FidelityConnects: Denise Chisholm – Sector watch

[00:02:47] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. With July's U.S. CPI reading now booked and showing inflation growth we sit at the countdown to next week's highly anticipated Federal Reserve rate decision. Expectations are still for a cut but the data could serve to muddy the rationale for it in some quarters. Homebuilders are a subsector that often see valuations bottom in the midst of a recession. At the moment though this may not be the case. What is the current set-up for this traditionally interest rate sensitive subsector, and why might its near term future picture for the homebuilders mark the interest rate story less influential to its multiples expansion story? Our next guest reminds us that starting points matter. Please welcome back to Fidelity Connects, Fidelity Director of Quantitative Market Strategy, Denise Chisholm. Hi, Denise. How are you?

[00:03:42] Denise Chisholm: Hi, Pamela. I'm well, I am enjoying the fall weather in Boston.

[00:03:46] Pamela Ritchie: Oh, I bet it's glorious. It is a lovely time of year. Great to have you with us here. It's lovely here in Toronto as well. Let's have you just give us a couple of thoughts on the inflation report. We saw CPI this morning, it was higher. It was expected to be higher. Nobody's really flinching. Is that sort of, is that right?

[00:04:05] Denise Chisholm: I think that's right in the sense that nobody flinched. Certainly, the market didn't. I think overall CPI came in a little bit higher. Core CPI came in in line. The interesting part is always remember that the Fed focuses on the PCE deflator which does run a little cooler statistically than the CPI overall. The PCE deflater is made up of elements that are in the core CPI and elements that are in the PPI that we got the day before. You put those two together and most analysts are actually estimating a .2% rise in the PCE deflator. So yet we sit again wondering if we will see a broad-based rise in inflation from the impact of tariffs. It keeps getting delayed, or we're not really seeing it be in a broad-based fashion, which again gets back to the point that the Fed can, has the potential to, renormalize policy because inflation hasn't arced up the way that I think they initially thought that it would going forward. I do think this probably cements the odds for a cut with the next meeting. I think that that creates an interesting dynamic for the market because we still are in this kind of slow growth but not a recession format of the U.S. economy which when the Fed is cutting because they can, tends to be bullish for equities.

[00:05:28] Pamela Ritchie: It's so interesting. As you say, the cut could transmit through to equities and make that picture a bit shinier overall. You're looking in some recent research specifically at the sub-sector for homebuilders. They traditionally are very cyclical, very interest rate sensitive. It's an area, of course, you think of housing, anything to do with it being very interest rate sensitive. But you're looking at something that shows a little bit of a disconnect there and that they have their own story outside of the interest rate story. How are the homebuilders set up at this point?

[00:06:02] Denise Chisholm: They do have their own story in terms of valuation. I mean, as much as I say the U.S. economy has not been in recession, certainly not a broad-based recession, there have been segments of the economy that had been in a rolling recession, and certainly housing is one of them. We saw residential investment contract in 2022, '23 and we are seeing it contract again. So even though the overall economy is not in a recession you could certainly say that housing very much has been. Now, the reason why we call it interest rate sensitive is because of the math then. With the Fed now being on hold for the last nine months, resuming their cutting cycle again what can we expect from housing stocks? You can see, and I wrote this in my note, that, on average, home sales do rise when the Fed cuts interest rates. That didn't really happen over the course of the last year because usually the translation mechanism is when the fed cuts interest rate 70% of the time long end yields, or the 10-year,  fall and take mortgage rates with them. So the Fed cuts interest rates, most of the time housing becomes more affordable and that spurs demand.

[00:07:06] That transmission mechanism didn't work a year ago but I do think we're in a much, much better position for that to work now. Even, again, with the inflation we were talking about you definitely see a line in the sand. When inflation is above 3.5% on a core basis you don't always see that translation mechanism work. But when you are under 3.5%, and that's exactly where we are from a median perspective on a core CPI or core PCE deflator, which is even lower, you do see that translation mechanism take hold. I do think that this time if the Fed does cut this translation mechanism will likely make housing marginally more affordable.

