FidelityConnects: Denise Chisholm – Sector watch

[00:03:47] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. For the first time in over three years median earnings growth in the U.S. has turned positive. Our next guest says it's finally looking like recovery just got a whole lot more durable. Are changes to tax policy hindering that path, ultimately, and which sectors could be poised for upside against this backdrop? Joining us here to dissect her latest sector thesis is Fidelity Director of Quantitative Market Strategy, Denise Chisholm. Hi, Denise. How are you?

[00:04:20] Denise Chisholm: Hi Pamela. I am very well. It's nice and sunny in Duxbury, Massachusetts.

[00:04:23] Pamela Ritchie: Oh, fantastic. It's a little bit rainy here in Toronto but I hope the sunshine remains for you. Thank you for joining us. I'll invite everyone else to join us here and send questions in for Denise. The median earnings growth, why is it important? It's something you follow.

[00:04:42] Denise Chisholm: It's important because it's a leading indicator and it has been what has been different this cycle. Everybody's heard me say I think 2022 was the landing, whether or not you call it a very hard soft landing or a very soft hard landing, I do think the landing we saw in 2022 was recession-like and we are in sort of the maybe early to mid stages of what could be a decade long recovery in both GDP growth and potential earnings growth. What has been different in these last three years is that the entirety of the earnings recovery we've seen thus far has really been cap-weighted earnings. It is only now that three years later after what I would call a landing that we are finally seeing the median earnings of a company actually emerge from a contraction.

[00:05:30] This has really been the longest situation in history where you've seen a deviation between median and cap-weighted earnings. Usually there is a lag and it's about six months, we've been 2X that, the longest on record. I think it's interesting that we've already seen sort of the beginning stages of recovery so what might it mean now that the median stock is recovering from an earnings contraction? It likely means it's a much more durable upside, and you can see that in the data.

[00:06:00] Pamela Ritchie: These are companies that are average companies that are not the household Mag Seven, for instance. These are other companies that are more normal sized, I guess you'd say, and so you're watching that part of the economy and those companies have durable ... I mean does it have to do with interest rates is sort of the obvious question here but what else?

[00:06:21] Denise Chisholm: In some ways interest rates might be a factor but the interesting part about recoveries is that once you see how long the earnings contraction has been there's a relationship or a proportionality between the duration of the contraction and then the duration and magnitude of the recovery, meaning that the longer the median contraction has gone the more likely you are to see upside. Sometimes there are just cycles for cycle reasons where yes, there have been tailwinds. We can sort of debate the tailwinds in lower energy prices, in, certainly, the legislation in terms of tax cuts, the tailwind sort of being that predictive of this evolution from contraction to growing again but on some level there is just a time element, meaning that the longer you spend in contraction to the extent that the economy doesn't collapse you usually do end up spending and growing and hiring.

[00:07:18] These are really important, we would call them green shoots if we were coming out of a recession which we're not. We're not in an economy wide recession but we have been in these rolling recessions. We talked about housing being in a rolling recession and the median stock has been in a rolling earnings recession much like we saw, and you can actually look at the charts on my charts of the week, much like what we saw in 2009, in 2001, in 1990 This is in some ways no different. That's why earnings recessions are very predictive as it relates to stocks because at the end of the day with all the noise that we're talking about with headlines there is, for the most part, stocks do follow earnings so for this to be in the nascent stages of recovery is a really strong sign to underpin what I would say is a continuation of the secular bull market.

[00:08:10] Pamela Ritchie: It's so interesting because the durability piece of what you're talking about, there've been a few goes with, okay, interest rates are falling, as you say, a couple years ago, and the broadening out, and it did happen, and then also, oh, small-caps might be a really interesting place, sort of last summer it took a real bid at it and it didn't last, it wasn't durable. Why is this different?

[00:08:36] Denise Chisholm: You're right to question the false starts. I mean, one is time. I mean, three years is a long time to see contraction in earnings growth without a contraction in GDP. Two, I think that we definitely have to talk about just how important the legislation has been as it relates to earnings for corporate America. I still don't think I hear enough commentators talking about that where, yes, there was no change in the statutory rate but when you add up all the R&D expensing and the bonus depreciation pull-forward it's an effective tax cut of almost 7%. That is extremely significant to not only big businesses which definitely see a very large tailwind from this, specifically in the technology sector and the Mag Seven, but it is a very strong tailwind for the average small business as well.

