Just Where Is the U.S. Economy Headed?

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Stubborn inflation, high interest rates, and the debt ceiling debate are creating a lot of uncertainty. I’ll talk with Morningstar Research Services’ senior U.S. economist about his economic outlook. Plus—fight back against inflation in your portfolio. An analyst recommends three ETFs. And—what Morningstar thinks about Disney’s plans to combine Disney+ and Hulu. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Disney’s Disappointing Fiscal Q2

Disney has posted disappointing fiscal second-quarter results under CEO Bob Iger. The entertainment giant’s parks delivered another impressive showing, and streaming losses continued to shrink. However, Disney+ lost 4 million subscribers worldwide while Hulu saw modest gains. The direct-to-consumer segment appears on track to turn a profit by the end of fiscal 2024. Morningstar thinks Disney needs to bring in more customers and drive stronger top-line growth to replace revenue from declining pay-TV bundles. Average monthly revenue from each Disney+ subscriber grew in the U.S. because of a December price increase. But the figure dropped everywhere else. Overall, however, it looks like fewer customers than expected quit the streaming service over higher prices. Disney’s CEO has said the company will hike prices for its ad-free tier again later this year. Iger also announced plans to integrate Hulu into Disney+ in the U.S., like its international versions. The company believes that having one app will promote higher usage and increase advertising opportunities. General entertainment content should also help Disney+ add and keep subscribers. Morningstar doesn’t think combining the streaming platforms means Disney would pay any price for Comcast’s Hulu stake. Most of the content on Hulu comes from Disney and other providers besides Comcast. Morningstar is lowering what it thinks Disney’s stock is worth by $10, to $145, and views shares as undervalued.

PayPal’s Strong Start to 2023

PayPal started 2023 off strong and beat expectations in the first quarter. The digital payment company’s earnings report shows an uptick in net revenue and volume. This marked a modest acceleration in both areas compared with the previous quarter. Morningstar is pleased with the results. Investors should focus less on near-term absolute growth. Instead, focus on the growth compared with competitors. PayPal picked up share in the quarter. Holding or increasing market share is critical for the company’s long-term growth prospects. Still, active account growth remains stalled, and accounts declined slightly. However, management’s strategy to pivot toward driving more transactions from its current customers makes sense. Morningstar is encouraged to see that transactions per active account grew 13% year over year. It appears PayPal has significant room to improve margins over time. The company bought back $1.4 billion in stock during the quarter. And management expects about $4 billion in share buybacks in 2023. Morningstar considers this a good use of cash because the stock appears undervalued. It still estimates PayPal’s shares are worth $135.

Shopify’s Stellar Quarter

Shopify’s big layoffs and spin offs are overshadowing a stellar quarter. The Canadian e-commerce giant reported a 25% uptick in revenue in the first quarter to more than $1.5 billion. Payments volume, subscription, and merchant solutions revenue increased. The results beat Morningstar’s expectations. Management signaled a better performance next quarter than Morningstar has predicted. Shopify also announced it’s cutting 20% of its workforce. And it’s selling its logistics business, including Shopify Fulfillment Network, to Flexport. Morningstar thought Shopify Fulfillment Network would help drive growth but pressure margins. It appears macro conditions are negatively affecting results despite the good quarter. Shopify will likely continue to find success in attracting larger brands. Morningstar is lifting its per share estimate of the worth of the e-commerce company’s stock to $57 from $45. The shares appear fairly valued.

Where Is the U.S. Economy Headed?

The U.S. economy is dealing with stubborn inflation, a strong jobs markets, and 10 straight interest-rate hikes. The debt ceiling is also looming. A question on many minds is: Where is the U.S. economy headed? Morningstar Research Services’ senior U.S. economist Preston Caldwell is joining Investing Insights.

Let’s start with inflation. It’s set at just over 4% in March from a year ago. Talk about where it looks like it’s headed.

