Last week, the U.S. Federal Reserve raised interest rates but, while the U.S. economy grows, the threats of inflation, tariffs and an all-out trade war may dampen future growth. David Pearl, Co-CIO, Epoch Investment Partners, discusses the impact of the Fed’s move, President Trump’s economic agenda and stocks to watch in these uncertain times.
Hello, and welcome to the show. I'm Kim Parlee. It is great to have you with us.
The US Federal Reserve raised its key interest rate and suggested two more may be on the way this year. It was the first meeting chaired by Jerome Powell, who was stuck to script, signaling there would be a total of three hikes this year, even as the Fed gave a more upbeat forecast of the US economy.
For a closer look at this and much more, I am joined by David Pearl. He's the Co-Chief Investment Officer of Epoch Investment Partners. And he joins us from New York. David, great to have you with us.
And I'm going to jump right in on the Fed announcement. And yet, I know you guys aren't a moment-by-moment watching things, and that's not how you make your investment decisions. But given that you're here, I wanted to ask you-- what did you make of what Mr. Powell had to say, and the decision, and the context in which he shared?
Yeah, it was completely as expected as far as the decision to raise a quarter percent. The issue was that when Powell gave his press conference, he inferred that the path of rate hikes, not so much this year, where there's two more hikes expected, but for 2019 and 2020, might have more hikes than expected, maybe by one, so not a whole lot, but a little. So the path of rate hikes might be steeper. And the inference to the market was maybe that the Fed had been a little behind the curve, keeping things too low for too long. That's what actually kind of spooked the market at the very end here today.
Yeah. And do you share that concern? I mean, it's a delicate balance for a Fed to come in and try and do something. I mean, on the one hand, they don't want to slow things down. But at the same time, you've got some fiscal stimulus. It's kind of like priming the pump, and you might have to worry about the engine getting flooded.
Yeah, no, that's absolutely right. It's much easier to lower rates than to tighten. Quantitative easing was easier to do than quantitative tightening. As you raise rates, whether it's in the short end or on long end through quantitative tightening, you have to instill confidence in the markets that the economy is strong enough to withstand the rate hike, that it's warranted to raise rates to make sure that the economy is growing at a moderate pace, and then inflation is likewise growing at only a moderate pace. You want to be ahead of the curve, not behind the curve. But if you're too far ahead, people get worried as well. So yes, it is very, very difficult.
I am not that concerned, given he's just got into the job. The actual rate increase was totally expected.
And the economy is just doing terrifically right now. It is kind of a Goldilocks. We have great economic growth, very low unemployment. It's almost historically low. You'd have to go back 60 years for this low unemployment rate. And inflation has just stayed, you know, just below the 2% that the Fed keys on.
Do you think that that inflation could move up in a hurry? I mean, you've got a lot of things going on. You've got the tax cuts coming. To your point, you've got very low unemployment rates.
Just anecdotally, I remember, I was listening to General Mills give their earnings today. And they talked about the fact they couldn't find any drivers for trucks. And that was causing them to up their costs. I mean, are we seeing sparks here and there?
Oh, there definitely is the beginnings of wage inflation. But you know, if you look back, it has been stubbornly low. And the only conclusion is that technology has moderated inflation. So when you look at the CPI, it's been just below two.
But if you segregate goods and services, goods are in total deflation. Everything we buy, physical goods, has actually gone down. And particularly, electronics, anything with intellectual property has gone down thanks to technology. It's only services, which is labor, which is beginning to go up. So it has been a very slow increase.
So yes, it is a concern, but it has been lagging every prior recovery. And so it has been moderate. We expect it will be moderate.
Let me shift to the fiscal side of things. And I want to let people know who are watching, I promise we're going to get into some names. We'll talk about those in a few minutes.
But if you take a look at-- you know, the Fed made their move. They've given their projections, well, and that's something markets are used to. We're not as used to the fact that you've got a president who is adding fuel to the fire.
