Barron's Streetwise - Factories Are Back. Plus, Schwab’s Bond Playbook.

Episode Date: July 21, 2023

Jack talks with UBS industrial analyst Chris Snyder and top fixed income strategist Kathy Jones. Learn more about your ad choices. Visit megaphone.fm/adchoices

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that drove an inflation-driven downturn. So maybe every cycle is different. Hello and welcome to the Barron Streetwise podcast. I'm Jack Howe, and the voice you just heard, that's Chris Snyder. He covers industrial companies for UBS, and he says that there is a manufacturing boom in manufacturing. America is building a lot of factories. We're going to talk about what that means for stock investors.

We'll also talk about bonds and how the relationship between short yields and long yields has gotten wacky. Schwab chief fixed income strategist Kathy Jones has advice on how to proceed. Listening in is our audio producer Metta. Hi Metta. meta hey jack you want to start with a manufacturing trivia question sure where was the first american factory built there's a city here but i'll settle for the state and i'll give you a hint it was during the washington administration as in george as in we're talking super old-timey and And back then, I think that if my knowledge of history serves, most of the stuff going on in the country was on the right side. So think East. Pennsylvania.

It's a good guess. The answer is Rhode Island and the city of Pawtucket. And if we have listeners right now from Pawtucket, I'd like you to give yourselves a round of applause. Let me explain to you just how important you are to this podcast and why we're here today. In 1790, a fellow named Samuel Slater built a factory to bring the secrets of textile manufacturing from England, a cotton spinning mill that eventually ran on water power. I'm getting this from UShistory.org. If you're raising your hand right now and saying, but, but, because there's a factory out there that you think started three years earlier, you got to take it up with them. I'm going with Pawtucket. This is important because

within 10 years of this, everyone in school in America learned about Eli Whitney and the use of interchangeable parts to make guns and how that led to the industrial revolution in America. Well, that happened shortly after the building of this first factory. And you needed a lot of money to build factories. And it turns out that around the same time in 1792 in Manhattan, some stockbrokers had gathered to sign the Buttonwood Agreement and they started trading. And they only had five securities, three government bonds and two bank stocks, not a very lively market. But you needed money to build these factories. And soon you had growth on Wall Street, growth of the business of raising money to the public to fund entrepreneurs and trading their shares and so forth.

The history of manufacturing in America explains a lot about why the country looks the way it does today. All these big cities near bodies of water that were used to transport goods and near rail lines and so on but manufacturing has been discussed as an industry in decline in america for decades now that accelerated close to 25 years ago when china joined the world trade organization it opened up a vast army of low-cost workers to manufacturers around the world, and it began to move a factory work toward China. But did you know that spending on building factories in the U.S. hit an all-time high last year? Did I know? Are you talking to me or the listener? You know, I think I forget.

The listeners can't answer you, Jack. I thought you knew this by now. Well, this one is for you, Meta. I feel like we don't talk enough about foreign direct investment. Did you know that over the past two years, the U.S. has attracted 24% of global foreign direct investment. And that's an eight percentage point increase from the prior decade. It's more than a hundred billion dollars of extra yearly spending. To me, this is a report card for a theme that we talked about during the pandemic. And that theme is reshoring. We talk about themes on Wall Street all the time. Some of them pan out. Some of

them never quite materialize. During the pandemic, we said there are shortages of everything. Supply chains have gotten too lean. All this manufacturing that companies moved overseas has meant that now there have to be these long transport routes. You depend on the availability of shipping. You have to have long lead times on the manufacture of goods. And that was a problem when we had some bottlenecks in these various supply chains. There was a shortage of semiconductors. There were ships backed up famously outside the port of LA. And so we said, companies are going to now look to make their supply chains more resilient and not just absolute lowest cost. What they're

going to do is they're going to onshore or nearshore or reshore. They're going to build more manufacturing closer to where their customers live. American companies are going to build factories in America. And now we're starting to see the signs that that's exactly what's happening. When China joined the World Trade Organization in 1999, the U S accounted for 27% of global industrial production. So 27% of the stuff manufactured in the world came from the U S in 2022, it was below 16%, so that's what we lost. Where is it going?

We believe it's going higher. How much higher we'll see. We think it's going higher. How much higher? We'll see. We think there's a pathway to get back to about 20%. That's Chris Snyder. He's an analyst covering industrial stocks at UBS. Chris says the reason that factory investment is flowing into the U.S. right now is that the benefits of cheap labor aren't what they used to be.

When you outsource, it's okay. The benefits of outsourcing being cheap labor is offsetting any sort of costs that I incur from outsourcing. That's, you know, you're not quite as responsive. Maybe there's some supply chain risk. But as we look at it now, labor and structural decline, I can't tell you the rate at which labor is going to go away, but if you look at any five or 10-year increment, the world will be less reliant on labor than previously.