[00:07:46] Now, the interesting part this cycle is really the valuation level of homebuilders. That is very much what is different this time because, like I said, what is different is despite the fact that the overall economy is not in recession housing very much is and we are seeing a contraction. What we're seeing now is what we've seen, this rotation into growth stocks, which I still like, technology is still a positive risk-reward, has left a lot of these interest rate sensitive sectors for dead from a relative valuation perspective. That, in and of itself, usually carries 60% odds just valuation of homebuilders working. You add in a Fed rate cut and all of a sudden with that translation mechanism you're approaching 90% odds which is a really strong risk-reward scenario when you think about market.

[00:08:35] Pamela Ritchie: If we go to the mortgage story, there's actually a lot in the headlines. In Canada there's a homebuilding discussion going on, sort of a national story here. In the U.S. there is a big mortgage story which has to do with the spin-off, we think, of Fannie Mae and Freddie Mac which are backers and they're kind of state entities on some level, aren't they? What will that release into the market in terms of momentum for your average person seeking a mortgage? Is there a particular connection there or is that more outside baseball?

[00:09:10] Denise Chisholm: There could be. I mean, I think that this is the debate. To the extent that there are buyers of mortgages, and to the extent that these buyers of mortgages are backed by the federal government, and that's sort of the sticking point in the debate, you can certainly see a situation where, among all the other differences this time, one of the main differences is that mortgage spreads, the delta between mortgage rate and the 10-year Treasury or the 30-year Treasury, has been at all time wides because of QT from the Federal Reserve, meaning that they've been selling mortgages. To the extent that this buyer or a natural buyer of mortgages could actually create a situation where mortgage spreads fall more than they have certainly in the last year, year and a half, you could even see a situation where, as much as the last time, there was almost zero translation mechanism from the Fed cutting to mortgage rates--

[00:10:04] Pamela Ritchie: It even went up.

[00:10:06] Denise Chisholm: --this time it could be supercharged the other way, meaning it might take a more minimal Fed cut to see a situation where mortgage spreads decline much more than you would think. That actually might create a positive risk-reward. And again, there's also rumblings out there, not just with Fannie and Freddie in that spin, but maybe if QT itself stalls or stops in January, that could also create a backdrop for more normalized mortgage spreads, which might mean that mortgage spreads fall more than you would think in any given Fed cutting cycle.

[00:10:41] Pamela Ritchie: So QT, the Fed just stops buying up mortgages, essentially.

[00:10:46] Denise Chisholm: Selling.

[00:10:47] Pamela Ritchie: I mean, sorry, selling.

[00:10:48] Denise Chisholm: They bought them all in 2020.

[00:10:50] Pamela Ritchie: Stop selling them. That's fascinating. The picture of the homebuilders themselves going through whatever sort of trough, you'll take us there, that they're in, what is sort of the backdrop of the home builders? They've had these enormous cycles, they're cyclical, through ... coming out of the great financial crisis as well as the pandemic, they've had these massive moves. Are we at sort of the cusp of another massive move?

[00:11:17] Denise Chisholm: Well, it's interesting. The fun part of my job is to look at the data when you go back in history and really evaluate which sectors and industries and sub-industries have become more profitable over time. Homebuilders would be a case in point where you see that generally speaking in the, let's call it '80s, '90s and maybe even the early aughts, it was really not a for — I don't wanna say it wasn't a for-profit business, but they certainly didn't maximize profitability. I think that that all changed in the late aughts, and certainly after the financial crisis. If you chart operating margins or returns we are seeing some of the highest levels in the data that I had going back to the '60s. Now they're down off all-time highs of 2020 where you would certainly say that the builder stocks and anybody exposed to housing was over earning, and you've seen a substantial decline in operating margins since then, but even just from a steady run rate perspective these are much, much more profitable companies than they ever have been when you compare them historically speaking.

