Dylan Smith, VP and Senior Economist at Rosenberg Research, joins Wealthion’s Andrew Brill to discuss the current state of the economy, the Fed’s next moves, and whether a recession is inevitable. Dylan also delves into the normalization of the post-pandemic labor market, the divergence between old-economy and green-economy commodities, risks and opportunities in markets like U.S. Treasuries, and much more.
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Dylan Smith 0:00
We haven’t had this high of a probability of being in a recession that, you know, without actually entering one in the past few years, and if we see the expecting unemployment rate, that brings faster, bigger cuts into the agenda, markets still not pricing the end point of the cutting cycle.
Andrew Brill 0:19
Welcome to wealthion I’m your host, Andrew brill, with news of a rate cut on the horizon, we now get earnings from Nvidia this week, and we’ll discuss what is expected from that coming up next. I’d like to welcome back Dylan Smith to wealthion. Dylan’s the Vice President and senior economist at Rosenberg research. He’s also has a weekly podcast that sums up the week’s economic activity. We’ll tell you about that later. Dylan, welcome back to wealthy and always a pleasure to have you.
Dylan Smith 0:48
Thanks very much for having me on again. Andrew, always my favorite non, not my own podcast appearance.
Andrew Brill 0:56
So let me ask you an exciting week. Last week, Chairman Powell did what he had to do or said, what we thought he had to say, and what do you feel is the current state of the economy?
Dylan Smith 1:07
I think, I think what Powell did really, was to lock in what the base case expectation was from market. So I think he took out a lot of tail risk that people still had priced here and there, and, you know, has entrenched a fair amount of certainty, at least, on how the Fed’s looking at the economy, and what that means for the rate outlook, at least as much as he can in one speech or one event. So the state of the economy. Look, I think Paul was right to diagnose maybe a little later than we would have liked, but nonetheless, he’s got there, which is the labor market having pretty much fully normalized back to where it was going into the beginning of covid 19. And remember that at that point we were on a rate reduction path, I think, you know, there were three rates, rate cuts, even before covid hit, and we were on our way down to, we thought, at that time, a rate of about one, 150 the neutral rate estimate is only slightly above that now at 175 and so, you know, based on similar looking labor markets and actually similar levels of, you know, underlying momentum slowing a little bit slack emerging and the economy, you know, after a five year round trip, we’re almost in the same place we were then, except with the big difference of a lot further to go in terms of rate cuts. So everyone’s gotten behind the September cut. Whether it’s 25 or 50 basis points, is more of a signaling mechanism for the Fed right now, we think there’s a strong case for them to use that to show. Look, this is going to be a fairly aggressive cycle. We want to get to neutral? I think that’s what 50 would say. And I think there’d be more easing priced in earlier if they were to do that, versus 25 which is probably should be the base case, and which is the base case of, you know, don’t get ahead of yourselves. We’re going to ease it down. And I think the fact that the speech didn’t get much guidance on the pace of cuts, just the need for for some some of the restrictiveness to come off based on what’s happening in the labor market is indicative of what’s going to happen in September. Now that’s the state of the rest of the economy. We think that labor market easing can happen quite rapidly now. And actually the paper that, or the presentation that followed just after Powell, was probably the most interesting thing that happened. That happened at Jackson Hole. This was a little bit underreported, but it’s given the sort of intellectual framework for what the Fed is looking at now, which is a much stricter focus on the labor market, essentially telling us inflation upside risks have dissipated. We’re confident we’re back on the trajectory to 2% let’s look at the labor market. And the sort of fashionable way to look at the labor market these days is not just unemployment, but the ratio of unemployment to firm vacancies. So who is looking for jobs, and what’s the sort of availability of jobs you know, that they could move into, and that gives you a sense of how tight the labor market is. Now, what this paper basically said is that when you have an extremely tight labor market, the sort of situation we were on post covid where part of the labor force was still excluded, people were switching industries, the need for labor was very different across industries than what we typically would have in a normal economy. Initially much more requirements in the goods economy, and then once that stabilizer services economy found itself short workers. So those very tight labor markets when you’re in that situation, one thing you get is the highly amplified shocks. And so if you have a supply chain issue, if you have a sudden increase in demand. Say that happens when you have a stimulus check suddenly not in everyone’s inbox, you get, you know, much more inflationary pressure than you would in a normal labor market. So that was finding one, and that, you know, there’s a lot of retrospective here. We could have, we could have had that information at the time, and that’s what kind of the very clearly transitory talk from the Fed and. Um, kind of markets. Markets didn’t believe at that time for a reason. But what you also get is the adjustment back to a normal labor market happens through vacancies, not through the unemployment rate. And that’s sort of how you know that you’re in an unusual labor market where the unemployment state rate is staying very, very low, but firm vacancies are dropping. And that’s exactly what been we’ve been seeing until about, you know, five, six months ago. And I think we were talking at that time, and we were saying, Look, vacancies have come down. We didn’t have quite the same language for it as the paper used, but we’re going to see the unemployment rate start to rise now. And that’s that is exactly what has happened. And now that we’re sort of in this more normal situation, we think that can happen actually quite quickly. And so that’s what the pace of rate cuts is going to be pinned on. Markets still not pricing the end point of the cutting cycle being around neutral within a year or so. And we think that’s where the risks are tilted towards a faster and more aggressive easing, even without an official recession. Then should be the case. And those recession risks, by the way, are still quite high. So that’s, that’s kind of where I’ll leave it on the overall state of the economy summary.