So our view is, all right, the benefit of outsourcing is in structural decline. And the cost was never really appreciated. If you ask a company back in 2015, 18, what's the cost of outsourcing? They would tell you about the working capital. Well, I guess we have to hold more inventory because there's more in transit. That what's the cost of outsourcing? They would tell you about the working capital. Well, I guess we have to hold more inventory because there's more in transit. That's not the cost. The cost is all the disruption that we've seen, the ability to take share, the ability to lose share based on that.

So we feel like the benefits are in structural decline, and that's always been the case. But the catalyst is that the cost of outsourcing has been very much highlighted for everyone to see. Manufacturing growth had recently slowed to a crawl. Chris says that the U.S. manufacturing capacity increased by 4 to 5 percent over a period of 22 years. It used to grow that fast on average every year. Using what he calls a conservative estimate, the U.S. has under-invested in manufacturing by $5 trillion over two decades. So that would include the structure, but more importantly, the equipment that goes into the structure. So it's like the whole complex. And then when you're looking at industrial facility construction, it's very equipment heavy. These new plants that are being built, they don't cost, you know, $8 billion because they have really nice roof.

They just have very intense equipment that's going in. Investors should not picture factories suddenly closing in China and reopening in America. Chris says what's likely to happen is that companies will look to the U.S. for their incremental factory investment. So if you want to know what types of industries are going to move manufacturing to the U.S., ask yourself which ones are growing, which ones need more factories. Also ask how much labor is needed. Chris says the factories with the lower labor intensity are likely to be among the first to move to the U.S. And what's local demand like? If you're building more goods in the U.S., it's helpful if you have people to buy them here too. Also, is there local support from policymakers? Chris names the

automotive industry and specifically electric vehicles as an example of an industry with low labor density, a robust local market, and plenty of policy support. He also mentions semiconductors. You know, we saw what happened when the world was a very moderately short semis in 21 and 22. Well, what if something more significant happens there? Everything has semiconductors. Everything. You can maybe get underpants, but you can't get a TV, you can't get a refrigerator.

But you can't make them. You can't make underpants without semis because whatever machine makes them is going to have a ton of semis. And whatever thing ships them to your house and figures out where to go and all that. America's manufacturing renaissance is going to be good for workers, even if there are fewer workers required per factory or per unit of output. And it doesn't take a genius investor or a semiconductor-powered pair of smart underpants to tell that this will be good for industrial stocks, too. Chris has been bullish on factory automation for years. He mentions Rockwell Automation, ROK, and Emerson Electric, EMR, as key players there. He has recently turned his attention to some additional names. I'll let Chris run through

them. I'll give you the tickers in a moment. And then the next derivative that we started really liking this year has been E&E TN. They are an electrical systems provider. It's a very broad portfolio, and there's just a lot of touch points to the process. When you build an industrial facility, they get paid. When you take the equipment and put it into the facility, they get paid. When you connect the facility to the grid, they get paid. When you need to buy data center space to kind of handle and process all the information that these facilities will be capturing, they get paid. So they have the most touch points to the process.

If you look at a big US industrial facility, the estimate is that about three to 5% of that is electrical content. So if you take that and you kind of overlay it on all these new big project starts, it is arguing for at least a 2x growth rate in the market for the next five years. So a market that used to grow 3% is now going to grow at least 6%. On the electrical side, we'd also call out Amphenol, APH. Train is one we like. They're very US exposed on HVAC. All these facilities that are coming, they're going to have HVAC. And then the, uh, the last one was Keysight. They do test and measurement systems into the semi-industry. So all these new fabs that are being built, they need testing equipment. You want to make sure the chips are working as they're produced and that's driving demand for them.

Those companies again are Eaton, ticker ETN, Amphenol, APH, Train Technologies, that's TT, and Keysight Technology, that's Keys. Some of these stocks look a little bit expensive. I mean, the whole market looks expensive. Some of these have price to earnings ratios somewhere in the 20s. I asked Chris whether investors should prefer to try to seek out the cheaper stocks in the industry or go with the ones that are expensive in hopes that they'll continue working. Ideally, all things equal, you'd want one that hadn't participated. But the ones that have done well, we're still positive on

them. Numbers need to go higher. Estimates are still too low. So we think estimates into this earning season and out of this earning season are going to go materially higher. That includes E&M. That includes Trane. For some of the ones that are already kind of at record high levels. Thank you, Chris. Note that a bunch of these industrial companies are slated to report quarterly results at the very end of July or the very beginning of August. Meta, is this a good place for a break?

I think it is. Have you been reading about Pawtucket the whole time I've been talking? or the very beginning of August. Meta, is this a good place for a break? I think it is. Have you been reading about Pawtucket the whole time I've been talking? Definitely not. But did you know that a home rule charter went into effect in 1954, providing a strong mayoral and unicameral city council form of government?

