Quarterly Edge Webinar: Q4 2022 Market Analysis

October 13, 2022 at 4:00 P.M. E.T.

Transcript:

Daniel Dusina 00:05

Good afternoon, everybody. This is Daniel Dusina from Blue Chip Partners. I've got 4:02 on my clock, so I think it's about time to get started. For those of you who I haven't spoken with yet, my name is Daniel Dusina. I'm the Director of Investments here at Blue Chip Partners. I oversee the investment department, as well as the overall investment committee. I'm excited to talk a little bit today about our forward-looking views. Just a couple of housekeeping items: if you are interested in asking a question, you should be able to see a question section of the GoToWebinar application on your computer or phone or however you're viewing this. Feel free to throw in questions throughout the discussion. I'm going to give some prepared remarks, but I also want to leave plenty of time at the end to address any questions. Those can be related to the content of this presentation or broadly market oriented. I'm happy to field and address any questions, comments, concerns, etc.

We've been putting on these webinars for the past four or five months and want to continue to do these on a monthly basis, covering a number of different topics, evergreen and timely. I would say this topic, or this webinar, is going to be a variety that's a bit more timely. It aims to outline what we have spoken about in our Quarterly Edge, which is essentially the forward-looking commentary that we release at the beginning of each quarter. More specifically, as we look forward to the next three, six, and nine months, we try to identify some themes that we view as most pertinent, unpack them, and express some of our views on them.

Today, we have a fair amount to digest in the marketplace. One of the most driving factors of financial market returns, and just the economic landscape overall this year, has been the United States dollar. Throughout this presentation, I'll provide some information in terms of what is actually driving the strength of the U.S. dollar relative to other countries' currencies and what that means potentially for U.S.-based corporations going forward. Next, I'll talk a little bit about one of the indicators that we think is very interesting; it's very contrary to nature and stems from the American Association of individual investors. I'll talk a little bit about where it's been this year and where it is today. Finally, as we've been doing in past quarters when we put together our outlook, we put together what's called our "Blue Chip Radar." Essentially, it outlines what we view as some potential scenarios for forwarding returns. In this case, we're just going to look at what we view as potential catalysts in the fourth quarter. Those can be catalysts to both the upside and the downside - for more optimistic or more pessimistic scenarios.

Daniel Dusina 04:50

Jumping into things here, I mentioned the United States dollar, and the strength of the dollar relative to other currencies has been an incredibly dominant trend as we work through 2022. To understand what is driving this strength requires first an understanding of monetary policy and how that impacts the value of a currency. You also need to understand the economic conditions in the country underlying that currency and how that can impact the value of that currency. As it relates to monetary policy, I'd say this is an impact that is incredibly direct. When you look at a central bank, in order to accomplish the objectives that they set out for, really, they have two primary tools at their disposal: they can purchase or sell securities in the open market, and they can influence the short-term interest rate. When you are looking at an economy that needs to be stimulated, such as that which we had from 2008 to 2014 or directly after the pandemic through 2021, you have a central bank, and, in our case, the Federal Reserve, that'd be looking to spur growth.

How would they do that? Number one, they would begin rapidly purchasing securities in the open market. That essentially increases the money supply and lowers the yield of financial assets. At the same time, they will be looking to reduce the baseline interest rate, which essentially is an effort to stimulate borrowing. Taken together with the asset purchases, the now lower yield that's offered by this country results in capital outflows as foreign investors can find a much more attractive level of yield elsewhere in the world.

The exact opposite is happening today, as we're essentially looking to put a lid on growth as the Federal Reserve looks to fight inflation. So what's happening today? We have essentially too much money facing a few things, right? That's exactly what inflation refers to. When we look at what's going on today, and what has happened this year, the Federal Reserve is looking to sell securities, which reduces the money supply and rapidly increases interest rates. Now that we have higher yields offered in the United States today, much more significant from an income perspective than we were at, say, one year ago, two years ago, or really any point in the last 10 to 15 years, we now have foreign investors that are much more attracted to U.S. dollar-denominated assets. In order to buy U.S. dollar-denominated assets, they need the U.S. dollar. That has been a significant driving force behind the strength of the U.S. dollar relative to other currencies, whether it's the British pound, the euro, or the yen.

