Jeremy Glaser: For Morningstar, I am Jeremy Glaser. I'm pleased to be joined today by Pat Dorsey. He's the former Director of Equity Research here at Morningstar. He's now the director of research at Sanibel Captiva Trust, and is still a great friend of Morningstar.
Pat, thanks for joining me today.
Pat Dorsey: Thanks for having me. Always happy to be here.
Glaser: So, the market took quick another beating today after a pretty rough week. There's a lot of talk of sovereign debt downgrade that really got the markets roiling. And there's also speculation of if it was the European sovereign debt crisis, or if it was an economic slowdown. What do you think is the big driver behind the sell-off?
Dorsey: I mean, to me it really is these signs we've gotten over the past few weeks that the global economy appears to be slowing down. Certainly, the European sovereign debt crisis plays into that somewhat, because as the public entities like the ECB commit more money to buying Spanish and Italian bonds, that's going to have an effect on economic confidence in business investment. So, it does look like Europe is slowing down some.
Importantly, China is also slowing down some. Inflation has been an issue there over the past year. You've seen the monetary authorities raising rates and trying to rein in growth a little bit. You've seen its PMI index of manufacturing come down. Construction orders for heavy construction equipment went negative year over year for the first time since the big crisis in 2008-09. So, overall, it's a huge issue because China added 25% of all incremental GDP over the past decade. So, if China slows, Europe slows, and looks like the U.S. is slowing down. It's not disaster, it's not Armageddon, but it certainly is going to cause the equity markets to re-price.
Glaser: So, it certainly doesn't look like 2008 again, but a big slowdown in China is going to have an impact on a lot of firms. Caterpillar is down a lot today. Are there other names that you think might be a little bit defensive and be able to hold up in the face of a slowing in emerging market or emerging economies.
Dorsey: Yeah, and I think a good thing to keep in mind is that people talk about emerging markets and China plays with its giant broad brush. And you kind of have to parse A from B, because, again, China is probably going to be slowing down, but we're talking about slowing down from 9% growth to 6% growth. So, let's not want to hide under a rock anytime soon, and that slowdown is most likely going to be felt in the heavily cyclical areas like construction, such as with infrastructure spending. I think it's one of the reasons why you saw Caterpillar, for example, off, today, about 9%-9.5%, about twice as much as the broader market.
If you think about a company like an AB InBev or Yum! Brands, that's selling more to Chinese consumers whether it'd be fried chicken or beer, they are probably going to be hold up a little better because it's not like the Chinese consumer is overlevered. The savings rate tends to be very high right there. So, I would expect, for example, consumer spending in emerging markets to hold up much better than say capital spending.
The one thing you would want to be careful of, especially if you happen to be a fund or an exchange-traded fund investor is that the indexes, especially like the MSCI emerging-markets index or the EAFE, which is the main sort of developed markets index, they are stuffed with big-cap companies that aren't really tied to their domestic markets. A Big chunk of the Brazilian stock market exchange, their index, the Bovespa, is tied to Petrobras which is an oil company. A big chunk of Korea's index is tied to Samsung, which is a huge exporter. So, if you are trying to get this defensive consumer aspect in emerging markets' holdings, know what you own because you may actually own sort of a global place, and not a place tied to the those domestic markets.
Glaser: One thing that a lot of people own are dividend-paying stocks. A lot of investors are looking for that income, and certainly after the sell-off, some companies are looking a little bit more attractive from an income. But what's the chance these dividends are going to get cut? We saw it in 2008, you had an attractive yield that got snatched from you before you could get it. Do you see that happening again this time around?
Dorsey: It's a great question. I'm sure, it's really on the minds of a lot of income-focused investors, and what I would say is, don't worry quite so much because most of those dividend cuts that came in 2008-2009 were from the banking sector, which has historically been a big source of dividends, and more levered companies like GE, which was half a financial company anyways.
Right now, America's corporate balance sheets are in some of the best shape they've ever been in. Most industrial companies have net cash on their balance sheet, or they refinance at extremely low rates. So, the odds of a giant rash of dividend cuts seems much, much, much lower than it was in 2008-2009.
That said, you always want to be wary of I call sucker yields. Anytime a security is yielding far more than similar companies or in absolute terms more than say 7% or 8% in the current environment, you want to be very, very careful of whether that dividend is sustainable. But bigger picture as an income investor focus on the dividends you get every month, not how much your portfolio fluctuates week-to-week.
Glaser: Now, one of the things we're going to hear from the Federal Reserve tomorrow is its interest rate decision. I think everyone's pretty clear that it's not going to be touching interest rates right now.
Dorsey: You think?
Glaser: We'll see what happens, but we are going to be watching the statement very closely see if the Fed's going to be more accommodative in the future with possibly another round of bond buying, or quantitative easing 3, if you will. Do you think that's a possibility, or do you think the Fed just going to stay a put?
Dorsey: It is tough because we are at some point getting to let's call it a liquidity trap in economist terms, or pushing on a string is perhaps the more jocular way to say it. There's not a lot of tools they have left in their kit. I think they will likely still be accommodating even if that doesn't mean QE 3, it does means keeping rates very low. And I think it's worth thinking about because there are lots of these microeconomic indicators out there, such as leading indexes, ECRI indicators, or PMI.
One that's actually been pretty good over time is the yield curve. The yield curve has inverted before just about every recession we've had. Inverted meeting that long-term rates have gone down below short-term rates. It happened before just about every single recession. Pretty hard for long-term rates to go lower than short term rates when short-term rates are almost at nothing, and I think that the Fed is likely to stay accommodating so that situation is likely to stay in place.
Now, the other side would argue that of course this is not like the history right now because the Fed is keeping rates artificially low, and I would just say, well, we invest in the world we live in, not in the world that's normal. If the reality is, you have a fairly steep yield curve and Fed stays accommodating, that probably may mean slower growth, but a recession seems unlikely.
Glaser: Pat, I appreciate you coming in today.
Dorsey: Thanks so much for having, Jeremy.
Glaser: For Morningstar, I am Jeremy Glaser.