That's the, what's the opposite of a fun fact? Also, Hasbro is based there now we're talking shout out to mr potato head welcome back we heard several weeks ago in this podcast from a strategist who says that investors should look for some new answers for the bond side of their portfolio. He said that treasuries are no longer providing the safety or diversification that investors have come to expect. And he recommended assets like dividend paying stocks and convertible bonds and preferred stocks and so forth. Let's now hear from someone on the other side of that discussion who says there's still very much a place in your portfolio for bonds. I spoke recently with Kathy Jones. She's the chief fixed income strategist at

Schwab. I want to ask you naturally what we should do about our bonds, but what do you make of the latest reading on inflation? Getting kind of lowish, almost normalish. Are we, is the problem solved? Is it in the rear view mirror? What do you make of inflation here? Yeah, I think the worst of the inflation burst is behind us. And I think we are looking for it to continue to come down. Monetary policy, you know, works with a lag and it looks like it's working. We're seeing slower demand, supply side issues that were a big part of coming out of the pandemic are getting resolved.

They're not fully resolved, but they're getting resolved. And all that should mean slower inflation, a declining trend continues. So we're pretty encouraged about the trend in inflation. Is it the right kind of slowdown on inflation where it comes down to a level that we like? on inflation where it comes down to a level that we like? Or is there a risk that it comes down so far that it gets worrisome and it starts to look recessionary? What do you think? Oh, yeah, I think it's a possibility. I mean, a lot has to do with what the Fed decides to do here. So it's been my feeling that the Fed should probably be done with their rate hikes, that the risk is greater that they send the economy into

recession than we reignite inflation, but I don't get a vote. So the Fed seems determined to continue to hike rates, continue quantitative tightening, and keeping policy pretty tight. And that probably skews the risk on inflation more towards it falling too much because of recession rather than a re-accelerating down the road. I'm looking at some treasury yields. Sophisticated people would call this an inverted yield curve, meaning as you go out further, you get less of a yield. Usually when I see that sort of thing, it's just a little bit inverted. This one's like kind of a lot inverted. As we speak on short-term treasuries, you're getting somewhere between

5.3, 5.4 percent, a very short term. And on a 10-year, you're down to 3.8 percent. So what should an investor make of that? Do they go for the yield and stay short on that yield curve? Or is it time to lock in some of those longer-term issues, even though the yields are lower? It's been our view that it makes sense to add some intermediate and longer-term bonds at these levels. And we've actually been suggesting it for quite some time, most of this year, because what an inverted yield curve tells you is the market's expecting rates to be lower in the future. And given that the Fed's hiking

rates so aggressively, that makes sense. And so we think that locking in some of this cash flow for the future makes a lot of sense because there's a good chance that when, say, you have a six-month or one-year T-bill, it will roll over, it will mature, you may be investing at lower and lower rates. So capturing some of that income now makes sense, especially if you have a long-term plan to generate income, like in retirement or some other use for the income flow. And I'd also make the point that real interest rates are high here. Inflation adjusted or adjusted for expectations for inflation are about the highest level since 2008. And that

suggests to us that it's time to lock in some of that yield as well. What about going after some extra yield by taking on a little credit risk, buying some corporate bonds, high-grade corporate bonds, maybe not so high-grade corporate bonds. I know that investors do all of these things at the same time. They have a mix of different bonds. Describe to me the relative appeal here of the various credit grades of bonds. How much credit risk should an investor be taking on right now? Well, we like the investment-grade corporate bond space. You're getting yields that are typically 5%, 5.5% issued by the bigger companies with better balance sheets, better cash flow, the ability to make those payments in the future. You can dip down into high yield. We've been pretty cautious on it. We continue to be cautious,

just because the extra yield you get above treasuries or above investment grade corporate bonds for similar maturities isn't that high compared to history. And so we typically favor over-weighting high yield bonds when you're at a different point in the business cycle, and those yields are really high relative to what you can get on safer bonds. Now they're relatively low. And I think that that means there's an added risk. If we get some defaults, if we get a recession, you'll see a deterioration there. So we're pretty cautious on high yield, but we like investment grade. We think that five to five and a half percent space is really attractive for a lot of investors looking for yield without too much risk. And what do the opportunities look like,

broadly speaking, in municipal bonds? How do they compare with other issues? Yeah, municipal bonds look good. We like the credit quality. Most municipalities, state governments have really reaped the benefits of the growth in the economy coming out of the pandemic. So from a credit quality point of view, most are in very good shape. Obviously, you can always find one or two that aren't. But in general, credit quality in the community space is always high. And revenues from taxes, income taxes, sales taxes, property taxes, all of that has been really strong and robust over the last couple of years. So it's kept the credit quality high. Obviously, you want to look at what's