[00:12:19] That's the interesting part to me because, for the most part, the valuation levels have not changed. The absolute valuation levels are roughly the same as where they have been in the past. No real difference despite the fact that these are much more profitable companies than they ever have. On a relative basis, and this gets back to the interest rate sensitive sectors left for dead, on a relative basis they've massively derated relative to the rest of the market as we've seen this shift towards technology, which is in its own more profitable. Now, the interesting part to me is that as much as I still think that technology is a risk-reward, a positive risk-reward, I do think that we need to be open minded that there are many other sectors and many other areas that we should be looking at as investors. Given this is sort of teed up by it being different this time you might have a better translation from the Fed cutting to overall interest rate sensitive sectors, plus the fact that a lot of this is already priced in with the relative valuation being where it is, I think that creates a unique set-up where the interest rate sensitive sectors might even be able to keep up with those more cyclical technology-oriented sub-sectors like semiconductors.

[00:13:37] Pamela Ritchie: That is fascinating. You mentioned operating margins are at their lowest. They've been able to make sure those are a place that's manageable for them. There's a big discussion about margins certainly across many different sectors and industries but it seems like particularly in the homebuilding side of things, I mean, it's only anecdotal but it seems like everything's incredibly expensive for costs towards anything to do with home improvement, building and so on. Is that not the case for these companies?

[00:14:07] Denise Chisholm: No, it's definitely the case. There actually is, in a segment of the PPI there is the construction PPI for builders specifically that you can look at. I wouldn't say that it's gone up a lot since the pandemic but it hasn't gone down at all,  meaning that the builders saw this massive cost shock and it hasn't gotten any better since. I would say that on the margin it hasn't gotten any worse either, at least the way I look at the data. We've already seen a pretty significant margin decline. Again, always remember that as much as, yes, costs are high, and in some ways housing is uniquely unaffordable, it is very different this time, the question as it comes historically is, do these stocks price in bad news ahead of time? Meaning is there a situation where, yes, costs are high and continue to go up and, yes, housing prices have to come down and are you at the valuation where the stocks can work anyway? When I look at the math of that, that's exactly the situation I see.

[00:15:08] The odds that when margins decline do homebuilders decline with them? Actually, most of the time they don't. In fact, a lot of their outperformance comes when margins are declining, which doesn't tell you that margins declining are good but it does tell you that the stocks have a really strong track record of pricing in that bad news in advance. The interesting part for me, at least in sort of the rock-paper-scissors world of probabilities, when you look at house prices. On a national average, 2009 was really the exception, not the rule, where housing prices declined. Maybe that is the situation currently.

[00:15:57] Well, interestingly enough, when you look at the starting point as your point, starting points matter, when you're in this level of valuation, meaning the bottom quartile, yes, you underperform on average if you're a homebuilder stock in terms of relative to the S&P 500 but not by a lot, about 300 basis points. Your downside is fairly limited because, again, historically speaking stocks have usually priced in the bad news ahead of time. If you are wrong and home sales do bounce and that translation mechanism does work, you have about 30% upside. From a risk-reward perspective we usually like to use three to one. I like three to one my upside to downside. This is more of a 10 to one. I think, again, there are no guarantees, certainly in the stock market or really in life, but when you see a risk-reward like that I do think that there's a fair amount of alpha to play for.

[00:16:51] Pamela Ritchie: That is fascinating. There are a lot of offsets and other things that come into the story. Interest rates is a massive, blunt instrument that we know about for this particular sector but what about on the policy, on the fiscal policy side of things? The one Big Beautiful Bill, we've got the tax cuts. You have to imagine for homebuilders all the lines of depreciation that they can add in earlier on and so on will have an effect as well. How does the fiscal policy side of things fit into this?

