Recession worries spiked as the inverted yield curve on U.S. bonds made its appearance last month. But the latest manufacturing numbers from the U.S. and China suggest that the economic worm could be turning. Kim Parlee speaks with Damian Fernandes, lead manager, TD Global Equity Focused Fund.
- Hello, and welcome to the show. It's great to have you with us tonight. The markets saw a massive sell-off at the end of 2018 on rising concerns on slowing global growth, especially from China and the United States.
But after a solid rebound in the first quarter of 2019, the market's singing a very different tune. And then there's the inverted yield curve. So what's the real picture for the economy? And what could that mean for earnings?
Joining me now, Damian Fernandes. He is portfolio manager on TD Asset Management's Fundamental Equity Team. He's also the lead manager of the TD Global Equity Focused Fund, TD Strategic Yield, and TD Balanced Growth Fund. You are a busy guy. That's a lot of funds you're working on.
- I try to. Try to keep busy, Kim.
- Let me ask you, first, it's good to have you back. Let's talk a bit about the inverted yield curve and recession. I mean, you know, people tend to think that's a fairly reliable indicator in terms of what's going to be happening. What's your view on it?
- I think, look, historically, the yield curve has been a great indicator. Seven out of the eight times it's inverted, there's been a recession. But think about what goes into the yield curve, right? It's the difference between the short-term bond rates and the long-term bond rates.
Right now, long-term bonds in the US are 2 and 1/2%. But are they really representing growth? Or is it because long-term bond rates in the rest of the world, in the rest of the biggest economies in the world-- Japan, Germany, Switzerland-- are 0%?
So what's really happening, in our view, is that US rates, especially in the long end, are being pulled down by external factors. Think of it this way, Kim. If you have a compass to give you directions, and the compass is pointing south, and that's what people are looking at the yield curve. The economy is going to head south.
But what happens if you have a really powerful magnet beside that compass? The signals are confused or wrong, right? So the yield curve might be giving us signals of an impending recession. Or there might be other factors influencing what that's telling us.
And we like to look at a compendium of factors, you know, a whole broad swath of them, to see if we're getting the right signal from the yield curve. And when you look across different factors-- manufacturing activity, employment growth, what companies are actually seeing on the ground, inflation-- the other indicators that normally lead a recession just aren't there. So we feel like there's more to this than, you know, what the yield curve is telling us.
- You've brought in a number of, I'll say pieces of data to take a look at those, too. Before we get there, though, China-- you know, that seems to be, I think, for the past few months, when I look at the markets every day, it's always like bad news or slowing news coming up from China. What are your thoughts on what's happening with China?
- Well, the Chinese stock market is up over 25% year to date.
KIM PARLEE: Mm-hm.
- There must be indicative of something happening on the ground. And what's happening on the ground is literally, is that you've had over six months of policymakers in China stimulating the economy. And then, of course, you have what I'll call the sentiment that you'll have a resolve to trade. So that is, you know, reviving animal spirits.
So yo have two things happening. You have accommodative monetary policy in China, easing fiscal policy with, like, tax cuts, and you have a resolve or potential resolve to trade. That is literally, like, increasing, you know, risk appetite. And I think that's constructive.
So I think what's happening on the ground with China is that-- and you saw this more recently in data that's come out from there-- the Chinese manufacturing PMI indices, they turned positive for the first time in over 10 months. So you're seeing on the ground on both sentiment and what you're seeing in terms of data, you're seeing actually like a stabilization and maybe even a move up. This is good.
KIM PARLEE: Hm, all right. Well, let's take a look at some of the data coming out of the States. You brought some charts for us to take a look at. So let's bring up the first one here and see what it is telling us.
And as we ask you, this first chart-- why did you bring this first one in when you came in? Like, why is this one, one that you're watching?
DAMIAN FERNANDES: Sure. Right. OK, what we're looking at here is the PMI-- Purchasing Manager Indices. And what that is, is that these are purchasing managers who buy goods before they go into end production.
