Markets are 'euphoric' and pricing in strong growth: Pettit

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[00:00:00]We have breaking economic news for you now. We are just getting in at the GDP figures GDP figures from the US first quarter data and joining us now to discuss this more. Let's talk about the numbers. First one we have is a 1.6% for GDP annualized quarter over quarter.

[00:00:13]Survey was 2%. So joining us now to talk a little bit more about these numbers Drew Pettit director of US equity strategy at City research. Drew thanks very much for coming in the studio.

[00:00:23]Appreciate it. Joining Dan and I today 1.6 survey was 2%. In line a little lower than expected?

[00:00:31]>> Yeah, a little lower than we expected.

[00:00:33]It's it's funny. I I heard this when you're talking about this at the beginning of the show.

[00:00:37]Everyone wants to translate this right to what this means for the market and you said about half the S&P is tech.

[00:00:44]We think over half of it is AI when you start thinking about the industrials. So market impact directly pretty low to us.

[00:00:53]But when you start thinking about areas like the consumer, I would definitely say the consumer.

[00:01:00]That's where you get a little bit of concern and this is why to us you probably stay in a little bit more of a narrow market range where we're focused on secular growth tech AI for example and stuff like small cap probably continues to underperform when you have you know macro readouts that look like this.

[00:01:17]>> What might be what would have brought it dragged it down?

[00:01:20]>> It again it's the consumer. It's a little bit of spending power. It's kind of the traditional side of the economy.

[00:01:26]AI AI investment infrastructure build out probably drove most of the growth.

[00:01:33]If you take that out, you're probably looking at real GDP growth that's flat or negative in the US.

[00:01:39]>> What's interesting about that conversation too is just the big release of the balance sheets of the big Fang stocks, the Googles, the Metas of the world. I wonder how much runway there is to go beyond what they've already done because they've basically spent most of their free cash flow at this point. So that impulse of growth from here, I'd be curious what you think there.

[00:01:57]>> What you're starting to see in the hyperscalers generally is the cash ROI is leveling out.

[00:02:03]So, I think there is runway while they're spending a lot of their free cash flow, there's ways for them to get more cash. They actually have good returns on cash in their underlying businesses. And the concern kind of in the CapEx numbers is the volume they're getting for the dollars. We always talk about dollars when it comes to CapEx, but when memory prices go way up, when server racks, building infrastructure, that goes way up, for every dollar they spend, they're not getting more compute. But now that you're seeing leveling out in cash ROIs, you feel a little bit more comfortable and I think that's why you're seeing like the hyperscaler trade start to come back as of late.

[00:02:41]>> That's true.

[00:02:41]>> And I'm just trying I'm just trying to pull up some of the numbers as we're looking at them.

[00:02:46]Real final sales to private domestic purchases was increased 2.4%. Real gross domestic income increased 0.9%. Some of the numbers, what do they tell you when you hear those numbers?

[00:02:59]>> Uh you're you're hoping you get maybe a better outlook into the back half of the year for the consumer. Again, like it's funny, like it's all backward-looking.

[00:03:08]>> Yeah.

[00:03:09]>> And and what's the concern today? It's it's oil prices and inflation.

[00:03:12]>> yeah.

[00:03:12]>> Yeah. So, to us, probably expected. Q1 numbers for the like retailers and consumer, not really that bad.

[00:03:20]>> They're fine.

[00:03:20]>> No, like let's let's be honest with you.

[00:03:22]No one really misses a whole lot when you think about US earnings, it's how much you beat by. But the market right now is looking for are you raising? And when you think about consumer and traditional cyclicals, they beat in Q1 and then they implicitly lowered their numbers for Q2, 3, and 4.

[00:03:38]So, the forward-looking, yeah, backward-looking, okay, we get that, but the forward-looking, is this sustainable? Uh questionable to us.

[00:03:46]>> So, what will you be looking for then going forward?

[00:03:48]>> So, it's growth. Like it it's we talk a lot about the NASDAQ still looks really attractive to us. And everyone says, "Oh, that's the easy trade, isn't it?