Andrew Brill 6:08
I had a question about vacancy rate. Do you think the companies are just tightening, tightening their belts, not filling vacancies? In other words, if they have, let’s say, five slots, there’s okay, you know what? We’ll go down to four slots or even three, and maybe, you know, have someone job share. So they may not have laid people off, but they’re not filling a vacancy that they may have had. They may have just said, okay, you know what? We’re going to do away with that job and have fewer people working here.
Dylan Smith 6:36
That’s exactly right. We would completely agree with that. I you know, I think the process that firms have largely been following, you know, if you take it from the point where labor markets were extremely tight and all the companies have these job ads posted, there was a fierce, fierce war for talent at that time, right? We saw job hopping numbers increasing. We saw people getting huge pay bumps for for changing jobs, and that caused a little bit of a mindset of labor scarcity among companies. And so there’s, there’s been a few things happening since then. One is that they’re reluctant to trim down the workforce, having, you know, just made all those, all those hires. And so the adjustment, as you say, has been fairly organic, right? Companies have been very happy to let people leave on their own. We see this in being reported all over the place, especially in services industries, where, you know, the big four accountants or the consulting companies have all been on the news for wanting to get their labor force trimmed down, but they’re doing it by sort of, you know, putting people on review and almost sort of waiting for them to leave organically and find something better. They’re not taking the sort of mass layoff approach that say the more flexible tech industry was able to take quite early. Outside of the tech industry, it’s all been let’s wait and see. But in the meantime, we’ll take down those job posts. And I think we’re now entering a phase where the companies who are seeing demand looking a bit tight, they’re losing pricing power. Margins are getting squeezed. That’s when you see the layoffs start to happen. And so that’s, you know, in a one year outlook, we think that’s a much more likely scenario than it’s been for the last year or so.
Andrew Brill 8:08
So the layoffs might still be coming. You think, from Judging from your research.
Dylan Smith 8:13
you start off by taking the job posts down, then you take hours down, and we’ve seen total hours falling and hours per work of falling you let those part time contracts kind of slip away, and only then do you take the much more difficult step of actually trimming full time labor force. So that’s that’s still in the pipeline, and we know from from prior recessions, the labor markets probably the most lagging element, right? You see all the layoffs happening way off the recession started, right? It’s something that companies, you know, don’t like to do. It’s generally a last resort to do sort of large scale layouts or to cut departments or things like that. So, you know, in the meantime, we’ll see, and we are seeing efforts to be made to avoid that, especially coming off quite a tight labor market. But that’s, you know, if you follow the the beverage curve down. That’s where we get to.
Andrew Brill 9:02
So you think that there, there could be a recession, or do you think it’s possible to avoid that, given what the Fed is about to do,
Dylan Smith 9:11
Fed will help? Um, they certainly are far tighter than either inflation or the labor market is telling them that they need to be. So, you know, certainly if they weren’t easing very soon, we’d be 100% sure recessions gonna stop very quickly. Fast conditions are easing, and that provides a bit of a demand stimulus, which is helpful in terms of avoiding recession. But those risks are all there and very high. You look at the whole swathe of different ways of measuring recession probability, they’re all telling you, you know, we haven’t had this high of a probability of being in a recession that, you know, without actually entering one in the past few years. And whether it’s a som rule Type Indicator or labor market thing or a yield curve based one on financial markets, they’re all saying, you know, it’s kind of 5050, whether we get into a recession or not. Now, everyone’s always full. We’re seeing on the demand side of the economy when they’re thinking about recessions, what’s happening with the consumer are interest rates sort of hitting firm activity, hitting reactivity. But one thing we’re seeing this time that’s a little different and maybe a little more reminiscent of the early 90s and mid 90s, is productivity is growing very rapidly, and the supply side of the economy overall is growing quite rapidly, and so you’re seeing high levels of labor force participation and growth in the US economy. And you’re seeing productivity improved, partly, as you say, because companies have been forced for a while to work off a smaller labor force than they’d like to. And so what that means is that even as demand tails off, you can have enough supply side growth to help you avoid a recession now that is still highly deflationary or disinflationary, but could be outright deflationary if you combine you know the fact that you’re not going to see much in the way of price increases on the subside of the economy, with the fact that the goods sector is still deflating and commodities are down like 15% this year. So you know, all these forces lining up behind the idea that there’s probably going to be an undershoot from the Fed that may only may not come with a recession, but all the types of things that outperform in a recession, from a market perspective, are going to do well. So you’re going to see the outlook for bonds very strong. Excess supply conditions mean interest rates should be low. And the sort of open question is, what happens on the equity on the equity market? Is there a is there a shock that that brings valuations down a bit, or can this keep going? That’s the thing that’s a little less certain. In in this type of situation where you have supply growth, not stripping demand growth without without an explicit recession. But as soon as that news starts to happen, as soon as people worry about earnings forecasts being overly optimistic, you can see very quick reversals on that front. So that’s something with would flag, as you need to watch out for that.
