FidelityConnects: Denise Chisholm – Sector watch

[00:00:31] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. Earlier this month the Federal Reserve cut interest rates for the first time this year but did the Fed cut because its conditions allowed, simply pulling back on policy that was too restrictive, or out of necessity, reacting to a weaker economy? How can you spot the difference while it's actually unfolding in real time? Our next guest says that profits may hold the answer there, a leading indicator that can help cut through some of the noise. Joining us here today to discuss all of this and more, including her top three and bottom three sectors, is Fidelity Director of Quantitative Market Strategy, Denise Chisholm. Happy Friday, Denise. Great to see you, welcome.

[00:01:14] Denise Chisholm: Happy Friday, Pamela. It's great to be here. I'm never here on Friday so I love saying happy Friday.

[00:01:20] Pamela Ritchie: We're delighted to have you. Let's begin with exactly what's going on with the economy and, ultimately, why the Fed cut. I mean, the pivot from Jackson Hole was very much to the discussion of the employment picture, and that seems to be the reason for the cut, but that said, why did they cut? Why did this happen?

[00:01:41] Denise Chisholm: Well, we don't really know. I mean, we know what they said in terms of why they cut, and they think they're cutting because they can because monetary policy is overly restrictive relative to their employment mandate. But I think the concern in markets, anytime the Federal Reserve is cutting interest rates you do have to be wary that, hey, half of the time they're cutting because they can but half of time that they're cutting you're actually approaching recession. With the weak jobs numbers is that exactly where we're headed? If history is a guide to that you sort of have two different paths. One where the recession is already discounted, I would argue we have to open-minded that that's exactly what April was, but if not, usually, the Federal Reserve can't actually help you on the way into the recession, meaning that more often than not as much as you would expect interest rates to cushion the blow it usually doesn't.

[00:02:32] Again, going back to that you need to be open-minded, in real time you don't really know why they're cutting, and in some ways what they tell you might not be the real answer anyway. If we look to the data can we point to something that gives us some sort of signal or a bifurcation of options? In fact, you can, and it's profits. Only a third of the time that the Fed is cutting interest rates are profits growing above average. Average is around 10 to 15% and right now we are above those historical averages. That tends to be a really strong starting point. Let's go back to some historical paradigms and say the Fed cutting because they can, that's double the average market returns historically, versus cutting because they have to, those are a little bit murkier because you have to grapple with what the market is discounting. That's a big sort of tip pointing in the direction of the Fed at least cutting because they can.

[00:03:41] Pamela Ritchie: And within that why the connection of profits to employment and unemployment, I mean, I guess now that you point us in that direction  you can see the connection. If profits are up then people are less likely to be fired in those situations. Is that it? You're looking at profitable companies, basically.

[00:04:00] Denise Chisholm: That's exactly right. I mean, I think it's back to sort of the statistics that we always talk about, as much as we as consumers interact with the U.S. economy or any economy, via our jobs, right, our wages and salaries, are we laid off or not? We tend to think that that is the most important thing as it relates to the overall economy and, therefore, as it relates to stocks. What you can very clearly see in the data is if you use that as your investment discipline to either buy or sell equities it can lead you very astray because it's statistically a lagging indicator. What you see is the worst payrolls have been historically, or the worst the revision has been historically, the more likely stocks are to go up over the next 12 months, not down. The relationship is linear. Again, I can't give you 100% odds but what I can tell you is that, ooh, there's a whole lot of historical data saying don't look at that, don't look at that because it's not going to help you make investment decisions.

[00:04:54] Then the question is, well, what should we look at? Because if we think jobs are important what's the leading indicator of jobs? Here we see the same historic relationship meaning that it's linear. The more you see profits grow, the more you go across the quartile of growth spectrum, the more likely jobs are to accelerate over the next year. That makes a whole lot of intuitive sense because if corporate America is more profitable then they're probably more likely to hire rather than fire. Again, there are no guarantees, there are no certainties but what I can say is that when I see data that has these historical patterns I tend to lean in that direction. I don't think it's an accident that the market is hitting all-time highs when the Fed is cutting interest rates. It's around this because profits as a starting point are very strong which might suggest, again, if history is a guide that the softness we're seeing in payrolls is a soft patch that then resurges over the course of the next 12 to 18 months.

