In this episode of William Blair Thinking Presents, macro analyst Richard de Chazal provides insight on what’s happening with cyclicals versus defensive stocks, details how the Fed may be thinking about the latest CPI report, debates the economic impact of immigration, and explains his thinking about what he deems the next leg of the capex revival.

Podcast Transcript

00:00:21:18 - 00:00:43:03
Welcome back everybody. It's May and things are starting to heat up, both figuratively and literally. Which makes it a perfect time to sit down with macro analyst Richard de Chazal for another episode of Monthly Macro. Richard, welcome back as always.

We're happy to have you, heading to a very busy period of 2024. The election’s now in full swing, we've got conference season underway, plenty of macroeconomic data to dissect. But to start, I was hoping maybe we could jump into what's happening with cyclicals versus defensive stocks and what they might be telling us at the moment. Figure that's a pretty good spot to start.

Hi Chris. Yeah. Great to be back again this month and good question. Apologies if it sounds a little bit basic, but probably worth just fleshing out a little. You know what we mean by cyclicals versus defensive and why it's worth, looking at the stock market sort of through this prism and I'll just say that whilst the stock market I think does tend to reflect, economic activity taking place in the economy, it is definitely not a perfect mirror for that activity.

So the stock market does not exactly equal GDP. You know, there's no government in the stock market and of course, you also have a lot of global companies in the stock market so their behavior will obviously, to varying degrees, tend to be a reflection of those global trends as well as the domestic ones.

If you want to take this to an extreme, there's that old joke or comparison that certainly in Europe, or at least in the UK, is often made between, Chelsea Football Club and the Footsie 100. They're both English, but none of them really contain English players which is why the weaker pound, at least in the UK, tends to be that much more beneficial to the UK stock market than, say, changes in the dollar to the U.S. So, I think it's interesting. I think at the last count, say for the S&P 500, foreign sales were around 42% for the S&P 500. For the UK, for the Footsie 100, it’s something like 80%. So quite difference there. And I think it kind of highlights some of the reflections of the stock market versus the economy itself.

So not quite a perfect mirror, but I think still hugely important. Why is that? Well, I think the good reason is really because what's happening in the real economy is ultimately what does drive corporate profitability. And if you think about it, it's those corporate profits that investors are ultimately paying for in the stock market. So there's a very clear transmission channel there, is why I think it's sometimes silly when people say, well, I just don't do macro. My point is that what's often the case is because of that link between the economy, corporate profits and the stock market. It's really macro that's often driving the bus here. So it's really the current that's in the river that the fish are swimming in. And of course you can ignore that up to a point. But at some point, that's going to be reflected in the market. So some companies, our guests are pretty good at swimming against the tide. But for the most part it's generally easier to swim with that current than against it.

And I think kind of against that backdrop is maybe how you can look at this sort of cyclicals versus defensive and segmenting the stock market into those stocks or sectors that are most highly correlated to the economic cycle against those that are least correlated. So that would be things like consumer discretionary stocks or industrials, financials, against say sectors like utilities, consumer staples or that kind of thing which tend to be more defensive and less technical. And then as a base comparison, you can then plot those against something like industrial production or an economic surprises index, which are both kind of proxies for underlying GDP growth, but just in a in a more timely manner.

And I think what that sort of relative performance of the cyclicals versus defensive against the performance of the economy, that can tell you, a few things. Because stock market is more forward looking, it can sometimes help to give you a good sense of what the current wisdom is of the market, what it's telling you about the economy, am I missing something here? Is, you know, the market is really bullish or bearish on growth? When the economic data may be showing something else or, or vice versa. Is the market too pessimistic or optimistic, relative to that economic growth, relative to what the boots on the ground are telling you, so to speak?

And I think what we're seeing at the moment is interesting because we're seeing a bit of divergence between the two. So the cyclical versus defensive stocks, have been rising a lot. And in fact are very near the top of what we would call that sort of normal range that they're in. Where as measures of economic activity, so taking say the Economic Surprises Index, have very clearly dipped into negative territory. So we're seeing a lot more negative surprises on economic growth than positive ones. So historically you'd expect to see the cyclicals starting to underperform the defensives here, but that's doesn't seem to be happening at the moment. So you know the question is why is that?

And I think maybe what's different this time, which as we all know, is probably one of the most dangerous phrases in finance. I mean, what's different this time, I think, is one is that inflation is still not quite back in the box at 2%, and also is that, you know, the market seems to be or seems to have maybe a one-track mind at the moment. It's absolutely obsessed with rate cuts or, you know, expecting rate cuts coming through.