Andrew Brill 12:02
So is the Fed late? I don’t think they’re they’re not early, but are they late, or they you think they’re right on time?
Dylan Smith 12:09
They’re probably a little late, in our view. And the reason we say that is because it was fairly clear that the labor market was heading in this direction at least six months ago. And instead of taking a fairly anticipatory attitude to this, you know, trying to get it ahead of the curve and say, you know, we’re not there yet, but we can see the situation coming where inflation is settling down and and labor markets are going to start to ease. So what we’re going to do is take on some excess policy restrictiveness in the knowledge that lags along this. You know, we’re still tighter than than we were three years ago, four years ago, and so now is the time to start trimming. I think a couple of things have spooked them on that front. The first is, you know, they were late in the other direction on the inflation issue. And so, you know, the classic quote that central banks are always fighting us, you know, the previous battle probably does apply here. The other thing is that, you know, in December, I think it was late November, early December, Powell made a fairly double shift. We had a very dovish Beige Book, and Paul made some comments in that press conference that were more on the diverse direction and definitely wasn’t his intention. But markets went from two to six cuts priced in really early financial conditions eased significantly and almost did the cut for them, and that spooked them. And at the same time, there were some wobbles in the inflation, in the disinflation process, and that all meant that they basically got scared and said, We’re just looking at current data. We’re just looking at current data. You know, blinkers on for the future. We’ll get to that in Jackson Hole. So, you know, I think that’s made them a little late, and probably raised the risk that they that they that they end up tipping the economy into into something of a mild recession, versus being able to avoid it earlier on.
Andrew Brill 14:06
How much of a rate cut do you think is necessary? And then I’ll, I’ll follow that up by saying, I, you know, I did listen to your Rosenberg Roundup, and there, there’s about eight cuts, as you said, uh, built in. But wouldn’t that depend on the size of the cuts?
Dylan Smith 14:22
so that’s, that’s eight standard, quote, unquote standard, 25 basis points, point cuts within the next year. So, you know, almost one a meeting pace, not quite how much is appropriate to cut. Well, I think you can get a lot of focus on what’s happening at the next meeting, cut or not or you know, this is important for September, because the first cut signals that there’s more cuts to come. Generally, it means that we’re in the easing cycle, unless they do a huge amount of effort to talk their way out of that which we don’t see coming. So the two questions that Margaret should be asking are how much cutting is required in this cycle. Neutral in total, and how fast they’re going to do it. So question one is fairly easy to answer. They need to at least get to neutral, and they probably need to go a little bit lower based on, you know, to counteract some of the lagged effects that are happening there. And the fact that once you project that far forward, inflation is below 2% right? So you’re looking at something like a 2% target rate, maybe a little higher, maybe, you know, 25 basis points higher or lower doesn’t really make much of a difference. The fact is, you’re coming from, you know, from five and a half down below two and a half, right, way more than priced in. How fast should they do it? Well, not all in one meeting, because they run more panic. But there’s no point doing it too slowly, right? If you’re restrictive, you’re restrictive. And if the economy’s saying, you know, neutral is probably appropriate to slightly easy, you know, you might as well set it on a path to get there before it’s too slow to do it. So we would say within the next year, that should be happening, and that’s a little more than markets are priced in. Their markets are only about halfway there right now. We would say the thing we do have some sympathy with is, you know, when you start making larger than 25 basis point cuts, you can cause overreactions in markets. You can cause a little bit of panic by looking a little out of control. That’s something that Fed would generally want to avoid, which is why, personally, I think they will do a 25 basis point cut, but they can do a lot by signaling. Look, we want to ease a lot. We want to get down to a certain level, or we see this level as appropriate, and we don’t see any reason why it would stay much tighter than that for much longer. And the markets will do the rest of the work for you. In terms of general financial conditions. You don’t need to do those big, chunky cuts, but the size of the cut will depend on what markets are doing. If we do see another big pullback from markets that brings larger cuts onto the agenda, if we see big spikes in unemployment rate that brings faster, bigger cuts into the agenda. So the labor market is going to be very, very important. And you know, what’s happening generally in equity markets is going to be important too.
