Regardless of the pace of underlying growth, it's important to look beneath the hood of the economy. Based on recent financial results and forward commentary from large businesses, should investors prepare for additional cloudiness in financial market returns? Or, have domestic corporations provided indication of clearer skies ahead?
Blue Chip Partners’ Director of Investments, Daniel Dusina, discusses Q3 earnings season and provides insight into what business leaders are saying about the road ahead. Daniel is joined by Managing Director, Dan Seder and Senior Financial Advisor, Matt Mondoux.
Watch this 35-minute video to find out Blue Chip Partners' perspective on the current market. Topics covered include:
November 16, 2022 at 4:00 P.M. E.T.
Daniel Dusina 00:06
Alright, everybody. I've got 4:02 P.M., so I think it's best to get going here. We've got a fair amount to cover today. First and foremost, thank you all for joining yet another rendition of the Blue Chip Partners live webinar series. I think this one will be pretty interesting for everyone on the line. Today we're going to talk about what our business leaders are saying about the road ahead. More specifically, this is going to involve a bit of a recap from the third quarter earnings season and distill some of the comments made by chief executive officers and other leading members of the community here in the United States. I'm joined by Dan Seder, managing partner at Blue Chip Partners, and Matt Mondoux, senior financial advisor. And, of course, I'm Daniel Dusina, the director of investments here at Blue Chip Partners. Just a quick housekeeping item: if you guys want to ask any questions, which we will address at the end, you can use the chat and Q&A functionality in the GoToWebinar application on your computer, phone, or wherever you're viewing this from.
To get started, we're going to have this be more of a roundtable discussion. I'm going to kick things off to broadly level-set in terms of how corporations did in the most recent quarter. When we look at the results from the domestic marketplace in the third quarter of 2022, technically speaking, roughly 70% of the companies in the S&P 500 surpassed consensus earnings estimates in the quarter, and to the vast majority, that sounds like a positive outcome. However, I will always urge folks to take this into context, especially considering that both the number of U.S. firms and the magnitude by which they exceeded earnings estimates in the last quarter are below five and ten-year averages. With the S&P 500 index-level earnings rising roughly 3% year over year, the market is actually on track to post the smallest aggregate beat since the first quarter of 2020.
I would say that some of the readings you see at the broad market level can be a bit misleading as these aggregate S&P 500 earnings have been pulled down by a few notable misses of some of the largest names in the marketplace today (you can think of Google, for example), but also skewed to the upside due to one individual sector in particular, and Matt will talk about that in just a moment. Other notable insights on the top-line, aggregate revenue from U.S. businesses grew double digits, roughly 11% in the most recent quarter, but more notably is that margins, which are profitability metrics, contracted year over year for the first time since 2020. We've been watching for these types of hits to profitability for the last year, especially with rising wages, high commodity prices, and broad inflation among goods and services. As we look forward, a deceleration in some of those inflationary pressures, which I'll touch on later, further normalization of supply chains, which we will also be touching on in a moment, and a loosening labor market should really lead to less margin and profitability pressures in 2023, relative to 2022.
When we think about the answer to the question, "Did corporations broadly meet expectations for results during the last quarter?", the results haven't been great, but they haven't been terrible, either. There are certainly outliers underneath the surface, which, in this type of environment, become more visible. As we get started in this roundtable format, Matt, I'm going to ask you a question: what parts of the market have shown resilience from a profitability perspective, and which segments have struggled?
Matthew Mondoux 05:00
Thanks, Daniel, and thanks to everybody on the webinar, too. We really appreciate your attendance and we love putting these on. Thanks for being here and letting us share some of our insights. If you're viewing the slide here, we'll start with the good: energy, outstanding year. A lot of that we have to credit to higher commodity prices, specifically oil driving a lot of the sales growth, and also the earnings per share growth. One thought here, too, is the seeds were sown many years ago. As we know, oil has been lower since 2015-2016 as shale production came online in the U.S. With lower oil prices, the energy sector was forced to be extremely disciplined from a cost standpoint. You're seeing the effects of the higher commodity price and cost discipline over the prior few years paying off in the form of outstanding earnings per share growth, way above the market average. The true story is really kind of twofold - from the cost side and the commodity side.
