By: Stash Graham
The last month of the second quarter produced mixed performance from the three major domestic indexes. The Dow Jones industrial average had a slight loss for June, while the S&P 500 and the NASDAQ reported gains. For the second quarter (April 1 to June 30), the technology sector lead the way as the NASDAQ appreciated approximately +9%. The S&P 500 and the Dow Jones Industrial Average appreciated +6.9% and +4%, respectively, for the three months. The technology sector was the beneficiary of a decline in long-term interest rates as investors are starting to be concerned about economic growth levels in the second half of the year. Gold had a difficult June (losing approximately -4%) and took from gains from April and May to settle appreciating by +2.4% during the quarter. Our commodity basket (ticker: PDBC) had a slight increase for June that added to a solid performance from earlier in the quarter, appreciating +14.6% during the 90 days.
First, we start with the labor market, where we have witnessed demand across all sectors. Job openings with the leisure and hospitality sector have naturally been strong for several months now, but other industries like finance and transports have seen solid job opening growth. In June, there have been several stories of major companies looking to hire back former employees. After laying off 32,000 employees in the winter of 2020, Disney offers $1,000 bonuses to recruit kitchen staff and housekeepers at their theme parks. On Sunday, June 20, American Airlines canceled almost 200 flights and delayed 755 flights because of labor shortages. Keep in mind the Dallas-based airline projected that flight capacity will be down 20-25% during the second quarter compared to 2019. Labor crunches are popping up across the labor spectrum, and thus wage pressures have also increased.
In addition to the current labor market issues, per the May JOLTS report, we are witnessing more Americans willing to voluntarily quit their existing jobs with other jobs in mind or already lined up. We term this “good unemployment.” Former Federal Reserve Chair Janey Yellen referred to this as her favorite labor market indicator (she also gave this a name called “the Quits Rate”). I recognize that some people could be quitting their jobs to find roles that provide better work-life balance (work from home), but we believe most people are looking for and finding higher wages. In summation, this type of “good unemployment” has been on a four-month tear and historically has a leading solid correlation (0.90) with wage growth. Putting this all together, we are projecting that wages will continue to grow at abnormally high rates for the remainder of the calendar year. Abnormally high wage growth is an inflationary force.
So why are higher wages a complex variable for the stock market? Well, U.S. businesses right now are fighting off multiple battles on the expense front. Remember, companies have been trying to manage rising raw material costs and supply bottlenecks for the last year. Throw in higher wage expenses (generally the most significant expense for every business), and U.S. businesses could struggle to meet earnings margins and expectations.
Finally, Citigroup’s Panic/Euphoria index ticked up to 0.99 in the middle of June. According to their famous model, there is a 100% historical probability of stocks declining over the next 12 months. The bank’s Chief Equity Strategist Tobias Levkovich has been bullish on stocks for well over the last decade. Unfortunately, he is not bullish today. His lack of excitement with the stock market is consistent with the latest Deloitte CFO survey (CFO Signals). A record 86% of finance chiefs polled by Deloitte say they believe U.S. stocks are overvalued.
Please see the following updates on existing positions held at the firm:
Merck (Ticker: MRK)- June was an eventful month for the pharma giant. This month marked the entire first month of their spin-off Organon (Ticker: OGN) trading by itself. Merck spun off their woman’s health and biosimilar assets into Organon in a tax-efficient manner to existing Merck shareholders. Organon shares have traded poorly since becoming a free-standing entity, and we will keep a close eye. Separately, Merck got a nice win with their positive data from their primary drug Keytruda in the treatment of adjuvant kidney cancer. This market is close to $3 billion in size. A 32% reduction of disease recurrence or death is good enough to project for a significant adoption of use. Merck pays an approximate 3.6% dividend yield fully covered by free cash flow and is above average in size compared to the rest of the S&P 500.
Dominion Energy (Ticker: D)- On June 9, the company announced the completed syndication of sustainability-linked credit facilities totaling $6.9 billion. The first of its kind $6.0 billion master credit facility is for five years (maturing in 2026), and the $0.9 billion supplemental credit facility expires in 2024. The master credit facility links pricing to annual renewable electric generation and diversity & inclusion milestones. The supplementary facility presents a unique structure whereby pricing benefits accrue for draws related to qualified environmental and social spending programs. This debt capital raise will help finance the utility’s $32 billion five-year growth capital plan. The management team reiterated their goal to produce 10% annual returns for shareholders over the next ten years. We would not be surprised to see more debt like this in the future.
W.P. Carey (Ticker: WPC)- The industrial-focused triple net lease REIT acquired three investments totaling $137 million and covering approximately two million square feet. The investments comprise five operationally critical properties net leased to industry-leading tenants. These three transactions being WPC’s investment volume to roughly $900 million (year-to-date) with a weighted-average lease term of approximately 22 years.
We closely monitor several developments (possible Federal Reserve tapering in the Fall, U.S. Government Debt Ceiling, Bipartisan infrastructure package, etc.) as we progress through the Summer. Over the last few months, we have witnessed a severe breakdown in the correlation between growth and value stocks. While this does not require immediate action, it bears watching as correlation breakdowns of this severity speak to investor complacency. We hope you have a good 4th of July holiday and feel free to reach out to us with any observations you have!
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