[00:05:53] Pamela Ritchie: So it's already happened, as you say, it's lagging. I mean, do we think that the Fed chair and those voting on the FOMC are telling us a slightly different narrative? I mean, they're, obviously, seeing profits are up so why are they telling us maybe something different? I mean, it doesn't really matter, I guess, in the end but it seems like they would have the same info to make that decision on.

[00:06:17] Denise Chisholm: Yeah, I'm not sure that they would ever make the decision based on profitability of companies. As much as they're statisticians I think that that's well outside their benchmark. I mean, at the end of the day I'm not buying and selling units of GDP like they are, I'm buying and selling units of stock or equity investments so the relationships that I see in the data is less relevant to them. I'm talking about stocks and the stock market as it relates to that but look, I mean, it might be the rationale behind why they're not making 50 basis point cuts. We don't really know, right?

[00:06:51] I don't think that they're particularly transparent, or at least maybe other people feel differently but I do read the Fed minutes and I don't find them particularly transparent. In terms of their economic models I'm not sure that we have the full picture, but what they have said is look, we think we can cut because our employment mandate is a little bit weaker than we expected but we don't think that we need to cut with haste because we don't think that the economy is weakening quickly. In some ways that might be a function of, well, if corporate America is profitable then we are seeing weak growth in terms of jobs but we expect it not to be persistent. Maybe that's the exact reason why you see a bunch of 25 basis point cuts instead of a bunch of 50 basis point cuts.

[00:07:36] Pamela Ritchie: And, of course, there was one member voting for a 50% cut. We know that was Stephen Miran and we knew that he literally flew into that position just in time to vote, but he also made some comments around it. I'm curious, there's much discussion about Fed independence, what do you think about what he said and the reasons for, in his mind, a 50 basis point cut?

[00:07:59] Denise Chisholm: I found it fascinating. Back to what we just were talking about which is I find the Fed, for me, and again, this is Denise Chisholm's opinion, not to be particularly transparent on why they do what they do and how they see the economy playing out. He laid out a very cohesive view that you could argue with, you could debate about, which is very rare from a Fed policy, somebody on the FOMC. It's interesting that you saw that but from my takeaway and again, he said a lot in terms of the information and why he would recommend a 50 basis point cut, but one of the reasons was because R-star is lower. R-star is your normalized run rate of growth, what you think that the underlying growth rate of the U.S. economy is.

[00:08:43] In some ways that makes a ton of sense to consider when you're thinking about policy because you're going to have a different interest rate on a nominal basis if you think the run rate of your economy is growing at 2% versus you think it's 4%. That's going to be very different structurally. That's why we always have to struggle with what neutral is and what the .... there should be a proportionality between your nominal interest rate and the underlying growth rate that you think that the U.S. economy can achieve. The interesting part is that he said I think we should cut interest rates more because the underlying growth rate to the U.S. economy is weaker than we thought. That's my interpretation. I think that there is some debate of the interpretation of those views around the savings and investment and CapEx expenditure maybe changing the dynamic behind that.

[00:09:29] But look, I mean, to the extent that R-star is lower then interest rates can come down but that might not actually be the most beneficial setup for the U.S. equity market. Remember, I always say that you have to step back and look at the data. When you look at interest rates both on a nominal and real basis more often than not higher rates are a reflection of growth rather than a deterrent to it, and more often than not that's a good thing for U.S. stocks. Be careful when you say as an investor we want lower rates. Maybe you want marginally lower rates because we don't need to be overly restrictive but we don't want lower rates in size because usually, to his point, it's a reflection of a much lower growth rate. I don't know that we'll get there but I thought it was an interesting twist on why you want lower interest rates.