[00:17:20] Denise Chisholm: No, that's exactly right. I mean, for corporate America if you sort of do the math of a potential headwind from tariffs, which are the cost shock, and then sort of to do the math of the potential tailwind from the legislation that was just enacted, it's two to one positive legislation versus the tariffs that we've seen. I don't think builders are any exception. In terms of capital-intensive businesses, this is a boom so you will see more profitability. I mean, it's an odd time to think about it because we're seeing in the overall economy there's very, very little job growth and potentially now a negative revision that might actually lead to a contraction in job growth that we'll see now in retrospect. With that, you are seeing not only right now with profits growing 10% but you're actually seeing quite a strong tailwind for profits over the next 12 months. To your point, homebuilders are really no exception. So you do have a tailwind on top of this starting point in terms of relative valuation so it does increase your odds that you get that dual tailwind of you get better earnings growth and valuation expansion, which is something that we're always looking for as investors.

[00:18:28] Pamela Ritchie: Fantastic. A couple of questions going to different sectors. We might circle back to this one as well. Asking for your outlook, I think this is at the bottom, for oil, gas, the energy side of things. Looking a little further out, so a year and beyond ... it's been a rough go, there's lots of oil, how do you take a look at the energy sector, that particular part of it?

[00:18:51] Denise Chisholm: I think it's still going to be rough. I think that the main reason why it's so rough is the renormalization in profits. Look, that can go two ways. I mean, it can go quickly in time, meaning that profit margins can fall a lot and maybe you'll get a different answer from me in six to nine months. Or we can sort of drift lower, like we have been drifting lower, and it takes two to three years to get to more normalized profit levels. To me, this is the biggest statistical headwind for the energy sector, which is to say that 2022 was the most profitable this sector has ever been. That's a problem from a starting point perspective. When you have an oversupply situation, yes, we can debate how oversupplied it is but when you have that situation on top of the fact that you are already starting from a very profitable level, you are much more likely to continue to normalize. That means the energy sector is seeing margin compression at the same time where other sectors in the United States are not seeing that. So from a relative perspective it looks much worse.

[00:19:56] Now, I think that there are a lot of investors that say, well, the fact that the stocks are cheap should offer some downside protection. This is where I think history can help. I can show you the statistics that that's usually true in homebuilders. I can show you the statistics that that's usually true in technology. And I can show you statistics in energy where that has not been the case historically. Energy is the only sector where you get trough multiples on trough margins, meaning you get bad business conditions and you get cheap stocks on top of it. That makes them very tricky to play to be early from the cycle but it also makes them go up a lot when you have that bottom of the cycle because they're one of the only sectors where you get that dual tailwind coming out of a downturn. So there will be a time when energy can not only keep up but will easily beat the market but I don't think that we're there yet, and it could take as long as two to three years to get to those normalized levels.

[00:20:54] Pamela Ritchie: That's fascinating. Let's ask, actually, just for your sector line-up, top and bottom. I think you said tech, tech, tech for your top three in the past. Let's get those in. I want to ask you about Fed independence because we really need to get your thoughts as we get closer to this meeting. But yeah, top three, bottom three in the sectors.

[00:21:12] Denise Chisholm: I will say my top three have basically been the same, tech, financials and consumer discretionary, and I keep changing the rank order. The last time I really wanted you to focus on technology and then it was financials and then consumer discretionary. I'm going to re-rank them again. Tech is still the first. I do think it's the best risk-reward, they have the best fundamentals in the market. Now I would say consumer discretionary given the rate sensitive nature and the fact that I think that the translation mechanism is much more impactful this time around, and specifically because I think homebuilders are a better risk-reward this time than last time, consumer discretionary is now ranked number two. Financials would still be number three. I do think that as much as I'm enamoured with banks because they have a good starting point on valuation themselves I do think brokers in capital markets look much more interesting from a leverage to the market perspective, which I think that we're in a secular bull market. 

