Higher Bond Yields and Interest Rates Are Here to Stay

Sarah Hansen, Morningstar Inc markets reporter, explains the new normal of bond yields and interest rates and where investors can find fixed-income opportunities. Adam Fleck, director of research for ratings and ESG for Morningstar Research Services, discusses how companies with union workers can compete against non-union firms.

Apple’s Solid Fiscal Fourth Quarter

Eli Lilly’s Diabetes Drug Lift in Q3

McDonald’s Is Resilient Under Inflation Pressure

‘Higher for Longer’ Era

Tight vs. Loose Financial Conditions

'Higher-for-Longer' Side Effects

Fixed-Income Market

Opportunities for Investors

Are Labor Unions Bad for Business?

Risks and Benefits of a Unionized Workforce

Can Unionized Companies Compete with Non-unionized Companies?

GM, Ford, and Stellantis Uncertainty Ratings

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Why investors should consider higher bond yields and interest rates the norm *and* not anomalies. Plus – Morningstar’s outlooks for Apple and Eli Lilly and the sales of their popular products. And – a look at the debate whether companies with union workers can compete against firms that are nonunion. 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. 

Apple reported a solid fiscal fourth quarter. Revenue came in a bit under $90 billion. It dipped year over year but fell in line with Morningstar's expectations. iPhone sales were up. It’s a good sign that demand for iPhone 15’s will continue although the macroeconomic environment remains shaky. Gross margin reached a record high of about 45% thanks to cheaper components. Those usually refer to memory chips. Switching to in-house processors within iPhones, iPads, and Macs also contributed. Services revenue impressed as more subscribers join Apple’s iOS ecosystem. That provides opportunities to upsell apps and services. Morningstar predicts Apple’s revenue will be flattish for the December quarter. iPad and wearables revenue should be down significantly due to the timing of new product launches compared with last year. Morningstar estimates Apple's stock is worth $150 and modestly overvalued.

Diabetes drug Mounjaro and other medications helped lift Eli Lilly’s third-quarter results. Sales rose 24% even after excluding coronavirus products and the sale of one of the company’s drug portfolios. Morningstar expects this rate to continue over the next couple of years. Mounjaro brought in $1.4 billion in sales and remains key to Eli Lilly’s growth potential. It could reach annual sales of over $30 billion. Lilly has also made strides in increasing its supply of Mounjaro, so that it will no longer appear on the FDA’s drug shortage list. However, Morningstar thinks supply constraints may limit the medication internationally in 2024. Lilly's remaining portfolio and pipeline are performing well. Both are reinforcing its competitive advantage. Morningstar is maintaining its $368 estimate for what Lilly's stock is worth. However, the market seems too optimistic about the pharmaceutical giant’s outlook.

McDonald’s is showing resiliency during this time of inflation pressures. The global fast-food giant brought in nearly $6.7 billion in sales in the third quarter. It also reported $3.17 in earnings per share.  Both results beat Morningstar's estimates. Store traffic dipped lower than expected in the quarter. It’s facing competition for lower-income customers and breakfast sales. So, Morningstar has lowered its 2024 comparable store sales estimates. Meanwhile, McDonald’s has made strong progress. It has launched its McSmart value menu in response to customer demand. The company has rolled out a marketing campaign to highlight its media appearances over the past two decades. Furthermore, it’s seeing more of its sales come through digital channels in its top markets. Morningstar estimates McDonald’s is worth 290-dollars per share, up from 285-dollars. Its stock price looks compelling. 

This higher-for-longer environment is flipping many investors' expectations about what's considered normal. The Fed's fight against inflation is bringing a lot more attention to the term financial conditions. Morningstar Inc.'s markets reporter, Sarah Hansen, has written about bond yields and other factors affecting the economy. Thanks for joining me, Sarah.

Sarah Hansen: Thanks so much for having me.

Hampton: So let's start with an explainer of financial conditions, what it means in when they're tight and when they're loose.