[00:10:17] Pamela Ritchie: He also talked about tariffs, he talked about different aspects of what tariff to do to an economy and, ultimately, does that then require lower interest rates? There were some other pieces that he added into that. I mean, I'm kind of curious what you thought about some of those pieces of the story. It goes back to the Fed independence. It sounds a lot like the talking points from the administration but again, they are points to be discussed. What did you think?

[00:10:44] Denise Chisholm: To me, it reminded me of being back in college and studying Econ, probably this is 401 not 101, but it was all around that savings and investment and rebalancing global trade to make us less of a consumption economy and more of an investment and savings economy. The math around that says that you do not need rates as high. That's what I mean by he thinks R-star is lower in part because the underlying growth rate is lower but in part because we will now be savers and investors rather than consumers. That, to me, is very theoretical. So far you haven't seen that in the data as it relates to tariffs. I think, for me, it's a bridge too far. When I see theoretical math I would like to be able to prove it in the historical data and that's something I think that we haven't seen yet in the United States.

[00:11:35] What I do think, and you know, is that I think tariffs are a tax, not necessarily an impetus for a generalized rise in the overall price level.  Because of that I think that they will not really cause sustained and persistent inflation, which is back to that Fed cutting because they can because they expected the tariffs would lead to a resurgence in the overall price levels that you are just not seeing, or not seeing in the magnitude that they thought, which means that you don't need to keep policy so restrictive, which means that you can lower interest rates, and it means that inflation is probably more likely persistently lower. Will it be 2% again? Probably not because that's well below median levels historically but it doesn't mean that inflation is going to resurge to 4, 4 1/2% which is the problem point for equities. If we don't enter the problem point for equities, even if we don't get back to 2% inflation, we're in the sweet spot. Interestingly enough despite tariffs we still have inflation in the sweet spot for positive equity returns.

[00:12:44] Pamela Ritchie: Fascinating. It's fascinating how that works. Let's go into the tech companies.

[00:12:51] Denise Chisholm: So technology as leadership. I do think that is sort of the bullet point from all of the macro pictures that we're talking about, the Fed cutting interest rates, why, because they can, how does all these probabilities sort of lead you to what to own as an investor? I think that all of that math tilts you towards economically sensitive sectors. I think if the first slice of what do I own in this environment is it's do I want to own defence like consumer staples, utilities, health care, energy, or do I want to lean towards cyclicality? I argue that you want to lean towards cyclicality. Technology looks like leadership to me based on the fundamentals. Yes, they've snapped back in terms of valuation so they're not nearly as cheap as they were in April but not snapped back to the extent that they are as expensive as they were going into sort of the beginning of the year either. That has set us up for a better risk-reward.

[00:13:46] I do think that you have the dual tailwind still existing in technology stocks, meaning that I think that earnings growth is strong and likely getting stronger as a result of the tax cut. Free cashflow growth is very solid plus the fact that I think you could even get more multiple expansion back to those peak multiples. Remember, to me, statistically, expensive stocks or sectors or the market is only just saying that I think earnings growth is more visible. I do think that you have that in triplicate in technology stocks.

[00:14:19] Pamela Ritchie: It's really interesting. Do you think that the tech companies themselves, and along with the rest of corporate America, is going to get sort of more efficient without having to do layoffs? That's almost aside from the profits side of the equation. Do you think just within that the layoffs maybe don't need to be as bad as feared because it can be worked inside the companies themselves to sort of make things more productive for individuals.

[00:14:49] Denise Chisholm: No, that's an excellent point. I think it's not just true of technology companies in America, it's true of most of our corporates. I mean, when you think about how efficient they've been at full employment labour doesn't need to be the flex. We lived through the cost shocks as it related to the pandemic and now tariffs and you're seeing the flexibility of corporate supply chains to be able to squeeze costs to make them more efficient to then be able to sustain full employment. So it's back to that what we talked about, there's a reason why there's a relationship between profitability and payrolls. I do think that the productivity as it relates to corporate America and the efficiencies that they've gained and the flexibility around the supply chains has just set up for a much better risk-reward from an economic recovery perspective.

