Weekly Wisdom – October 4, 2023

By Hightower Great Lakes on October 4, 2023

Congressman McCarthy Ousted

The House voted to remove its speaker, Kevin McCarthy, on the evening of October 3. Ex-Speaker McCarthy is now the first Speaker of the House to be removed since 1910, just nine months after being elected. The U.S. government recently passed a stopgap budget agreement that narrowly avoided a government shutdown.

With hardline conservatives ousting their more moderate leader, and uncertainty around who will be the new House majority leader, we expect volatility ahead of the mid-November funding deadline.

Yields Move Higher, Equities Struggle

Bond yields continue to move higher at a fast pace. Elevated yields are concerns, but the velocity of the move is even more alarming. 10-year yields are up 70 bps since early August. The resilient economy is driving the move in yields – allowing the Fed to continue its quantitative tightening (QT) policy.

Multiple government data reports including job openings (JOLTS), ISM Manufacturing New Orders and Prices Paid have pointed toward the U.S. economy’s strength. China has been a net seller of U.S. Treasuries as it raises liquidity for stimulus amid ongoing U.S./China tensions – this also creates a larger supply and higher yields.

At the beginning of 2023, markets were pricing in rate cuts by the end of the year. Many investors have underestimated the price risk in bonds, which can experience losses, particularly impacting investors in longer-duration securities.

Equities, too, are struggling primarily because of the higher rates picture. There is quite a bit of negativity in consensus opinion, despite the fact that the S&P 500 is up 9% year to date and the Nasdaq is up 24%. It may look like a formidable time to take profits here, but there are reasons to stay the course on equities.

Third quarter earnings have the potential to be better than expected due to the economy holding strong. We remain selective, favoring high quality companies with strong fundamentals, and avoiding high-multiple, interest rate sensitive companies.

The Atlanta Fed GDPNow is currently projecting 4.9% for the third quarter. There is finally competition for equities when compared to the last 10 years, including cash-equivalent vehicles yielding 5%, four-year municipal bonds paying 6% on a tax-adjusted basis and compelling four-year paper.

It is also important to look at the historical trends; the long-term average S&P 500 annualized total return is 10.5% and the aggregate U.S. bond index (AGG) average total return is 2.7%.

Earnings Season Kicks Off With Some Bright Spots

Third quarter corporate earnings are upon us, and we see it fit to offer insights into some of the early reports. Thus far, we have seen some positive results from retailers and a memory chip producer which provided a mixed outlook but remains situated for a strong recovery.

Given the many crosscurrents in the economy, ranging from decade-high interest rates, a possible government shutdown, a strong U.S. consumer and a stubbornly tight labor market, management commentary offers a differentiated, boots-on-the-ground perspective of the economy.

We have confidence that the U.S. consumer will continue to spend, as retail sales have come in better than feared and wages continue to provide consumers with cash on hand. Considering that savers are being rewarded with 5% cash returns, there is still spending availability. We like to remember that U.S. consumers account for 70% of U.S. GDP.

Stronger Back to School

Nike (NKE) began its fiscal year with a stronger-than-expected earnings report, which points to consumers willing and able to spend. Nike highlighted strong back-to-school trends where it sees sales strengthening into the quarter. Total Nike brand sales were up 2.5% y/y, with regional outperformance coming from China showing +12% growth ex-currency, and Europe, the Middle East and Africa showing +6% growth ex-currency.

To quell investor fears, Nike reiterated full year guidance, market share growth in North America/China, continued progress on inventory levels and positive commentary around its innovation pipeline. This is an important narrative before retailers’ favorite time of the year: the holiday season.

Now that most retailers have made progress on right-sizing their inventories, we are watching to see how retailers will fare over the next couple of months with a stronger-than-expected consumer ready to spend into the holiday season.

Besides the destocking theme, e-commerce has been the other dominant trend in the retail industry over the last couple of years. The pandemic dramatically accelerated this theme by putting pressure on companies to invest in their e-commerce platforms. It seems like the true winners were able to balance them both. Nike, for example, has led the way with a strong presence in the Nike app as well as utilizing its retail locations to display new products for customers to see in person.

When thinking about strong retail footprints, Costco (COST) is one of the first that comes to mind. It reported +3.8% total core sales and +5% traffic growth last week, continuing to take market share as its value offering is top tier for consumers. Membership growth continues, up 7.9% y/y.

Margins largely came in line, but we found an important tidbit that the disinflation trend continues to make way at Costco. In Q1 2023, the company was still experiencing inflation of 6-7%, fast forward to today and disinflation has retreated to 1-2% levels. This will be beneficial to consumers and management teams alike.

