Reading the Tea Leaves (Ep. 2) – Consumer & Industrial Sectors

Chris Zand: Hello and welcome to our quarterly series "Reading the Tea Leaves." I'm Chris Zand, and today I'll be joined by portfolio managers Nael Fakhry and Greg Hermanski. As we wrap up another quarterly earnings season, we thought we'd focus today's episode on themes that we're seeing in the Consumer and Industrial sectors of the economy and what that means for how we're positioning client portfolios. Now, consumer consumption accounts for over two-thirds of the domestic economy, so the state of the consumer is particularly of interest. Nael, what's your perspective on how the U.S. consumer is currently doing?

Nael Fakhry: We'd say that the consumer is doing okay, definitely facing some pressures, but hanging in there despite that. From a macro perspective, unemployment was 4.3% as of July. That's a really healthy level of unemployment, up from a year and a half ago when it was below 3.5% but that was unsustainably low in our view. So we're watching the increasing unemployment trend, but we think that it reflects a healthy consumer today.

In terms of pricing across the economy, prices have moved up significantly versus a couple of years ago, and that's obviously put real pressure on the consumer, but the rate of price increases is moderated. Headline CPI was under 3%, finally at 2.9%, as of July. Gasoline prices are moderated, and generally speaking, wages have kept pace with inflation through this entire period over the last couple of years.

From a more micro perspective, where we really focus, it's a similar story. Companies, whether they're retailers, consumer-backed goods businesses, are reporting consumer spending that's up on a year-over-year basis, but consumers are clearly a little more cautious. They're delaying large purchases. Discretionary spending is under more pressure, although it's improved a bit more recently in the last couple months. So from a macro and micro perspective, consumer's doing okay but facing some headwinds.

Chris Zand: Nael, that's a very helpful backdrop. Now, are there any areas where the consumer could see some relief?

Nael Fakhry: Yeah, we think the big area is interest rates. If the consumer has a car loan, credit card balance, floating rate mortgage, the Fed cutting rates, that's going to really help the consumer by reducing interest expense, because rates today, for a lot of consumers are as high as they've been over the last 20 to 25 years. So that could be a real source of improving financial status for consumers.

Chris Zand: Thanks, Nael. Greg, we just heard about how the consumer is doing. Can you discuss how the industrial economy is doing?

Greg Hermanski: Yeah, absolutely. If we go back to the beginning of the year, the expectations from industrial companies more broadly was the year was going to start pretty slow, but that there would be strong price increases as we went through the year, and then as we got to the second half of the year, things were going to get better, order rates were going to get better. But things have been weaker than expected overall.

Chris Zand: What areas would you say are particularly disappointing, Greg?

Greg Hermanski: Probably number one has been China because that economy is big and it continues to weaken, and that's weighed on factory automation companies as well as general industrial companies. But we've also seen weakness in the agriculture economy, so we've had three strong years of farmer income, but this year, 2024, it's expected to decline. And so we've seen an increase, a pretty large increase, in used equipment, used tractors.

Now, more recently, the last quarter or so, we've also seen used equipment start to back up in construction equipment, so that's a poor sign for 2025. And then we've also seen weak EV sales, which has negatively impacted the automobile supply chain. So in short, there's been a lot of weak industrial activity. It's led to weaker order trends than expected, and pricing looks like it might be rolling over in some cases as well.

Chris Zand: Wow, thanks Greg. Anything on the positive side to note?

Greg Hermanski: Yeah, aerospace and defense continues to be quite strong, especially commercial aerospace aftermarket. That's been growing mid-teens. Semiconductor growth has been pretty robust in '24, and it's expected to be even better in '25, and then electrical business has been really strong, especially those associated with the data center activity. Then more recently, the last few weeks, maybe the last month, rail activity has inflected and started to get stronger as well. So that may be a good sign for the industrial economy and the economy overall.

Chris Zand: Thank you, Greg. It is very insightful perspective on both the consumer and industrial side. Maybe one of you could share with us how all this ties back to how we're positioning client portfolios.

Nael Fakhry: Sure. The way we think is as long-term investors where we want to buy very high quality growing businesses, and given that framework, I think that continues going forward. Where we've made changes is we've reduced valuation, so where companies got really stretched in terms of valuation as prices have run for some of our companies, we've reduced exposure there and we've, I think, increased, partly as a result of that, the defensive nature of the portfolio. So overall, we want to take into account some of the risks that are out there, and that's why we've reduced valuation and increased the defensive instruction of portfolio.

Chris Zand: Thanks, Nael. Very helpful. Well, I think this is actually a good spot for us to conclude today's episode. I'd like to thank you, Greg, and you Nael for taking some time to speak with us today. And thank all of you for tuning in to this quarter's episode. We hope you found the information informative and beneficial, and we'll look forward to connecting with you again next quarter.