Energy made up 4% of the S&P 500 earnings prior to the pandemic; this year it's actually 11%, all while being about 5% of the index. Pretty impressive from energy. These higher prices are really going to pay off, no pun intended, as they still remain disciplined from the cost side, knowing how things can turn quickly for them should oil slide. The story was not so rosy in the communication services sector. As you can see, the sector earning per share growth was down 25.7%, and sales growth was slightly positive, but that earnings per share growth really took a hit. It was pretty broad-based, but a lot of the news has been reported on Google (which Daniel just mentioned) and also on Meta or Facebook. As ad revenue growth slowed, costs remained high. There's really been this talent acquisition binge occurring in Silicon Valley from these companies' accumulation of talent. Again, as the seeds were sown for the energy market long ago, the same is true with communication services. This is not a one-year story; the story of costs and excess hiring has been a decade in the making. As we started to slow, you would expect some effect from the earnings per share growth side to actually contract. The benefit is this will force them to be more disciplined from the cost side. It could be a year or two down the road when we start to see profitability really tick back up because these companies are wildly profitable. Although the growth side "turned negative," they're still very profitable businesses, when looking at Google, specifically.
That's kind of a good recap on the sector's big winner and big loser. I'll frame a question towards Dan: in our opinion, what's on the mind of CEOs right now as things stand today?
Dan Seder 08:18
Thanks, Matt and Daniel. I'll touch on two things. You both hit earnings or at least a component of earnings, but I think there are two other items, labor and the health of the consumer, that I'd like to talk about. The chart that we have on the screen, I think, is a great reflection of how hot employment is still running.
The dark line represents the U.S. unemployment rate, which ticked up slightly recently, but is still really, really low. I also think it's notable that the number of job openings, which is the beige line, is just tremendously high. The labor market is still running hot, but it is a tale of two stories. I think it's different, or it can be different, based on the sector.
Matt, you touched on the communication services sector starting to go on this hiring binge. The large tech firms right now are slowing down, having heavy hiring over the last couple of years. Retail, you really can't quench that thirst; they're really struggling to staff properly. I think it's notable to look at Shake Shack CEO Randy Gruta. You look at his comment, "We've got to get staffed up. We just got to continue to get staffed up." I think labor is one major issue that CEOs are thinking about and talking about today. Secondly, I would say it's the health of the consumer. Customers are continuing to spend freely. We can look at what some of the bank CEOs are saying, but account balances are higher than they've ever been before.
The consumer has strong credit, and delinquencies are really low. If you look at Brian Moynihan, Bank of America CEO's comment, he says the customer's resilience and health remain strong. There has been a shift, and that shift is kind of coming from a goods-oriented consumer to a services-oriented consumer. We're seeing that in some of the comments made through Airbnb and United Airlines. Guest demand on Airbnb remains strong; they had another record quarter. That was from Brian Chesky. Then United Airlines CEO, Scott Kirby, just said September, which is typically an off-peak month, was their third strongest month in history. That, to me, is pretty impressive. Labor and the health of the consumer are the two areas that I wanted to touch on.
With that, it's my turn to ask a question. I'll send this one over to Daniel: are companies finding it possible to navigate around inflation? This is the topic du jour. This is the item that the media seems singularly focused on.
Daniel Dusina 11:25
I would say it continues to be a mixed bag. It's very much a continuation of the trend that we've seen for the majority of this year. There have been winners and there have been losers. While we have seen businesses display results that continue to indicate inflationary pressure (i.e., the margin declines we saw in communication services), the easing severity of those pressures is very present in current management commentary. You look at what Costco's CEO said on their earnings call just recently, the fact that they're starting to see "light at the end of the tunnel," is incredibly encouraging. I think this is broadly representative of what a lot of management teams are seeing and saying today.
I think one of the best examples of a company that has not just been able to manage through this inflationary period but really thrive and continue to grow profitability in this type of environment is Pepsi. Pepsi's most recent quarter saw them experience declining volumes by way of negative 1%, but their organic sales growth was up 15%. How does that actually happen with negative volumes? They pass through increased costs to their consumers. By realizing higher prices, that net price realization is up 16%. That's really what a good company does in this type of environment. Despite some challenges, they're able to adapt, be dynamic, and really provide the resiliency within their business that investors like us would be looking for.