[00:09:23] So I do think that that in combination with lower interest rates, in combination with lower energy prices and time, a three-year contraction, puts us in the sweet spot of saying this is probably not a false start, this is probably green shoots. If that is the case what does it mean over time? It usually means that earnings growth is going to be higher for longer, much more durable and, more importantly, and who knows, it might be different this time, but it usually means that the median company will begin hiring again, which means that the lagging indicators that we're really focused on right now, especially because we don't have a lot of information as it relates to the government shutdown, that might be the lagging indicator that profits. If profits are in fact emerging from this contraction it is likely the pause that ultimately refreshes.

[00:10:17] Pamela Ritchie: That is fascinating, in which case the unemployment numbers that we've seen, the sort of slide and the directional story for that may be coming to an end once you start to see profits which should indicate hiring at some point.

[00:10:31] Denise Chisholm: Right. On the margin you would say ... again, I can't tell you in the next month or two or even three but if you're willing to look out over a year and you look at all the data that we have currently and say, okay, given the probabilities and the relationships that you see in the data is it likely for the employment picture to be better or worse? I would say they're all pointing to better right now. I mean, that doesn't make it so but it does mean that the weight of the evidence is on that side.

[00:10:56] Pamela Ritchie: Let's go into the data story here right now. It does seem like there's going to be a fairly, I don't know if we call this a crisis of data, there's lots of crises when a government is shut down because there are lots of things that aren't happening but just particularly for what we're discussing, the data and the lack thereof, it seems like a moment of review and sort of attempting to make things better and review the way we've been looking at data. Data dependency, that term seems so logical and correct and that's actually something you've always pushed back on a little bit because you thought it, I think, lagged, basically. Are we supposed to stop thinking about data dependency?

[00:11:34] Denise Chisholm: Well, it's a very tricky issue when you think about the Fed. You're right in that it sounds very logical process. I want to be data dependent, I don't want to make subjective decisions, I want to make objective decisions based on the data. That seems to make sense. The problem is with government data is that it's very heavily revised. That is so true in terms of non-farm payrolls that not only we saw the biggest negative revision in history outside of recession but even on a month-to-month basis the variability around 50 that you think is some job growth is between 100 and zero. That's not a data dependent approach that you can really hang your hat on. The question I think is, does that mean now that this cycle is unique in that the Fed is more flying blind to the data, and does that mean it's unique in the sense that they will be late?

[00:12:26] For me, I think that we can tackle that question by looking at the historical data. I find the most interesting relationship in history from the Federal Reserve is that the higher real interest rates have been historically the more likely real GDP is to grow over the next year. Now, this is in some ways very controversial because once we lived through 2022 there was this whole discussion about the lagged impacts of monetary policy, which is to say if monetary policy was restrictive we don't know at what point but at some point that is likely to slow the U.S. economy. The problem is the data shows most of time it's the opposite, which is not to say never. We did see real interest rates spike in 2007 and then we saw the economy collapse. But the question is, in the data is that correlation or is that causation?

[00:13:16] If you say, okay, give me all my data points does that happen more often than not? The answer is no, it's actually the opposite, which means that I think, again, this is my opinions based on the data, that more often than not the Fed already follows the cycle rather than creates the cycle. While we're struggling with is it different this time and is it bad because the Fed is flying blind and because that means they're likely to be late, I would say based on the data I don't think it's a unique cycle from that perspective and they're always kind of late and they always follow the cycle and that hasn't been the definitive reason to own or sell stocks.

[00:13:52] Pamela Ritchie: So interesting. Because they cut interest rates last year and for instance, mortgage rates went up. I mean, it doesn't necessarily have this immediate effect that translates into an investment decision. When did this begin? I mean, data dependency, just go back not that far into Fed history but does it come out of the great financial crisis where the Fed kind of took over some major reins that maybe needed to be taken over at that time? Has it sort of outdone its usefulness at this point?

