Motley Fool Hidden Gems Investing - The Bond Market Selloff is Showing up in Earnings Reports

Starting point is 00:00:00 The bond market is talking a lot louder. Motley Fool Hidden Gems Investing starts now. Welcome to Motley Fool Hidden Gems Investing. I'm your host, Tyler Crowe. Today I'm joined by longtime Fool contributors, Lou Whiteman and Matt Frankel. Earnings season is still happening. We're winding now. We're going to cover a couple earnings reports today from Klarna and Home Depot. But before we do, guys, the bond market is moving a lot more than it normally is. And it's moving in a direction that most people aren't a big fan of right now. Bond yields are the dividend yield, basically, of a bond or how much its value is rising, which basically means that people are not as willing to pay as much for bonds.

Starting point is 00:00:41 This isn't just happening in the US either. Yields on government debt in many countries are hitting 20-year highs, right about 2007 numbers, which when people hear that number, 2007, a lot of alarm bells start to go off because we all remember what happened in 2008 through 2009 when we had high bond yields and the mortgage markets started to do things that we didn't want it to do. And of course we got the great recession. Not saying that that is happening now, but we are seeing some of the highest yields we have seen in a long time. So guys, what is going on? Why is this all happening at once? The last time the 30-year treasury was this high, like you said, Lehman Brothers was still one of the largest Wall Street firms. It's been a little

Starting point is 00:01:20 while. If I'm a retiree and I need to shift some of my portfolio to fixed income, I'm loving this, but for most of us, it's not a great thing. This isn't the Fed's doing. The long-dated end of the yield curve, meaning the 20-year, 30-year treasuries, it's primarily market-driven. Remember in 2023, when the Fed rapidly raised interest rates to combat inflation and short-term interest rates spiked over 5%, the 30-year yield was actually lower then than it is now. If investors expect rates to stay higher for longer, if there's added uncertainty, let's say a Fed chair who doesn't believe in forward guidance, just for one example, or if debt issuance is unusually high, like a combination of a lot of government borrowing

Starting point is 00:02:00 and a surge in corporate debt, it can push long-term interest rates higher. So you're right that this is global. This is not just the US issue. Japan's 10-year has had its highest yield since 1996. UK's 30-year bond is approaching a 6% yield. I could go on, but investors expect more compensation on top of inflation to hold long-term bonds because there is simply more supply to go around. Matt's right. This is not the Fed's doing, but it's also kind of the Fed's doing, which is kind of the problem here. There are two things going on. First, the market is looking around the industrial world and seeing no end to budget deficits. The way it's happening in the U.S., it's happening in Europe. Higher debt means more risk. So investors are asking

Starting point is 00:02:42 to be compensated for the added risk. That's how the bond market works. But secondly, and this is where the Fed comes in. There is this lingering worry about political independence of the Fed and the Fed's ability to act if needed to raise rates and combat inflation. I hope those fears are overstated, but I think they are justified. And until the Fed proves otherwise, it is in the penalty box with investors. The credibility of the Fed is probably its best tool for keeping rates down or to at least tamper rate expectations. So to the extent that it is not credible right now or less credible than it was, that's a big thing driving the 30-year in the U.S. Around the world, there's country-specific issues going on everywhere. But got to remember, this is a global

Starting point is 00:03:29 competition for funds. If the Fed is paying more, it forces competition. It forces everybody else to pay a little more because they all want to attract flows. Couple that with what's going on corporates tyler which i think we'll get to next there's just a lot of people battling for bond funds right now and that is causing rates to go up to try and entice people to choose them for those of you who aren't are motley fool members maybe this is just the pitch to becoming a member the three of us actually did a live q a yesterday where we were talking about this too with like the supply and demand of debt in general is way up and with that much extra supply obviously the people who are buying it get to be a little bit more choosy. What do you call it? The buyer's market,