Andrew Brill 17:05
So we, I want to ask you about individuals for a second. You we put up a bunch of polls on our YouTube community page, and it seems that most people that you know answered this poll are just keeping their heads above water. We have a some that are struggling, some that say they haven’t been effective, that it’s about 10% but and some that are doing well, I’m that’s also about 10% but most people are just they’re getting by. As we say. Is that what you guys are seeing in this economy right now,
Dylan Smith 17:39
it’s definitely what the macro data tells you, alongside a bunch of other evidence, you know, I think it’s difficult to avoid the fact that, you know, the cumulative level of inflation that we’ve seen over two years been a very sharp shock for a lot of people, and not everyone’s wages have kept up, right? So we are seeing, you can see them the sort of distributional accounts data you get from the Fed, you see that earnings reports from places like Target, Walmart, etc, who are saying, we’re seeing people, you know, becoming much more price sensitive. We’re seeing them trading down to basics, chicken, not pork at the moment. And variously, if you if you add up all the sort of big retailers, the Walmarts, the targets, etc, their growth, total sales growth for the last year has actually been below inflation, right? So there’s been a real volumes contraction, and that’s even with people who would be shopping at the high end markets parking their nice cars and Walmart parking lot now. So that evidence is all there. And the question that that emerges, I think, is, how come it’s not, you know, a bigger drop in demand on the macro side? Why isn’t that actually recessionary? And there’s a few reasons for that. One, as I’ve been describing, is this big increase in supply. The other is that wages have gradually been catching up to prices as well. So that’s that’s been helping. There’s still some larger settlements happening, although way lower than we were seeing in the past couple of years, and that process is mostly done. But I think what’s informative is that those 10% of people who said they’re okay, and the 10% have said they’re doing well, my guess would be they have a nice savings portfolio. Either they accrued some funds in over covid which they’ve been able to deploy. They made the right bets on Nvidia, whatever. There are certainly wealth effects happening at the economy right now that are very strong. Anyone who’s been able to release home equity is in a very strong position. Anyone who’s been favorably exposed to the stock market is in a very strong position, you know. And that happens through through a variety of different channels. It’s general sentiment based. It’s the fact people do draw down savings occasionally for large purposes. So that’s been keeping things ticking along. But that’s also why I think the Fed is even more sensitive to the stock market than usual, because it’s the main thing keeping people ticking along. And without that force, or if that force starts to. First you’re gonna see a pretty sharp pullback and a very steeped up in sentiment from the consumers who are keeping the economy moving right now.
Andrew Brill 20:06
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Dylan Smith 21:30
Wages are still rising somewhere just under 4% a year in nominal terms. So that’s about a percentage point higher than inflation is growing. So there is some aggregate, gradual real income catch up happening still to the higher price level. We’re at about the point now where, at the aggregate level, people are sort of pairing pass through with where they started before the big inflationary surge. But it’s obviously taken a while for just to catch up. Obviously those settlements happen a lot more slowly. The space for that to happen is reducing right firms are seeing their pricing power diminish. Kamala Harris’s work is going to be done for her by the time she gets into office. If she does get into office, she is correct that a lot of companies, especially grocery companies, did not reduce prices once costs started to go down again, but now they are. Competition is doing what it’s supposed to do. Consumers are pulling back. They are not tolerating any more price increases. They are asking for prices to go down, and that competitive forces decide to make that happen. You only need to look at, you know, McDonald’s new pricing strategy from a few months ago to see that in action. So firms are aware that, you know, their ability to create margins is going to depend on their ability to manage costs going forward, rather than just purely looking for price advantages in the market. And that’s going to put pressure on wages, especially in light of the fact that, you know, there has been a catch up in real wage terms.
Andrew Brill 23:01
So consumers actually doing their job in enforcing prices down themselves and creating that competition. So that’s actually a really good thing.
Dylan Smith 23:11
Yeah, it’s time to happen. There’s enough competition on the market to drive that process.
Andrew Brill 23:15
So we, a lot of our viewers, look, look for long term wealth, and they’re looking for, obviously, saving for later on. But Dylan last a couple Mondays ago, we had a downturn. I guess you’ve gone to the market a bad day. We’ll just chalk it up to a bad day. But it’s all turned around again. And, you know, everything is back up higher than it was. Are we expecting more days like this? Or could there be a market correction at some point?