[00:14:25] Denise Chisholm: It's interesting. I think that they evolved to a consensus organization when they moved from Greenspan, which seemed like there was a whole lot of power in the hands of one person, where I think it became a more consensus data-driven it'll be a committee view. Yes, not only that to a sort of more consensus view but I think that many things changed from a financial crisis perspective. I think there is a lot to be discussed now in terms of the Fed mandate, which is sort of wrapped up in the question of independence, did they have mission creep? Do they have a mission creep? What is necessary in terms of the balance sheet when you think about the benefits and the costs as it relates to  both the Fed, the government and the U.S. economy.

[00:15:12] Now, originally, the Fed back in 1913 was not put in place to manage economic cycles so much but to act as a lender of last resort. When you think back all that time ago the reason why there were so many booms and busts is a little bit of what we might have experienced with SVB, Silicon Valley Bank, what was that, two or three years ago at this point, when people just instantaneously pull their money when they lose confidence. The Fed, basically, was enacted, or in 1913, to stop that process and be that lender of last resort so there weren't these panic crises. Now, since that we've evolved into this dual mandate and what does it mean to have a dual mandate and what does it mean be a risk manager, and then in that risk management approach what does it mean to flex your balance sheet?

[00:16:01] I think all of these are big questions right now in terms of what are the benefits of the policies that we've enacted since, essentially, the financial crisis, to your point, as a regulation or as a regulatory state, and what are the costs? There is a five-year review being sort of constructed as we speak. I think all of these things are coming up in some ways at the right time because I do think that we should all be open to debate about the benefits and the cost to monetary policy.

[00:16:35] Pamela Ritchie: When you discussed a risk manager for the economy, which sounds right as well, there's no way that you could be dictating the cycles because a risk manager is almost always needing to react to the risks that are there and I guess trying to get ahead of some of them. It does sound anathema.

[00:16:57] Denise Chisholm: Yes, and well said. I think that that is the one thing or maybe, you know, I don't listen to all the press conferences but when I listen to Chair Powell that is what I hear him say, is that forecasts are risky because you never really know, of course, we don't, and in some ways he inherently knows that data dependence is risky because you know that the data is revised. He knows this. At the end of the day with that, if you know forecasts are risky and data is risky then, ultimately, you're left with this risk management approach which he highlights. It's sort of not we know that all the data is wrong but let's think about the balance of the data and what the right answer is. Even in this moment of potentially flying blind with the government shutdown and with the lack of data I'm not quite sure that it's going to change what the Federal Reserve does one way or the other because I think the focus is very much risk management in that we already know that the hiring situation is quite weak, and weaker than they expected coming in, and inflation, as much as it's stickier than we thought or stickier that they want it to be, it's also lower than they thought with the onset of tariffs.

[00:18:04] Pamela Ritchie: Right, with the onset of tariffs, I know, that's so interesting. There's a little bit of luck there because they might not, I mean, if the government shutdown had happened, I mean, it didn't but if it had happened a couple of months earlier when we got that big revision, for instance, certain things would have been missed. We don't know what's been missed in not seeing the September numbers at this stage but as you say, there was sort of a pivot to taking a look at the labour market which is deteriorating which, again, might be okay now but you think the cut is in no matter what, or not no matter what, but would you say the cut's in?

[00:18:36] Denise Chisholm: Yes, I would say the cut's in. I don't know about the no matter what but it's back to that sort of balance of risks in the sense that the labour market was weaker than they thought and inflation came in better than they thought. It wasn't as bad as they thought in the beginning of the year.

[00:18:50] Pamela Ritchie: There's some great questions coming in. They'd like you to actually just swing back to the beginning. Can you explain the difference between cap-weighted earnings and median earnings just again, kind of more fully so everyone understands?

[00:19:03] Denise Chisholm: Absolutely. Maybe an average, close enough, like the average stock, the median company is if you add up all the dollars and you just divide it by however many companies there are cap-weighted you, obviously, have a bias towards those larger companies. Nvidia, Apple, Microsoft, they all count more from a dollar perspective so you can either weight it by market cap or you can weight it by dollar. From that context we've been in a cap-weighted earnings recovery for, I think, 16, 18 months, something like that. If you plotted earnings growth that way you would say, oh, well, earnings were in a recession in 2022 and you'd say, ah, and we're recovering. We contracted by, I think, on a cap-weighted basis and now we're growing at 10 to 15%, especially after the tax cut. This looks on a cap-weighted basis, you go, ooh, we're already recovering but if you plot that same thing for the average company or for the average dollars, average earnings, what you would see is that we contracted and we haven't recovered yet.