Hansen: Sure. So financial conditions is this big umbrella term that refers to a whole bunch of different factors that affect the economy, that affect businesses, and that affect consumers. So different economists measure it differently, but the category generally includes things like interest rates, bond yields, equity evaluations in the stock market, the strength of the dollar and credit spreads. And these are all things that both affect the economy and they change based on how the economy is doing.

So tighter financial conditions point to a situation where credit is harder to access for businesses and for consumers. It means that borrowing costs are more expensive, and that means that over time the economy is likely to contract. On the other hand, looser financial conditions are just the opposite. They point to an economy that's growing and expanding. It's easier for people to borrow, money flows more freely. This is what the Fed is aiming for, right, when they're trying to prevent a downturn. They'd want to loosen conditions, whereas recently they've been trying to tighten conditions because they're worried that the economy is running a little bit too hot. So it's overall, financial conditions are just a snapshot of where we are in the economy at a given point in time and where we're headed.

Hampton: And Fed Chair Jerome Powell says, "Higher bond yields are tightening those financial conditions." What trends have market watchers seen?

Hansen: Sure. So one side effect of the Fed's higher-for-longer strategy, where they're telegraphing to the market that they intend to keep rates elevated compared to where we've seen, has been a pretty dramatic run-up in yields. It's probably worth noting that that has softened a little bit over the past week, but still yields on the 10 year, for instance, recently hit their highest level since 2007. Those yields are an important benchmark for lots of borrowing costs, like mortgages for consumers and also for businesses. When those costs go up, as yields go up, spending goes down and growth slows. Also at play is a stock market angle. When bond yields are that attractive, when yields are rising higher than we've seen, the outlook for stocks becomes a little bit more uncertain. So stocks rallied last week, but still over the last three months, they're still 3% lower than they were.

Hampton: And you've written that current bond yields are normal and lower rates before now were the anomalies. Talk about that.

Hansen: Yeah, it's kind of counterintuitive. During the pandemic, a lot of attention was paid. The Fed brought rates down very, very dramatically and then raised them very, very dramatically up from about zero to over 5% today. And that was a big change in a very short period of time. And a lot of people wondered when we would normalize and drop back to our pre-pandemic levels. But actually, strategists have pointed out that the years between the 2008 crisis and the pandemic were themselves abnormal. It has to do with a policy called quantitative easing, which is what the Fed used during that time to stimulate growth, and strategists say that it kept rates artificially suppressed. So over the past 60 years or so, if you take a much longer time horizon, yields have averaged about 5.9%, 6%, which is actually higher than we are today. So long story short, the last 15 years were the exception rather than the rule when it comes to rates... yields.

Hampton: And why are many investors paying close attention to the so-called neutral rate?

Hansen: So the neutral rate is a funny thing. It's a pretty abstract concept. There's no formula, there's no one way to measure it, and it's pretty backwards looking. But what it refers to is this interest rate where the Fed's policy is neither restrictive nor accommodative. So the Fed isn't tightening the screws, but it's not loosening them either, and everything is riding in equilibrium. It's hard, obviously, to determine that exactly, but the conversation that's been happening is strategists have been saying, "Maybe right now the neutral rate is actually higher than it was before the pandemic." And what that means is that the economy can support tighter rates than we used to think it could, and still have things growing. So the implication then, it's more evidence that rates could stay higher than they were for a longer period of time.

Hampton: And what did the folks you talked to say about opportunities in the fixed-income market?

Hansen: Sure. So it goes back to this period of normalcy in an abnormal period for yields. For years, we've had negative real yields, yields that are adjusted for inflation in fixed income, which meant that bonds were boring, they were staid, they were not an attractive class for investors. But now with interest rates and yields rising, that's flipped a little bit, and with higher rates, investors can find virtually risk-free opportunities in fixed income that weren't there before. And so what that's prompted is people to reconsider cash, which used to be a very attractive part of a portfolio and a very important part of portfolio construction. People are saying, "Maybe we're going to reallocate a little bit towards fixed income, where I can get those returns more so than I would if I just kept my money in cash."

Hampton: So Sarah, what is your final advice for investors right now?

