Quarterly Edge Webinar: Q4 2023 Market Analysis

Daniel Dusina: Okay everyone, I've got 4:02, so I think it's best we get started. Thanks again for joining another edition of Blue Chip Partners’ Quarterly Edge. We will share our outlook for the fourth quarter. As usual, we have highlighted three themes as we look towards the fourth quarter and beyond, for the equity and fixed income markets as well as the economy.

Just as we usually do, we've put forth three specific themes. Generally, I try to focus one on the economy, one on fixed income markets and one on the equity markets. So today, just as usual, we've got three themes related to equity, fixed income, and the economy. To start off, the cash wave. We'll talk about the fixed income market. We'll discuss a little bit about cash, why it has a place today, but why we think there are some other options that investors should be looking at. We'll talk about the economy. We'll talk specifically about the labor market and the predictive power that it can have, the path we've taken, and where we see ourselves heading. And finally, we'll talk about the equity market and why it's important at this juncture we find ourselves at today to be selective.

Worth noting that we have the ability to field questions. We're going to save those questions till the end, per usual, but you can use the GoToWebinar functionality to submit those questions. We'll save those for the end and I will do my best to address any that come in.

With regards to the fixed income market, I would say that it's no surprise when I say that cash has a place in investor portfolios today. With money market funds yielding north of 5.3% today, I think it would be a bit egregious to say otherwise. All that said, we do think that the time is right to continue exploring other options in the traditional fixed income market.

This assertion is founded in data. Yes, you can get 5.3% risk free today, technically or more or less risk free, but the path forward, that 5.3% might be selling investors short. What do I mean by that? We all know that the interest rate environment has been driven by the Federal Reserve. The Federal Reserve aggressively hiked interest rates for 18 months and that, of course, had an impact on the yields available in the market today. Also had an impact on the prices of bonds last year and the first portion of this year. The reason that we are compelled by the traditional fixed income market today is because the data that has historically been presented based on investing in the fixed income market after a Fed pause, also known as when the Federal Reserve holds interest rates steady, versus investing in the fixed income market after the Federal Reserve cuts interest rates, is starkly different.

Understanding that bond yields and bond prices move in opposite directions, otherwise said, as yields move down, bond prices go up, we think it's important to invest ahead of the actual baseline interest rate moving lower, because performance in the bond market moves ahead of the Federal Reserve. The bond market is a forward-looking entity, and performance has been shown to be just that, historically speaking. The table in the middle of the page that I'm showing shows the forward returns investing after a Fed pause, which we very likely may be at today, versus after a Fed cut, and actually moves the baseline interest rate lower. As you can see here, on a forward six-month, twelve-month, 24-month, 36-month basis, investing after a Fed pause and not waiting until the Fed actually cuts rates is significantly more beneficial. We're not trying to necessarily catch a bottom in absolute terms in the bond market, but given the fact that we have suppressed prices in the bond market and yields available on high quality instruments that are at 15-year highs, we don't think we need to catch a bottom. We think that moving some money out of the cash assets that we have in portfolios today and towards those high-quality fixed income instruments will beneficial over the years to come.

Now, if you take a look at the chart on the bottom of the page, again, it's no surprise that money market fund assets have moved up to all-time highs. As the Federal Reserve has lifted the baseline interest rate, so too have those very short term, relatively low risk assets. So those have been very popular, those money market funds we are talking about. It's also worth noting, if you see on that chart that, as I kind of alluded to before, the bond market is going to move ahead of the Federal Reserve actually changing the baseline interest rate.

The ten-year treasury yield, I'll use that as a representation of the bond market. That line shown in green on the chart below, it generally moves ahead of that line in brown, which is the Fed funds rate. The idea of investing ahead of a change in tone from the Fed, ahead of a change in the bond market at large, we think can be very beneficial. And it's a theme that investors should keep top of mind as we progress through the fourth quarter and beyond. Now, all that said, we do think there's a fair amount to unpack on the economic side of things, but one facet in particular that should have been top of mind through the last 18 months and remains top of mind for us today, is the labor market. If we think about the primary causes of inflation, I don't think it was necessarily the labor market that kicked off a wave of inflation, but I think the dynamics that were presented in the labor market certainly exacerbated and elongated some of the inflationary pressures that we saw.