Dylan Smith 23:50
Well, I think what this, what this event shows us, is that, as you’d expect from a market with with various stretch valuations, you know, for price earnings over 22 on the S&P 500 we’re calling that being priced for perfection, right? And so as soon as something imperfect happens, you can get very large responses. So in this case, it was, you know, an unexpectedly hawkish boj. It started a bit of an unwind on the enormous yen carry trade that has been quietly building up in the background that led to all sorts of covering. It had stocks. It had tech stocks, particularly hard, and people started thinking like, have we overdone a little bit here? Have we been too optimistic? But what I think is really fascinating about this whole episode is the pattern of the reversal that we’ve seen, because we haven’t, you know, in price terms, we’re sort of back to where we were, right, I think compared to the day before this all happened. SB, 500 is up about 1.3% so it’s very easy to say, Well, we haven’t. We had a wobble, and everyone actually doubled down and recommitted and went back to where we were. But I think that actually is. Slightly the wrong interpretation, because if you look at the cross asset picture, there have been a lot of changes. The most important and revealing one is that we see treasury yields way lower over that period. So the Treasury market did not round trip. We’ve actually seen all of those gains pretty much being held on to. I think that. I think that 10 years 150 beeps down from where we started before that episode. True, it sort of was 100 lower at one point. But that’s revealing, gold is up. Gold goes up when interest rates go down or interest rate expectations go down. So that’s interesting. And general commodities are kind of flat and having a bad year otherwise. So there’s been a change in the relative value of assets. And although equities look like they are where they were compared to treasuries and gold, they’re cheaper, right? And the one sort of unifying theory of why that could all have happened is that we have seen interest rate expectations really decline over that period, and that’s what’s driven the recovery. So there’s really, there’s two things that should drive stock valuations, future expected earnings and the discount rate you apply to that. Now, expected earnings may actually have gone down a little bit since that episode, but the work of the lower discount rate is actually offsetting that right now. So this is all an interest rate story, and it’s come at a very good time in terms of where that little panic was and where the Fed making it very clear that its rates are going to come down, and sort of a lot of economic indicators, especially from the labor market, saying that that needs to happen. That’s all flowed into the price
Andrew Brill 26:38
with rates coming down. Is this the last time that we could see, you know, Treasury rates, where they are, or is this a good time to get into treasuries? Obviously, the government has to pay their debts, so they’re going to sell treasuries. Is this the last best time to get in I guess
Dylan Smith 26:55
that’s probably right. Yeah. You know, we’ve been, we’ve been liking the tenure for a long time. We saw a lot of good buying opportunities when it was trading, you know, above 420, 425 it’s now, you know, just below 4% we see it going down to, you know, below 3.5 as the easing happens and as the yield curve normalizes. And, you know, given what you get in terms of duration effects and so on, it’s still very appealing. We would say buying on treasuries is still a very strong strategy. And the second part of that is it can go a bit lower because Treasury demand has been over subdued. Portfolios are under allocated to fixed income and to treasuries and so beyond just the pure mechanical effects of fairies and dragging 10 year T rates down, there should be a demand resurgence as well as portfolios start to rebound. Same goes for gold as well. So yeah, we would still be buyers, for sure, but you know, some of the move has been missed. So you know, the next time you get a more hawkish macro print that, you know, we would say, probably is going to open up some buying
Andrew Brill 28:04
with the market as inflated as it is, and people worry about their long term wealth, obviously, long term well, you hold on to it. You don’t worry about it. You just sit with it. It’s going to turn around again. It could come down for a year, maybe two. But if you’re, you’re in it for the long term, doesn’t matter. But you’re, if you’re looking at people from from retire at retirement age, or almost at retirement age, is it time to get some money out of the market, take your profits and maybe put it into something that, yeah, the it’s not going to grow as fast, or the interest rate like in treasuries, is not as good, but it’s a little bit safer.
Dylan Smith 28:38
I mean, I think if you have, if your main goal, and this is sort of evergreen wisdom. If your main goal is income from your portfolio and wealth preservation, you want to curtail your your exposure to to the riskier asset classes, right? So you know anyone who’s it’s interesting, older Americans and all Canadians too, are at historic levels of proportional investment in equities, right? It used to be the almost default that you would get out of equities the day you retired. It’s not happening anymore. And so there’s, there’s a build up of risk for the boomers, who are, you know, quite highly exposed, basically, to the AI theme. And so, you know, I if Warren Buffett, Boomer number one is, is taking profits, I think that says something to that generation. It’s time to and there’s kind of a golden opportunity at the moment, because if you move into rates now, you can still lock in pretty high interest rates through various different, different mechanisms, right? So before, before the base rate shifts on down to 2% so 2% you can get very good, you know, just fixed income generation, very low risk. There’s almost a golden window for that opening up. And so that would, that would definitely be our advice. Now, more interesting question. What happens if you’re still in a growth phase you want to build some portfolio wealth, maybe you have some cash to deploy, but you’re looking at valuations and saying, Well, if I go and now I’m going in a bit of a peak potentially, well, there’s cross asset ways to fix that, so just make sure you’re very diversified. Follow the old wisdom and rules about not overexposing to the riskier side of the asset class. Probably overweight the fixed income complex at the moment, and keep your sector allocation sensible right. You should definitely have some tech exposure that’s still a potentially massive AI storing out there. But don’t go all in on that. Utilities are great. Utilities are benefiting from almost everything out there. So stick to that. There’s some real opportunities in real estate outside the commercial and office space, which we still read online. So trying to find value, trying to wait in a way that you know is resilient to potential downside and to potential corrections.
Andrew Brill 30:57
if you’re into the commercial real estate, stay away from regional banks, because they may get hurt a little bit, right? Yeah, I heard that on your podcast, so we’ll stay away from regional banks at this point, right?
Dylan Smith 31:07
Yeah, there’s been so much going on that everyone’s forgotten about that. But you know that combination of, you know, nearly insolvent looking bond portfolios and very high exposure to real estate is not a nice combination of regional banks.