You heard Dan talk a little bit, and Matt as well, in terms of where companies are having trouble navigating around it. I think the fact that you've seen those larger firms, notably in tech and communications services, that were on a hiring binge go from first hiring freezes to large-scale layoffs. It's very clear that wage inflation continues to permeate across the board. I don't think that's one that any company would argue they're challenged with right now. I think that we have hit somewhat of a turning point because if you look at not just the Consumer Price Index, which is the broad indicator or the broader representation of price inflation here in the United States, something that leads this is actually a component of a survey that's compiled monthly: the purchasing manager indices, specifically the one put out by the Institute for Supply Management. If you look at the price index within the Institute for Supply Management's PMI on the manufacturing side, when that turns either upwards or downwards, it does tend to precede the turns in inflation. The fact that we saw those prices experienced by manufacturing firms for raw materials peak back in May is an early indication that we're starting to get some easing of the severity of this inflationary pressure. Again, I think that's displayed in management commentary. Costco is just one example of many. With one of the major factors that drove inflation upwards being supply chain disruption, I feel like we've lost a little bit of sight on that specific topic.
Matt, my next question for you: have supply chains meaningfully improved based on the commentary that we're hearing from business leaders here in the U.S.?
Matthew Mondoux 14:43
Before there was inflation, there were supply chains. Last summer, even in 2020, it was all we talked about. They're not perfect. We're not suggesting any are. Certain industries are facing greater difficulties than others, but I think it's pretty positive. We can find toilet paper; we can find these things that became really hard to find for a period. In a couple of meaningful excerpts from earnings reports, Tesla commented on the price of shipping containers. At one time, it was $20,000 to get a shipping container from China to the U.S.; that's down to $3,500-$3,600. That's a much more healthy market, something we saw prior to COVID. Those numbers are not shocking. The other one was Costco; Costco certainly touched on the log jam at the ports. That was a really big issue, ships idling at sea, waiting in Long Beach to unload cargo, and thus kind of continuing the global supply chain. Those things have also improved. Two really big components, costs and productivity, within the supply chain are looking better. We'll still have hiccups here or there. That kind of leads me to a potential positive for next year. If China does ease this zero-tolerance COVID policy, and through vaccination and various methods, that can be a really big positive for global supply chains. It can be positive for the Chinese market and also our ability to get ships and some of the things that are produced over there. Look for that to potentially be a shot in the arm in 2023, not just for the markets but just the economies in general.
Daniel Dusina 16:38
I think it's especially visible in one of the other sub-indexes of that ISM Manufacturing PMI survey. The fact that supplier delivery times are actually decreasing for the first time in a very long time, almost three years. I think that's very supportive of exactly what these management and business leaders are saying. I guess, on the back of what we talked about, with regards to the challenges, the inflation, and the supply chain, Matt, how are CEOs actually feeling about the current and expected business and industry conditions? And what has the sentiment reading typically told investors?
Matthew Mondoux 17:19
Great question. This is one we certainly wanted to touch on. Oftentimes what CEOs are saying and what they're doing can be conflicted. I like to say, "Watch what people do, not what they say." Right now, in the chart at the bottom, you can see CEO confidence is at a low, not seen since the Great Recession.
After four, five or six quarters ago, we're at all-time highs, literally never seen before. Back in quarter three of 2021, nobody was thinking about a recession or thinking about inflation at that point. Here we are at the depths of CEO confidence, really, going back to the recessionary periods.
An overwhelming number of U.S. CEOs are preparing for a mild U.S. recession in the next 12 to 18 months, which is something you want to see corporate leaders do. If we're thinking about a slowdown, preparing for that slowdown (slowing down when it starts to rain on the freeway as opposed to putting the pedal to the metal and jamming at 100 miles an hour) is probably the appropriate course of action. I'll couple that with, while appropriate, they are still surveying that a vast majority of CEOs expect capital spending budgets, so their investment budgets, to have the same increase in 2023. Although they're, perhaps on the labor side, easing hiring, the longer-term investment side remains positive, which I think is a really important underlying component of the CEO Confidence Index.