Daniel Dusina 07:40

In the chart on the bottom part of the screen, you can see that there is a very direct impact in terms of what the Fed is doing. You can see that the dotted line in red shows the effect of the federal funds rate, which is the interest rate level that the Federal Reserve sets. You can see the correlation between that and the strength of the U.S. dollar. I think it's very direct, so it's important to understand that it's a humongous driving force. In addition to the monetary policy's impact on currency strength, there is a fair amount of emphasis that foreign investors would place on the overall economic strength of the country's underlying currency. You can ultimately take it as a vote of confidence that the U.S. economy is on stronger footing relative to other countries. That's exhibited by this U.S. dollar strength. Certainly, we're dealing with inflationary dynamics right now, but that's not necessarily as significant as what we might be seeing in some other parts of the world. For example, with the doubling of utility costs in England, I think the U.S. has traditionally been thought of as a safe haven. Again, that's something that has been reflected in the U.S. dollar this year.

Now, that's all well and good, but what does it actually mean going forward? Number one, I think that the most important thing for us here is that we need to watch very closely what the impact of this stronger dollar is having on United States corporations. While the dollar being strong is advantageous for consumers, like you and me, that are looking to import goods or travel to other countries, it can have some negative effects on corporate earnings. For example, in September 2021, the euro was trading at about a 20% premium to the United States dollar. This year we're at parity for the first time, essentially since the euro was launched in 2002. Put in a different way, if you had a firm that was based in Europe that was looking to purchase, say, a $1 million piece of equipment from a domestic firm, the price that they're paying this year relative to last year essentially resulted in a 15% markup, just because of the action in the foreign exchange rate. I think that there is certainly, as we progress through this, a need to watch closely to see if firms with foreign exposure are seeing clients pull back at all. However, there also can be a translation effect on financial statements, which is, again, what the chart on the bottom of the screen will tell you.

Firms like Meta Platform, Alphabet, and Microsoft are experiencing that in a significant way due to the fact that they do have sizable international exposure. It's important to note that it shouldn't just be taken in absolute terms; many of the firms that we've looked at, and I would say those that were interested in, have an ability to offset that translation effect and the impact of the foreign exchange rates from continuing operations, focusing on their core business, and growing within that business. I think a good example of that is Pepsi. We saw them report earnings two days ago, and I'm happy to go into more detail on why I think that was a favorable outcome later.

Daniel Dusina 11:10

In addition to the U.S. dollar, something that we've been watching pretty closely is the contrarian indicator, a survey that is put forth by the American Association of Individual Investors. This is a survey that is released each week that polls individual investors and asks them a pretty simple question: what do you think the conditions for market returns over the next six months will be? The options that they can respond with are bullish-optimistic, bearish-pessimistic, or neutral. What we have found is that when investors are overly optimistic in this survey, the forward returns are actually not as attractive. Then, when investors in this survey are overly pessimistic, the forward returns are actually pretty compelling. This is based on history and data that goes back to 1988. What we've pegged as a "key level" is when bearish respondents outnumber bullish respondents by 35 points, and that's what you can see exhibited by the green line in the chart on the bottom portion of the slide.

That generally serves as a fairly nice inflection point. It is essentially saying that the broader market has gotten too negative. Based on the data that we have, going back to 1988 since the survey was first launched, the forward 12-month returns for the S&P 500 index are significantly positive. Again, this is just an average. That's not to say that it happened every time. It did happen in 12-13 instances going back through that 40-year track record, nearly. Again, this is just something that we look at because it's important to not just follow the crowd.

Certainly, we have concerns that we are weighing right now, but at the same time, we're able to find some fairly attractive opportunities that are, call it, on sale with very healthy fundamentals that we've been wanting to buy on sale for many years. This is something we watch fairly closely. Although sentiment is not the be-all end-all aspect of financial markets, we think it's very compelling and important to keep a pulse on as we look at the fourth quarter here.

Daniel Dusina 13:50

We have outlined what I view as three key catalysts. The first is related to the Federal Reserve, the second is related to the overall economy, and the third is related to corporations. These are catalysts. Depending on how they're developing in the fourth quarter, I think they can dramatically influence the outcome and financial market returns. Starting off on the pessimistic side, in a bear case, we very well could see the Federal Reserve hike the U.S. into an economic recession. The Federal Reserve has voiced a commitment to do whatever it takes to manage inflation. We're seeing that with aggressive monetary policy and rapidly rising interest rates. They are of the opinion and say that their goal is to manage inflation. It doesn't really matter right now, what that does to the overall impact on GDP, or economic growth, but it remains to be seen where the terminal rate will be and what they are comfortable with from an inflationary perspective. That's certainly a possibility, as we've seen in cycles through history. Secondly, as we look at the overall economy, we have seen a bit more softness in consumer spending over the last few months. I wouldn't say to a concerning degree, but should this continue, (in tandem, we have consumer balance sheets starting to deteriorate a little bit) it would certainly be very detrimental to economic growth as consumer spending represents a very large portion of domestic economic growth. With that higher inflation and fairly tight financial conditions, you might start to see some of the individuals throughout the country pull back and, ultimately, pull a floor out from underneath the domestic based corporations.