What's probably going to get to those rate cuts is a mix of lower inflation and bad economic news. So, at the moment, I think the market is still very much in this bad news is good news type world, where every weaker than expected economic report that comes out is a reason for the market to celebrate. And the cyclicals are still doing well because the market believes it's still going to be a soft landing. So nothing to fear there. And admittedly, that's not quite a bad assessment at the moment where the economy is definitely coming off a boil. But growth is not collapsing. So I think that's kind of what those stocks are sort of telling you at the moment.

Unfortunately, it's also a bit of a dangerous game. And in that this divergence can only last for so long or up to a, you know, a certain point in time where at some point, you know, if the bad news continues to get bad, then that bad news really does become bad news. and of course, we don't actually know, you know, when that's going to happen. the market can clearly tolerate, a bit of bad news, a small rise in unemployment, say, or some negative growth in nonfarm payrolls up to a point.

But ultimately, I think it'll probably be when the corporate sector starts to say, hey, you know, the economy's really suffering here and that's starting to eat into our earnings and maybe then that's when the market's going to turn. And judging from the latest, you know, earnings numbers we've just seen that that's really not happening just yet. But it does leave kind of the pathway open to further volatility ahead.

I think also conversely, you know at the moment what the market really doesn't want to see is overly good news.

Because then that clearly limits the potential for those rate cuts. And if it's actually strengthening enough it could actually mean rate hikes which the market was a little bit sort of flirting with earlier on this year. So that would be a clear risk too and I think, for me, it's actually one of the things I'm really looking forward to seeing in the next couple of weeks when we have our William Blair Growth Stock Conference. That's going to be helpful, I guess, from my point of view, in giving you a real or more sort of boots on the ground, gauge of what companies are trying to tell us.

Why don't we go into what Growth Stock Conference is for those who, might not be familiar? I think this is our 44th. It's one of our flagship events. But, Richard, do you mind, jumping into a little more detail about what the conference is all about?

Sure, I mean briefly, you know, it's a growth stock conference. We hold it every year. It's the 44th, annual one, as you say. we invite about 250 to 300 companies to come to present to our clients who, for this event, are mostly institutional equity investors globally. I think it's probably one of the oldest ones on the Street, if not the oldest. You know, being 44 years it's probably also the 23rd or 24th that I've actually attended.

Generally, I think what's great about it is that it's not specific to any one sector or industry. So it's a generalist conference except for the fact that it's obviously orientated towards growth stock investing and those growth related sectors that we cover. And also I mean, what I think, you know, our clients appreciate is that it it's pretty much always the CEO or CFOs that are presenting and they tend to give an overview of, how they see their companies and how they see the economy as well.

So that's, you know, great. From my, sort of macro perspective as it can it gives you this kind of deep dive where you get to see a bunch of companies in a very short space of time, providing this kind of health check on the economy, if you will, really giving you, you know, is the data that, you know, we're seeing in the government statistics every week, is that consistent with what the corporate sector, the message we're getting from them? So I find it tremendously helpful from, from that point of view.

Yeah. You always do a great deep dive following the event. I think that's probably going to be one of our main, conversation points next podcast so looking forward to that.


But moving on, let's talk a little bit about the latest CPI report. It showed that inflation caused a bit in April after ticking up for a little while. From your perspective, how is the Fed maybe thinking about this new reading and then has that change the futures market expectation of cuts at all?

Sure. I mean, I think after three pretty disappointing inflation reports, I think we were due for a bit of good news. And I think that's what we got with the last CPI report. So the month on month growth rates were a little bit lower, certainly on the headline rate than the market was expecting. And you know, on the back of that you got a pretty nice rally in both stocks and bonds. I think it was probably a bit of a relief rally, where the market maybe was bracing once again for the potential for some disappointing news there.

So I think that that was helpful. you know, if you look at the details, most of the strength was once again in the services and shelter component as opposed to the goods portion of that. There are good reasons to believe that those trend, or the trend in those areas is still quite disinflationary. You know, I think in the last couple of months where we have seen some outsized increases is has been in this sort of motor vehicle insurance category which being which has been a big driver and you know that's not fun to see your insurance premiums rising. So that's definitely been a sore point for many consumers.

But I think what's important here from sort of an inflation perspective is that those insurance pricing increases are really a reflection of past economic activity in the sense that they reflect the behavioral shifts that were going on, say, a year or two ago when coming out of the Covid, everyone was buying second hand cars or also keeping their cars for much longer, which in turn meant you were seeing more, broken parts and failures there, resulting in more claims on insurance policies, which is why those insurance policies, prices have been, have been rising, today.

