The Era Of Low Quality Earnings

On May 7th, during the Fed’s latest meeting, Chair Jerome Powell announced that U.S. interest rates would remain unchanged at 4.25%, «until the economic situation becomes clearer».

Unlike his counterparts in the ECB and Bank of England, Powell continues his hawkish path, fueling fears of a U.S. recession as inflation shows signs of easing and trade war tensions linger in the background. With core CPI falling from 5.6% in March 2023 to 3.8% in March 2024, a resilient job market, and a strong domestic demand, Powell might indeed be behind the curve. Donald Trump, never short on words, called him “Mister Too Late”.

Yet despite over a decade of liquidity injections and ultra-low rates, today's 4.25% level has not stopped the machine. Valuations are near all-time highs, earnings are solid, and liquidity remains abundant. Put into perspective, the U.S. economy absorbed much higher rates in the past — up to 20% in 1981. So why this widespread feeling of vulnerability?

The common thread here appears to be linked to leverage. Public, private, or corporate debt has become the cornerstone of our system. And the main characteristic of debt in both economic theory and corporate finance is that it carries long-term fragility, which might explain why, beneath booming numbers, we sense vulnerability. In 2024, we saw how sensitive the system has become. The unwinding of yen carry trades nearly triggered a financial shock. The U.S. regional bank crisis revealed unrealized losses and raised questions about systemic risk. Despite strong metrics, markets have become highly reactive, almost allergic to risk.

There is a paradox here that sits right at the heart of our model: have we shifted to a new economic paradigm without fully realizing its consequences? And more importantly, have we lured ourselves with leverage?

The answer is not simple. In a post-industrial economy where intangible assets, leverage, and disruptive technologies have been driving unprecedented value creation, it does seem that investment return has reached a plateau despite being positive in absolute terms. The return on equity (ROE), which Warren Buffett rightfully described as “the primary test for managerial economic performance,” has remained modest for the past two decades, closely resembling levels seen during the inflationary challenges of the 1970s and 1980s. With the U.S. market capitalization-to-GDP ratio at an eye-watering 2.1x, the absence of inflation coupled with an abundance of liquidity seems to have driven up valuations only, not returns.

This not only raises a question of valuation, but of the very foundations of corporate profitability: are today’s profits built on a solid foundation, or are they propped up artificially through financial engineering?

Answers lie at a crossroads between microeconomics and macroeconomics. History reminds us that the economy can only be understood backward. Adjusting corporate metrics like ROE for both inflation and leverage anchors a macro framework around a distorted risk-free level, reshaping our understanding of the true cost of capital in the modern era.

The Foundations of Earnings Quality

Return on Equity (ROE) is a key metric used to perform cross-sector benchmarks. As a straightforward ratio of net income over shareholders’ equity, its standardized accounting treatment makes it less susceptible to manipulation by market practices or management projections. However, it remains sensitive to four variables: inflation, leverage, risk-free rate, and operational efficiency. Thus, comparing ROEs across different periods proves incoherent without adjusting each element to reflect the underlying economic context.

In the 1970s–1980s, U.S. corporate ROE historical averages show about 12–14% nominal ROE. Inflation was high (~6–8%), so applying a Fisher-type adjustment, real ROE (adjusted for inflation) stood around 5–8%, depending on the exact years. This period witnessed disciplined financial management and a focus on genuine value creation rather than financial engineering.

In contrast, the 2010s–2020s era saw U.S. Corporate ROE remain between 10–15% nominal, with low inflation (~1.5–2%), resulting in a real ROE of around 7%. However, leverage ratios were significantly higher. Although nominal ROEs appeared robust, the underlying quality of these earnings has come into question.

Given the widespread use of debt-based growth strategies today, compared to the relatively restricted liquidity during the Volcker era, when monetary tightening fought inflation, adjusting ROE for leverage is crucial to ensure a true like-for-like comparison of corporate performance across periods.

Leverage is known to magnify returns on equity. Un-leveraging ROE involves assessing its stake within the capital structure of the firm, as indebted companies may experience high levels of net income at the expense of a weakening equity base. Contrary to ROE, which mechanically increases with debt, the company's actual operating profitability (Return on Assets, ROA) remains unaffected, making it a more appropriate indicator when analyzing performance relative to the debt-to-equity ratio.

Period	Real ROE	Debt/Equity	Unlevered ROE (proxy ROA)
1970s–1980s	~6.5%	0.5x	~4.3%
2010s–2020s	~7%	2.0x	~3.3%

What we notice is that even though the 2010s–2020s have similar or slightly higher real ROE compared to the 1970s–1980s, the leverage increase and changes in capital structure deteriorated the economy’s real earning power per unit of asset, with an operational return level noticeably lower compared to the stagflation era of the 1970s–1980s.

