Capital markets perspective: No going back

Capital markets perspective: No going back 

04.30.2024

For growth stocks, declaring a dividend has clear benefits. It makes sense to be as flexible as possible with your capital structure. However, sending money back to investors may allow skeptics to argue that management might be running out of ideas. Besides, declaring a first-ever dividend is also a pretty big commitment: Once you start, it’s difficult to go back.

Recently Google’s parent company, Alphabet Inc., declared its first-ever cash dividend in conjunction with its first-quarter earnings on Thursday (a $0.20 payment due to shareholders on June 10). Incidentally, those earnings were spectacular and the stock popped 10% in the after-hours session. But what was even more interesting isn’t how markets reacted, but rather how they didn’t: There was scarcely anything written about the potentially negative signal sent by the dividend payout, and virtually no evidence of it in the stock’s after-earnings performance. 

There are several possible explanations for that ambivalence. First and foremost, it’s not as if Alphabet’s management team is in danger of running out of ideas to profitably deploy capital anytime soon, and besides, the company continued to buy back stock – something that sends an equal and opposite signal to markets than a dividend declaration does. Moreover, Alphabet’s valuation means the stock probably had more headroom to run with after a strong earnings report.

But there’s also another way to think about Alphabet’s blowout earnings and the market’s happy reaction that carries broader implications for markets and the economy. One of the reasons the company posted such great earnings is that its cloud division – logically one of the first and most powerful beneficiaries of the AI wave – absolutely crushed expectations. It wasn’t necessarily that Google’s cloud unit sold a whole lot more than analysts expected (the division’s topline only exceeded estimates to a moderate degree), but rather that what it did sell appeared to be far more profitable than markets assumed, as was clear in the operating income attributed to cloud (which beat analyst estimates by roughly a factor of 1.33x).

In the quarterly earnings minutiae of a single company, there is a bigger point to be made: If GOOG’s cloud results are any indication of how much more profitable the transition to AI might be for those who are leading it than analysts were already assuming, then it could justify at least some of the hype. Last week’s results (which, by the way, were echoed in some ways by Microsoft’s cloud earnings earlier in the week1) could be an indication that the capital intensity of the transition to an AI-enabled world is far lower than the transition from the industrial age to Web 1.0. That’s clearly a good thing.  

Last week stands as a reminder that the details of each cycle are different, even if the broad strokes are the same.  

Meanwhile, the U.S. economy continues to chug along somewhere in the grey zone between growth and contraction. Last week’s big news was the Bureau of Economic Analysis’ first estimate of first quarter GDP: Due to weaker-than-expected spending by consumers and a big spike in exports (which, through the magic of national income accounting represents a detraction from GDP), economic growth came in at a sluggish 1.6%.2

When it comes to the consumer, that may not be a surprise – the consumer is becoming increasingly stretched. That conclusion was supported last week by Friday’s income and outlays report (also from the Bureau of Economic Analysis3), showing spending growth once again outpacing income growth – something that has become almost commonplace since inflation at the consumer level first crossed the 3% threshold in mid-2021.

Let’s be clear, the consumer hasn’t conceded yet, and last week’s GDP report was just kind of ”meh” rather than awful. It’s also entirely possible that the next estimate of first-quarter GDP (BEA routinely estimates each quarter’s GDP a minimum of three times) will be better. But what last Thursday’s GDP release did do was lend a smidge of credibility to the idea of stagflation. By almost any standard, GDP growth of 1.6% is below long-term trend for the U.S. economy, and core Personal Consumption Expenditures inflation of 3.7% (which was also a line-item in Thursday’s release) is above it. That’s not stagflation, but both indicators are suddenly pointing uncomfortably in that general direction.  