Andrew Brill 31:23
I almost had a personal question, but I’m sure some of our viewers will be interested in in finding out, with bond rates being right around four, there are some quality stocks that give dividends. Why not put that don’t move a ton. Why not put some of your money there and get it’s almost like fixed income there as well, isn’t it?
Dylan Smith 31:45
Absolutely, yeah. And if you look at our sort of overall recommendations from our different models, that’s sort of where, where we’re pushing people. So we like to talk a lot about those recession proof stocks, things like Walmart, anyone selling necessities, you know that that people have to go to, but where they’ll be looking for value that tends to outperform the rest of the market and tends to generate very nice dividends as well. You know, other things we like utilities are really fascinating right now, because the general income structure of utilities is very predictable, very fixed, you know, take something like a toll road as the key example. People don’t really stop driving around much. They have to pay the tolls. You know how much they’re going to pay, and it’s going to be a sort of fixed yield. And the cost base about utility will also be very, you know, predictably structured, and so it’s very safe, generally, quite boring. But what’s happening now in utilities is these two big things. One is AI and this massive build out of manufacturing capacity, of data centers, general infrastructure. That is meaning that a lot of investments flow into utilities, and there are shortages emerging which, which means high profit opportunities for utilities. The other is a general, and this is where they are, but it’s broader, a general recognition that there will be a surge in demand for electricity over the next decade, or decade, two decades, coming from the general kind of transition technologies emerging, right? So if you switch to every car on the road tomorrow to an electric vehicle, well guess what? You need to power them from the grid. That that trend is happening kind of all through the economy, and it means that power and water are basically going into a regime of scarcity, which they haven’t been in a long time, and so everything connected to utilities and those two themes is outperforming for a very good reason, and in the meanwhile, it still has predictable dividend flows and limited downside risk. So that’s a part of the market we really, really like. And then there’s always other ways to benefit from some of the thematic things emerging. We saw some reporting today on how profitable defense stocks have been of late. We don’t think the geopolitical situation is going to get any better anytime soon, and so those, those remain goodbyes. We’d like the gold miners, who we think are undervalued. That’s part of our general gold coal, but people have been staying away from them because of the cost base. Well, the demand side, on the price side, is good enough to make those we think undervalued at the moment. So there’s, there’s pockets of that performance, pockets of value you can have even when you think the macro picture and the valuations picture is unappealing.
Andrew Brill 34:33
So before I get into the obvious, because Nvidia reports this week, I want to ask you about real estate now, with rates coming down. Do you do do you think now, and I know that a home sales increased in July, so we’ll get the August numbers in a couple weeks. But do you expect real estate sales to pick up even more? And I would imagine refinances are going to go into effect, that you know, from people who. Bought in the last couple years.
Dylan Smith 35:02
Yeah. So this is another, another big, an important effect of rate cuts, and another reason we say they’re moving, they’re going to move as far as they have, or as far as they will, rather, back towards neutral, right? If you look at housing affordability, it sounds most stretch level, pretty much ever. That’s a combination of very high interest rates, so expensive mortgages and the fact that prices have actually been very high. Reason being that everyone who mortgaged out for 30 years, four years ago and is paying, you know, a 3% fixed mortgage rate, they can’t move right. So supply has actually been highly constrained. It’s been mostly limited to new builds, and that has really pushed affordability now to get affordability back down again, these things to do is reduce all those interest rates and get and get mortgage rates down. And if you get a sort of 300 basis point reduction in mortgage rates, you start to get to affordability levels that are much, much easier, that, in turn, makes real estate a lot more, you know, appealing in our view, and sort of unsticks some of the markets that are very sticky, because, you know, it unleashes all this demand back onto the market that’s been constrained out by lack of affordability. Point is, you have to get all the way down there for that to happen. The Fed will be pushing on a string for its first few rate cuts because it’s, you know, it’s still at such tight, such tread levels that you won’t get an effect for a while. So that’s a theme that’s emerging and that we like, but it takes a little while to get there. In the commercial space, I think it’s still a very bifurcated market. I think we can all, you know, ring the bell on work from home, being, you know, having settled into a sort of pattern, which is essentially, you know, partial hybrid, three days a week, whatever you want to call it being, being the norm, and general demand for upper space just being a lot lower. So that is unavoidable. And I think that the market is busy readjusting to that part of the effect is that the better you’re building, the higher quality, the greener the building, the more appealing and into monitors. But it’s so it’s really the lower ends of the of the office and commercial market that are in genuine trouble. And we don’t see interest rates doing a heck of a lot to fix that, because that’s not the main issue there. What it will help do is push the sort of related markets around retrofitting, you know, making buildings cleaner, greener, that part of the market we like when interest rates are low, because those investments can be made. And in fact, to be competitive in commercial real estate, you have to make those investments. So that’s going to start picking up a little bit on the periphery of that sector, but there’s a little bit of, you know, cleaning up that needs to be done in the rest of the market, which we would avoid
Andrew Brill 37:47
with interest rates coming down Dylan, you would expect home prices to go up right now, the median home prices I was reading is about 400,000 and if it goes up from there, it’s going to price Some people out of the market, even though a mortgage will be a little bit cheaper, and even with candidate Harris’s, you know, $25,000 for a first time homebuyer, that doesn’t cover the 10% down payment. So at some point that bubble has to burst, right?