Macro economic shift: the untold story

Isolating the true cost of corporate earnings allowed us to seize the evolution of U.S. firms' value-creating power over time, regardless of idiosyncratic factors and variations in economic cycles. When we put into perspective the promises of growth inferred by the 4th industrial revolution, one is reminded of Robert Solow’s quote: “You can see the computer age everywhere but in the productivity statistics.” Have we, despite all technological advances, lost our ability to generate genuine economic profit?

The answer is more complex than a simple yes or no. As seen earlier, ROE doesn't exist in isolation, nor can it be properly apprehended in absolute terms. No matter how efficient companies are, they operate within a macroeconomic environment that dictates the availability of capital, the cost of risk, and the reward for deferred consumption.

Here, the concept of risk and its pricing is central. The risk-free level or risk-free rate sets the minimal return granted to an investor with no default or liquidity risk. Benchmarking economic opportunities against safe-haven assets allows economic agents to pursue arbitrage and adjust both pricing and expectations for stakeholders. U.S. 10Y Treasury bond yields are considered a proxy for the risk-free rate in the U.S. market. Thus, the level of risk-free is intimately linked to interest rates and inflation. In most asset pricing models, it forms the base over which risk premiums are built. Concretely, what does a positive or high risk-free rate imply?

It signals that investors expect higher compensation to part with capital, typically due to inflation risk or tight monetary conditions. It also means that unproductive or marginal investments will struggle to meet the return threshold. In that sense, a high risk-free rate acts as a natural filter for capital allocation, rewarding efficiency and curbing speculative excess.

Less with more

If we put that into perspective, historically, the U.S. nominal risk-free rate — proxied by the yield on 10-year Treasuries — averaged between 7% and 10% during the inflationary 1970s and early 1980s. Applying the Fisher equation, which states that nominal rates roughly equal real rates plus expected inflation, these nominal yields adjusted for inflation translate to real risk-free rates of approximately 1% to 3%.

In contrast, the 2010s and 2020s were characterized by nominal risk-free rates hovering around 1.5% to 2.5%. With inflation rates during that period ranging from 1.5% to 2%, the resulting real risk-free rate was frequently negative, estimated between -0.5% and -1%.

This simple adjustment highlights a profound structural shift: the baseline return for safe capital allocation not only declined sharply but, in many cases, became negative in real terms. In effect, investors are penalized for choosing safety over risk and are being pushed to riskier assets in the absence of a risk premium, with limited hedge.

Period	Inflation	US 10Y	Unlevered ROE (ROA)	Risk-free (real terms adjusted)
1970s–1980s	7.5% - 5.6%	7.4% - 10.6%	~4.3%	+1% to +3%
2010s–2020s	1.8% - 3.5%	2.4% - 2.9%	~3.3%	-1% to 0%

On a macro level, the fiscal framework’s unbalance has become tributary of low interest rates. To sustain the unsustainable deficit, the US Treasury under the Trump administration faces the delicate task of refinancing nearly $9 trillion by the end of 2025. A massive debt rollover aimed at keeping interest payments manageable, shedding light on the frustration of Mr. President towards America’s First Banker.

Beyond the immediate horizon, it is a textbook case of how, in modern economies, a supposedly independent monetary policy, focused on price stability, ends up serving broader fiscal needs. The result is a system where structural deficits and past policy missteps force central banks to deviate from reflecting the economy’s natural rate, thus distorting the perception of the risk-free level to serve the purpose of perpetually low-yield bonds.

Negative Risk

Has the economy become so stable that any asset is expected to yield a return, regardless of underlying fundamentals? Are economic agents still rewarded for deferring consumption and undertaking risk, the cornerstone of capitalist entrepreneurship? Quite unlikely.

In a distorted economy, firms can appear to maintain a certain return, but the source of wealth generation has shifted. Productivity gains, the essence of growth in a capitalist system, have been difficult to measure since the economy shifted towards intangible assets at the beginning of the century. Rather, valuations have skyrocketed due to the unprecedented ease of access to liquidity and accommodative financial conditions.

Twenty years of quantitative easing, yield curve control, and liquidity injections have suppressed the natural clearing price of capital, creating an environment where capital is cheap, risk-taking is encouraged, and asset prices inflate independently of their fundamentals.

In more technical terms, valuation multiples expand not because companies earn more per unit of asset deployed, but because discount rates collapse under monetary excess.

Deus ex machina?

Our era is not safer; it is mispriced. Thus, riskier than ever. The clarity that Mr Powell awaits before engaging in further steps might refer to a broader understanding of the situation, beyond the immediate horizon.

When the fundamental mechanisms driving the invisible hand of the market are impeded, natural clearing systems are muted by artificial intervention, sacrificing the long term for the immediate. One would rightfully argue that it is in phase with the postmodern diktat of our societies. A precarious harmony that drives us away from the promise of any sustained growth.

Only an external shock (a deus ex machina) may restore the natural order of capital allocation. Liberal economic thinkers have long argued that markets should self-correct. But if capital markets no longer reflect scarcity, risk, or time preference, then is the economy still operating under liberal principles at all?