Hansen: So the last thing I'll say, that's been repeated by strategists to me, is that yields may have further to rise, but it's better to be earlier to this trade than later. Investors shouldn't feel like they need to wait for that peak to start thinking about reallocation.

Hampton: Well, Sarah, thank you for your time today.

Hansen: Thanks so much for having me.

Hampton: Worker strikes have gained momentum. United Auto Workers recently reached tentative deals with the big three automakers – GM, Ford and Stellantis. Employees and other industries have also staged walkouts to call for higher pay or better working conditions. Adam Fleck has written about whether labor unions are bad for business. He is the Director of Research for Ratings and ESG for Morningstar Research Services.

Thanks for being here, Adam.

Adam Fleck: Thanks for having me.

Hampton: So, let's start off with the question that you posed in your article. Are labor unions bad for business?

Fleck: Well, the shorter answer is, it depends. We do find that some of the long-held negative beliefs about unions are true. Companies with higher levels of unionization on average tend to have fewer moats and lower returns on invested capital, which is an important profitability metric. But there are some positives as well. If you look at things like employee turnover or lost time incident rates or uncertainty, for instance.

Hampton: What are the risks and benefits for companies and investors if a workforce is unionized?

Fleck: Well, one of the biggest risks is work stoppages, as you talked about it. Employees walk out on the job. And we do find a moderate positive correlation with companies that have higher unionization levels and incidents related to human capital challenges over the past five years. But there are benefits as well. As I mentioned, companies with higher unionization levels tend to have lower employee turnover. And recently, we've seen a positive trend of lost time incident rates or injury rates. I think the argument here is that unions create a better workplace environment for their employees and perhaps a safer environment as well. So, some benefits to consider when you're looking at investing in companies with high union levels.

Hampton: Now, there is this debate whether companies with union workers can compete against firms that are non-union. What have you found?

Fleck: I think case studies are really helpful here. For instance, we can look at the U.S. airline industry. Delta, one of the largest carriers, is a company with a lower unionization level. And indeed, they have higher return on invested capital over the past several years than their legacy competitors like United or American Airlines. But Southwest, a low-cost carrier, is also heavily unionized, but actually has the highest ROICs over the past five years compared to all four. And I think that's because Southwest has found a niche that it can operate in and again has that low cost advantage.

In the parcel carrier space, you can look to UPS versus FedEx as another example. UPS, again, a highly unionized company. FedEx has a lower unionization level. But we assign UPS a wide moat and FedEx a narrow moat and that owes to UPS's denser package network as well as their combined Express and Ground networks, which customers really appreciate. So, I think, overall, companies with high union levels can certainly compete with companies with lower unionization levels, but it takes a differentiated strategy, solid execution and ultimately, robust competitive advantages.

Hampton: Now, Morningstar Research Services strategist, Dave Whiston, he came on Investing Insights. He named GM his top stock pick. How does Morningstar view GM, Ford and Stellantis through its uncertainty ratings?

Fleck: Well, like I mentioned, companies with higher unionization levels tend to have lower uncertainty ratings, meaning that we see them as lower-risk investments over the very long run. But it's still very industry-specific when we dig into individual companies. So, GM, Ford, Stellantis, all three, we assign a high uncertainty rating that aligns with most large global automakers like Toyota, Honda, and Volkswagen. We do assign Tesla a very high uncertainty rating. It is, of course, not unionized, but that owes more to the uncertain future around electric vehicles than it does their unionization level. So, as always, we have to consider individual perspectives and valuation remains critical. And GM does indeed look like one of the cheapest automakers out there right now.

Hampton: All right. Well, Adam, thank you for your time today.

Fleck: Thanks for having me.

Hampton: That wraps up this week’s episode. Thanks for listening. If you enjoy hearing market trends and analyst insights on our podcast, feel free to leave a five-star review on Apple Podcasts. It will help others find us. Thanks to senior video producer Jake VanKersen, and lead technical producer, Scott Halver. I’m Ivanna Hampton, a senior multimedia editor at Morningstar. Take care.