So my point is this is not necessarily a reflection of ongoing economic momentum in those prices. And I think what most economists would sort of view those as being as more of a relative price change. So for example, when you get price increases in something like a consumer staple like auto insurance, that can act as more of a tax on consumption. So the more that you're spending or effectively forced to spend, on that, good or service, that often gets offset with less spending elsewhere because you simply can't afford it. And I think that's definitely a little of what we're seeing at the moment. and hearing from companies where they're telling us that consumers are really now pushing back on prices, i.e. they're no longer willing to accept all the price increases that companies over the last couple of years have been, you know, pushing their way.

Unfortunately, at the other end of the spectrum for the corporate sector, they're also seeing their input prices being pushed up. So there's a bit of a squeeze going on in the middle, and it's the corporate sector who's then having to accept, some kind of squeeze on margins unless they can eke out some efficiency gains elsewhere. Or that could in turn start to be putting more pressure on the labor market as companies look to rationalize costs to keep those margins. So that's a little bit of a concern.

I think the fed will be happy to see this inflation data. definitely. I think the bar to hiking is very, very high. I think Powell basically told us that. But I think the bar for actually cutting rates is, you know, we're not quite there yet. The Fed has been pretty specific about telling us that it really wants to see maybe a minimum of three months of better inflation data or lower employment data before it's confident enough to start cutting rates. And, you know, we're definitely not there yet. You know, we've just had this one report.

So in terms of what futures markets are expecting, know, at the start of the year they're expecting seven eight cuts. Then that fell back to maybe one cut this year. I think now after this report we're basically at about two cuts for later this year, which I think at the moment is actually quite feasible.

All right. Well, moving away from the cyclical themes, which I'm sure we can just keep on talking about. There's a lot to digest. I thought we can maybe get into some of the more secular themes. First and foremost, you recently published an economic, weekly around immigration, something that of, of course, is a very hot topic ahead of the election, but one that you acknowledged is probably one of the most or, I'm sorry, least divisive among economists. I thought that was a really interesting take. I think quote unquote, you say for most economists, the question of immigration is actually a pretty easy one. Do you mind, just diving into this one a bit?

Sure. Definitely a hot topic ahead of elections and definitely a topic that I keep getting asked by clients and I think you know exactly that. I think it's a very divisive one and a lot of disagreement amongst the general public on the issue of immigration. But then, weirdly, you have a lot of agreement amongst economists who generally strongly, strongly favor immigration. Which is pretty weird because most economists pretty much don't agree on anything ever. So it is odd to see, some agreement amongst them on, on this one topic.

And I think part of the reason for that, is that, perhaps it relates to social cohesion. So you have a big influx of people coming in, with potentially different cultures from your own, different languages, that can feel quite destabilizing for those existing native populations. But then for economists, maybe that's not a factor that actually features all that prominently, if at all, in many of their economic models. So they don't sort of, filter in the, social aspect, for all of that. And could argue that that's actually been a bit of a mistake in recent years, because if you start to get less social cohesion, which is maybe what we've been seeing over the last few years, that can be actually quite destabilizing politically. Which can in turn have some significant impacts on growth and the economy and in turn, financial markets.

And to be fair, on immigration, they're definitely real, we could call them negative externalities around that, particularly illegal immigration, which I think most economists would actually agree on, in the sense that if you're going to have immigration, there should be rules around that. And they should be adhered to otherwise, you know, what's the point?

But I think probably the biggest impact is, immediate impact, if you will, is where we're seeing is it is it puts more pressure on the housing stock. That's clearly not helpful at a time when there's already a significant shortage of homes, particularly affordable homes. So if you're going to increase the supply of the population, that's great. But I think you also need to think about the impact on the available infrastructure you have put in place to accommodate that. So, basically they do a better job of addressing the housing infrastructure there, you know, for sure.

But what are economists, like so much about it? Well, think basically, you know, from an economic standpoint, if you think what drives GDP growth, your potential GDP growth, it's basically growth in the labor force, plus growth in the capital stock plus multifactor productivity. And the more immigrants you have who are usually of working age, clearly the more you're going to increase the available supply of labor, which then increases the economy's capacity to produce. And if you're able to produce more generally, you're able to make more money. And I think a lot of research has also shown that, you know, immigrants also tend to be more entrepreneurial. I think, by definition, they tend to have more get up and go, than the people they've left behind back in the old country.