KIM PARLEE: OK.
DAMIAN FERNANDES: So before you consume something, it has to be manufactured. Before it's manufactured, you have to buy raw materials. So this is basically polling these people who buy these materials. So it's a very good indicator for the cycle.
You can see here, we have all these points of recessions. And what normally happens is that the PMI turns down, right? So what we're seeing right now, this is where we are.
It actually hasn't turned down at all. It's holding steady. And the most recent data point we had, that actually moved up.
So for us, for me to believe that the US economy is going into recession, I would actually start needing to see this move down, which we don't see. And so the fact that it's stabilizing and looks to moving higher-- because the last data point was higher than the previous one-- gives me some confidence that this mid-cycle slowdown we actually witnessed last year is easing.
- OK. Check on that one. Let's take a look at the next one here. And you've brought in-- this is initial jobless claims. Again, you've got a chart here that shows where the recessions are highlighted as well. So what are you seeing here?
- Oh, this is easily one of my favorite charts, because think about this from an on-the-ground perspective. If you have a job, you'll spend money. You will consume.
If you don't have a job, you will reduce consumption. And you'll walk into the government office and file for unemployment insurance.
KIM PARLEE: Yeah, and you don't spend.
DAMIAN FERNANDES: Exactly. So what this is doing is this is claims data going back for over 60 years. And what you find is, you know, we see these points before going into a recession where claims pick up, right? This is what you expect. People file for unemployment insurance because they've lost their job. But look where we are right--
KIM PARLEE: That's fascinating.
DAMIAN FERNANDES: Look where we are right now.
KIM PARLEE: Yeah.
DAMIAN FERNANDES: We are at over 50-year lows. And the interesting thing is the US economy, for the number of people who actually work, is 50% larger.
KIM PARLEE: What about-- I'm not trying to poke holes. But what about things like the gig economy and things like that? So maybe, you know, you're not filing for a jobless claim. But you've got a job that's temporary, doesn't pay as much. You know what I mean? So there--
- Oh, yeah, there's all these little nuances.
KIM PARLEE: Yeah, this is one data point.
- And particularly millennials are-- but the fact that they're not filing for jobless claims means that they are receiving income from other--
KIM PARLEE: Yeah, it's a striking chart.
- So, you know, we have advice when we speak to clients. It's like maybe just look at an objective data set. Yes, you look at the yield curve. People talk about that. But 50-year lows in claims is striking.
KIM PARLEE: Let's take a look at this. You've got one more here. This is a chart, I think, of the S&P 500. And we're taking a look. The title you've got here is "Has the Easy Money Been Made?"
That's the question that, again, media-- I know, which I am, you know--
DAMIAN FERNANDES: We're all part of it.
KIM PARLEE: There you go. So why are you showing this one?
DAMIAN FERNANDES: Well, I just think-- and I've just highlighted data points there, you know, just almost like tongue in cheek-- has the easy money been made, and how many times people have claimed that the easy money has been made. Look, we just did two things here.
What I want you to focus on is back in 2010, where earnings were, and back where earnings are expected to be this year. The fact that earnings have doubled probably goes a long way in telling you where the market's up over 250% since then. My point being is if you follow the direction of earnings, which follows the economic cycle, like, it pays to be invested. And, you know, if we don't see ourselves go into recession, earnings will be higher. I would expect markets to be higher, too.
- It's interesting. You were showing some pretty compelling data points in terms of where the economy is right now. But I want to get a sense.
I mean, you're not shouting, all clear; it's all good. Or are you? I mean, what are you kind of saying at this point?
- Look, I'm not saying-- there's always risks on the horizon. But as a fundamental PM, our job is to identify companies that can actually grow regardless of these macro concerns, and what's happening with China and the US, or, you know--
KIM PARLEE: Because stuff's going on--
- Stuff's going on. But can we identify companies that will generate cash flows? Because that's what goes into valuation, despite these things.
