TERADAT SANTIVIVUT
U.S. Fed Chair Jerome Powell says inflation is starting to ease, but that more interest rate hikes are still likely needed to cool prices. Justin Flowerday, Head of Public Equities at TD Asset Management, speaks with Greg Bonnell about the market implications if rates go higher than expectations.
Transcript
Greg Bonnell: Markets rallied to start the year on hopes Fed rate hikes were nearing an end. But booming US job creation may have some investors wondering why aggressive rate hikes aren’t having a bigger impact on the economy and what the Fed might do about it. Well, joining us now with more, Justin Flowerday, head of public equities at TD Asset Management. Great to have you back on the show, Justin.
Justin Flowerday: Great to be here, Greg.
Greg Bonnell: All right. So we got a lot to parse through. Let’s talk about that. Let’s talk about the fact that we went through an aggressive rate hiking cycle. We definitely saw the impact that it had on a number of asset classes. But the labor market is so resilient. How do we square these ideas?
Justin Flowerday: I mean, that’s the mystery. And you look back over the last 50, 100 years, and the impact of 450 basis points of Fed hiking is clear. Credit creation slows. Aggregate demand slows. Business owners lose confidence. They stop hiring as much, and obviously, unemployment begins to rise. And that’s the series of events that typically takes place.
This year is a little different. And we saw the first few dominoes start to drop, right? Credit creation has slowed. Business owners are not as positive, but that kind of last half of that equation just hasn’t played out.
I think it’s due to a couple reasons. Number one is this really big kind of chunk of savings that consumers have on their balance sheets. And they built it up over COVID, and they’re working through it now. And I think that’s dampened some of the impact that higher food costs have had and higher gasoline prices last summer had. They were able to offset that, and demand didn’t slow as much because they used their excess savings.
I think the other part of it is this kind of re-engagement with the real economy and all the kind of pent-up demand to do stuff, to travel, to go to restaurants. You really saw that last Friday with the huge jobs numbers that you’re referencing. Over 20% of the new job creations last month was in the accommodations and food services kind of category. So I think that plays a big part of it.
And then the last one, I’d add, relates to just the fact that we came in with a really tight labor market. And we saw, obviously, a big discrepancy between the amount of people that were looking for jobs and the amount of jobs that are available. And that just takes a long time to work through. So I don’t think it’s necessarily this time is totally different. I just think maybe this time the timing and the sequence of events may take a little bit longer.
Greg Bonnell: That leads us to what the Fed might have to say or do about it. I mean, when we heard from Jerome Powell, he did say, listen, if we continue to see– or paraphrasing– we continue to see all of the strength in the labor market, maybe, just maybe, the terminal rate, the place we end, is going to be a little bit higher. That still seems that card is still in play.
Justin Flowerday: Yeah. And look, I mean, it’s funny. Just when you thought, look, we’ve got inflation under control and the Fed’s not going to be as big of an impact on the markets, everyone, yesterday, you saw it during the announcement, hanging off every word that Powell had to say.
And so this is still the big question: What’s the terminal rate? When is the first set of cuts once we start to see the economy slow? And people are trying to get their head around it. I think what Powell did yesterday was he pushed that out from, particularly in the US, late this year cutting, which is what was in expectations, to sometime early next year. And I think the market is starting to realize, yeah, we might not get a rate cut this year. And I think that’s a bit of news for the market.
Greg Bonnell: Definitely. And D, let’s talk about the other big pieces of news that’s been happening for several weeks now. We are in the thick of earnings season. We had warnings. You and I had discussions last year about when are we going to finally see what was being billed as an earnings recession. Are we starting to actually see some, I won’t say honest, but more realistic commentary from corporations?
Justin Flowerday: Absolutely. And it’s funny, because this is the first quarter of that earnings recession, the first quarter in three years that year-over-year earnings have actually declined thus far. And a lot of it has to do with just the operating leverage and the negative operating leverage that is in the system. And you’re just seeing, it’s not that companies are not growing their revenues anymore. They’re still growing their revenues. They’re just– the cost profile is– and the growth of the cost is just a little bit higher.
And you’re seeing it kind of across the board in terms of companies coming out and saying, yeah, no– McDonald’s (MCD), people are still buying burgers and shakes and fries, and I’ll get the nuggets too. And the demand is still there, but they’re saying labor costs are higher. And so their margins are suffering. And they’re actually taking it as an opportunity to push out, push down full-year guidance in terms of operating margin expectations.
Magna (MGA) had the same thing. They said, yeah, no, we’re still expecting $38 billion in revenue, a nice healthy number. But we’re going to see higher costs, and so our operating margin profile is going to come down a little bit. And a lot of these companies are setting this up now in order to lower the expectations, which again is a really positive thing.
We needed to see that. Coming into this year, we had– particular, mid last year– expectations for earnings and expectations for margins were way too high. And they’ve started to come down. And it’s a healthy reset for the market.
Greg Bonnell: Now, the markets are supposed to be forward-looking instruments. We saw a pretty healthy start to the year in January. We’ve had these concerns about what we were going to get out of corporations when they started to realize what rising costs are going to do to them. Have the markets, I guess the question is– and people are trying to wrap their head around– have they priced it in already in the last year’s sell-off and we’re beyond that, at least from an equity perspective?
Justin Flowerday: Yeah. So, I mean, Januarys are typically wild. And this one was really wild. And you saw some big, big moves, some really big short covering from some of the companies that got hammered last year. And so if you look at the sectors that were up in January, you have consumer discretionary, communication services. And consumer discretionary is Tesla (TSLA) and Amazon (AMZN). Communication services is Meta (META). And Meta’s up 60% year-to-date. Alphabet (GOOG, GOOGL).
And so these sectors, real estate had a big run. Technology’s had a big run. These sectors have been leading it. These are the sectors that were weakest last year. So this is a big short covering rally. We didn’t hear anything from management teams during earnings season that gave us the impression that fundamentals have bottomed and everything is going to be rosy going forward. I mean, if anything, a lot of these tech companies are using this as an opportunity to reset expectations as well.
And I mean, think about some of the layoffs we’ve heard in January. I think we counted over 100,000 new, just in the US, layoff announcements across businesses in the US. And that’s not necessarily a thing that’s going to drive revenue and drive new growth for the market, but it is going to help protect margins, and so, it is a positive. But in the very short term, we need to see how demand settles out.
Greg Bonnell: As far as the rest of the year goes, it’s very hard to [inaudible] you said it was a pretty– January can be a wild– this was a particularly wild one. Does it give us any sort of guide, any kind of map to follow for the rest of this year? Or should we just sort of buckle up and get used to wild swings?
Justin Flowerday: Yeah. I’d say from what we heard from companies that have reported and CEOs that we speak with, we speak with management teams every single day, I would say that the biggest positive coming out of this is there is a huge focus on efficiency and a huge focus on making sure that their operations are a little more streamlined.
And it goes back to the jobs comment. All these companies had big pet projects. And a lot of these pet projects are getting kind of shelved. Because in a world of a higher cost of capital, the big focus is on efficiency. It’s on balance sheet flexibility. It’s on financial strength. And so, I think what this does is, if we’re able to have the soft landing, these companies will have a much better starting point in terms of their cost structure to allow that positive operating leverage to come out.
The issue is, this isn’t going to happen next quarter. It’s not going to happen probably in the second quarter. It’s probably a back half to the 2024 thing, when you get through a lot of the cost cuts and then you start to see demand start to recover as people start to anticipate the Fed pivot.
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