Dylan Smith 38:17
It doesn’t cover it. And this is, you know, this is, you know, this is the thing that makes economists really annoyed about politicians, is when they don’t think in equilibrium terms, or in general equilibrium terms. You know, the mistake in thinking that’s happening there. It’s not just Harris, the Trudeau government’s doing the exact same thing in Canada, which is, you know, if you give everyone their down payment, well, there’s still the same housing stock prices just go up, right? And that does quiz irrefutably. So we don’t think that’s going to do a lot, if anything that’s that’s going to push prices up. That said, they are trying to put incentives on the other side of the market to bring supply online to try and offset that. But yes, you know in general, if, if, if rates come down, demand does go up. And it’s it’s indeterminate mathematically, whether or not that pushes prices up, but if you get a one from one offset, you’re still in the same situation you were in. So as rates come down, as people come back into the market, I think the very important factor is that there is constrained supply that will come back into the market if rates are low enough. So the people who are struggling to afford the 3% mortgage that they’re locked in and whatever June 2020 currently can’t sell because they can’t get a similar or lower payment without a massive downside. That house comes on the market once rates are back down at 3% right? So it’s a very difficult balance to read, and it will probably be pretty choppy in terms of looking at the price data and looking at the sales data. But there is supply coming online. In fact, the multifamily sector is way overbuilt. That’s that’s a big downward track on prices coming the homeboys have been building like apps are crazy. They’re starting to build up extra Inventory. And so the supply picture is not looking too bad, even with a pickup in demand, especially if we do get that extra marginal supply coming online. As a result, it’s a strange and disordered market that needs to rebalance
Andrew Brill 40:12
But as more comes online, I guess competition is will do what it does, and hopefully bring some prices down to affordable levels again, which is what we’re looking for. So let’s, let’s talk about the elephant in the room. The 28th is when Nvidia reports earnings. Any expectations Dylan? Because there’s a lot of people that are anticipating this, but are there any expectations?
Dylan Smith 40:38
Yeah, look, we don’t have a strong view on whether, you know, we got to see missile beat. But obviously the that’s the big sort of fulcrum that the market’s going to move on this week. People like to point out, you know, the the one cent Cisco miss in the 90s that triggered a crash. And I think Nvidia is starting to be priced in the same direction, right? I think there just is an expectation that whatever the analyst consensus is because of recent patents, markets are going to be expecting a beat. And so if we get something that’s not an exciting beat, any news of the old books starting to be sort of tailed off a little bit. Any news around just issues around production. And sell them like the markets, very, very, very sensitive to a downside Miz, and so it’s going to move a lot if that does happen. But, you know, it’s one of the best companies out there. Despite its valuation stretch, it’s managed to capture the entire AI narrative, and it has phenomenal competitive advantage in that market. So it is, it is something of a unique company.
Andrew Brill 41:43
Is AI still the rage, you know, from all the research that you do and the people you talk to, or is it the tentacles that AI has created? Like you said before, because of AI, we’re going to need new power centers. We’re going to need new data centers. Is AI still the rage, or is it the tentacles that it has created that has brought us to where we are?
Dylan Smith 42:05
Well, it’s interesting. I think we’re reaching an important point, because basically the AI theme has been expressed so far as a hardware play as a physical plane. So that’s why Nvidia is has done so incredibly well. They’re providing the chips that should power this revolution. Those chips demand power utilities are outperforming. It is still an open question, and still, I think, deserves to be treated with some skepticism. What the banning creation is that comes afterwards, right? So we know what AI can do, but it hasn’t seemed to have developed much since GPT T came out, right? There’s been some efficiency, there’s been some module improvements. People started implementing it, but we haven’t seen the we haven’t seen the Google emoji yet, right? We haven’t seen the company that defines what this thing is, and how to, how to make it extremely valuable and completely monetized. And we don’t know. It’s just, it’s a fact that we don’t know. No one in 1997 was predicting the existence of Facebook. There was no concept of a social network. We all thought the internet was about other stuff at that point. Amazon was predicted, right? So, so maybe, maybe you can say that the way Microsoft plans to you use AI is a bit more predictable and a bit more price. But as to whether we’ll see a huge revolution in economic productivity, whether we see enormous new well being companies emerging, maybe, maybe not, but we’re certainly acting like that’s not going to happen. So there is potential for oversupply of the hardware to happen. There is potential for us to be pricing the value in the wrong area. And so yes, the theme is all the rage, but I think we’re starting to see the theme coming into question a little bit in terms of how it gets expressed and how it gets played.
Andrew Brill 43:58
All right, so you have these massively powerful chips that are the size of your thumbnail, but what you do with them is still the question. So the the programmers have to get with the program and make them, make them work, so to speak.