I will say that they're pretty bearish on Europe. Generally, they are expecting a more major recession in Europe that could have a mild global spillover. That is one area to watch and an area that might continue to be a little bit underweight, Europe and international, within the portfolio. Just like I said, the CEOs are pretty good at telling you what the weather is today, maybe what the weather is tomorrow, but longer term we don't have as much confidence in this; but, it's worth noting. What I do think is important, and this is where the "watch what they do, not what they say" component comes in, we're actually on pace this year for another record and share buybacks. This is generally not something we see in a declining market. This is pretty unique. Generally, as stock prices head lower, counterintuitively, companies buy back their shares less. That's a pretty positive signal, in our opinion, and really is a vote of confidence, too, of how well their balance sheets are structured. I think CEOs are feeling very confident in the amount of cash on hand, lower amounts of debt service, and their ability to withstand a recession, so confident that they're using excess capital to buy back shares and continue to increase dividends. I think that's a really big positive that we need to focus on, maybe more so than the headline level of the CEO Confidence Index.
With that said, the application of all this information, Dan, I ask you a question: what are we not buying?
Dan Seder 20:37
I'll touch on two items. I'll go to international first because you just wrapped up talking about Europe. International investments have still been massive relative underperformers to the domestic U.S. market. Most of our clients understand that we're buying high-quality Blue Chip dividend-paying, dividend-growing companies, for the most part, so that overweight to the United States is in the portfolio. We're often talking about a lot of those businesses. Very rarely do we talk about what we're not buying, which is international. We have a very low weighting to those international markets. It's not that we're opposed to buying international investments, but that trend needs to reverse before we really consider those markets.
What's really interesting is the defensive firms. Valuations in some of the sectors like staples, real estate, or utilities have really elevated as money has kind of flocked away from the high-growth areas, like tech and communication services, and also those areas that were traditionally defensive with yield, so they would pay healthy dividends. They were really attractive when interest rates were at rock bottom levels because bonds paid almost nothing. Today, as interest rates have gone up, bonds are now producing real returns. After inflation, real returns are attractive, so you don't have to go to areas like consumer staples, real estate, or utilities in order to get some type of income stream. Just be cautious about the defensive segment or sectors in the marketplace in international investments. Hopefully, that answers your question, Matt.
Daniel, on the asset allocation front, since I touched on international (and maybe being cautious and defensive), are there any notable asset allocation trends you've seen visible today?
Daniel Dusina 22:56
There certainly has been one that we've observed, even in just the last month, that is fairly inline with some of the elements you just touched on. It really relates back to the attractive yields and the uncertainty, leading a fair amount of investors to flock to cash. The fact that we have, for the first time in over a decade, actual attractive yields available from short-term cash investments (such as money market funds), combined with a fair degree of uncertainty over the last few months, investors really have been fleeing the market and heading towards cash. In fact, global money market funds saw $89 billion worth of inflows in just one week, for the week ending October 7. That's the largest weekly injection into cash since April 2020, in the depths of the pandemic.
It's not just retail and institutional market participants, it's also fund managers holding a record amount of cash; we saw that tick up to 6.3%, last month, moderated down to 6.2% just yesterday. Still a very high level of cash relative to average levels, which is roughly in the force. I would say this can be a bit of a contrarian indicator. Generally, when people fly to cash, it tends to be at just the wrong times. We've all seen the stats around what missing just the best five or ten days in the market does to you. I think it's a little more enticing now that we do have the short-term yields that have ticked up the way they have this year. Having said that, it's not as compelling as some of the valuations that we're seeing in the equity markets today. I do think it's a nice resource to have, but the fact that we're seeing so many folks on the institutional, retail, and fund managers' sides fleeing to cash is a little bit interesting for us to see, especially given the fact that some of these big inflection points happened about a month ago, and we've seen what the market has done since then. Certainly a very large visible trend, and I think it lays into a lot of the commentary that we've gotten from management teams that we touched on. Yes, things are improving; there's light at the end of the tunnel, but there's still a fair degree of uncertainty. We don't have the tailwinds that we had over the last two years or pre-pandemic; it's just a challenging environment. That spurs the need for selectivity. There will likely be more winners and losers in the market over the next three to five years than there were over the previous ten.