If you think about where were coming out of, the pandemic, companies were aggressively trying to staff back up, but they hit some hurdles trying to do so. There simply wasn't enough availability of workers. What did those companies do? They had to pay up to get those workers in the door. As you pay more for employees, individuals have more money that they're willing and able to spend. That pushes prices higher, and that's inflation, ladies and gentlemen. The reason I think it's so important to highlight this gap between the supply of labor and the demand for labor, which is shown at the chart on the bottom, this jobs-workers gap, is because it does have some predictive power in terms of the path of inflation. If you have a very large gap between the availability of workers and the number of jobs that are open, you're going to have inflationary pressure.

When this jobs-workers gap is near the top of this chart, I would term that as inflationary. That just means that corporations and small businesses have to spend more money to get employees, and those employees have more money to spend to push prices upwards. Now, the exact opposite can also be a problem because that would indicate more of a recessionary environment, where companies really aren't hiring and there's a lot of available labor because people are out of work. That's not necessarily an environment we want to be in either. It's problematic for different reasons. Finding a sweet spot in this job-workers gap within the labor market I think is going to be paramount if we want to achieve what is termed as a soft landing, or what the Federal Reserve is looking to do in terms of finding that balance between interest rates, but keeping the economy chugging along.

This is something we're watching very closely, especially because we are seeming to find a closer level relative to equilibrium, at least in recent months. We have seen some volatility in these readings, but the trend in general over the last six to twelve months has been closer to equilibrium. This is certainly something that we would call encouraging as we look at the overall economic picture today. All of that said, given the labor market dynamics that we have at play, I do think it's fair to expect a softer level of consumer spending going forward and probably a little bit of softness in the labor market as well, by way of a higher unemployment rate. That doesn't necessarily mean that we're headed for disaster in the economy, and that doesn't necessarily mean that it's all doom and gloom for the equity market.Now, understanding that, I do think that it calls to mind the need for selectivity in the equity markets. Specifically, looking at companies that are exposed to higher interest rates, I think those should be met with a fair degree of caution. The Federal Reserve, although they may not be raising interest rates further, they're certainly taking a “higher for longer” posture. Now, what this can do as it works its way through the economy and through the corporate landscape, is pose some serious problems for firms that aren't adequately prepared to weather that type of situation. Firms that are holding a fair amount of variable rate debt on their balance sheet might have the extra expenses start to catch up to them. Firms that have a high degree of leverage and a low level of interest coverage or low ability to cover that interest, we're very skeptical of those firms today. A lot of those firms might be smaller in nature, found in the small cap space. A lot of those firms might have high yield credit ratings indicating lower quality borrowers, but also some of those firms are found in a large cap space as well. Some of those firms have actually performed pretty well to start this year, or the first nine months of this year. I think, simply put, that's investors’ way of saying that the potential benefit just outweighs the risk of them having some trouble with the higher interest rates that are present today.

We're very cautious on that side of the coin, especially understanding that historically speaking, in the slowdown phase of an economic cycle, which is likely where we find ourselves today, it's not those firms that are highly leveraged and are overly optimistic on growth expectations that perform well. It's actually the firms that have very strong balance sheets and are actively returning a significant amount of cash to shareholders through dividends and buybacks that perform very well in this slowdown phase. With that in mind, that really is our primary fishing pond right now. Those firms can be found across all sectors. We think it's important to mention this, because as we're starting to look at portfolio and model level allocations here at Blue Chip Partners, this is very much a portion or a piece of our investment process. When we're looking at businesses, we're going deep under the hood to try to understand how these companies might align with our overall investment outlook.