And those new workers also tend to bring with them new ideas around production and production processes. They often retain links back with the old country, you know. And they can bring with them, you know, new financing connections or new and markets to sell into. And all of that, I think, you know, is also helpful for GDP growth and increasing productivity. Of course, more mouths to feed increases consumption as well.

So economists really see all that as as pretty good stuff. And I think, you know, one of the biggest negative externalities that's usually cited is around wages and fear that if you basically increase the supply of something like, labor, all things being equal, that would lower the price of that labor for everyone i.e. wages. But surprisingly, a lot of economic research actually shows that the impact of immigration on wages is really not all that large in either direction. So some economists might argue that it increases a bit. You know it increases, consumption, productivity, that kind of thing, which increases wages. Others thing. It kind of dampens a bit. But most would really say that the impact in either direction isn’t overly large.

I think the other thing to keep in mind to particularly today when we're in a really tight labor market and when we're seeing participation rates of native born workers really plunging today because of, you know, retiring baby boomers, this net inflow of workers has been super helpful in, in helping to plug the gap that we've seen, you know, emerging in the labor market. So it could easily have been the case that maybe your business would have actually had to close down over the last few years because you couldn't actually find the workers to help run your business.

So, arguably, you know, international comparisons, you know, if you want to think about Japan, you know, one reason maybe it's stagnated for so long is that that's a country that historically has been quite adverse to allowing in new immigrants. And I think that's clearly not a model which the U.S. has followed and I think the results are clearly being that's made the US a, a very dynamic and much stronger economy.

Finally, I want to touch a bit about your report on what you deem the next leg of Capex revival. So, in short, you know, the evidence suggests momentum has started to pick up as a result of a surge in structures investment, which should soon start to see follow through investment into equipment, as well as other stuff from economic dynamics like innovation, demographics, geopolitics and government support. Do you mind breaking that down a bit for us?

We're very much in the next wave of innovation and productivity growth. And I think that's being built on three, call it four factors. The first is that we're clearly in a structurally much tighter labor market. So I think companies need to respond to that by investing more, to help to increase productivity efficiencies.

And I think one of the reasons why productivity has been so low over the last couple of decades is basically, we had a ton of labor around and an easy pool of labor to dip into, and companies could use that to offset capital costs. So why invest in a lot of capital when you've got a lot of workers out there, and then you can squeeze them on the wages and help maintain, profit margins? I think that's basically what they did but now the labor market is much tighter. Those workers are harder to find. We've got deglobalization going on. So you're starting to have to invest more in capital to still reap those efficiencies and those margins.

Secondly, I think the Capex boom is probably going to be helped by the fact that the nation's capital stock, so it's infrastructure, it's plant equipment, machinery, all that kind of stuff is really old. And it needs a good upgrade. So there's a lot of low hanging fruit there, which should, you know, given a little bit of investment yield, a big uplift in growth and hopefully productivity.

You know, another reason I think is that we're clearly in a major innovation wave with, I don't know, digitization, AI, nanotechnology, whatever. So effectively, there's a really good reason for companies to invest. And I think increasingly they'll probably find if they don't, they won't be competitive anymore. So they just need to invest to keep up.

And lastly, obviously, the government is providing a massive amount of fiscal incentives to invest with its new industrial growth policies. And I think companies are definitely, yielding to those, incentives and unfortunately, we also have a number of geopolitical considerations that the corporate sector is also, taking into account, when it's considering where to set up production.

So I think those are the four kind of main structural reasons for this kind of increase in, Capex spending. And I think the first stage where we've already seen this is, unsurprisingly, in structures. So, you know, I think it's kind of hard to expand if you don't have the physical space to actually expand into. So companies have been building, you know, these warehouses. So far a lot of that has been tech related. So a lot of building is being related to semiconductor fabs, data warehousing, that kind of thing.

But then I think the next stage, call it stage two, which maybe it's a little bit early still in, in calling for this, but is you know, a follow through pickup into equipment spending. So essentially if you're building all these structures you need to fill them with equipment. That's been a little bit slow in coming. definitely some cyclical factors at play here. So the uncertainty around the economy, around the direction of interest rates, maybe the election's a bit of a factor here. Some companies are telling us they're holding out until after the elections to make any big investment. But ultimately, I think it's, you know, a pretty good structural backdrop for a lot of companies and it's definitely going to be a key driver of economic growth going forward.

All right. Well, Richard, appreciate your time. Look forward to seeing you at Growth Stock Conference coming up June 4th through sixth. I think that's all the time we've got. So we'll see you next month.

Great. Thanks, Chris.