That's all we have today in terms of prepared remarks. I'm going to look and see if we have any questions from the crowd. At this time, it looks like we've asked all the questions there are to ask since we don't have any questions coming in. When I think about where the market is today, how do we feel about equities and fixed income? In general, we've seen equities rally over the last month. Do we think this is a rally that is supported by results? Are we seeing investors weed out some of the lower-quality players and bid up the higher-quality players? Do you guys have any comments in terms of what we've seen over the last month in particular?
Dan Seder 26:24
I don't know if this is going to answer your question, Daniel, but it's just general in nature. The number one question that I get is, "What do you think the markets are going to do?" That's what people want to know. What about the markets? Where are they at? We know where they've gone and what they are going to do moving forward. I think it's important that, particularly in times of volatility, and volatility means drawdowns because nobody really views huge upward moves as the market being volatile (they only think of volatility when the markets go down), it's important to remember your timeframe as an investor. So, I can say I'm really bullish on the market, and my timeframe might be a month. Matt might say he's really bearish on the market, and his time frame might be three years. We could both be right. In general, when we're looking at stocks and bonds, regardless of your stance, it's important to know your timeframe. I think it's a little bit confusing when you're watching financial media because everybody has an opinion. You'll have commentators out there saying the stock market's great or the stock market's terrible. At the end of the day, their time frame might be different than yours. So, just take it with a grain of salt because it's all about your timeframe, how you make decisions, and how that's impactful to your financial plan. I just wanted to throw that out there first.
Matthew Mondoux 27:57
I'll jump in, maybe counterintuitively. I'm probably more comfortable today with a recession looming than I was 11 months ago. "What happened coming into this year?" is the big question. A lot has been made about inflation and tightening the economy. There's also the component of the markets being a little overheated. If you basically had annualized performance from February 2019 to 2020, at the high point in the market before the pandemic started, to the high point in the market on January 3 of 2022, the S&P 500 was annualizing at 20.5% per year. One thing I'm fairly confident of is that the S&P is not going to annualize at 20.5% per year annually; it's just not going to happen. Generally, returns can be anywhere between 6 and 10% annually, and that's a pretty good rule of thumb over the long run.
If we take that same anchor date start, February 2020, and we do the same analysis to today, where are we at? We're at about 6.5%. We're kind of on that lower-end of average per year. What I can tell you is how we've got to average has been a roller coaster ride; we took the ride all the way up the hill and then took the drop down. Ultimately, we're shaking out as average. From that perspective, I think the markets can produce some pretty good forward returns. Again, reiterating what Dan said, the time horizon is really important. A lot can happen. I would say the possibilities are endless; the probability is over the long run. High single digits are what you're looking at, but the possibilities in the short run are endless. Daniel, again, I don't know if that answered the question, but I think the context of what happened to come this year is really important.
Dan Seder 29:54
As Matt said, we got to average by taking the roller coaster. The way I describe that is the pendulum, and the pendulum often swings too far in each direction. That drawdown after COVID hit might have been extreme; the rally up in that recovery might have been extreme. Here we are running along with average.
Matthew Mondoux 30:19
The fact of the matter is, balance sheets are a lot more healthy at the corporate level than they were in the '08-'09 situation; balance sheets are just incredibly more fortresslike than they were before. I think there's like $2 trillion of cash sitting on U.S. companies' balance sheets. That is a positive to weather a downturn.
Dan Seder 30:19
And the consumer level.
Matthew Mondoux 30:46
Daniel Dusina 30:47
I think those are all great points. It's really about perspective and kind of digging a little bit deeper than just the surface level. We did get two questions that flowed in. I know we are slightly over time, but I'd like to address these really quickly. They're both about international and the dollar, the first being, "How about potential dollar weakness increasing the viability of international stocks?" And secondly, "Is there a global push by other countries to weaken the U.S. dollar?"
I'll take the first stab at these. On the second one, I don't think there's any coordinated or global push by other countries to weaken the U.S. dollar. I touched on this in the most recent Quarterly Edge, which was released a couple of months ago, and in the most recent webinar about a month ago. In terms of the dollar's strength, what really drove that was monetary policy and economic strength here in the U.S. Until that changes, I would say that the direction of travel has been north in the U.S. dollar, but that's what's driven it. If we do start to see a tipping point, which we've seen over the last month or so, I don't think that is a result of any concerted effort by a cohort of international entities.
