By: Stash Graham
Domestic indices had a mixed reaction to a U.S. debt ceiling deal, with the technology-heavy NASDAQ leading the way, increasing +5.8%. The Dow Jones Industrial Average fell -3.5%, and S&P 500 grew +0.3%. The discrepancy in performance this month and year-to-date is readily evidenced by the 9.32% difference in performance between the S&P 500 capital-weighted index and the S&P 500 equal-weighted index. The market capitalization weighting favors the larger companies as they would be a more significant portion of the index. As a result, the performance of this index will largely be determined by the largest companies. The equal weight index is precisely as it sounds; each one of the 500 companies within the S&P 500 has an equal component in the index’s performance. The separation in performance is reaching historic proportions as the cap-weighted S&P 500 is more than 9% higher than the equal-weighted S&P 500. This has only occurred thrice in history (March 2020- COVID sell-off, November 2008- After Lehman Brothers Bankruptcy, and December 1999- The year before Dotcom Bubble popped).
The U.S. economy continues to limp, showing signs of slowing growth rates. Gross Domestic Income (GDI) and GDPplus (a Philadelphia Fed metric combining GDP and GDI) have contracted in the last two quarters. This development does not mean the U.S. economy is in a recession but that the economy is weaker than recent GDP prints. Last week, the Bureau of Economic Analysis estimated that GDI contracted at a -2.3% annualized rate during the first quarter while falling even more during the 4th quarter of 2022 at an annualized rate of -3.4%. When you compare this to the recently revised first quarter GDP (Gross Domestic Product) of +1.3%, questions start to crop up. First, we should understand what GDI is. Gross Domestic Income is the sum of incomes earned from producing GDP (GDP is the sum of final expenditures- what people, businesses, and government spend). While a 2008 white paper deduced that there was no statistically significant predictive value of GDI estimates to revised GDP figures, we think that real income levels contracting quarter over quarter do not bode well for consumption in the future. Consumption is needed for the economic cycle to continue to turn.
A deteriorating business investment landscape will not help these weak income growth figures. Capital expenditure intentions provide an excellent forward indicator for household income growth levels in the near/intermediate-term future. Core capital-goods orders (excluding military spending and aircraft) were adverse in February and March. In April, we saw a positive print, but an observation of underlying components indicates a narrow rebound breadth. Over the last two years, we have witnessed year-over-year declines in core goods orders. There are no signs that this more significant trend is abating. C-level surveys indicate several concerns domestically and abroad. Lastly, when observing the decline in profit margins and earnings quality, it is evident that management teams are trying to stave off a material fall in profit margin by cutting expenses (labor) and capital expenditures. Business investment and expenditures are another person’s income.
Now with the U.S. Debt Ceiling “crisis” dealt with and the banking system showing some fight, we are watching specific sectors that we believe could represent good risk/reward or value. The energy sector continues to screen an attractive combination of cheap and capital scarce. We must ask – is the energy sector priced cheaply because the market hesitates on forward-looking estimates? The answer is yes. However, over the intermediate term (3-5 years), the reward outweighs the risk of a near-term pullback. Companies like Pioneer Natural Resources and Valero Energy represent different parts of the energy sector. Still, they are generating a lot of free cash flow and returning that capital to shareholders. The question with Pioneer is, what does leadership look like in the coming months, and will that change reflect a change in capital management? In the case of Valero, how much will WTI discounts and diesel margins narrow during 2023? Both companies have strong balance sheets, but what will cash flow look like in the coming years? “Sin stocks,” like tobacco companies, are routinely dismissed due to regulatory concerns yet continue to generate a lot of free cash flow that funds above-average cash dividend yields. As interest rate expectations rise on growing worries of a rebound in inflation, high-quality, short-dated bonds continue to offer a mid-5% annualized yield. This represents value as a way to make a respectable return consistent with inflation, yet not take the same risk as investing in equity markets that trade at a standard deviation above the historical norm.