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Friday Five: 2016 Looks More Likely for Rate Hike

December is still possible for a rate increase, but Fed minutes this week suggest it's becoming less likely. Plus, what the market is missing about Yum Brands, Twitter CEO's uphill climb, and more.

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Jason Stipp: I'm Jason Stipp for Morningstar. Welcome to The Friday Five, Morningstar's take on five stories in the market this week.

Joining me with The Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome, Jason.

Stipp: Up first this week: We got Fed minutes on Thursday that gave us a behind-the-scenes look at their last meeting. What is your takeaway?

Glaser: It's a lot of stuff we already knew. They thought that the job market is pretty much fully recovered, if not totally there yet, that inflation remains low, and there's some concern about whether it's going to get up to a 2% level again. Also they were worried about what was happening overseas, particularly in China.

What does this mean for when they are going to raise rates? I still don't think we have an exact date yet. They obviously don't have an exact date yet. But if you look at September's job number, that was much weaker than expected. That raises some concerns about the strength of the labor market. There are no signs yet that inflation is going to come back up, or at least we're going to get signs of that in the next couple of months. Particularly, they think one of the big vectors is that the labor market tightening could create some inflation. So, as the labor market slackens, that maybe means that's less likely.

Things overseas look quieter now; we're not seeing the kind of financial market volatility [we saw earlier]. But all the concerns about China slowing down are still very much there. China is still very much slowing.

It seems like October for a rate increase is pretty much off the table. December is a possibility if we see some strong data between now and then, but it's looking like 2016 is more of a possibility. Stocks rallied Thursday because people think that the rate hike might be coming later. December is certainly possible, but it's becoming less likely.

Stipp: You mentioned China there. We got some clear signs that China really is slowing down in Yum's results. What's the latest on that?

Glaser: As our analyst RJ Hottovy said, Yum Brands' results were the clearest sign to-date that the Chinese consumer is exercising more caution. We saw it in their results, and the shares plunged on this news--both the disappointing results from this quarter but also the guidance and the headwinds that management was describing in China.

There are a lot of things happening in China that are impacting consumers. There were also some company-specific issues that are impacting Yum, things like online aggregators having very aggressive discounting, which is hurting their profitability and their sales in China. But for the most part, it's definitely weak, and looks like it will be below trend for quite some time.

But RJ thinks that investors are overlooking a lot of what's going right for Yum right now. Even if there's some short-term pain in China, long-term it's a great story for restaurants. China's growing middle class is going to want to eat out more, their restaurants are well-positioned, and they are going to be able to succeed over the longer-time horizon. They are also not getting credit for the turnaround that's happened at Taco Bell, the strong results happening there in the United States. KFC outside of China looks like it's doing pretty well. So, he thinks there's a lot of good news coming out of the company. We did lower our fair value estimate a little bit, but even at the lowered estimate, the shares still do look undervalued.


Stipp: Twitter confirmed that cofounder Jack Dorsey is coming back to the company as permanent CEO. We've talked about some of the issues Twitter is facing. Will the return of Dorsey help them get over some of those hurdles?

Glaser: It doesn't seem that way. Rick Summer, our Twitter analyst, doesn't think this is any kind of transformative appointment, putting Dorsey back in charge of the business.

He has already been very involved. He has been CEO before, he has been on the board, he has been able to put his input into the company. It's not clear what's going to be different this time that's going to allow Twitter to reaccelerate user growth and engagement--the things that Twitter really needs to do in order to get its growth engine moving again. It isn't clear what changes he is going to make.

He is also staying on as CEO of Square, the payments company, so he won't even be at this full time. Square is a fast-growing business in a very fast-growing industry as well, and either of them would need his full attention. So, the fact that the board acquiesced to him being a part-time CEO is a bit of a headscratcher on how that's really going to work on a day-to-day basis.

Twitter is going to continue to have trouble becoming a mass-market platform. Maybe there was a brief period where it looked like it could keep expanding. But now it seems like there is a cap on where their growth is going be, and given where the shares are trading at right now, it just doesn't seem like a great investment idea.

Stipp: Pepsi also reported earnings this week, and they had a pretty decent quarter. What were the drivers behind that?

Glaser: They did. A lot of it was pricing. On a net basis, that excludes currency, pricing was up 6% year-over-year, which is pretty healthy. Volumes were even up 1%, and that's from a flat volume level just a quarter ago, so we're starting to see a little bit there. It's not just price increases. They are getting some volume increases as well, and that's good to see.

But there are some things that are obscuring these good results, mainly currency. Management thinks there's going to be a 10-percentage-point headwind on full-year results because of currency, and that's up from a 9-percentage-point headwind they were predicting before. So, that's pretty significant.

They also had to take a big charge because of their Venezuelan operations in the quarter. That weighted on the results in the short term. Obviously, there are some macroeconomic issues happening down there that are weighing on the firm.

But still, Pepsi is seeing pricing and volume [gains]. They have good cost controls, have good profitability, and although the shares don't look like a bargain right now, they are definitely moving in the right direction.

Stipp: Sticking in the beverage space, we talked about the big potential merger between Anheuser and Miller. That hit some turbulence this week, though. What's the latest?

Glaser: This deal became more public and more hostile this week. Anheuser-Busch InBev came out with a public offer at GBP42.15 for SABMiller, and that was rejected by the board. Even though some of SABMiller's bigger shareholders were supportive of it, the board doesn't seem ready to give in at that price level.

Phil Gorham, who covers this space for Morningstar, actually thinks this level is very close to the "value-neutral" mark. If you go too much higher than this, it's going to be difficult for this deal to make economic sense in the medium term.

If you do go higher than this--and he thinks that it likely will, that they will ratchet up the price somewhat--you are going to have to be much more aggressive when you are doing asset sales to make sure you're getting a very high price, something that is uncertain. You never know what kind of price you're going to get, given that there are very few buyers for some of those assets. You would also have to assume that there are even more cost synergies they can ring out of bringing these companies together. Integration becomes that much more crucial when you're paying a higher price.

So, we'll continue to watch this one. I think a deal is still more likely to happen than not. It might get a little bit higher than where we are. Maybe you change some of the terms of the deal to make it easier for regulators or to make it less susceptible to regulatory risk. But certainly, this is going to be an interesting corporate battle.

Stipp: Great insights on the news of the week, Jeremy. Thanks for joining me.

Glaser: You're welcome, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

Jason Stipp does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.