The chart at the bottom of this page is just a very helpful representation of some of the metrics that we can use to identify certain businesses. The bars you will see show a combination of balance sheet strength, the brown portions, and average shareholder yield, which is composed of dividends and buybacks shown in blue. This is not to say that we're only looking for companies in information technology or in energy because those in aggregate have the best combination of balance sheets and average shareholder yield. That's not necessarily what we're saying. But it is worth noting that we're looking around the space to try to determine where we can find some of the best balance sheets and what the construct of shareholder yield looks like in different sectors. Certainly, a buyback and a dividend are both ways to return capital to shareholders in some capacity. But it looks different across the eleven GICS sectors.

I do think that keeping our primary fishing pond aligned with what has historically worked at this portion in the economic cycle is the overall message that I'm looking to portray today. Just to kind of close the loop and reiterate on the fixed income side of the equation. Yes, cash undoubtedly has a place in investor portfolios today, but so too is the historical evidence regarding what it looks like, historically speaking, investing in the traditional bond market at this juncture, moving some cash off of the money market funds and into the traditional fixed income market.

On the economic side, we think following and paying very close attention to the labor market, more specifically the gap between the availability of workers and the level of open jobs, is going to be very important. Finding an equilibrium there could hold the key for economic prosperity over the next 12 to 18 months. And then finally, as we just discussed on the equity side of the equation, selectivity is absolutely paramount here. We're very cautious on firms that are exposed to higher interest rates by way of higher degrees of leverage on the balance sheet, lower interest coverage, potentially high yield credit ratings. We think it's very important to focus on firms that have historically done well at this phase in the economic cycle; that's firms with really strong balance sheets and firms that have the ability and willingness to actively return an excess amount of cash to shareholders.

All that said, I will field some questions right now. I'll look what's come in thus far, but feel free to keep throwing in questions using the chat functionality if you haven't done so already. All right, first question is related to the equity markets: Is there anywhere in particular that you're finding opportunities in the equity market today?

What I would say is that it's not like we're finding an undue amount of opportunity in one specific sector. I can call out a few different sectors that we've looked at very recently, or at least we've looked at companies within very recently. I would say one kind of hot topic right now is talking about the utilities sector. The utilities sector actually has underperformed fairly meaningfully this year and I think a large part of that is simply due to the interest rate environment.

If you think about sectors like utilities, consumer staples, the telecom portion of communication services, these are what can be known as bond proxies. They're called bond proxies because investors generally use them as replacements for fixed income allocations, when interest rates are very low. These sectors generally pay a high degree of income through dividends and investors like the stability aspect of that. Well, that's great when interest rates are low. As interest rates are high and moving higher, investors tend to look towards the traditional fixed income market for their coupons as it's just safer and it doesn't come with equity risk. You've seen one of the most traditional bond proxy sectors like utilities really take it on the chin this year as a result of that.

Having said that, if you look at the valuations in the utilities sector today, they are actually significantly below where they have historically been when we have the ten-year treasury between 4.5% and 5%. So yes, I think you're getting a fair opportunity and a fair deal on utilities today. But perception is reality, and if investors continue to shun and favor fixed income over the utility space, I think there could be some continued pain to come. We're not actively increasing our allocation to utilities at this time. We have made some changes to our model allocations within the sector just on the basis of discounted opportunities, but not actively looking to add to the sector at this time.

Elsewhere, I would say we have done a fair amount of work in the consumer discretionary space and this isn't really related to the sector at large, but more so what we would call balanced opportunities within the space. Companies in a specific industry that can be fairly resilient in times of economic and corporate stress, but can also give you a fair degree of upside, should the going stay strong. Things like auto parts retailers kind of fit that bill when we think about some companies that are set up well for this environment, also trying to take advantage of what we would call some secular themes in terms of more miles driven. Realistically, it's not like we're just looking at one sector or finding opportunities in one sector in particular that's really screaming at us. We have a fair amount in our investment review pipeline that is kind of across the board. It's all across the eleven GICS sectors.

Okay, next question. Let's see if I can pull this one up. Okay, on the topic of reallocating some cash from money market funds, do you think it is finally time for investors to lock in some bonds with longer durations? I.e. 10-year or 20-year muni, corporate, and treasury bonds. It's a great question. We have been advocates of extending duration moderately and we've been saying this over the last year. There has been continued pressure on rates to the upside over the last nine months, and that certainly has an impact more so on longer duration bonds than it does on shorter duration bonds.