Dylan Smith 44:11
yeah the programmers don’t get replaced by AI, exactly because that, and that’s actually the best use case that we’ve seen. And the reason that text locks not performed a lot, and the reason that we we’re seeing the theme most obviously expressed, even even outside of the chipmakers in the tech industry, is well, we know this thing can program it can do language, and it can do well structured programming language is best. So you know, most people need to be worried first. And as for the rest, I’m not so sure.
Andrew Brill 44:36
So let’s see you touched on it earlier. Commodities Gold has gone crazy. The commodities market has not done well. Oil was up a little bit because of the unrest in the Middle East, from 75 to about $80 that’s still relatively low from what we’ve seen it in economic times that have troubled us. So what. It is commodity. Some is that at a low? Now, is it, you know, people, oh, buy low, sell high. Are commodities at a low? Now, is this something that we should be really taking a look at?
Dylan Smith 45:09
Depends on the commodity, which I know is not, is not the, not the answer that you wanted, but the distinction we’ve been drawing is essentially between kind of all economy commodities and new economy commodities and new economy commodities. And it’s really China exposure that’s critical here. Things like iron and steel have been really driven by enormous construction levels in China, and that’s really, really tailing off as that whole sort of sector of the Chinese economy works its way out of basically a debt delawareging cycle. So a huge source of demand has been removed from the market for those types of commodities. And that’s why you’re seeing copper, pretty weak iron or pretty weak, you know, those types of industrial economy, industrial materials. Meanwhile, you’re also seeing, you know, things like the automotive industry going through a little going through a little bit of a pullback. And so that’s, you know, trading on to demand for everything from sort of steel to platinum as well. That’s a little more cyclical. I think that’s where you could make the argument of, you know, we’re in a bit of a dip there, but it’s going to come out again. Where we remain very bullish is on the green commodities, there’s the EV narrative is coming into question a little bit, but markets are enormous in China, and we’re in a bit of a sort of excess supply area in terms of how much EVs have been built at sort of current technological state, given where demand is, But that technology will improve, and we still think that that transition is, you know, most cars will eventually end up being EVs, and those cars will need batteries. Meanwhile, commercial battery demand for the clean energy industry for matching sort of when people use power to when power is produced in terms of solar, wind, etc, as battery technology improves and improves. The related commodities, you know, we think are in a very, very bullish state. So that’s the that’s the piece of the market where we’re suggesting the bias happen, in addition to gold and silver, from from a precious perspective, which is driven by completely different factors.
Andrew Brill 47:18
Could your outlook on the green market change depending on who wins the presidency, or is it the Global Green Market that you’re looking at?
Dylan Smith 47:26
I don’t really think so, partly because of the Global Green Market. In fact, where our outlook would change actually is we will become very, very bullish on oil and natural gas in the event of a Trump win, because you said so explicitly that he wants to deregulate the sector and sort of give it a what we would see as almost a last hurrah for the next couple of decades, but in terms of green No, and actually the place I point out as being like the most interesting case study here is Texas, right, completely Republican controlled, and yet has made full use of the Biden subsidies has realized it’s in a sunny and sometimes windy place and has aggressively, aggressively invested in greening its grid and becoming, actually a green energy center. Very, very quietly, even as you know, most of the debate around the sort of Texas oil club is about the oil outlook. It’s a very green state, and I think you know that speaks to how powerful those themes are, how powerful incentives can be. And it’s a global theme. And so, yeah, we would say that if you know that all gets repriced on a Harris one, people are missing a trick, and you should probably go in
Andrew Brill 48:37
Dylan, thanks so much for joining me. I really appreciate it. It’s called the Rosenberg Roundup. And you, you host, and sometimes co host, I know this past week, you did it solo, and it’s, it’s a great listen. You can find it. I would assume anywhere you can find a podcast, you can find the Rosenberg Roundup.
Dylan Smith 48:52
Yep, Apple, Spotify, YouTube. Those are the big ones were there.
Andrew Brill 48:56
It’s a succinct summation of of the week, the week that just happens. So it’s a it’s a great list, and I listen to it, and I really enjoy it. Where else can we find you in your research, Dylan,
Dylan Smith 49:08
well, that’s the podcast. The written research is all on the website, Rosenberg research.com and we are very generous with our trial. If you sign up, just give us your details. You can get a full month of all of our research for free. So that’s market strategy, that’s econ special reports, all of our models and data. You can just find that all on the website, Rosenberg research.com
Andrew Brill 49:29
And social media? Twitter?
Dylan Smith 49:32
Twitter, yep, you know, our Twitter is dominated by Dave Rosenberg himself. He is unbeatable in terms of Twitter fun. So if you want to see what’s going on in terms of Twitter, that’s, that’s, that’s the person to look for. We also have our company profiles on LinkedIn, of course, and I do a fair bit of notification there as well. So that’s another place you can find us.
Andrew Brill 49:55
Awesome. Dylan, thanks so much for joining me. I really appreciate it as always. And great. Insights. I thank you for joining me.
Dylan Smith 50:02
Thanks, Andrew. Great fun as always.
Andrew Brill 50:04
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