I mean, you talk about a Goldilocks right now. And we're putting tax cuts in. And you've got potential trade wars looking to ratchet up. How does that affect your market outlook?
Yeah, I mean, prior to the tariff, almost everything that the administration actually did-- forget about some of the things they say. But almost everything they did was typical Republican policy, you know, tax cuts, less regulation. It's all pro-business, and it has had a very good result economically speaking. It's the tariffs that raise the big red flag.
Now, in this particular case, we would say it really is a deep belief of President Trump. It is one of the constituencies that got him elected. And you know, he's, in effect, paying them back. He believes it will grow US jobs. That's debatable. But in the short term, that might be the case.
Now, the true effects on the United States right now are very, very small. For instance, steel and aluminum are, like, 3% of imports. And imports are only 15% of US GDP. So it's trivially small. It's a big deal to other countries obviously.
The truth of the matter is, we have thousands of tariffs today. Europe has thousands of tariffs. So this has been going on a long time. But he is potentially going to ratchet it up.
Now, I think there's consensus that China has been a violator. They have had excess capacity, particularly in steel that has come on the market. So they are the one nation where there is an issue.
And secondarily, or even not secondarily, they have big issues with intellectual property. There is a wide-ranging belief in the US and Europe that they have stolen technology. So there is reason to do some trade tariffs with China.
The issue is what will happen. And you know, there is always a risk that this escalates. So you know, it's very hard right now to say what the answer will be.
Let me start, David, if I could-- I know you've got some names that we're going to talk about. But before we do, given the fact that you've said we do have a rising interest rate environment, inflation, though, seems under control, we have synchronized global economic recovery, still some trade tension, what sectors are best set up to benefit in this kind of environment?
Oh, yeah. Well, this is probably the greatest sweet spot for financials since well before the financial crisis, obviously. It's the combination of rising rates leading to more profitability if you're a bank or an insurance company, lower regulation allowing you to return capital. Tax rate matters because it turns out financials are the highest tax payers in the US, so they get the biggest benefit. And the economy itself-- there's just going to be more loans, more people making investments. So financials are the number one.
And technology has, you know, basically been a driver of US growth. So there are certain demand, secular demand drivers, like the cloud, like different new product cycles that are going into new devices, like an automobile is now just really a computer on wheels driving demand for semiconductors.
And then lastly, infrastructure spending and capital goods. And because of a synchronized world recovery, airplane deliveries and backlogs are at all-time highs.
Let me ask you. It does sound like a sweet spot for a whole lot there, which is exciting, I think, for investors. But is there an asterisk beside the technology? I mean, technology is a huge sector. If we break it out into the subsectors, things like Facebook-- given what they're going through-- I remember speaking with an analyst not too long ago who highlighted the fact that when these companies get seen as utilities, they start to get regulated more, we could have a problem. And is this privacy kind of the tipping point for this, what could happen with Facebook?
Well, that is a distinct possibility. It is one of our concerns about it. You know, there is no free lunch. We know this from investing. So in other words, the service Facebook is giving you for free on the website, your payment is your personal data. Now, there is a implicit relationship that they will protect your personal data. But you know, what we found out is there are ways that companies can get a hold of that data.
You know, this current crisis is something that started, actually, with the Obama campaign. They were using-- they called it data heavy. But it was literally the same data mining that Cambridge Analytica was doing for Trump during his election. So this has been going on a while.
And you know, in Europe, this is a number one concern. So the EU is, in fact, starting to go after this. And now it's raised hackles in the US and on a bipartisan basis. So it is a risk.
Facebook is a great company. They are super profitable. There are other issues, just law of large numbers. But this on top of it, and any regulation, of course, could really hamper their profits and profit growth.
Yeah. Point well taken. Let me ask you about some names. You've given us a few, I know. And this goes back to the theme of the sectors you were just talking about. Bank of America, one that you think is interesting right now.