With all that said, if you think about how far the Federal Reserve has gone from an interest rate perspective, I think the easiest way to think about it is even if we do get another 25 basis point rate hike, the pain felt in the bond market and more specifically by longer duration bonds will not be anything close to the pain felt from 500 basis points of rate hikes. I do think you're starting to get a fair amount of compensation in the belly of the interest rate curve, the active treasury curve. You can think of five to ten years, there's a lot of value there. I think extending farther than that, you kind of have to have a more pessimistic view on the economy to really place a large allocation on longer duration bonds because those long duration bonds are really going to come into favor when you have significant economic stress, recessionary times.

That is a true kind of like flight-to-safety. I don't necessarily think that now is the time to really pile into the long duration space, but for folks that have been, in the very short term, very short maturity space, I would put money market funds in that camp. Anyone who's in the ultra-short duration or very short duration corporate bond space, I think now is certainly the time to start to leg outwards a little bit. You can do it slowly but steadily. You don't have to do it all at once. And that's kind of what we're recommending right now, is that you start to move out into the yield curve a little bit, but you do it slowly and steadily. I just think that's prudent, and again the data would agree with me with regards to the forward returns at this type of juncture.

I think we got one more question that came in. What else are you watching in the economy today? What else are we watching in the economy today? Well, of course inflation is still top of mind. We've been getting a lot of questions around the last two months and how we've seen a bit of a pick back up in the Consumer Price Index, which is used as an indicator or a measure of inflation, if you will. I think it's important whenever you look at any economic indicator to look underneath the hood. So, okay, month over month, Consumer Price Index was up significantly more than expected and more than the prior month. All right, well why was that? What drove that inflation?

Well, as we've seen over the last two months and as we saw today in the Producer Price Index print, which is a measure of wholesale inflation, it was very largely driven by items in the energy space, so gasoline prices. Oil prices have recovered on the back of some Saudi production cuts that have been extended through the end of the year, it's no secret that you're starting to pay higher prices at the pump and it's also no secret that's starting to feed into inflationary metrics. I don't necessarily think that this derails the conversations that we've been having with regards to the trajectory of inflation being steadily downwards. I also don't think that these prints are going to have an impact on the Federal Reserve's decision making. Realistically, higher prices at the pump, I really don't think that one specific category is going to have a very large ability to sway the Federal Reserve, who is looking at a significant amount of data more than just some piece of the inflation story that's very volatile month-to-month. In fact, they are actively looking at items that are less volatile, so excluding things like food and excluding things like energy.

Obviously, we're watching inflation closely. At the same time, we're also watching, throughout the economy, other measures like PMIs or Purchasing Manager Indices, which can give you a read on the optimism or pessimism across the manufacturing and services spectrum from managers who are actually pulling the trigger on corporate decisions. One pretty notable observation we had last month from the manufacturing Purchasing Manager Index was that not only did prices continue to show their descent downwards, but we actually saw a bit of a rebound, a continued rebound in the overall index indicating healthier manufacturing activity. And to me, that doesn't really indicate any doom and gloom in the economy coming anytime soon. That's not generally what you would see in a kind of pre-recession environment. All things considered, we're watching a lot of different things in the economy. But the overall kind of read that we have right now, the first nine to ten months of this year, economic data has just, quite frankly, come in a lot stronger than expected.

You've had a resilient consumer, you've had steadily declining inflation, and you've had a job market that continues to chug along, albeit a little bit slower, in the last couple of months. This is actually a very good place for us to be. You could make the argument, like I did in the last Quarterly Edge, that we're kind of seeing elements of a Goldilocks scenario, so a lot of elements of the economy to watch right now, but those are just a few of them.

All right, I don't have any other questions that have come in. With that, I'll give everyone five minutes back. Thanks very much for joining another edition of Blue Chip Partners’ Quarterly Edge, and we will speak to you next time.