[00:22:02] On the downside let's pick on energy again. I would say that energy is not a sector that I would recommend owning. I would pick on, in conjunction with energy, the utility sector. So, yes, it's in the bottom half of the distribution in terms of the valuation, no, I don't think it's a really succinct AI play just from a sector level. You can certainly say it's one of the better defensive sectors, or at least it has been, but I think that creates its own negative risk-reward. Usually you want to sell utilities after they've worked. They've worked, and while fundamentals isn't necessarily negative I do think that when you see sort of the Fed cutting in a non-recessionary perspective utilities has one of the lowest odds of all the sectors. In terms of not to own energy, utilities and then all adding consumer staples is your other classically defensive sector that I think has a negative risk-reward.

[00:22:54] Pamela Ritchie: Fascinating. So interesting. Such a different skew to what some people look at with the rate decision, it looks like on the horizon. This rate decision has been discussed a thousand different ways because there's a politicalization of the Fed make-up, I'm really curious on what your thoughts are on the independence question. First of all, does it matter if they're completely independent? Maybe they never have been completely independent. Take us to where you see a sort of meeting point here.

[00:23:22] Denise Chisholm: Yeah, I always think that there's a difference between what we debate sort of in the kitchen table format versus what we think is most important for investing in stocks. This is where I think that's there's wide range of outcomes as it relates to this but, I think, to your point, I'm not totally sure that the Fed hasn't sort of had an agenda that was completely independent over the last five years. I think that 2020 certainly we saw an aligned administration. I think that there's a lot of arguments. Are you sure, number one, that this is really a critical difference from anything that we've seen over the past six years? So number one, you have to make that that is an argument that, again, I'm not really sure. I think number two is that you also have to argue that now we think that policy from that perspective is that the administration will get exactly what they want to get. We've talked in the past of, look, administrations, they can do a lot of things but a lot of the times the ultimate arbiter is the market. We don't have to go back very far to see that. So just because they want a different result doesn't mean they get a different result.

[00:24:37] The third point I think finally is, are you certain as an investor where lower interest rates aren't the correct policy? Because if they are the correct policy then, again, it might not be a situation where the market has an issue with it. I've long since said when you take housing of it, even on a CPI basis, the overall CPI was at a run rate of around exactly 2% for the last 18 months. It's ticked up a little to 2 1/2 % outside housing with tariffs but, generally speaking, inflation isn't a broad-based problem, which means that 4.3% from the Federal Reserve perspective, when there's very little growth in the U.S. economy doesn't need to be that restrictive. I think that you can make a credible argument that interest rates could be lower. I think that you could make a credible argument that there's not really that difference in the Fed over the last six years, and I think you can make a credible argument that even if the administration wants a certain result, they might not get it. All three of those arguments mean that none of this might have the impact on the market that you think it might have.

[00:25:41] Pamela Ritchie: It's so interesting. The phrase data-dependent and data dependence, where does that belong now? I mean, it seems like data has changed, and there are reasons for that. Some of them might be meddling and some of them might be other things, we don't really know, but depending on the data and the pieces of data that come out to guide what the market is trading on and thinking that will guide investment decisions, is that the same as it was six months ago?

[00:26:13] Denise Chisholm: Well, that's the irony, I think. The data dependence, I mean, I think that we can all look at the BLS revisions and we can all say, well, those are big revisions and what does response rates mean and should we change that and make the data a little bit more robust? But I think that at the end of the day you have to step back, look at all those revisions, and I think that we knew this from the beginning, the data-dependent nature and the consensus building of the Federal Reserve has a major flaw in it, to the extent that you are making decisions with data that is heavily revised and not particularly clean does set you up to be potentially behind the curve. I do think that that is something that was ... the market understood that. I think from my perspective, as you say, okay, well, doesn't that have an impact that the Fed is now chronically behind the curve because the data that they get is heavily revised and it's really in the rear view mirror, from my perspective when I look at the data it looks to me more like that the Fed follows the cycle rather than creates the cycle most of the time.