In terms of dollar weakness and increasing the viability of international stocks, I certainly think that's an element that would be very supportive. You look at what's happened in the dollar over the last month or month and a half, and you look at what emerging market companies' stock prices have done as a result. It's a one-for-one correlation, actually inversely correlated. You definitely see that. What I would say is, in reference to what Dan said earlier about the long-standing trend, I'd like them to show me before I buy into simply betting on a lower dollar. I think that would certainly provide a tailwind; it would also provide a tailwind to large U.S. exporters. I think there are a number of ways you can spin that and play it. Again, I think the proof is in the pudding at this point. Until we get some real viable dispersion in the current trend, our conviction would still remain with the domestic players. The dollar story is certainly a very big factor.
Dan Seder 33:10
Is there a global push by other countries to weaken the U.S. dollar? This is probably above my head, so maybe I'll defer to Matt. I mean, can other countries really do that? At the end of the day, isn't it kind of a function of the central bank? As the Federal Reserve starts raising rates, and you look at the attractiveness of yields, where people want to park money, and if the Fed is hiking rates, treasuries need to be bought with the dollar. I'll pose that question to you. Do you have any comments on whether other countries could make a global push to weaken the U.S. dollar?
Matthew Mondoux 33:51
It would be tough. If you're South Africa trading with Belgium, you're probably settling your trade in dollars; most global trade settles in U.S. dollars. Oil markets are priced in dollars. The dollar really is, to this point, the global currency. To weaken it, you're going to have to do so at the expense of raising interest rates within your own country to attract foreign investment to your currency, which you're seeing in the U.S. slow growth. In a lot of ways, it really wouldn't necessarily make sense for a company to slow its own growth to attract deposits that would potentially weaken the U.S. dollar. I'm not exactly sure. I think the way you weaken it long term would be a long-term story through improved trade, through trading partners, through technological dominance, kind of like what we see in the U.S., and it's a longer term picture. I think it's something that'd be extraordinarily difficult to do in the short run.
Daniel Dusina 34:57
We have one more question that flowed in; we'll address that and then wrap up. Sorry, two more, another one just flowed in. The first question, "Are you saying by mid-2023, we'll be around 10% for equities?" If you're talking about 10% price appreciation, I don't think we've said exactly that. What I would say in terms of relating it back to the conversation today, if you look at the most recent quarter of earnings here domestically, they're all compared to one year ago, which was an incredibly strong period. The comparisons are very challenging. You couple that with the inflationary and supply chain dynamics we've seen this year, it's been very much a troublesome year for managers to try to navigate their businesses through. When we look towards the next year, what I talked about in terms of margin pressure starting to dissipate, I think next year, the runway is a little bit less snow-filled and is a little bit cleaner for companies to start to get back on track to earnings growth. Whether or not this comes to fruition to the degree that we've seen post-pandemic, who's to say, I certainly don't think that's likely. I think that a recovery here is going to be less of a V-shaped type like we saw back in March of 2020 and one that is slower and allows prices to actually be supported by earnings. I think it's very dependent on the health of the consumer. Right now the consumer is in very strong shape, like Dan said, but I don't see this being an inflection point that just bottomed and will rip immediately higher.
Final question, does cryptocurrency affect us? I would say cryptocurrency here at Blue Chip Partners we do not have any exposure. There is no real house view on cryptocurrencies. Realistically, for me, as a fundamental investor, there's no way to find an intrinsic value for something that is essentially art. It's whatever someone's willing to pay for it. If you're a gambler and believe in technology, that's one thing. I think the blockchain has applications, but to be participating in a casino where the deck is a bit stacked in some ways, we really don't see participation as something that's prudent on behalf of our clients. I appreciate everyone's participation today. I think it was a productive discussion with the roundtable format, as well as some engagement from the participants. Thanks again very much for joining us. Spread the word that the replay will be available on our blog at bluechippartners.com and will be pushed out on LinkedIn, as well. Thanks for your time. Apologies for going a bit over time here, and hope you all found it insightful and interesting. Until next time.
Dan Seder 38:00
If you haven't already, please go to LinkedIn to like and follow us. We would appreciate that. Thanks, everybody.