Earnings season: 'These companies are a conduit for inflation,' strategist says

CAPTRUST Director of Investments Christian Ledoux and Optimal Capital Director of Strategy Frances Newton Stacy join Yahoo Finance Live to discuss the recent market rally, earnings season, inflation, and interest rate hikes.

Video transcript

JARED BLIKRE: Here's your closing bell.

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RACHELLE AKUFFO: And there you have it, how your markets have closed for Tuesday. Let's take a look. We're seeing the Dow there ending the day up about 1.1%. The NASDAQ there up just shy of a percent. And the S&P 500 up also by a percent there. So some positivity in the markets today. We'll see how short-lived or long-lived that might end up being. We'll break down the market action with our guest now.

Let's bring in Christian Ledoux, CAPTRUST director of investments, and Frances Newton Stacey, Optimal Capital director of strategy. Welcome to you both. So Christian, what do you make of the current market that we're in at the moment in terms of what they're digesting, knowing that the Fed isn't going to change course any time soon?

CHRISTIAN LEDOUX: Well, I think we had a bit of a panic about a week, a week and a half ago, when we saw the news out of UK with their pension system problems. But when it was reassured that we did not have the same systemic kinds of risk in the US, we recovered a lot of that. But I don't think that the market is clear in a way until we know where the Fed is going. And frankly, a lot of market participants are starting to think maybe the Fed is going a little too fast here and should slow down.

DAVE BRIGGS: Frances, what has rallied the markets the last two days?

FRANCES NEWTON STACY: Just the fact that it was oversold. Just the fact that bonds and the NASDAQ have lost over 30% this year, and people are starting to think it's cheap. And I think there's a contingency of traders that thinks that the Fed is not going to make it with their hawkish sentiments. And particularly due to the liquidity crisis in the UK, we could easily have that over here as well, as we reduce the money supply at a record rate.

And so I think traders are starting to think, well, the Fed may have to pivot even if it doesn't want to, to protect the system. And they have proven to do so in the third quarter of '19 when they had a spike in the overnight rates in the market because of tax payments. And they did so during COVID. So that's what-- I think some of those pivot traders are starting to get a little trigger happy again, thinking the Fed's not going to make it, even though we have two more 75 basis point hikes priced into the Fed funds futures.

SEANA SMITH: So, and Frances, what does that mean for downside risk? Because here we are today with the S&P back above 3,700. It looks like you might think that we have some downward moves here ahead. What does that potentially look like?

FRANCES NEWTON STACY: Well, we could have a rally, for instance, if the Fed decides that they're not going to make it through those two hikes or if they change their sentiment whatsoever. We could see a rally in risk assets.

But the thing is, is that the 2's and the 10's are inverted by 80 basis points. And that's pretty extreme, going back to the '80s. And the swaps markets and the corporate over treasuries, the option adjusted market there is-- those spreads are widening slowly.

And so the credit risk is starting to get priced in. We've got 61% of people living paycheck to paycheck in America. The credit card usage is going up. Every time we raise rates, that debt service is getting very onerous. And so in the background, we're pricing in a hard landing, which is a credit event.

RACHELLE AKUFFO: And so then, Christian, obviously, this is all happening while we're getting into the thick of earnings season. What are you expecting in terms of forward guidance, given some of these pressures?

CHRISTIAN LEDOUX: Well, we've seen a few of them already. Some of the food companies have shared that they've passed on prices very successfully. I think we all know that the volume of the economy is starting to slow down, but we're not seeing it in pricing data. And these companies are a conduit for inflation. And their pricing power is being demonstrated here.

And I don't think that they're going to give that up. At minimum, they'll slow down their price increases or keep them flat, while at the same time, working on costs. So I would expect that you're going to see some layoff announcements in Q3, or at least implied in some of the guidance for margins. And that will hold stocks up. That will hold earnings expectations up pretty well for next year.

And then on the flipside of what's happening in the market, you've got really cheap valuations. So if those earnings can show that they are durable, I think investors will welcome that with some higher prices.

DAVE BRIGGS: Christian, you say you're seeing inflation coming down. In what data?

CHRISTIAN LEDOUX: Oh, just the real-time commodity numbers. We've seen-- well, food has continued to stay high. Even though the Zillow home indices show that there's rollover in actual prices transacting, but you're not going to see that in the inflation data that the Fed tracks because that is just lagging.

SEANA SMITH: Frances, what do you make of the strong dollar? Obviously, a headwind here. We've heard it a number of times from corporations over the last week, week and a half. We heard it during the second quarter earnings. How big of a risk do you see this being, at least over the coming quarters?

FRANCES NEWTON STACY: Well, obviously, it's putting a lot of pressure on emerging markets, right? The thing is, is that the strong dollar is not going to remain if the Fed pivots, right? I'm watching 1,250 as a line of support or resistance, coming down or going up. And that's the thing. So I'm watching the dollar, the 10-year. And I'm watching gold, and I'm watching the corporate spread.

And I'm watching this inversion, and I'm watching the swap to see when one of these things indicates that there's something else occurring with traders because, actually, the Fed can control the discount rate. But they only really give an estimate for the Fed funds rate. And then that's actually priced in by traders. They've had to remain quite hawkish in their narrative so that traders don't try to anticipate a pivot, as they did in July, and then once again in September, and undo those tighter financial conditions.

And as far as inflation goes, most of those components, even though the prices have dropped precipitously, for oil and gas, you've seen that come down. That has a one to two-month lag in the CPI rating. Food has between a four and an eight-month lag in the CPI reading. The thing that's going to keep CPI sticky for quite a while is owners' equivalent rent.

Owners' equivalent rent makes up about 1/3 of the CPI. And because housing has become so unaffordable with mortgage rates hitting the 7 handle, those rents are going to remain quite high. And then it takes 18 months for that 1/3 of CPI to come down on a lag effect. And so that keeps the narrative for the Fed very strong in the labor market, even though we've heard about hiring freezes and potential layoffs that haven't occurred yet.

And so that keeps those narratives in place because they're so lagging. So the Fed can remain hawkish until something breaks so that they actually then know where the liquidity threshold is for the amount of debt because we've put a lot of new fiscal and monetary money into the system. We're trying to take that money out of the system, but you can't remove the debt from the system.

RACHELLE AKUFFO: So then, Christian, with those narratives in mind then, you're saying that stock valuations are getting really attractive, but what is cheap and actually good and looking attractive to you right now, out of what's out there?

CHRISTIAN LEDOUX: Well, I think you've seen a better outperformance in cyclical stocks recently. And a lot of cyclicals are trading at sub 10 times earnings, even on lower expected earnings in 2023. I think the analysts have done a decent job at forecasting where earnings are going to trend in places like homebuilders and steel companies, chemical companies. And if you can get a sub 10 PE on a lowered 2023 estimate, you've probably got a pretty good entry point.

And I would say one thing about rates here. So everybody's talking about these lagging effects, including your other guest here. Higher rates have a lagging effect, too. These are going to have to hit the economy over time. We can only hope that the Fed realizes that soon enough that the higher rates are already having a big impact.