When we look at the business environment through the fourth quarter, one of the things that we have been looking for very closely over the past three quarters now is the impact of these price increases around the U.S. on actual profitability. We've been looking for margin compression, but we haven't necessarily seen it in a very broad sweeping way, yet. Certainly, that remains top of mind today. Have the tighter financial conditions, potentially lower levels, and softer overall consumer spending impacted corporations in a meaningful way? I think that if you get a worse-than-expected outcome, probably speaking as we get financial results over the coming months, that would be a fairly detrimental equity market return. At the same time, I think that the outcome that is being priced in right now is a little bit overly pessimistic. Nonetheless, certainly a catalyst worth noting.

Daniel Dusina 16:34

The same three catalysts could have positive outcomes as well. I would say the Federal Reserve, starting there, there's very much a possibility that they ultimately become satisfied with the trajectory of inflation. Based on the print today, that doesn't appear overly likely, as we just got another fairly hot print on the CPI. However, there is potential as we work through the next couple of months, the Fed adjusts the level of interest rates, and the overall financial tightening has gone. In terms of managing inflation, I still think some of that inflation will continue to moderate naturally, especially as we have less of a floor placed under for the significant price increases from things like gasoline. Again, this is something that I probably would say is the largest catalyst for financial market performance right now, and that's the Federal Reserve. Secondly, consumer spending is softening a little bit, but we really haven't seen major cracks. Certainly, the whole household capitalization across the domestic parts of the economy, I would say, has held up fairly well. There are certainly prospects for that to continue. You know that spending and continued financial capitalization at the household level would support continued growth and demand at corporations. Another metric that I would say supports a bull case from an economic perspective is the fact that when you look at personal disposable income relative to the level of debt service payments, it is generally a good indicator in terms of the health of consumer spending; it's still very much at average levels going back through history. That tells us that there is a fair degree of ability of consumers that continue spending on what they want to, not just what they have to. Finally, if this does end up being the case, that certainly is a tailwind for corporations based domestically. We have seen corporations be very dynamic, we fought through the pandemic, and we're seeing it now in terms of their ability to exhibit newer financial controls, and ultimately, just to work around and focus on core businesses in order to offset some of the macroeconomic headwinds that we're seeing today. You got consumers that still have a reasonable capacity to spend, and although the backdrop might not be as I would say, compelling, as it was a year ago, based on the level of inflation that we've seen, there still are a number of avenues that corporations can travel down in order to maintain their margins, and ultimately maintain productivity in the stock market, as well. Those are the prepared remarks I have for today. I'm going to pause right now and see if we've gotten any questions that have come in that I might be able to address.

Daniel Dusina 19:22

As I see it, I don't have any questions that have come in quite yet, so I'm just going to take a couple of minutes and talk through where we are finding opportunities in today's market. There's a lot to unpack as it pertains to how markets have moved this year, but at the end of the day, I've mentioned this earlier and alluded to it in the sense, there are a lot of firms in the U.S. from an equity market perspective that are fundamentally unchanged today. You're essentially able to buy them at a steep discount, not just to their price at the beginning of this year, but even to their valuations on average over the last five years. When we look at the market backdrop in the volatility, we actually utilize what's called our "Lane Assist Market Monitor." That's something we built internally, and it essentially serves as an initial guidepost in terms of where we should be looking for our initial fishing pond for opportunities and markets today, based on where we have volatility and the overall trend of economic growth. It's actually, right now, the cyclical side of the equation. That includes firms in technology and energy in the financial sector, and so on (the more economically sensitive areas of the market), which is a little bit counterintuitive relative to what we see going on today from an economic perspective. This has been backtested for over 20 plus years, and that just serves as our initial fishing pond. Within that, we've found a fairly large amount of opportunity. When we look at valuations and the quality of businesses in technology, there are a number of firms that have glide paths to continue to profitability, regardless of the economic outcome. Information technology has traditionally been bucketed as a cyclical part of the market, but, really, it appears more defensive. We've been vocal about this over the past couple of years, so really just looking for firms that can provide that opportunity set for attractive upside participation. Not looking to shoot the lights out, but really focused on capital resiliency. That includes firms with good balance sheets, really good capacity for dividend growth in the future, and, ultimately, just making good management teams that are going to be able to continue to emphasize efficiency in their businesses. Another thing, when I mentioned the United States dollar and the impact that it has, this is not always an explicit input to our analysis. However, in times like this, I think it's a healthy exercise to make sure we understand how we're positioned. When we look across the various sectors, something that stood out to me (I don't believe I'm allowed to name specific security names just for compliance purposes, so hopefully I get some brownie points from our head of compliance here) is that there's a specific subset in the industrial sector where our decision to invest in one logistics company relative to another is further supported by the fact that the impact from foreign exchange rates has been significantly less, and is anticipated to be significantly less going forward. That type of healthy analysis, I think, is very important when I talk about the importance of selectivity today. You will see us do exercises like that on a very frequent basis. What it's all about right now is just making sure you know what you own and making sure that you're positioned in a way that emphasizes quality. Given the fact that you are now able to obtain a more meaningful level of income throughout the fixed-income space, I think some selectivity is required there as well, there are more options on the table. It's important to note, too, that it's not all doom and gloom, but certainly some risks to manage throughout the remainder of this quarter.