Soft GDP numbers weren’t the only sign that the U.S. economy might finally be reacting to 5%-plus worth of Fed-sponsored rate hikes by slowing down, either. Regional Fed manufacturing reports from Richmondand Kansas City5 each showed a decline in manufacturing activity in their respective regions, echoing the New York Fed’s Empire State manufacturing release a few weeks ago (one positive outlier worth mentioning, though, was the Philly Fed, which surprised to the upside last week). But one consistent theme in each of these reports – even Philly – was declining hours worked and employment growth. Ditto for last week’s flash Purchasing Manager’s Index from S&P Global, which saw manufacturing activity return to contraction and registered the first decline in employment in four years as “companies cut payrolls at rates not seen since the global financial crisis” (if the early pandemic lockdowns are excluded).6 As we’ve documented, labor markets are usually the last to decline during a Fed-engineered slowdown. If that pattern holds, the idea of a “soft landing” might once again become scarce.

What to watch this week

If a Fed meeting wasn’t enough (begins Tuesday, ends Wednesday), then there’s also Friday’s non-farm payroll report and all the preamble that comes with it to digest. In the meantime, there’s also the final ISM/PMI reports (manufacturing on Wednesday and services on Friday), as well as a consumer confidence report (the Conference Board releases its version on Tuesday), and two separate reads of home prices (Tuesday).

Earnings season is still underway, with no fewer than 800 notables set to release first quarter results on Wednesday and Thursday alone. This week’s highlights include Amazon (Tuesday) and Apple (Thursday.) There’s also a host of semiconductor companies and the potential read-through into the fast-developing story of AI that they may (or may not) offer (ON, NXPI and AMD report on Monday and Tuesday), together with any insight that consumer brands Starbucks and McDonalds (both Tuesday) might have to offer about the health of the U.S. consumer. To cap it all off, Warren Buffet’s Berkshire Hathaway – always relevant as a microcosm of the economy and worth following simply to get a sense of what Buffet is thinking about in any event – reports on Friday.

Regarding that Fed meeting, markets have moved on from the expectation that May would be the month that the Fed finally started cutting rates: Futures markets are currently predicting about a 3% chance of any move at all. To be sure, recent commentary from the Fed has redirected traders away from aggressive expectations concerning cuts, with Fed reps such as John Williams (New York), Raphael Bostic (Atlanta), and Neel Kashkari (Minneapolis) each suggesting that the Fed is in no hurry to begin cutting, and one or two of these individuals even hinting that they’d be open to increases if the economic data evolves in the wrong direction.

If anything could succeed in bending the Fed narrative back over on top of itself, it would be an unexpected result of any kind in this week’s labor data, which begins on Wednesday with the Bureau of Labor Statistic’s JOLTS report (the headline of which will show if there are still more job openings than job seekers) and extends through Friday with the all-important non-farm payrolls data. And as always, I’d give special attention to Thursday’s layoff tally from Challenger, Gray & Christmas, which has hinted at labor market softness for a few months running even as weekly unemployment claims data loudly suggests otherwise. Again, the labor market is walking a tightrope as far as capital markets are concerned, and a surprise in either direction could create pressure: If labor markets are too strong, then the potential for Fed rate increases is back in play, but if the balance of jobs data is surprisingly weak, then recession is back in play.

For what it’s worth, I view the latter scenario as the more likely of the two – particularly given employment declines singled out by the regional fed reports and anecdotes like the flash manufacturing PMI’s contention that firms are “cutting jobs at a pace not seen since the financial crisis,” both described above. But if recent experience has proven anything, it’s that betting against the U.S. jobs market is not effective. Still, if the labor market is about to tip over, that would square well with its historical tendency to weaken only after a round of Fed tightening has been in the pipes for months. 

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1 Company reports, Zacks.com and Bloomberg 

2 https://www.bea.gov/sites/default/files/2024-04/gdp1q24-adv.pdf 

3 https://www.bea.gov/sites/default/files/2024-04/pi0324.pdf 

4 https://www.richmondfed.org 

5 https://www.kansascityfed.org/Manufacturing/documents/10130/2024Apr25mfg.pdf 

6 https://www.pmi.spglobal.com/Public/Home/PressRelease/2a6d069e95b3402f85a5e44e3ff49917 

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Tom Nun, CFA

Contributor

Tom Nun, CFA, Portfolio Strategist at Empower, works alongside teams overseeing portfolio construction, advice solutions, portfolio management, and investment products and consulting.

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