, the effective corporate tax rate for S&P 500 non-financial firms fell from 34% in 1989 to 15% by 2019. Considering the current near-record levels of the US debt-to-GDP ratio and last year’s mandate by the Biden administration of a 15% minimum tax rate, further cuts appear to be improbable.

Smolyansky asserts that if corporate tax and interest rates remain around the 2019 lows going forward, corporate profits will only grow at the same pace as EBIT. Citing a lag in EBIT growth against US GDP growth between 1962 and 2019, he suggests that it’s unlikely to exceed a growth rate of 2% annually in the long term. Additionally, limitless expansion of P/E multiples also seems out of the question.

“This scenario carries serious implications for stock returns,” States the economist, “If actual earnings growth fails to outdo 2% per annum in the long run, then the prospects for stocks are grim.”

“Expect future stock returns and corporate profit growth to be considerably lower,” he warned, describing the persistent boost to earnings growth from tax reductions and interest rate cuts as “a trend that has now hit its limit.”

Smolyansky cautions that his bleak outlook could be seen as conservative. And if the stock market isn’t presently pricing in slower earnings growth, he warns that P/E multiples may suddenly shrink once they do. Additionally, the reduction in interest and corporate tax rates might have artificially stimulated EBIT growth in recent decades, setting the stage for an even greater downturn than anticipated.

“The risks associated with this forecast, if anything, lean towards the downside,” he concludes.

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