Semiconductor Inventory Reset Still Underway

Semiconductor stocks have been some of the best performing stocks so far year to date (YTD). The VanEck Semiconductor ETF (SMH) is up 40.91% YTD, however, down 11% from its high on July 31. There have been two main drivers to the poor performance in the past two months.

First, a continued trend higher in U.S. Treasury yields, which recently hit 15-year highs, has driven investors out of interest-rate-sensitive technology stocks. Second, following Nvidia’s (NVDA) fiscal Q1 earnings report, AI exuberance drove most technology growth stocks higher at an unsustainable rate, and a sell-off has since ensued.[1]   

Micron Technology (MU), a company that manufactures memory chips that are found in essentially all technology hardware – including data center servers, computers, automobiles, phones and industrial machines – reported fiscal Q4 earnings that beat consensus estimates, however, provided a mixed outlook.[2]

While the company guided revenue above estimates, profitability remains under pressure due to continued work down of double and triple ordering over the last three years. Management noted that data center inventory is improving, yet will not normalize until 2024, signaling there is still a ways to go.

Despite the tepid outlook, management signaled that it is reallocating idled equipment previously used for lagging-edge chips toward leading-edge chips. This is indicative of increasing demand for more expensive chips, leading to higher margins and better financial performance.

Within the semiconductor industry, fundamentals continue to improve as supply and demand come back into balance. Going forward, we will continue to monitor earnings from other semiconductor manufacturers as an upcycle is on the horizon. Semiconductor research, development, manufacturing and workforce development will continue to be subsidized by the $53 billion CHIPS Act, providing a long runway for industry growth.

Chart 1: United States Dollar Index [3]

Dollar Strength

The strong U.S. dollar (USD) may weigh on U.S.-based multinational companies’ earnings during this third quarter. Bloomberg’s Dollar Spot Index, which tracks the performance of a basket of ten leading global currencies versus the USD, rose ~2.7% during the third quarter.[4] For reference, this index rose nearly 6% in the third quarter of 2022. The impact felt by a strong USD on North American companies was a notable $43.15 billion in the third quarter of 2022.[5]

Although the Bloomberg Dollar Spot Index has not risen as much in the third quarter of 2023, when compared with the third quarter of 2022, it may still pose a significant challenge for U.S.-based companies with foreign revenue exposure. The U.S. dollar strength is due to the U.S. Federal Reserve’s continued interest rate hikes.

Currently, Bloomberg is estimating that there is a ~30% chance of another interest rate hike during the Federal Reserve’s November 1 meeting, which should theoretically add to the USD’s strength.[6]

When the USD is strong, it makes a company’s exports more expensive to foreign nations, therefore making them less competitive in a global marketplace. On top of foreign goods and raw materials being cheaper than domestic, any earnings made in foreign currencies must be exchanged by U.S. multinational companies for USD.

In simple terms: the stronger the USD, the less the U.S.-based companies will earn when foreign currency is exchanged. Philip Morris (PM) has already estimated that currency impacts will fully offset its strong business performance for Q3. We expect that this is just the beginning of currency impacts to Q3 earnings releases.

Click here to read last week’s Weekly Wisdom (9/28).

Disclosures

Investment Solutions is a group comprised of investment professionals registered with Hightower Advisors, LLC, an SEC registered investment adviser. Some investment professionals may also be registered with Hightower Securities, LLC, member FINRA and SIPC. Advisory services are offered through Hightower Advisors, LLC. Securities are offered through Hightower Securities, LLC.

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All data or other information referenced herein is from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other data or information contained in this presentation is provided as general market commentary and does not constitute investment advice. Investment Solutions and Hightower Advisors, LLC or any of its affiliates make no representations or warranties express or implied as to the accuracy or completeness of the information or for statements or errors or omissions, or results obtained from the use of this information. Investment Solutions and Hightower Advisors, LLC assume no liability for any action made or taken in reliance on or relating in any way to this information. The information is provided as of the date referenced in the document. Such data and other information are subject to change without notice.

This document was created for informational purposes only; the opinions expressed herein are solely those of the author(s) and do not represent those of Hightower Advisors, LLC, or any of its affiliates.

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[1] Source: CNBC. As of May 24, 2023.

[2] Source: Barrons. As of September 27, 2023.

[3] Source: FactSet. As of September 20, 2023.

[4] Source: Bloomberg. As of October 3, 2023.

[5] Source: Reuters. As of February 1, 2023.

[6] Source: Bloomberg. As of October 3, 2023.