[00:15:35] Pamela Ritchie: Just quickly before we go, a couple of thoughts on data. It seems like the data question has been a bit cracked open. There's some concern about the BLS, the survey itself, those collecting the data, there's going to be reform and so on. What should we think here? Is it an opportunity to get better data? This is what you look at all day and inform us on how we should look at it. What is sort of the outcome of the fact that there's been a big bust-up over the data?

[00:16:05] Denise Chisholm: I think it's important to know that there is no correct data. There is no ... there is a gold standard number. These are all estimates. This is a very large, quickly moving economy. There are benefits and risks associated with any calculation. Can the calculations get better? Absolutely. I mean, one of the trickiest issues with the BLS is that the response rate of the people who report in for the non-farm payroll numbers has drifted massively lower, not just marginally lower but massively lower. They haven't really taken any steps to rectify that response rate. We have seen revisions always be a problem because there's always going to be some slice of data, some slice of non-farm payroll employment people that haven't reported the data yet. They're the people that are disproportionately struggling so when a shock hits the U.S. economy you usually see revisions after the fact. That is one of the trickiest issues around defining recessions because by the time you know you're in a recession you've already been in one, and more likely it's discounted with stocks. That's why it's always tricky from an investment perspective.

[00:17:11] Theoretically speaking policymakers know that. There is a trade-off between smooth data that policymakers can correctly interpret that gives up a little bit of accuracy for very volatile data that might be, quote, more accurate but less able to be read by policymakers. There's that trade-off as well. Look, I think at the end of the day there's a whole lot of data points as it relates to the job market or the U.S. economy overall and it's not just the science and the data, it's the art of the interpretation of not only the collection of data but the interpretation of it. I think that even if you made data and data collection better I think you would always have that debate around interpretation. As much as we can make it better I don't think it'll be any different in the next cycle. We'll still be arguing about the same stuff. From an investment point of view the thing that you always need to remember is that a lot of these things that you're arguing about are lagging indicators as it relates to stocks.

[00:18:17] Pamela Ritchie: As much of the concerns are already priced in. I've always thought that your reports are artwork-like so that actually makes a lot of sense. So just quickly as we close out, bottom three sectors for you. You mentioned tech at the top as leadership so top three, bottom three.

[00:18:35] Denise Chisholm: Top three, technology, consumer discretionary, specifically homebuilders, and then financials, specifically within that brokers and capital markets which I like. Bottom three, without a doubt now utilities would be my top sector to pick on. I think that the risk-reward is deeply negative there. After that it would be energy and after that it would be consumer staples.

[00:18:55] Pamela Ritchie: Amazing. Denise Chisholm, we are so grateful to have you here to round out the week. We do apologize for the technical difficulties, those are on my part and I am very, very sorry about that. Denise, you are a superstar as always. Have a great weekend ahead.

[00:19:08] Denise Chisholm: Great to be here.

[00:19:10] Pamela Ritchie: That's Denise Chisholm joining us here today on Fidelity Connects. Coming up, we look to next week, on Monday we kick off the week with Fidelity Director of Global Macro, Jurrian Timmer. He will be here to unpack macro themes that he's taking a look at across a wide swath of graphs, charts and so on which he'll share with you.

[00:19:27] On Tuesday portfolio manager, Reetu Kumra, she joins us for an update on Canada Long/Short Alternative Fund. Fascinating how the Canadian market has done, how she's been invested in it. You'll want to make sure you tune in for that one. Both Monday and Tuesday will be additionally there with live French audio interpretation so join us in either official language.

[00:19:45] Speaking of official languages, on Wednesday portfolio manager, Max Lemieux, he will be on the program at 10:30 Eastern en français with Charles Danis, and then at 11:30 Eastern on Fidelity Connects to walk us through what is moving Canadian markets specifically, how he is taking Fidelity's True North Fund in different directions, if at all. We'll catch up with Max on Wednesday. Have a great weekend. I'm Pamela Ritchie.