[00:20:01] The second derivative has recovered but we are still growing at a slower rate, or profits are lower, at a lower level for the average company than they were three years ago. That's different. That's what has made this cycle different, that's what has made in some ways the performance that we've seen from a cap-weighted perspective very different because the fundamentals of the average company just haven't kept up, which isn't to say that I think that this is now the green light for going down the cap spectrum by definition and it's more all about the fact that it finally means that we are seeing a very diffuse earnings recovery. I do think the legislation means that cap-weighted earnings is likely still to grow faster than median earnings but finally for the first time it's all inflecting together. From that perspective it makes everything much more durable because the average company as opposed to just the people who make a lot of money are finally more profitable.

[00:21:01] Pamela Ritchie: That's fascinating. There are many pieces of the one Big Beautiful Bill which is why they coined it as such. The tax implications you discussed a little bit. On the side of regulations or deregulation, essentially, we are just seeing mergers and acquisitions all over the place, IPOs as well bouncing around. There's a real moment. This is largely to do, would you say, with some of the groundwork that's been done on the deregulation front, we are seeing this in the back half of the year?

[00:21:34] Denise Chisholm: without a doubt. I mean, I do think that we are seeing much more on that front now than we did certainly 12 to 18 months ago. That is still all to come. I do think the deregulation story has been the — I don't want to say the last leg but certainly tariffs came first and then a tax cut came after and deregulations is going to take a little bit longer then has been the case but I think that from a regulation perspective, especially for financial industry, this is a friendly environment for the first time in some ways quite a long time so you would expect to see more capital markets activity. You highlighted IPOs and, yes, you're starting to see sort of a nascent pickup but off of a very, very low base.

[00:22:21] People are already asking me are you seeing signs of access? No. Not what we've seen thus far. We'll see. I think that that is still to come over the next year or two or maybe even three which will be the final leg of the stool where it was theoretically global trade rebalancing via tariffs coupled with legislation that will lower the tax rates and also provide opportunity for corporate America to spend capital in the United States coupled with deregulation as sort of that tailwind that we have behind corporate America, that part of the story is still to come.

[00:22:58] Pamela Ritchie: It's amazing. The type of data that you have been sharing with us over the years is a fascinating view and sometimes you do often push back on the lagged nature of the data that the Fed makes decisions on, that most economists use to make decisions. Does every company have a Denise Chisholm slicing the data in different ways that are not at all necessarily apparently what the Fed is using, for instance?

[00:23:25] Denise Chisholm: No. I would say that Fidelity is unique. I will say I know other asset managers, I actually worked in other asset managers and at Fidelity, I always say debate leads to better investment conclusions and we don't have a house view. We really do let people make the decisions with the available information that they find relevant. We're not very dogmatic. I mean, we certainly have our processes which is not to say we don't have any but we're not very dogmatic in terms of the way you must make money at Fidelity. I think that that's just a huge benefit because not every other firm has that ability to have that diversity of thought, where we, maybe it's because we emerged from a retail base which is, look, just make money for your shareholders. That's the goal. If you find a process that you think is repeatable, hey, we'll see it over time. We'll give you a shot.

[00:24:14] I do think people like me which don't exist at other firms, look, I mean, I like to say that I can disagree without being disagreeable. A lot of the narratives in the market, when I look at the data are just, I don't want to say false but more often than not lead you in the wrong direction as it relates to making decisions about your investments. The more I see that in the data the louder I am about it which doesn't always make me popular but I do think that it makes you a better investor over time to understand the other side of the argument.

[00:24:47] Pamela Ritchie: I feel like you can be both popular and pushing back on certain things,  Denise Chicholm, absolutely. There's an interesting moment at the Fed, you've mentioned the review and what they're going to do over the next little while but a diversity of thought was seen in the last meeting. I mean, people disagreed, certainly, with Mr. Miran's bid for sort of a 50 basis point cut but at the same time it was real diversity of thought you could argue. There's other things going on. That was one piece.