Starting point is 00:04:11 if you will. And I feel like we have to ring a bell because we're going to bring in AI here because part of that, as you were saying, Lou, the corporate issuance part is in large part because of all this AI data center spend and most directly the Magnificent Seven and a lot of these hyperscale companies. We wouldn't normally bring them up in a conversation about debt and bond yields for years because they were these massive free cashflow businesses. They didn't need debt. They were sitting on massive piles of cash to the point where people were like, why don't you guys do something with it? Pay a dividend or something. But now we're at this point where CapEx for spending for AI is leading to significant added debt, also using equity, and also using things

Starting point is 00:04:50 both on and off the balance sheet to make a lot of this spending happen. So where do you think, as we think about AI build-out and the corporate issuance sort of stuff, obviously it means that the cost of capital is going up. And where do you think this increase in capital will actually start to show up in this trajectory of AI build-out? Because we've watched the CapEx guidance for these Mac 7 companies, and they'll just raise guidance and just kind of brush their shoulders off. Like, yeah, it's fine. We'll just do it. So where do we actually see it start to bite? Like you kind of just mentioned, it wasn't that long ago, like within the past couple of years that most investors thought the AI build-out would be entirely funded by the cash flow these

Starting point is 00:05:35 companies generate and the cash they had sitting on their balance sheet, like you said. But that's not happening. The numbers got too big. Hyperscale or CapEx is on pace to reach $750 billion this year, and estimates are calling for about $1.2 trillion next year. Trillion with a T. Debt funding is about one-third of that $750 billion this year, and it's likely to be an even greater percentage of that higher number next year. For example, Goldman Sachs is forecasting 35% of that $1.2 trillion will be debt funded. And there's also that off-balance sheet part of the discussion, like you mentioned. The hyperscalers now have about $1.65 trillion of what we would call off-balance sheet debt. This is things like lease commitments, which it's definitely a part of the

Starting point is 00:06:20 AI revolution, JV structures they have on their balance sheet, things like that. That figure has 8x since 2022. So the debt from hyperscalers, and we kind of talked about this in the first section, competes with treasuries for investor dollars. And when you have a surplus of just long-term debt instruments, it can help push yields higher. And we're already seeing that. We're seeing wider credit spreads on hyperscaler debt, just to name one example. So we're already seeing this show up. Tyler, to answer your question on when the increase will show up, it already has shown up. Alphabet just reported its first quarter of negative free cash flow since going public more than a decade ago. So the question I think isn't when it'll show up. The question is

Starting point is 00:07:02 when it will stop. And the only answer we have is not soon. And one of the things hanging over the market is, is that we don't know the answer to that question. Arguably the corporates have more of an ability to manage higher rates than a lot of these sovereigns do. And I think that's reflected in rates. You know, I mean, look, they're not trading at US standards, but they're trading pretty close, something has to give eventually. But at the same time, that eventually can be a long ways away. It's not a crisis right now. It's a crowding. I don't get the sense that bond buyers are anywhere near going on strike, so we can manage this. What we have to worry about is when that day comes where suddenly there is a bond buying strike and what we do then.

Starting point is 00:07:45 It's lingering out there. It's a threat. It's not there yet, but it's something we have to watch. I think one of the interesting thing that's going to be to follow is what changes the dynamic here, because we've seen this all happening worldwide kind of all at once and very curious what to see how this transitions and how it's able to move from this rising interest rate into something either flatlining or starting to go back down to levels that we've seen previously. But after the break, we're actually going to talk about two companies that have pretty direct exposure to what's happening with rising rates.

