The Big Conversation
Episode 131: How low can equities go?
This week Jamie McDonald looks at whether recent weakness in equity markets could have further to go amidst signs of an economic slowdown. Although regional manufacturing surveys are rolling over, there are mixed signals coming from other important indicators which suggest the outlook might not be quite so bleak, as guest Charles Van Vleet explains. Earnings estimates may have further to fall, but Charles believes that it won't be a repeat of previous crises given things like favourable debt service ratios supporting the consumer.
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Jamie [00:00:00] This week, we see a slew of economic data showing us that economies are rolling over. And worse still, we have sentiment indicators at all-time lows, at least in recent memories. The point is that corporate earnings for 2023 have not seen major downgrades yet. So to talk about this and other things that have been going on this week, I am joined by CIO of Textron, Charles Van Vleet. That is this week's Big Conversation.
Jamie [00:00:29] Charles, welcome to the show.
Charles [00:00:31] Thanks for having me.
Jamie [00:00:32] Now, this is the Big Conversation. So in this show, we do ask, what are the biggest issues of the week. So just from your point of view, what do you see as the biggest issues in markets right now?
Charles [00:00:42] No surprise. It's about the Fed and response to inflation and, and implications not only to monetary tightening, but how the market reaction to that.
Jamie [00:00:50] And if you were to give like a time, a time duration, I know it's almost an impossible question to ask, but this dislocation that's going on right now, how long is it going to be until the market starts to find its feet, whether it's the credit market or the equity market?
Charles [00:01:03] I think we're done with the rate correction. I don't think we're quite done with the spread correction. So remember, there's rates and then there's credit spreads on top, and the equity correction has, has more to go.
Jamie [00:01:15] Okay. So let's stick with equities for a second, because I do want to ask you about the other asset classes. In equities, as we alluded to in the introduction, we have seen economic indicators, Kansas, Dallas, there's been the Fed manufacturing rollovers over the past week that came out last Thursday. We've seen those numbers rolling over quite heavily. Yet for 2023, we're still not seeing material corporate downgrades yet. Now, does that mean that the, does that mean that equities still have further to go lower because consumer sentiment is like is is at low in recent memory. So what do you what do you think?
Charles [00:01:48] Now, you make a good point. That so far the correction we've seen was simply a result of the discount rate. So remember, you know, equity valuations, you look out at 20 years worth of forecast earnings on selling those those Apple phones and then you do a net present value of those cash flows, that net present value, you need something called a discount rate. The discount rate you reference, U.S. Treasury rates, Treasury are higher, your discount rate is higher, so your net present value was lower. That's what's driven the stock market crashes so far. We've done nothing yet on actual earnings revisions. Much to your point, so that's the next shoe to fall, or maybe that's too aggressive a word, is the next bit of a correction. It's not that this is not an '08 correction, this is not '01 correction. It's a '94 correction. It's it's not, this is not a death knell.
Jamie [00:02:35] Okay. So, I mean, is the best thing to do, wait to see these downgrades come through, filter through these stock prices, and then like look at what you like, what you don't like? Or do you think there are certain sectors now which are just being dragged down by equity markets more broadly and now's a good time to buy?
Charles [00:02:50] Yeah, I'm not a I'm not a big market timer in terms of what's in and out. I would rather be picking my spots. I think you said that well, so, you know, in markets like this, what you want is products or services which have pricing power, things which, you know, you know, good times or bad, you're going to buy. There's an old saying about drinking, right? I drink in good times and I drink bad times, which is exactly why alcohol stocks is a great place to invest.
Jamie [00:03:14] Is that one of your biggest area of holdings?
Charles [00:03:16] You know I teasingly called to my team that we should be investing a lot in a 'cat' stocks. And they say cat stocks? Chocolate, alcohol, tobacco. Why? I consume all three and I will pay any price they want for it. So those are called consumer staples which have perfect pricing power. So in good times or bad, people are going to buy chocolate, alcohol, tobacco. And you can add to that iPhones, you can add to that maybe your your Google search engine. So things which have pricing power, so rising rates, the company is able to pass that through to the consumer, the consumer is glad to pay it, so that's rather than time your market, I'm in or i'm out, or what's the right timing? You know just be thoughtful about what sectors, where's their pricing power what kind of products or services?