the adjusted yield after tax will depend on your tax bracket. But in general now, particularly for intermediate to longer term munis, maybe five years and beyond, what you get after taxes relative to what you might get in treasuries or even highly rated corporate bonds can be pretty attractive as well. So we're pretty enthusiastic for high income investors about the muni space. Last year, stocks did poorly and bonds did poorly too, which disappointed a lot of investors. A lot of investors come to expect, hey, bonds will be there to help me out when my stocks do poorly. And I have spoken with some people who've said bonds in general are no longer holding

up their end of the bargain. You can't count on them for the same type of hedge or the same type of safety. You can't count on them for the same type of hedge or the same type of safety. And they say it's time to look to other areas to get better hedging. And they describe all sorts of different asset classes, be it preferred stocks or convertible bonds or BDCs or all sorts of different things. What do you think of that assessment? What do you think of that take? Well, I would disagree with it pretty wholeheartedly. The reason bonds did poorly last year is because we started from near zero interest rates and went up really rapidly,

you know, 500 basis points in a very short period of time. So usually what you get out of a bond is the income, the yield, the coupon. And that usually is what gives you that cushion when rates move around. This time we had no cushion from the coupon and we had this massive resetting of rates in a very short period of time. The prospect of repeating that is really low because now we're starting with much higher coupons, much higher yield, and we're moving into a time period that looks like the economy is going to slow and rates are more likely to come down and go up. On the other asset classes, the issue you run into is the correlation with equities. So preferreds, convertible bonds, dividend paying stocks, all of these BDCs typically are highly correlated with equities. So from a diversification

point of view, they don't play the role that bonds typically play in a portfolio. Nothing wrong with them per se, but some of that's leveraged. Obviously, if you're getting a really high yield, you're taking some sort of credit risk and you're losing out on diversification. So we usually look at those sort of aggressive risk and you're losing out on diversification. So we usually look at those sort of aggressive income categories and say, yeah, they're fine, but keep it to a smaller allocation because they don't really serve the same role that bonds do in a portfolio. For an investor with ordinary means, they're looking at something like a bond index fund. In your opinion, do bond index funds deliver on the promise that these investors

are supposed to get? Are they giving them the right kind of exposure to bonds? Or are bonds the kind of thing where you really just need a lot of money in order to have your own portfolio of diversified individual issues? Yeah, I think bond index funds can be fine. It depends on what index you're following. So there's a whole host, as you know, of these kinds of funds. Some will be well diversified. They'll be similar to the aggregate bond index where you kind of have representation for most high quality bonds. Others will be more aggressive in what they hold. So you really need to understand the index that falls into that, know what you own. But bond index funds, mutual funds in general can provide that diversification,

that income generation, and a general positive, we think, capital gain prospect going forward. But whenever you're in a fund, as you know, you don't always get that sort of certainty that you get in individual bonds. But for someone with more modest means, it doesn't have enough money to buy a portfolio of individual bonds, mutual funds, index funds can be fine. Last question is, are there any mistakes that you're seeing out there that you think investors are making, things that they ought to rethink? And feel free to add here anything that I've neglected to ask you about that you think investors ought to know right now on the subject of bonds. I think the one thing that we're seeing still is a lot of people staying in very short-term

investments, not locking in those yields for the future. It's hard not to grab after that higher number. Absolutely. Absolutely get it, which is why we look at the corporate bonds and say, yeah, you get pretty close to what you're getting in short- term treasury, but you're locking it up for a number of years. So I see a lot of that. And I also hear a lot of people saying, well, when the time comes, and rates start to drop, I'll just move into stocks again, my dividend paying stocks. And I always say, you know, those are fine, but they're not the same as bonds. And so

there's a kind of notion that stocks will go up forever and ever, and that that's a better long-term investment. And instead of having that balanced portfolio, and you never know what's going to happen with the stock market. You never have clarity. And right now, dividend yields are just north of 2%. So why not lock up some of that, you know, 4% or 5% for the future? But I think that that's the most prominent kind of mistake that people are making right now. Thank you, Kathy. And thank you, Chris. If you have a question you'd like answered on the podcast, please tape it on your phone.

You can just use the voice memo app and you can send it to jack.how. That's H-O-U-G-H at barons.com. Thank you for listening. Meta Lutsoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. You know, you don't really have to subscribe. I mean, it says that here and I read it every week. But just between you and me, I'm not trying to tell you how to podcasts. You know, you don't really have to subscribe. I mean, it says that here, and I read it every week. But just between you and me,

I'm not trying to tell you how to live your life. You can just listen however you like. Jack, they still can't answer back. If you listen on Apple, please write us a review. See you next week.