[00:25:16] Denise Chisholm: Absolutely. I would say regardless of what you think about the policies or his recommendations I give him a lot of credit for laying out his thought process because that isn't something we have seen a lot from those on the committee, meaning we haven't seen real transparency, what I would say is real transparency. We get snippets and we get headlines and we get tariffs, we're worried about inflation or inflation's sticky, we get sort of soundbites but not a, hey, this is what I believe and why. If we are to get better monetary policy in the future, and we should always be striving to get better, then I think that this is the way to do that, which is to say that it's a bit like investing and the debate leads to better investment conclusions over time.

[00:26:02] Pamela Ritchie: That's really interesting. Would you say that ultimately the earnings season this season is going to be ... I mean, not even more important, it's going to very important but we don't have a lot of other data. You imagine investors would be really cottoned on to any data produced by the companies that they're invested in because they have other things that are not able to tell them the forecast of the economy in the way that perhaps they were once reliant on.

[00:26:29] Denise Chisholm: I think at the end of the day earnings is the driver. This is the most important variable. We're all focused on all of these other headline risks. Like I said, I can't tell you that it never matters but I can tell you based on the historical data I look at is that it often doesn't. It leads you astray. Earnings is core driver. What we're seeing, obviously, as a result somewhat from tax, certainly from tax policy and maybe even somewhat from the Fed, we're just seeing a better earnings picture than we have in history. Now, the interesting part about earnings is that ... I've been doing this job long enough I always find the interesting data, when you start the year everybody says, okay, we expect earnings to grow 12 to 15% or whatever the historic averages are. That's more like 8 to 10. As you go through the year the earnings growth usually tends to skew lower. Maybe you start at 12 and then you end up at 8 or something like that. Almost every strategist that sort of looks at data, I shouldn't say all of them but many say, well that's got to be a bad set-up for the market because you're overestimating earnings. You think that they're going to come in at 12 but really they only end up coming in at 8. That sounds like a bad setup.

[00:27:32] What you find historically is that actually happens, that trend happens in 80% of the years since 1962. We always have overestimated earnings coming into the start of the year. What happens in terms of stocks? Well, stocks go up 75% of time. It's in some ways like a complete non-event to think about that relationship. What's interesting is that here's the not non-event or the very important event is usually when you see that inflection go the other way, meaning that all of a sudden instead of numbers continuing to come down they actually start to inflect higher. That's one of the best buy signals historically. Your 75% average odds go to close to 90 and outside recessions go to 100. It's a very positive environment and that is exactly what we are seeing at this time, meaning that instead of earnings numbers coming down, especially when we started thinking about tariffs and would they be enough of a shock to be a tipping point in terms of recession, people took their numbers down a lot and then they took them back up and now it seems like they actually have to take them back out more.

[00:28:33] This has been a really strong set-up for stocks historically which is why I think, again, when you look at secular bull markets they even last longer than the one we're in. Even when you look back to let's say the secular bull market started in 2009 and say that even the bear markets of COVID and 2022 were sort of blips on the radar in this secular uptrend, they tend to last another 10 to 15 years. If you're interested in that data go check out a white paper that I just co-authored with Roy Justice and Darren Chaboton on secular bull markets and the history therein.

[00:29:07] Pamela Ritchie: That's on your LinkedIn, that's there?

[00:29:10] Denise Chisholm: I'm not sure it's on my LinkedIn. I should post it on my Linkedin. It's definitely on the Fidelity website.

[00:29:15] Pamela Ritchie: Okay, perfect. Everyone can go and take a look at that. Just with a couple of seconds we've got left here, the sector bets. I think we know probably what the top are but let's go through them.

[00:29:25] Denise Chisholm: Certainly technology, still technology is the top bet. I think that that's the most interesting risk-reward. Yes, I know it's regained its multiple over the course of the last month or two. Without a doubt it's not as expensive as it was going into the peak last year but it's certainly not as cheap as it was in April. That does not dissuade me at all. If you've listened to the approach it is that I think it's very tricky to use valuation as a risk reward mitigator or risk management approach just because more often than not the more expensive you are, to the extent that earnings grow the more likely stocks are to outperform. I think for technology you have to focus on earnings growth and I think that they've got a whole lot of tailwinds with that sector in particular. I certainly wouldn't underweight the sector and that is my top overweight. Next to that would still be financials and next to that would be consumer discretionary. I am still interested in homebuilders. I know they haven't outperformed over the last couple of weeks, certainly, probably because of the onset of tariffs but I do think that the risk-reward is favourable. Those are certainly my top three.