Jamie [00:03:58] And is balance sheet a very important thing to be looking at right now for these companies? I mean, we'll come on to credit in a second, but those companies that are inverted commas, 'growth companies' is it just going to take them a lot, a lot longer to come back?
Charles [00:04:11] Well, you know, the danger for companies with a poor or a weak balance sheet is they depend upon that ability to borrow. The credit markets are still open so far. They're able to borrow a bit more expensive, but nothing, you know, balance sheets for both of household as well over and over again for the balance as well as for for business in fine shape so far. So the way to measure it is things like the debt coverage ratio. So you take how much cash do I have or generate each year as a multiple of my, my, my debt service capacity, my debt service obligations. So right now we're running about two, two and a half percent, two and half times. So I generate enough or have enough cash to make two and a half times of my annual debt service. That's a very healthy number. That's both at a household as well as a corporate balance sheet. So credit spreads, yeah, not not a problem, but in great shape overall.
Jamie [00:05:05] So, Charles, at what point do you think you alluded to earlier about the Fed, at what point do equity markets have an effect on the Fed, the Fed's decision to keep hiking or to change that?
Charles [00:05:15] I think I think that's, you know, no doubt they're keeping track of this and monitoring, so, you know, the real, the real heavy lifting is being done by the markets. We've wiped out $5 trillion worth of equity market purchasing power. We've knocked out another $2 trillion worth of crypto purchasing power. I mean, that was, so that's $7 trillion worth of purchasing power that would have gone to, you know, buying an airplane ticket or buying a, you know, a new phone or to go on a trip to the West Coast or. So this is, or to buy private airplanes like my company makes. So that's 7 trillion less. So the Fed's just kind of sitting back saying, thank you market for doing my lift for me. So it's not only the market stock and crypto market, but the dollar's running, you know, unbelievably strong levels. Terrific time to be in London this week at an exchange of 122. And, but that that means that that helps to lower U.S. inflation as well and helps to again kind of dampen S&P earnings because 40% of the earnings come from abroad. So the Fed is sitting back saying, thank you, market.
Jamie [00:06:19] Yeah,.
Charles [00:06:19] They're not, they're not going to reach in and save it this time, but they're saying the market's doing the lift.
Jamie [00:06:24] Charles, it's something I've heard you say before and I'd love you to repeat it again. It's something my parents actually say to me all the time. There's all these fiscal stimulus packages and everyone, you know, my parents always ask me, well, who's going to pay for this in the future? We think, well, yes, higher taxes. But but you gave a lovely answer last time about, well, inflation is itself a tax. And I wanted you to just repeat that again.
Charles [00:06:43] Yeah, I guess I'd share with you. Goes back to my, my, my, my econ degree at U.C. Berkeley 1977. And, you know, they said, yes, inflation is a tax. And there's really only there's two kinds of taxes. One, you write a check to the IRS and the other is at tax called inflation. And the first one is a very progressive tax, one that you write the check, has, you know, progressively higher for higher incomes. And the latter one inflation is a very regressive tax, tends to hurt people with a small amount of disposable dollars. The least amount of disposable dollars. Well, we chose to pay for the fiscal expansion which began under Trump and ended under Biden. And I absolutely right thing for Trump to do, absolutely to response to the emergency, but we chose to spend for our PPP programme in March of '20 and then continued on end of '20 and again to '22 or '21 rather, we paid for that, not with the first kind of tax we're paying for, with the second kind of tax. So it's it's a it's either you pay now or you pay later with inflation, well we're paying later, that's all. It's not it's not the first time we've done this. Remember, it's, it's all the, the wealthy one percenters who are making, who are casting the vote about do we pay with the first kind or the second kind. Make no mistake, we're paying with the second kind of tax.
Jamie [00:08:03] And as you look out into the future, like if you were to try and predict how inflation's going to play out, what are you thinking into 2023?
