The Transcript 2Q24 Letter
Reviewing the key themes from 2Q24 through C-suite quotes
Summary: The first half of 2024 reveals slowing growth with retail sales and consumer spending barely up, hinting at potential rate cuts if inflation is truly below target. AI-driven gains have sharply divided the market, with the S&P 500's rise led by a narrow set of tech stocks, while traditional sectors lag. Amid this, signs of a possible mild recession loom, with bifurcated consumer behaviors and labor market pressures adding to economic uncertainty. What does H2 24 Hold for us?
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Macro
At the start of 2024, many people expected that the Fed would be lowering interest rates multiple times this year. Due to perceptions of sticky inflation, hopes for rate cuts have been dialed back. However, in the last couple of weeks, we’ve seen signs that growth is materially slowing.
"Inflation, we find to be lower than what the Fed is reporting. In particular, we think that the real estate numbers are significantly higher than what we're seeing in the real world" - Blackstone (BX) CEO Stephen Schwarzman [June 24th: Half Full or Half Empty?]
Bank of America and Capital One both noted that debit and credit card spending growth is now in the 1% range. This is consistent with the official report from the Census Bureau which showed retail sales up 2.3% y/y in May. The main reason that these figures are important is that they are not inflation-adjusted. This means that either real growth has turned negative or inflation on consumer purchases has slowed below the Fed’s 2% target.
“Our spending trends have…slowed down. We're down to sort of 6% net spending growth in Q1" - Capital One (COF) SVP of Finance Jeff Norris [June 24th: Half Full or Half Empty?]
"Bank of America aggregated credit & debit card spending per household rose 0.7% YoY in May, following 1.0% YoY rise in April.” - Bank of America (BAC) Institute [June 24th: Half Full or Half Empty?]
Neither of these possibilities seems to be discounted by markets or the Fed at this time. If inflation has fallen, then it could give the Fed cover to begin lowering rates later this year. If real growth has turned negative, it could give the Fed a reason to lower rates aggressively. Hardly anyone is talking about a recession at this time, but this data does give some cause for concern. The past couple of years have been somewhat of an anomaly in that we haven’t had a recession despite restrictive monetary policy.
"I was looking at an article this weekend. More than 50% of American consumers believe that we're in a recession. At some point, it doesn't really matter what the data says at the highest level. It is a question of how secure does the consumer feel” - Best Buy (BBY) CEO Corie Barry [June 17th: Slower Growth]
Underlying the slower consumption growth is a consumer who is at best bifurcated. We have seen clear signals for many months that lower-income consumers are struggling with diminished purchasing power and inflation. The lower-income consumer continues to spend but has been trading down. Recently we saw signs that this consumer segment may be beginning to worry about job markets. Either way, the economic data certainly seems to be sitting at a pivot point where the theoretical “risk balance” that Jerome Powell has frequently talked about may be beginning to tip out of favor of inflation and toward recession.
"We're seeing some consumer dynamics. This bifurcated consumer is the way we've described it, where those on the lower end are making, in some cases, move from branded to private label, and in some cases, moving from foodservice into retail” - Tyson Foods (TSN) COO Donnie King [May 21st: Less Sticky?]
Against this backdrop, the S&P 500 is up a spectacular 15% year to date. This is not consistent with the data that we’re seeing here, but it reflects a different dynamic. As has been chronicled extensively elsewhere, a very narrow set of stocks is driving the entirety of the S&P 500’s gains. The Dow is only up 3.79% this year while the Nasdaq is up 20%. Within capital markets, we increasingly have two classes of companies: those who benefit from AI and everyone else.
International
In our international section, the most noteworthy dynamic that we’ve noticed is the divergence in monetary policy in Europe vs the United States. As inflation has fallen in Europe and growth has been consistently more sluggish than the US the ECB has begun to lower interest rates. This could have some impact on currency markets and create a headwind for US companies’ earnings when translated back into dollars.