Starting point is 00:08:19 We're going to start with Clarnock coming up next. New from Nespresso. Blend wellness into your coffee routine with the Coffee Plus range, infused with functional benefits. Choose the coffee you love with added B vitamins, like Coffee Plus B12 to help support immune function and Coffee Plus B6 to keep your day moving. Or go with the flow and choose Ginseng Delight,

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Starting point is 00:09:11 Choose firmer or softer. Adjust cooler to warmer. And right now, save up to $2,500 during our massive Labor Day event. Hurry into your local Sleep Number store today, because we have your number. Like I said, there's not as many earnings going on as late, but there still are some pretty exciting earnings stories going on right now. And shares of Klarna Group, I actually had to check this while we were recording, because I think it's changed almost two or three percentage points since we started recording,

Starting point is 00:09:41 but the stock's down about 21% as we're recording right now after the company reported earnings. There was also some management changes that are going to be happening, a little bit of transition in the C-suite. So a lot of stuff is happening. Matt, what was in the earnings report? What was in it that actually sent the shares down 20%? Now we've seen a lot of 15, 20% moves this year, this quarter specifically related to earnings. So is this just another one of those? Yeah, big move at the earnings. We'll see what happens after a couple of days. I feel like companies getting beaten down after mostly solid earnings has become a pretty recurring theme this quarter. But Klarna is actually pretty explainable here. For the most part, their quarter was excellent. 27% year-over-year revenue growth, transaction margin dollars, which is a key metric of theirs, that was up 42%. They posted a net profit versus a net loss a year ago. Their merchant base, meaning the number of merchants that use Klarna, grew by 54%. And their credit quality actually improved. That was a big concern, if you remember, a few quarters ago. But like many companies, the real story here is a guidance cut, and it was a substantial one.

Starting point is 00:10:43 Klarna lowered its full-year revenue guidance. They blamed currency headwinds, and more significantly, they blamed reduced expectations from Germany, which is their number one market by volume. Plus, they announced some big management changes. Their CFO and their chief marketing officer, both of whom have been with the company for a long time, are stepping down early next year. So forward looking softness can crush a stock, even when the backward looking numbers look great. And that's definitely what's happening here. Right. This is pretty simple. When you're trading at 20 times expected revenue, and we can, as Matt said, they move to a profit, so we can give them a forward PE here a little 85 or so times forward earnings. when you're trading at these levels the market wants perfection yes perhaps a sell-off seems odd with decent numbers but we're in a situation where decent isn't good enough and that's what

Starting point is 00:11:36 we're seeing in the reaction today i also have to imagine too when you're seeing softer guidance in conjunction with two of the people who are largely probably responsible for creating such guidance the cfo and the chief marketing officer all talking about transitioning you can definitely see why the market might be a little bit more spooked than normal. And look, Klarna is a financial services company. And I have to imagine that some of what we're talking about here in the bond market up in the first segment, where we have rising interest rates in the private market, we're starting to see higher rates of default or write downs on private credit. And so there is creaks in the credit debit finance environment, which I think kind of just adds to the kind of

Starting point is 00:12:20 piling on, I guess, if you will, for all of this. So considering this, like what we saw, softer guidance, what we saw with rising interest rates, cost of capital, because, you know, Klarna does have deposits, which does mean like you got to fight for that capital. What can we expect from Klarna? Is this like the trend that we're going to see for a while now, or is there perhaps some sort of turnaround coming? On one hand, Klarna funds its business, at least 90% of its lending business with low cost deposits. So that's a nice competitive advantage. Klorna is a bank, unlike some of its competitors, but we're in a higher for longer rate environment. And the longer we go, the longer it seems like that's the case. And that leads to

Starting point is 00:12:57 a stretched consumer. For a company that relies on payment volume and fees from people buying things, that's definitely a problem. To tie it into your global bond question from earlier, their guidance reduction, as I mentioned, was mainly tied specifically to expected softer consumer spending in Germany. We mentioned European bond yields are at multi-decade highs in a lot of cases. So of course, the effects of this are not Klarna specific. So this is nothing the company's doing wrong. And the company's credit metrics moved in the right direction, but it's definitely, you know, they're being affected by this environment. Right. This is macro concern, not Klarna's ability to fund itself, but on the subject of Klarna. And

Starting point is 00:13:33 here's the thing. We never really know, fully know about a new fintech business, a new lending business until it has weathered a full cycle. Everything else is just modeling and the model tend to get things wrong. The market is focused on the near term. It's focused on things going wrong from here with the consumer. I think that's appropriate. But as a long-term investor,

Starting point is 00:13:57 I can't just whistle past this because we really don't know yet. There's a chance that Klarna proves itself out in a recession here. And we find out, yes, their models work. And this is a business that can weather an entire credit cycle. There's a chance that we'll learn that they can't.