Preston Caldwell: Inflation in 2022 for the full year was just over 6%. That was the highest level in over 40 years. But we are optimistic that inflation is coming back down to normal. And so we think by the end of this year, it should be within range of the Fed’s 2% target. And that’s because most of the high sources of inflation in the past are abating. So the supply chain disruptions in energy and food and durable goods and other areas are actually starting to work in the reverse direction. And that’s providing and will continue to provide a lot of deflationary pressure, we think.

Hampton: All right. The Fed has raised interest rates 10 times in a row to fight inflation. What are your thoughts on whether we’re headed toward an 11th hike or a pause?

Caldwell: We do think there’s going to be a pause. Now, some people have speculated whether the Fed could start cutting rates very soon because of what’s going on in the banking sector. We don’t think that’s going to happen. But we do think that by the end of this year, as inflation gets under control, the Fed will start to cut rates around December of this year in order to get the economy moving again. And then we expect those rate cuts to proceed aggressively in 2024 and 2025 with the federal-funds rate coming ultimately down below 2% compared with about 5% today.

Hampton: The April jobs report exceeded expectations. Can you describe what’s happening in the jobs market?

Caldwell: It’s a bit of a paradox right now because the rate of economic growth has been slowing and jobs growth has been slowing as well, but not as much as one would’ve expected. And so over the last year, we’ve seen job growth outpace growth in real GDP, and that’s abnormal. Normally, we have GDP growth slightly ahead of job growth, with the difference between the two being productivity. So employers are still in this mode of rapid hiring that they were early on in the pandemic recovery. But that’s going to change ultimately because if employers don’t shift gears and reduce their hiring, it will start to cut into profits. So we do expect job growth to slow over the course of this year.

Hampton: Let’s talk about the debt ceiling debate. It’s happening right now in Washington as we record this. Could you give a brief explainer of what the debt ceiling is and how it works?

Caldwell: So it’s a procedural quirk. When Congress enacts plans to spend money, it doesn’t automatically authorize the debt needed to pay for that spending in excess of revenue. So instead, a separate process has to occur where Congress periodically raises the limit on total US debt outstanding. And for a long time, historically, this procedural quirk didn’t cause much issue. It was neglected as an area of concern. But it’s become a tool for partisan squabbling in recent decades, and the culpability goes to both sides of the political spectrum. Right now, we are imminently reaching the debt ceiling today. So there’s a concern that as early as June, the US could brush up against that ceiling. And at that point, we’re not sure exactly what would happen, but the federal government would have to neglect to pay its bills or pay back its creditors. So that’s obviously a major issue of concern for markets given how unprecedented a default on US government obligations would be.

Hampton: And you touched on what debt default would look like. Are there any other areas that people should be looking out for if that were to happen?

Caldwell: Frankly, I think nobody knows what the impact would be on markets and the economy if a default actually happened. If the government came to a deal immediately after a default and remediated the situation and made creditors hold, then perhaps markets would just shrug this off as a small technical issue. But there’s a degree of self-fulfilling prophecy in terms of how bond markets assess the credibility, the creditworthiness of government debt. And so if this leads to a long-term loss in confidence in US Treasuries, then that has a major deleterious implication for the US economy.

Hampton: Finally, what kind of fallout will the recent bank failures have on the economy? Because people have been talking about that as well.

Caldwell: Right now, it looks like it’s going to be another contributor to slowing economic growth, but not a step change, certainly not a 2008-style scenario. Based off our analysis, including our banking equity research team, we think that the issues that have brought down Silicon Valley Bank and First Republic and the other banks that have failed remain fairly contained. Those are idiosyncratic issues that affected those banks, that, among other things, made their deposit bases especially risky and isn’t a harbinger of broader weakness or broader panic in the banking sector. Indeed, in recent weeks, we’ve seen deposit outflows become quite small, which suggests that the rest of the banking sector is stabilizing.