“We remind ourselves that China is still in recovery. We're seeing consumers understandably similar to what we saw in Europe as well as in the Americas when restrictions were lifted and people started resuming normal activities, the priority was on seeing family" - Estée Lauder (EL) CFO Tracey Travis [June 10th: Spending but Sweating]
"We're seeing that recovery in China, retail is a little slower." - Hormel Foods (HRL) CEO James Snee [June 17th: Slower Growth]
Meanwhile, in Asia, China’s growth remains slow. The economy has struggled to ever rebound from Covid and its construction industry is particularly weak. Management teams continue to want to move supply chains away from China and near-shore where possible. This is leading to economic benefits for countries like Mexico, India, and Vietnam.
"The supply chain patterns are fundamentally changing...Now to specifically, Mexico is an area where things are moving towards -- you can see it in Vietnam. You can see in Southeast Asia, you can see in India. And we'll see how these trends play out, but we see it, like I said, in the bottom up & we move past the manufacturing." - FedEx (FDX) CEO Rajesh Subramaniam [June 3rd: Working as Designed]
Financials
Capital markets have been more open in 2024 than in 2023 although they don’t seem to be fully healed from the impacts of a higher interest rate environment. We are seeing comments that the M&A environment could accelerate. Commercial banks continue to experience strong credit quality, but loan demand is weak.
“Look, I'd say the debt markets are open. The IPO market is not as open as investment bankers tell you it's open, but it's getting better…if the markets kind of continue on their current trajectory, I think you'll see a lot of realization activity…So I'm optimistic, but we need these markets to continue to improve." - Carlyle Group (CG 0.00%↑) CFO John Redett [June 17th: Slower Growth]
Consumer
In recent months the bifurcation of the consumer between higher and lower income consumers is the most noteworthy storyline for consumers. While the pressure on the lower-income consumer is now well understood, we have also seen some signs that even higher-income consumers are feeling additional pressure. In monitoring the consumer, we’re paying particularly close attention to labor markets now. We are seeing some early signs that labor markets may be less strong than markets presently expect particularly for lower income and temp staffing. While we have not seen any comments to support this, increased use of AI may be starting to have an impact on jobs in these segments.
"The temp penetration rate, it's been falling for 27 months and counting. Generally, when you see a fall in temp employment, it generally means that it's going to have an impact on the labor market. And you just look back historically, and those lag times have definitely become longer" - Korn Ferry (KFY 0.00%↑) CEO Gary Burnison [June 24th: Half Full or Half Empty?]
Technology
Many times during 2024, it has felt like our technology section should almost replace the macro section as the most important thing going on in the economy. The AI boom has been a focal point of capital markets in 2024 and effectively drowns out everything else happening in the tech sector. The most important storyline within AI has been the large-scale capex on data centers to train and deliver AI models. The world’s largest tech companies are currently in an AI arms race. NVIDIA’s GPUs stand at the center of the action. But all vendors to data centers including memory, networking, cooling, and even construction firms are poised to benefit from the spending.
"We're seeing a tremendous demand. And some of it is related to AI…What AI has done is it's put pressure across the ecosystem on pricing, so prices have gone up. And so that's allowed us to also raise prices while still having years of record sales." - American Tower (AMT 0.00%↑) CEO Steven Vondran [June 10th: Spending but Sweating]
"...the acceleration that we have seen, both in the last quarter of 2023 from an order standpoint and this first quarter of 2024 is predominantly coming from hyperscaler and colocation." - Vertiv (VRT) Giordano Albertazzi [May 10th: Center Stage]
In this section, we’ve also covered many use cases of AI. Companies in every industry have talked about AI on earnings calls. It’s well understood that the first two areas in which AI is having the largest impact are software engineering and customer service. However, we’ve seen many interesting and novel use cases for AI across industries beyond just these two.
“...there is the opportunity to use AI to understand how to mix and combine different flavors to produce something better than we've had in the past is happening as we speak. The work on Sprite and Fanta at the moment is derived from that new flavor technology that we have" - Coca-Cola (KO 0.00%↑) CFO John Murphy [June 17th: Slower Growth]
“We've launched our first order type -- AI-driven order type in our markets, Dynamic M-ELO. It's increased the volumes of that particular order type by 20% since we launched it” - [June 10th: Spending but Sweating]
As companies adopt AI we’re getting some early insight into the architectures that they're using as well. It seems that companies are trying to use a multi-model, open-source approach as much as possible to decrease reliance on any single vendor. Companies are also trying to figure out how to leverage models within their own security and permissions environments without having to directly train or fine-tune costly models. The result is that companies are trending towards patchwork AI systems that could lead to a proliferation of proprietary and individualized approaches. One company noted that “AI Engineers,” who can integrate AI systems, are a hot new job category.