Starting point is 00:14:13 And as a long-term focused investor, I just need to accept that risk and accept that just we don't know. And there's no way to know until they go through it if you choose to buy in here. And back to my earlier point, when you are paying a high valuation for that uncertainty, I'm probably not surprised that there's at least some weakness or at least some lack of eagerness to jump in now and buy this. We say the market doesn't love uncertainty, but it seems to like it when it's a bull market. But when the bear market comes, all of a sudden, everyone's afraid of uncertainty.

Starting point is 00:14:46 But speaking of a company that has definitely weathered the cycles up and down for quite a while, we're going to talk about Home Depot's earnings. New from Nespresso. Blend wellness into your coffee routine with the Coffee Plus range, infused with functional benefits. Choose the coffee you love with added B vitamins, like Coffee Plus B12 to help support immune function And Coffee Plus B6 to keep your day moving. Or go with the flow and choose Ginseng Delight, our new double espresso with ginseng extract. Whatever lies ahead, don't change your morning.

Starting point is 00:15:23 Let your morning change you. Discover Coffee Plus on Nespresso.com. I guess you could say it's the continuing theme of the day where we're talking about companies that are very much influenced by what's happening in the macro environment. And I think Home Depot is definitely in that realm. They reported earnings today. Shares are only up about 0.4% today. So it was kind of a little bit of a nothing burger reaction from Wall Street. Market's down. So maybe you could say, hey, they're up while the market's down. So putting a positive spin on it. Lou, what was in the report that might have people a little optimistic or is it maybe just a little bit of beating expectations, but the long-term trend kind of stays the same with Home Depot? They held serve, period. They didn't break. They didn't do anything too impressive, but they held serve.

Starting point is 00:16:07 They beat on the top and bottom line despite operating in what management called a frozen housing market. That's not great to hear, but look, again, they did okay. Looking under the hood, there's a lot going on. Comp store sales only up 1.7%, which looked a lot like price increases and not volume increases. So we would like to see volumes growing. Also, the company received $730 million in tariff-free funds in the quarter, which helped offset pressure on higher-than-planned fuel, higher-than-planned energy, and product input costs. Management said it expects the higher costs to, quote, fully offset the tariff benefit. So the macro net is negative right now. They are basically saying that we can't just count on tariff-free funds to cover our higher costs forever. Home Depot has gone nowhere over the last five years. The stock is up just 5%. To be honest, that's pretty great. That's pretty amazing that it's held up as well as it has considering

Starting point is 00:17:05 everything going on in the housing market. The company has lots of levers to pull. And I think investors kind of have baked in that the issues are macro, the issues aren't Home Depot specific, and that Home Depot will get through the cycle. So I think it's pretty impressive how patient the market has been and tolerant of kind of underwhelming numbers. But at some point, we would like to see acceleration here. I don't know when that's going to happen. Beating expectations in a frozen housing market is, it's certainly impressive and it really shows Home Depot's resilience compared to some other real estate plays, which we'll get to in a minute. The comp store sales growth, Lou mentioned it was 1.7%. That's not a knock your socks off number,