Yeah, in financials, I wanted to pick somewhat large companies that people would know. Of the four money center banks in the US, Bank of America is really the biggest improvement story, meaning they had the lowest operating efficiency of the major banks. And it has been improving now for over a year. So they're executing.
But there is more upside. One of the biggest things in Bank of America is continued return of capital. They will be now free, due to less regulation, to buy back more stock and raise their dividend, more so than some of their peers, actually. So we think there is more upside to B of A.
All the banks are going to benefit by what I talked about-- better economy, higher rates leading to higher profit margins, and tax rates going down. So it is good for almost every bank. And in fact, for small banks, there is more deregulation that will lead to some consolidation of some of the smaller banks so they're very interesting as well. But of a big name, Bank of America is one of the better ones.
Yeah, and one other-- interesting about the small banks. Another big name, you've got Morgan Stanley.
Yeah, and Morgan Stanley benefits by one additional point. If the stock market does do well, Morgan Stanley is going to do well because it has capital markets. And actually, it's the biggest wealth manager in the US as far as money management and wealth management. So very tied to the stock market.
One of the things that just flipped positively is money markets, that when you put your money in a brokerage account, the cash sits in a money market account. And during quantitative easing, that was zero. Now, zero wasn't good for anybody because, in fact, it costs them money to run a money market. They couldn't charge you. Now that you're going to get maybe a percent or more in interest, they can charge a fee. So it went from money losing to positive. And this is a trillion-plus dollars in money markets. So Morgan Stanley benefits by all of the same things as the banks, in addition, though, the stock market, and rates going up for money markets.
It really is a sweet spot right now, isn't it? Microsoft is a name that I know we've talked about before, but still one you like right now.
Yeah, Microsoft probably has the longest secular growth trend we can see because it's transformed from a consumer products company, basically, Windows and Office, to a cloud company and a subscription business, which is so much better. So now, people are basically paying them a subscription every month to have their IT done in the cloud and to use Microsoft Office on a subscription basis.
Fortune 50 companies have realized it is cheaper and better to have Microsoft do your IT than to have your own IT department. Like for Home Depot, their expertise is helping you refurbish your house or construct your house, not running an IT department. So they've moved to the Microsoft cloud. The payback is really high, and very, very quick.
It's also safer. In a world of hacking, the cloud is much more secure than having your own IT group, where one stray person in the organization let somebody in through phishing or something like that.
So Microsoft is growing the cloud at a 100% year-over-year. And therefore, their revenue and profit growth are accelerating. So this is really unknown. And the valuation of Microsoft is extremely low. It's at a discount to the market. Particularly on price to free cash flow, they're generating a ton of profit.
And by the way, repatriation of profits, they are one of the top companies with overseas cash that now can be brought back for share buybacks and dividend increases. So we love it.
David, I've only got about literally 30 seconds, David. I do want to ask you, and I should have. With Bank of America, Morgan Stanley, Microsoft, what are the risks with those ones? I mean, you know, what's the downside for those three names?
Well, particularly for financials, if rates get too high, it starts to dampen growth. So you really want rates to go up at a slow, measured pace. If they go up too high, for instance, loans and mortgages become too expensive. So it dampens growth. And if the stock market, you know, is affected by any of this, certainly, it will affect financials, and particularly Morgan Stanley. So again, if we predicted that the market would have a correction, it does affect them, although in the short term, volatility helps the financial companies.
And just quickly, if I could, with Microsoft, any risk there?
Yeah. It's not something that is so economically sensitive at this point. But yes, you know, if companies decide to delay spending at all, it will have an effect. So if we had a trade war and companies decide that they're not going to move to the cloud as quickly as they were going to, yeah, that would affect Microsoft as well.
So you know, we'd like this Goldilocks period to last as long as possible. And you know, any macro risk or a tariff risk would be something that could slow it down.
David, always brilliant to talk to you. Thanks so much.
David Pearl, he's the Co-Chief Investment Officer--
--at Epoch Investment Partners. And he joined us from New York.