"What's been referred to as the rise of the AI engineer. It's that person that's maybe not a deep data engineering or data science expert, but they've learned how to -- how to use brand-new tools and frameworks like [indiscernible] chain and LaMaindex to connect to LLMs using APIs and integrate them with business data and applications." - NVIDIA (NVDA) Director of Product Marketing Bethann Noble [June 24th: Half Full or Half Empty?]
We’re also seeing a divergence in strategies for how AI will ultimately be delivered. Apple in particular has made a bet on deploying smaller-scale models at the edge to protect privacy and security while leveraging higher-power models in the cloud as needed. This however seems to be somewhat contrarian compared to the rest of the industry.
“...two of these models — a ~3B parameter on-device language model, and a larger server-based language model available with Private Cloud Compute and running on Apple silicon servers — have been built and adapted to perform specialized tasks efficiently, accurately, and responsibly." - Apple (AAPL) [June 17th: Slower Growth]
Within the rest of the technology sector, AI has seemed to suck the air out of the room for traditional IT and SAAS companies. IT executives are increasingly focused on AI strategy and there are indications that budgets have shifted along with that. Sales cycles for traditional tech players have lengthened. Outside of GPUs the semiconductor industry broadly finds itself working through excess inventory.
"The momentum we saw in Q4 moderated in Q1 & we saw elongated deal cycles, deal compression & high levels of budget scrutiny." - Salesforce (CRM) CEO Marc Benioff [June 3rd: Working as Designed]
"Certainly, seeing that play out in some of the larger deals in terms of elongated sales cycles, elongated closing cycles with those.- Paylocity (PCTY ) President Toby Williams [June 3rd: Working as Designed]
“so all of that has resulted in an overhang that the industry is correcting through at this point. And we think we're getting to the bottom of this cycle and where it's at, but I don't think there's as much visibility into what is the shape of the recovery going to look like." - Microchip (MCHP) CEO Ganesh Moorthy [June 17th: Slower Growth]
Healthcare
Within the healthcare industry, the availability of venture capital in the life sciences sub-sector has been an interesting trend to monitor. This segment has been particularly hard hit by the higher interest rate environment. Less capital for R&D in life sciences has impacted several public companies that supply the industry; however, the environment seems to be trending slightly better.
"What we expect we will see is a growth trajectory similar to what was 2014 to 2017 as opposed to the exponential growth we saw between 2018 and 2021, where money was free, every VC firm in America was looking at life science… And so I would say that neither the technology nor the life science market is anywhere close to where it was in 2020 to '22." - Boston Properties (BXP) President Douglas Linde [June 17th: Slower Growth]
“Now as we think about the biotech segment…we have seen the improvement of the funding levels. And they're just above, I would say, the 2019 levels now after the peak, after -- between the 2 years here” - Danaher (DHR) EVP Rainer Blair [May 21st: Less Sticky]
Industrials and Transport
Freight transportation and logistics markets have been in a deep recession for many months. There has been some commentary that this may be bottoming out if not starting to improve.
"I think right now, the freight market is pretty steady, I'd say. You can see it in the spot rates that people charge. You can see it in -- we can see it in our activity…So we think we've kind of stabilized at fairly low levels, but stable being kind of the keyword." - WEX (WEX 0.00%↑) SVP, Global Investor Relations Steven Elder [May 28th: Healthy and Resilient]
In the automotive industry, high expectations for electric vehicle adoption have not been met. Meanwhile, many industry executives note that China’s EV industry is much more advanced than in the US.