[00:27:14] I say that because as much as people had said, oh, we're going to see the long lags of monetary policy when policy was overly restrictive, and then that's going to cool the economy, look, you chart the data and you look at the quartiles and you say the higher real rates are what do I see over the next 12 months? The more likely GDP is to accelerate. To me, that tells me the Fed more often than not, a), doesn't make a policy mistake but , b), follows the cycle rather than creates the cycle. As much as we can sort of pick on the fact that, hey, the data-dependent nature of the Fed, now looking at the data, doesn't make a whole lot of sense, I'm not totally sure that it is any different as it relates to the economy and the stock market and most of the history that we already have.

[00:27:59] Pamela Ritchie: What does it do then to the discussion of leading indicators? I mean, the non-farm payroll is not a leading indicator and so there's other job pictures that you use to help with that, but can the Fed use leading indicators? It certainly tries but, I mean, are they able to do that if you think, in fact, they're following the cycle rather than creating it.

[00:28:20] Denise Chisholm: I mean, that's the tricky point that I would say, you know, Powell addressed early on, which is to say that our forecasts weren't right for transitory inflation so we will stop making as many forecasts. So they think that their economic models, and look, everybody's got to have a model, all models are wrong, some models are useful, that quote that we remember from 2020, I think that that is the debate. Can you use leading indicators? Well, they can't in terms of the economy. I think it's been a tough slog and, obviously, the GDP changes, the trajectory has changed a lot. For me and my work the maddening part as equity investors is that equities are the ultimate leading indicator and that's the nonsensical part. I just had a conversation with a portfolio manager that said, yeah, but Denise, now we might think that actually jobs are in contraction and that maybe, even, in fact, that the NBER will say in retrospect that we had a mini recession. That's definitely possible if we saw a peak in jobs and jobs persistently decline over the next six months, which I think you've got to be open-minded and say that that's certainly possible, isn't that a problem now that we've snapped all the way back to not only the highs but well in advance of that?

[00:29:31] And I said, yeah, but when I look at the data that's what stocks were already telling you in April. When stocks go down 20% you usually see that negative result follow. What does it mean that stocks have advanced so rapidly? I think it means you need to be open-minded that that was a potentially temporary soft patch and the stock market is, potentially, correctly predicting the fact that growth and profits will rebound. I think that's the situation we're in. If you ask me of a leading indicator I sort of look at that, and it's interesting because you say, well, no, we should think about it the other way, if stocks are heavily valued then that could create a downside view, and what you see is stocks going up a lot usually means that the economy gets better. Now, all of a sudden you start having to bet on the fact that stocks are wrong this time when most of the time they are not wrong, in fact.

[00:30:26] Pamela Ritchie: So that's what it has, yeah, it would have to equal that stocks are wrong--

[00:30:29] Denise Chisholm: Right.

[00:30:29] Pamela Ritchie: --to make that work. That is fascinating. Your perspective, I think, changes all of our views just a little bit each time. Denise Chisholm, thank you very much for joining us. Have a great rest of your day.

[00:30:41] Denise Chisholm: Always great to be here.

[00:30:42] Pamela Ritchie: That's Denise Chisholm joining us here today on Fidelity Connects. Coming up tomorrow, equity research analyst, Nick Everett, he's going to be discussing innovations, disruptions and investment themes shaping the U.S. fintech and financial services sector. Fascinating discussion of all of the different options that are on the table, which ones are investible, we'll discuss that with Nick tomorrow.

[00:31:03] On Monday, portfolio manager, David Wolf, shares how the Global Asset Allocation team is positioned ahead of key central bank decisions. Next week is central bank week. He's going to be expanding on what the rate announcements could mean for markets and also for investors.

[00:31:17] On Tuesday, a special episode with Peter Drake, former Vice President of Tax and Retirement Research at Fidelity Canada. Peter comes back to share personal reflections and professional perspectives on life after work. He's also going to show how advisors might be able to better support clients through this evolving retirement journey. Thanks for joining us here today. Have a great rest of your day. We'll see you soon. I'm Pamela Ritchie.