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Friday Five: Fed Takes the Market's Hand

Jason Stipp
Jeremy Glaser

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five, Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Up first this week, we got Fed minutes, and it doesn't look like a June rate hike is going to be in the cards.

Glaser: These minutes confirmed that a June rate hike seems to be almost essentially off the table. That doesn't mean they won't hike rates later this year, but it just seems like, with the soft data that we've seen recently, particularly through the first quarter, the Fed is not ready to go ahead and move those rates upward yet.

I think the fact that people aren't terribly surprised by these minutes or this announcement shows that the Fed's communication strategy, at least for now, is working pretty well. The Fed, either through public speeches or through their statements, seems to be helping to guide the market to their thinking in a very gradual way, hoping to avoid some of the issues with the taper tantrum we saw, when they were going to start winding down QE and rates kind of got away from them very quickly.

The fact that this was seen as a non-event is a good sign for that communication policy.

Stipp: We also heard this week that six banks will be paying billions of dollars to settle currency-related issues--currency fixing. What's the story there?

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Glaser: I'm glad you're sitting down, because I know you'll be shocked to find out that these big global banks are being forced to pay a multi-billion dollar settlement for wrongdoing.

This stems from these allegations that the big banks were fixing currency exchange rates in order to enrich themselves. This cover six big banks; HSBC and Deutsche Bank are still under investigation and could have a separate settlement.

This supports the larger thesis that we've had on these banks for a while, which is that regulatory costs have become an ongoing cost of doing business. These aren't one-off bad actors; these settlements aren't something that's going to happen in a very brief period of time, but then isn't going to be an issue going forward. Banks are going to continuously have these higher legal costs. The incentives on a personal level for their employees are just too high to push the boundaries, and it's just too difficult to have good oversight on banks of this size. You should continue to see these legal costs.

That doesn't mean you should never own these banks. But you should keep in mind that these costs are going to be elevated forever. This isn't just a temporary thing.

Stipp: We've discussed some mergers in health care, particularly in the pharmacy benefit manager space. Another one of those happened this week.

Glaser: CVS Health is spending about $12 billion to purchase Omnicare, which is a pharmacy benefit manager that focuses on specialty drugs and also on senior-care facilities, which is a little bit of a different niche than CVS Health is in right now.

Like you mentioned, this is the latest in a string of mergers in the PBM space--UnitedHealth and Catamaran being the most recent. This speaks to the fact that scale is very important for PBMs. They have to negotiate with the drug companies, and the more patients they represent, the more discounts they are going to be able to negotiate, and the more clout they will have with those drug companies. That helps bring down costs and improve profitability for these PBMs.

Now, we still think that Express Scripts is the best buy in the space right now. Even after this CVS Health merger, we still think Express Scripts will have a great competitive advantage. Actually the consolidation helps them somewhat; it helps keep pricing rational across the entire industry. We do think Express Scripts shares still look undervalued.

Stipp: Wal-Mart posted another quarter of same-store sales growth, but profitability was weighed down a bit by investments that they are making.

Glaser: Wal-Mart is showing same-store sales growth in the U.S., which is something they hadn't been doing for quite some time. But they are also having some very heavy investments that are weighing on profitability on things like building up their e-commerce services and also in higher wage costs as they are investing in labor.

I think the real question for investors thinking about Wal-Mart is, will these investments pay off over the long-term? Ken Perkins, our Wal-Mart analyst, thinks the answer is probably yes. But it's going to take a really long time for these to show up. Wal-Mart is not the kind of company that can turn on a dime. If you make these investments in one or two quarters, you're not going to see the fruits of it right away. It's going to take years until you are really able to see that show up in the actual numbers. In the interim, you have these investments weighing on profitability.

This has left the shares looking fairly attractive. We have a low Fair Value Uncertainty rating on Wal-Mart, so we're not looking for huge discounts to our fair value estimate until we think that that it's worth picking up the shares. And if you look at the types of valuations assigned to other retailers, Wal-Mart does look fairly attractive, but investors will need to be patient as it could take some time for these investments to pay off.

Stipp: Sticking in retail, two home improvement retailers, Home Depot and Lowe's, reported this week. They are interesting in and of themselves, but they also can tell you a bit about the housing market.

Glaser: We do like to look at both of these, because it does give you a snapshot of what people are thinking about the housing market. Are they doing renovations? Are they thinking of sprucing up a home to sell? Or maybe they are doing some work on a home that they've recently purchased.

Home Depot and Lowe's both posted pretty good sales growth. Home Depot had the more-promising report, with good sales growth and some good news on profitability. Management raised its guidance for the rest of the year.

Lowe's seemed to have a little bit more pressure on the profitability front, even with decent sales growth, and management held the full-year guidance stable, which implies a deceleration in sales growth through the rest of the year. That concerned investors a little bit.

But we think that concern has actually opened up more opportunity in Lowe's versus Home Depot. When you look at valuations, Lowe's does look slightly undervalued, and Home Depot looks overvalued. But neither of them look like an incredible buy right now.

Stipp: Investors always get exactly what they need on The Friday Five. Jeremy, thanks for joining me.

Glaser: Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.