“I think most prognosticators were thinking that the EV market would be up to about 10% of total autos. We still see it trending kind of around that 8% level. As a result, we've talked before about 200,000 to 300,000 EVs this year. We're actually going to trim that to 200,000 to 250,000. So, at the lower end of that, I think it reflects the momentum that we have in the business...Well, I don't think of EV demand as disappointing." - General Motors (GM) CFO Paul Jacobson [June 17th: Slower Growth]
“China is also the world's leading EV market with 37.9% unit growth in 2023, in China, including 24.3% unit growth in battery-powered electric passenger vehicles. It's important to note that most Chinese EV operators have been self-developed without prior participation" - China Automotive Systems (CAAS 0.00%↑) Head of IR Kevin Theiss [April 8th: Done with the Noise]
“There is a bit of a sentiment in the Western world that the EV party is over. We totally disagree with it. EVs and hybrids together reached a 33% share of global car production last year, which is material. I mean, 33% is really big. And there is a total consensus that this year, from that 33% penetration, they will grow another 20% in unit volume. So in a flat SAAR, that 1/3, which is electric, they grow 20% in units this year, which is massive growth" - NXP Semiconductors (NXPI 0.00%↑) CEO Kurt Sievers [June 17th: Slower Growth]
Historically, we have tracked work-from-home dynamics in the Industrials section. The return to the office seems to continue to be winning even though it’s been a slow process. Employees are being asked to step up their time in the office back towards 5 days per week.
"What’s been missing is the kind of bold, disruptive innovation that Nike’s known for & when we look back, the reasons are fairly straightforward...In hindsight…it’s really hard to do bold, disruptive innovation, to develop a boldly disruptive shoe on Zoom. Our teams came back together 18 months ago in person & we recognize this." - Nike (NKE) CEO John Donahoe [April 15th: Growth Has Slowed]
Materials & Energy
The energy section of the Transcript has been a surprising echo of the technology section. AI training and inference come with gargantuan electricity needs. For the first time in many decades, utilities could be a growth area of the economy again. The consensus seems to be that current renewable energy sources are not able to fully meet the growth requirements. This has many people looking towards nuclear or even natural gas to fill the output. Meanwhile, oil demand continues to grow.
"Energy demand is continuing -- we've seen a lot of news recently about where energy demand has been relatively flat for many, many years. and now people are expecting increases. Obviously, driven artificial intelligence, a big driver of that. But also, I mean, just think about it as you take people putting -- people into EVs, that require more electricity” - Caterpillar (CAT 0.00%↑) CFO Andrew Bonfield [June 24th: Half Full or Half Empty?]
“One recent survey showed a projected increase in electric demand to power data centers of 13% to 15% compounded annually through 2030. Put another way, data centers used about 2.5% of U.S. electricity in 2022 and are projected to use about 20% by 2030. AI demand alone is projected at about 15% of demand in 2030. If just 40% of that AI demand is served by natural gas that would result in incremental demand of 7 to 10 Bcf a day” - Kinder Morgan (KMI) Executive Chairman Rich Kinder [April 22nd: Softer Spend Environment]
“The facts are clear. The demand in oil keeps increasing and will continue to do so because the International Energy Agency foresees a demand of 105.7 million barrels per day for 2028 against 102.1 million barrels per day in 2023” - TotalEnergies (TTE) CEO Patrick Pouyanné [June 3rd: Working as Designed]
Real Estate
Housing markets continue to tread water with higher mortgage rates. Prices have stayed surprisingly strong amid weak supply and continued buyer engagement.
"Turning to market conditions, demand has proven resilient even as rates increased from 6.75% to 7.5% through the quarter" - Toll Brothers (TOL) CEO Douglas Yearly [May 28th: Healthy and Resilient]
Within commercial real estate, office continues to be a major area of concern, but forward-thinking private equity firms appear to be getting increasingly bullish on deploying capital to scoop up bargains.
“Now, I'm not saying this is some sort of sharp V-shaped recovery. But as you get to this bottoming period, what you want to do is try to deploy capital into this. And most people are going to be very cautious because they're going to keep reading a lot of negative headlines from the past, and those are going to continue" - Blackstone (BX 0.00%↑) COO Jonathan Gray [June 3rd: Working as Designed]
Conclusion
We’re watching the environment extremely carefully for signs of slow growth given that weaker growth could tip the US into a mild recession over the next 12 months. It’s unclear how capital markets would react to a recession though because the economy is more bifurcated than it has ever been. Today’s capital markets are no longer even a game of upper-income vs lower-income consumers. Indexes are now more dependent on the dynamics of those who benefit from AI vs. those who don’t. At these valuations, as AI goes, so goes the market.