Starting point is 00:17:44 but it does represent an acceleration over the previous quarter, which that in a frozen in housing markets pretty nice. The company also reported a higher average ticket, meaning like the average sale they're making went up significantly. And the big projects, which are often funded through home equity, like a full kitchen renovation, for example, those are still mostly on hold. That's what's been holding their business back really for the past four years. But the larger average ticket, it does show that smaller projects at least are making a pretty nice comeback here. So that's really nice to see too. The only thing I would nitpick here too, though is yeah comps at 1.7 yeah it sounds good and it's accelerating but it's also below inflation

Starting point is 00:18:21 right now so it's not exactly keeping up certainly we need to follow up on as we kind of watch the home depot story and i want to tie this back to our theme on bond yields the macro environment going on higher interest rates has basically kept that firm lid on housing just like executives home depot said it's a frozen housing market so does this make anything like can you be there the home improvement companies, Home Depot, Lowe's, or anything else housing or real estate related look attractive as kind of like that bottom of the cycle type of investment, even if we're not necessarily at the bottom of the cycle here. As an investor, I'm quite content to be late here. Home Depot said most of their business is being driven by small projects, not, as Matt said,

Starting point is 00:19:03 huge renovations. And we got terrible housing numbers for July today. Single family housing starts fell by nearly 10%. We're close to November 2022 lows here. Pending home sales came in at the second lowest level in history. Glass half full, we got to be close to a bottom when we get down to these levels. Glass half empty is we can just scrape along that bottom for a long time. There's no guarantee that that bottom is rubber and we're just going to bounce off it. Given what we've talked about, given everything we're seeing right now, as I said, I'm very content to just kind of wait and see signs of an actual rebound. My guess is, is that there is going to be a quick rebound and I'll remain on the sidelines here. I completely agree with what Lou just said.

Starting point is 00:19:49 And this is coming from someone who's very long-term bullish on things like home builders and certain real estate adjacent stocks like rocket companies. The thing that makes these stocks look cheap, like they might be at a cyclical bottom right now is the same thing that the bond market is telling us right now is not going away anytime soon at the higher rate environment. I mean, with Home Depot specifically, there are bull and dare arguments to be made here. So the lock-in effect, meaning that people are being stuck in their homes longer than they want to because of high mortgage rates, that's what's fueling that small project demand. People are making improvements to their home, not moving, which is part of the resilience with this business.

Starting point is 00:20:25 The company's beating expectations in frozen market conditions, it really shows how resilient this business is. But I mean, like I said, while customers might be improving their existing homes, like doing projects they had been putting off the big projects are still largely on hold and that's not going to go away and the bond market's telling us it's not going to go away anytime soon so we'll have to wait and see on that if we are early to a housing market thaw it's like lou said he's perfectly content to be late to the party and there's nothing wrong with that but a durable business like home depot or lowe's could be a good way to play it at this stage just i mean be aware that you're getting a quality business but it might be a little while until your thesis

Starting point is 00:21:03 fully plays out. Yeah, I'd say as both an investor and also kind of sitting on the energy and materials like editing desk at the Motley Fool during the 2010s, a cyclical bottom can stay at the bottom for a long time. We saw it in oil and gas from like 2014 all the way through 2020. We saw it in mining and materials all through the 2010s as the China slowdown thesis started to play out. So if you are one of those investors who's like, I think we're at the bottom of the cycle, it's possible that these cycles can remain way, way longer than you might actually think is possible. So always keep that in mind. Well, guys, that's all the time we have for today. Matt, Lou, thanks for sharing your thoughts. I'm going to hit disclosure and we'll get out of here.

Starting point is 00:21:43 As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for our guests. So don't buy or sell stocks based solely on what you hear. All personal finance content follows Motley Fool editorial standards and is not approved by advertisers. Advertisements or sponsored content provide for informational purposes only. To see our full advertising disclosure, please check out our show notes. Thanks for producing Christy Waterworth and the rest of the Motley Fool team. For Matt, Lou, and myself, thanks for listening, and we'll chat again soon.

Motley Fool Hidden Gems Investing - The Bond Market Selloff is Showing up in Earnings Reports

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