- All right, let's talk about some names.
- You've got one in the health care sector, Abbott Lab. Why do you like this one?
- Oh, Abbott Labs. Look, Kim, we're in the midst of, like, playoffs, both for hockey and basketball. And you notice it's the same teams that make the playoffs.
It's because winners keep winning. They have good behaviors. And for me, Abbott Labs is one of these companies that just engineers good behaviors.
It has rising revenues every year. It has expanding margins. It has a great management team that's divested business that don't grow. And it's in industries that are on the right side.
So Abbott Labs, the biggest verticals that-- it makes medical devices, so pacemakers, and it does diagnostic equipment, so for example, testing for blood samples. Both these are on the right side of demographic changes, right? People are getting older.
So it creates devices that extend people's lives. Yet we don't have the risk of pharma. We don't have, like, high drug prices. Or we don't have the lightning in the bottle. You're trying to get the next drug.
KIM PARLEE: It's the plumbing of medical almost, yeah.
- It is the plumbing of medical that keeps growing year after year in a quality name that is attractively valued, that's growing earnings double digits, that trades at a 4 and 1/2% free cash, things that just excite us.
- What are-- and I don't want to get-- just to have some balance, but what's a risk for Abbott Labs? Like, when you look, or what are the things you have to consider when you're looking at a company like this?
- The risks for Abbott Labs are sometimes that management might do a deal that might actually destroy capital. That's obviously one risk because it is just so profitable. It looks to expand in the vertical in a different sector. That's--
KIM PARLEE: So management decision.
- A management decision then. But management has shown a history of actually being on the right side of change, of divesting its pharma business, of moving out of low returning businesses, of buying companies that add to its platform. So we feel comfortable with that risk.
The other risk, of course, is political. But I feel like that risk is also less so than it would be for pharma or--
- Insurance, exactly. Much more the points that the current platform of potential candidates is really highlighting.
KIM PARLEE: Got it. OK, next one you have on the list here, Texas Instruments.
DAMIAN FERNANDES: Sure.
- So why now? Because, I mean, it's been a darling for a long time in lots of things. But why now?
- Texas' core business is making analog chips.
KIM PARLEE: Yeah.
DAMIAN FERNANDES: Let me just tell you what analog chips are, because, like, sometimes people are like, analog semiconductors-- what does that mean? It means converting the environment into zeros and ones that can be processed by computers, right? So Texas' biggest businesses are automotive, are industrials.
So if you're in your car, and you have lane-departure warning, and how the computer in your car processes all that environmental information is what Texas' bread and butter is. There's more demand for these end-user applications. And we have the largest company doing it that's extremely profitable-- 60% gross margins, you know, north of 30% net income margins-- that has this great-- what we love-- this great shareholder proposition. Texas' shareholder proposition, their commitment to shareholders, is we will pay all our cash flow back to you in the form of dividends and share repurchases.
KIM PARLEE: Risks for these guys?
- Well, Texas already faced its risk last year. Over 45% of the business is in China. So you actually saw the stock price last year come under some pressure, because you saw Chinese growth slow down.
And so, so much of that-- the Chinese growth slowdown plus trade risks-- affected the stock. But the stock prices started to move up again because concerns around both those measures, trade and slowing Chinese growth, are abating. So, you know, you have a more normal thing.
And look, in the longer run, growth in the industries it plays in should be high single digits. So you could see, you know, a close to high-single-digits, double-digits EPS growth, but all of that cash flow being returned, and 15 years of dividend growth. These are just secular names that have a cyclical angle. But five years from now, they're going to be bigger companies. And like we said in the earlier charts, if earnings are higher, chances are the stock prices are higher, too.
- Yeah. They tend to work in parallel. Damian, it is always great to have you here.
DAMIAN FERNANDES: Perfect, thank you, Kim.