Charles [00:08:10] I still think, you know, Powell wasn't wrong when he said remember it was in February of this year when he said this is primarily a lot of is transitory. And I think he was very correct at that time, and then we ran into March and with the with the attack in the Ukraine and which changed the dynamic. So Powell, wasn't wrong or stupid, it was much more transitory prior to the invasion. With the invasion now, I you know, we had a one-time bump in oil. I think we're done with the oil. Oil's not going to 200. Oil's done, you know, in this ballpark. But we've taken out 30% of the stock for rolled crops and that's a permanent take out. Well, I say a good 5 to 7 years because we've destroyed that, that rolled crop ability in the Ukraine, the breadbasket for certain crops. So, but the, but the oil thing, Jamie, you know, this idea that oil's going to go to 200 and we're going to stop Russian oil. You're not going to stop Russian oil. Russian oil is too valuable. It will get out of Russia if it has to be carried by yak over the Urals. Russia's simply made a mistake of building the pipeline to the, to the West when they should have built it to the east. That's just a matter of time. So Russia will sell that oil to China, they'll sell to India, which means they buy it less from Saudi Arabia. Saudi Arabia will sell that oil, then in turn to Germany. Oil is fungible. Once the, once that Russian oil's in the pipe, it is indistinguishable from any other oil. Right. The G7's meeting today to talk about a you know, what do they do, how do they put it a tax? Or a different tier, of what they're willing to pay for Russian oil? Well, that's ridiculous. Because oil is oil. It all looks the same once it's in the pipe is the whole point. So the oil, the Russian oil hasn't disappeared. We just need to redirect the pipelines a little bit. So and you know, right now we're paying $9 per unit for LNG here in the U.S. Germany is paying $36 for LNG. The only reason why that spread is because we don't have the pipelines. We don't have the ability to, as you know, liquefy it and get it on a train. We're building that capacity and we will get to that capacity. So LNG will eventually resolve someplace between $9 and $36. There is only one LNG price once you have taken into account those, those supply, those pipelines that need to be built. Those pipelines are in the process of being built. So I think we're largely done with the energy impact.
Jamie [00:10:36] Okay. Oil is done for now. Yes. So let me just change tack a little bit for those people watching who are looking across their portfolio and trying to navigate these markets as you do so well. How about the credit portion of your portfolio? How are you thinking about that? What levels in the tier are you looking at investing in?
Charles [00:10:53] So I don't invest a lot personally, but in the pension that I that I invest in, I love first lien loans. And so particularly levered, first lien loans. And there's two ways to get levered first lien loans. One is called the BDC Business Development Corp.. Those are US, those are listed funds which are 2 to 3 times, but generally two, two and a half percent times levered firstly lien loans, they trade daily liquid on the on the on the exchange, they have a yield of about 8 1/2 to 9%, they have a total return expectation I'd say about 11. The second is a little more difficult to access in your personal account in an account, it's called CLO equities. so these are Collateralised Loan Obligations. You buy the equity tranche which is providing the support for the debt tranches above it. That equity tranche acts like a ten times levered first lien loan. Again, difficult to access personally for qualified buyers some private vehicles. It's available, it's a first lien loan where you are, these are double B and single B credits. But first lean on the company in the event of default. Defaults right now running less than one. Expectations could go as high as three. You're not going to lose money till goes as high as six or seven, which has never happened before. So I love that single B and double B areas of the market.
Jamie [00:12:09] Final question, Charles, just because as we sit here in June 2022 and for people watching at home, what areas of the investment world do you find exciting, if any?
Charles [00:12:19] Well, I still think, you know, the equity markets are exciting. I you know, these biotech stocks, these you know these growth companies are still phenomenal opportunities. What's going on with, you know, well, you know, what's going on in the life science and bioscience, what's going on with CRISPR, what's going with the MRNA? I mean, the breakthrough that's yet to come through there. So how about the big one? You know what's going on with nuclear fusion right here in England? You know, out of, out of Cambridge, I believe that's where the best work is being done in nuclear fusion. Can you imagine? And 10 to 20 years' time, when that becomes our best energy source, it gets commercialised in 20 years time, who needs oil? Who needs gas? In fact, once you get to nuclear fusion, I'll give you all the freshwater you want. The last time I look, the earth is three-quarters of water, it just has a bit of salt in it. So we get rid of the salt, you know, and give you all the freshwater you want, so it solves some many problems, including, you know, a lot of you know, a lot of, you know, military fighting over oil.
Jamie [00:13:23] Well, Charles, I feel like I could keep talking to you forever. There are so many nuggets of information there, I just want to say thank you so much for coming on the show.
Charles [00:13:30] Good luck with the show.
Jamie [00:13:30] Thank you.
Charles [00:13:31] Thank you.