Hampton: All right. Preston, thank you for your time today and breaking down a lot of economic news.

Caldwell: Thanks for having me.

3 Inflation-Fighting ETFs

Hampton: High inflation is refusing to budge as fast as some would like. And it has added to market volatility. Low-cost ETFs could help investors withstand the effect of higher prices. Here’s Morningstar Research Services’ senior manager research analyst Daniel Sotiroff with three inflation-fighting ETFs.

Daniel Sotiroff: Inflation has been ticking higher over the past two years. The Consumer Price Index grew by 7.2% in 2021 and another 6.4% in 2022. Those rising costs can be a short-term headwind for stocks and bonds, but some are positioned to cope with inflationary pressures better than others.

Gold-rated Vanguard Short-Term Inflation Protected Securities ETF, ticker VTIP—or “V-TIP”—is the first ETF for today. As its name implies, VTIP tracks an index of Treasury Inflation-Protected Securities with less than five years remaining to maturity.

The U.S. Treasury backs these bonds with the full faith and credit of the U.S. government, so they face little, if any, default risk. Their inflation-fighting power comes from their unique connection to the Consumer Price Index. The face value of these bonds, and their corresponding coupon payments, are designed to increase as inflation creeps higher.

The downside is that these bonds aren’t insulated from rising interest rates. The Federal Reserve tends to raise interest rates when inflation runs hot, which pushes bond prices lower. VTIP shields itself from some of that risk by sticking to bonds with five years or less remaining to maturity. While it’s not completely immune from the impact of rising rates, it should fare better than others in the inflation-protected bond category during strong inflationary bouts.

Avantis Inflation Focused Equity ETF is the second ETF for today. Trading under the ticker AVIE, it’s a stock-focused ETF that’s built around a handful of sectors best positioned to benefit from rising prices, including basic materials, energy, consumer staples, and healthcare. Companies operating in these industries are much closer to the raw materials that typically drive inflation, so they can benefit by passing along higher prices to their customers.

Despite stronger positions in these sectors, AVIE held shares in about 350 companies at the end of March, so risks specific to a given company are relatively small. Avantis also charges a relatively low fee for these inflation-fighting powers. AVIE’s net expense ratio lands at just 25 basis points per year.

Gold-rated Vanguard Value ETF, commonly known by its ticker VTV, also has the potential to serve up some inflation protection through similar risk exposures.

Like AVIE, VTV leans toward segments of the market that are best positioned to benefit from the rising costs of raw materials, including companies operating in the energy, consumer staples, and healthcare sectors. But its emphasis on these segments is more modest than AVIE’s, and it spreads the rest of its portfolio across a wide range of stocks from all industries trading at cheaper multiples.

VTV’s inflation protection won’t likely measure up to that from AVIE over the short run. It’s less dependent on cyclical segments of the market that offer the biggest punch. But its broader portfolio should hold up better over the long run, giving it a far better chance to compound its edge over rising prices.

VTV’s ultralow fee is another considerable advantage over its peers in the large-value category. Vanguard charges just 4 basis points per year for this ETF, which sets it up for great long-term performance, regardless of the direction that inflation travels.

Hampton: Thanks Dan. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas. You can hear market trends and analyst insights from Morningstar on your Alexa devices. Say ‘Play Morningstar’. Thanks to senior video producer, Jake VanKersen, and lead technical producer, Scott Halver. And thank you for checking out “Investing Insights.” I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.

Read about topics from this episode.

Disney Earnings: Smaller Streaming Losses Are Nice, but Subscriber Growth Needs Reinvigorating

PayPal Earnings: Growth Picks Up, Strong Margin Improvement

Shopify Earnings: Strong Results as Revenue and Profitability Top Expectations

Fed’s Powell Hints at—but Doesn’t Commit to—a Pause After the Latest Rate Hike

When Will the Fed Start Cutting Interest Rates?

What Will the Upcoming GDP Report Show About the U.S. Economy?