[00:30:34] Pamela Ritchie: There's a couple of questions coming in about GDP, the shutdown itself. It means a lot when you're watching some of these headlines. One of the questions is the U.S. economic recovery, what does it mean ultimately for the housing sector? Then there's a question on GDP. I might just put that housing sector question, is it finally time?

[00:30:53] Denise Chisholm: It seems like it's finally time. That's been in a  rolling recession so it is not nearly as in a contractionary state as it was in 2022 where residential investment contracted as much as it did in the financial crisis. We're not there but we are seeing a contraction with ... I do think that you will get the translation this time from lower interest rates on the short end by the Federal Reserve to finally lower mortgage rates. If we get that transmission that usually leads to a recovery in home sales, residential investment and builder outperformance. I think that the risk-reward is there. I think the one negative associated with that is that prices might still be too high and need to come down to get back to median or average level affordability over time. All that said, when I look at where the builders are priced from a relative forward P/E perspective I think have less downside when prices go down as that you have upside when interest rates go down to bolster new activities. I think that the risk-reward is favourable in housing and I do think that backdrop is much better than we saw the last time the Fed was cutting interest rates.

[00:32:01] Pamela Ritchie: Which was basically a year ago and things didn't move. The question on GDP, how much of a drag could the government shutdown be on GDP if it continues? There seems to be some thought that it is going to continue. I don't know what tea leaves you're reading on that one. I mean, we don't really know but what's the GDP implication?

[00:32:22] Denise Chisholm: I have no idea in terms of how long it's going to last. The longest lasting one was 35 days. We've had a bunch that had been prolonged. With that, even those prolonged ones you just don't see any impact on industrial production. If you want to sort of get outside the box and say, well, it's going to be different this time and instead of furloughing federal workers we're actually going to lay them off then you can go back and look at the austerity measures that we did in 2012 where we had a 6% contraction in the federal workforce but it wasn't enough to move the needle because government payrolls still aren't as big as you would think to move the needle for the private workforce. Again, it gets back to almost the math that I did on tariffs which is, look, we can add it all up and we can think about it structurally and we can put it in a model and we could say, geez, I just don't think that it's big enough to move the needle, which is why in hindsight when you look back at government shutdowns it's not really that big of a deal to the market because it ends up not being a big deal to earnings, industrial production, GDP or even jobs.

[00:33:34] Pamela Ritchie: Fantastic. We are so grateful for you sharing your thoughts and time and your incredible analysis. Denise Chisholm, thank you for joining. We vote for you for Fed Chair. There you go.

[00:33:43] Denise Chisholm: Oh, thank you. I appreciate that.

[00:33:45] Pamela Ritchie: See you next time. Coming up on the webcast tomorrow, portfolio Manager, Jed Weiss. He'll be giving us an update on international equities and how big market movers like AI, geopolitics, certainly, are affecting companies in Europe across Asia as well. He's been investing in international markets for a long, long time so it's really interesting to see how this year gets put into perspective. That's tomorrow.

[00:34:06] On Thursday, first at 10:30 a.m., this is Eastern Time for French language webcast. Host Charles Danis sits down with Antoine Guilmain, he is partner and co-lead of National Cybersecurity and Data Protection Group at Gowling, it's a law firm, for a detailed discussion on a range of data protection and cybersecurity issues that may affect your businesses and how to add more value to better protect your clients.

[00:34:30] Then at 11:30 Eastern on Thursday, host Lauren Gardy chats with Bobby Barnes. He's head of Quantitative Index Solutions. He'll take a look at where we are in today's business cycle and some of the factors, ultimately, that he favours to go along with the business cycle.

[00:34:45] On Friday we will be airing a replay of our conversation with Peter Drake. He's former vice president of retirement and economic research on the transition into retirement that he actually went into and some of the lessons that he's learned along the way so make sure you swing back for that one on Friday. Thanks for joining us here today. I'm Pamela Ritchie.