[00:03:58]Cuz it's worked." I would say it's getting more and more uneasy because it's worked so much. So, instead of thinking about traditional valuations, cuz we're in a completely different growth regime, it's disconnected from macros.

[00:04:12]>> Mhm.

[00:04:12]>> We think about what's priced in and and we think the market is pricing in 5-year growth of, let's call it 17% for the NASDAQ.

[00:04:22]The street consensus is modeling in 18. You can still buy that. You can buy high valuations if growth comes through and you have upward revisions. So, to us, growth, pricing power, when any company can expand margins, and efficiency improvement, where you're starting to see sales grow faster than assets.

[00:04:45]>> How do you think about this concentration in the US equity market? I personally don't think it's a problem, so it's a bit of a leading question, but how do you How do you think about just the big companies already scaling at such huge levels? And and as the returns on the CapEx do flow through, that implies a lot more crowding out of the rest of the economy as a whole.

[00:05:04]>> Yeah, this is to me interesting because all of your US portfolio managers now have to deal with stuff, I would say, your emerging market and single country managers have dealt with forever.

[00:05:16]>> Or Canadian portfolio managers in the Canadian market.

[00:05:18]>> Like So, concentration, like it's a new thing in the US, but it's never freaked us out, cuz you sit there and go like this this happens in other markets. It it's you do have to kind of change your toolkit. In from a strategist seat, this is why we don't sit there and please, like kick me off the show if I ever do this, oh, 20 years of history between rates and the S&P and economic growth and this. Like, that's what it means for the S&P 500. No, it doesn't. Like, throw that all out. You got to look at the market a little bit more bottom up. You have to have a view on the bigger names, but concentration in and of itself isn't bad if you're comfortable with those big stocks in the market.

[00:05:58]>> Yeah, and we had started at the end of last year we hadn't started to see a rotation away a little bit from it and all of a sudden it's all come back to it. Is it going to continue that way?

[00:06:06]Are there any reasons to look elsewhere right now?

[00:06:08]>> Not until you get some clarity on inflation and interest rates. When we talk about the broadening trade, like we do like diversified types of risk, but to have real conviction in it more than like a tactical bounce. So, let's say US small cap, again I keep coming back to saying like consumer traditional like cyclicals.

[00:06:27]It's not an either-or. You need good growth and rates down.

[00:06:31]>> Mhm.

[00:06:32]>> You need both. And it's hard to get conviction in the rates down and good growth happening. You're already looking at the market pricing in a hike for the Fed this year.

[00:06:43]And even if they do cut, you kind of get worried about how sticky the 10-year is.

[00:06:48]Because the Fed doesn't completely control that. On the growth side, you still feel good about the cash returns.

[00:06:54]You actually feel better about the cash returns versus 6 months ago. And then the back-end infrastructure side, they have great pricing power and they're continuing to beat and raise, so we're happy to stay there.

[00:07:07]I wouldn't say just by price momentum, by price momentum that has really good earnings momentum and we're comfortable being there.

[00:07:14]>> All right. Dan, I'll give you the last question.

[00:07:16]>> I think's interesting about that, fully agree on that. What I think's interesting is the higher long end and the impact on the housing market and repair remodel housing velocity. How do you think about the role that the AI pull is driving on the long end, which is then filtering into the the conventional housing market, which is historically been a huge source of jobs and economic confidence?

[00:07:38]>> This This is interesting because we talked about AI and productivity enhancements. And productivity enhancements should be okay for inflation, but the short run it it's pushing prices up.

[00:07:49]>> Mhm.

[00:07:50]>> So, short run it's it's a negative. When you actually look at the long end staying high, it's not because real rates or what they think the Fed's going to do longer term is more restrictive, it's all inflation expectations. So, that's what's moved up. So, AI is now affecting the short run inflation expectations because of the prices that go into chips, into your phone, into your car, into even your coffee makers are pretty smart today.

[00:08:20]>> Yeah. Mine's not so smart, but >> Well, my my wife calls me the coffee maker, so she probably [laughter] says the same thing.

[00:08:27]>> All right, Drew, we've got to wrap it up there, but thanks very much for joining us. Thanks for having me.

[00:08:31]>> Drew Pettit is a director of US equity strategy at Citi Research.