Daniel Dusina 23:34

A couple of questions have come in; I'm going to see if I can unpack them. Are we taking any precautionary steps regarding Ukraine and Russia? I would say that when the conflict first escalated back at the end of February and through March, we did do a bit of a robust analysis of the companies within our core model and their exposure to Russia. We put together a research pack that essentially outlined the actions those companies had taken. We then formulate an opinion on whether or not we thought it would be overly detrimental to the stock performance of those companies or not. I think a good example of this would be McDonald's. They enacted a policy to fully remove themselves from Russia, and ultimately, we decided to maintain exposure. Certainly, that had an impact, but it was not overly detrimental to the performance of not just the stock, but the business overall. Another example would be a tobacco firm, Philip Morris International; same idea, they're removing themselves entirely from Russia. The impact there was a bit more significant, but again, offset by some of the more new-generation technologies that they are doing right now. I think investors are giving credit where credit's due for items like that. We're certainly not geopolitical experts by any stretch of the imagination, but we're just trying to find dislocations and avoid any potential impact from negative business developments, such as removing a very key part of the business.

Daniel Dusina 25:32

One more question: with the hot CPI print today preferring to inflation, do you think it is likely that the Fed will be adjusting the terminal rate estimate higher above 5%? As we look at the Federal Reserve, they have been, I would say, a bit unpredictable through this cycle. When we look back at this time last year, inflation was already running incredibly hot. They failed to act upon it because they were of the opinion that the labor market had not fully healed yet. Clearly, they were a bit late to the party there. What you're seeing now, throughout this year and the next few months, is that they're playing catch up. As we see continued inflationary pressures, they will continue to keep their foot on the gas in terms of trying to put a lid on the inflationary pressures and ultimately raising interest rates. In terms of what today did, it was an inflation print that was modestly above expectations. I'm not sure that the terminal rate gets adjusted to anything more severe; I don't think it will pick up above 5%. However, the Fed has been pretty unpredictable through this cycle, so it's hard to place bets on this type of thing. I think what you look at is that, right now, where the terminal rate is at (as implied by market prices) is actually below what the Federal Reserve has put forth. I think that there is room for it to move upward, but I don't think there's a lot of room that will be extremely revised upwards. It's also worth noting that this hasn't really been talked about a lot. From a debt perspective, the level of interest rates does impact the level of debt service that a government has to put forth on obligations. Given the massive debt load that we have here in the U.S., I wouldn't be surprised if there was some pressure on the Federal Reserve to constrain its aggressive nature. Not saying this is going to happen overnight, but I think that's a factor that's worth considering. Also, when we think about higher interest rates, that certainly has an inverse impact on bond prices; it has an impact on financial statements for equities. At the same time, we have seen a lot of companies be able to manage through this. Again, we've been watching for margin compression, and we haven't seen it in a broad sweeping way. We've seen it in some places, and that's why selectivity is paramount here. I think, ultimately, what the Federal Reserve does is once they see economic growth be severely impacted, and they see some natural, moderate inflation, regardless of the level of CPI, is when you'll start to see them take a little bit of an easier stance.

Daniel Dusina 28:42

We're coming up to about 4:30, and I don't see any other questions right now. If you do have any follow-up questions, please feel free to email your Blue Chip Partners advisor, myself, or our broader mailboxes. I really appreciate you all for joining the conversation today. Enjoyed the engagement and enjoyed the discussion; I hope you guys did too. Stay up to date with us through our various mediums, whether it's on our blog, through our website, or through LinkedIn, where we post a fair amount of meaningful and compelling information. If not, I will see you next month! Thank you all very much for joining.