The Dividend Cafe - A Global State of Affairs

Episode Date: September 14, 2017

A Global State of Affairs by The Bahnsen Group

Welcome to the Dividend Cafe, financial food for thought. eventful because the markets are up over 300 points or so as of recording time. But, you know, as far as that onslaught we had had from the hurricanes and the political toxicity, you know, North Korea's muscle flexing continues to some degree, but not in the same, you know, context and level of noise as a few weeks back. No crazy tweets, although I guess that's kind of relative. You get my point, though. No major market shocks on the downside. So yeah, I mean, a nice regular week with earnings season kicking off here in another month or so. So like I said, Monday did see markets advance. It was actually one of the bigger days of the year. But significant chatter, mostly in a good direction,

has picked up around the promise of tax reform. I think that we're going to kind of talk bigger picture stuff today. But as far as the here and now, mostly good stuff. Boring is good. But let's delve into some global market circumstances. I want to visit a little economic education. And I would qualify that by saying it would be the fun kind of economic education. But, of course, there is no other kind. And we'll hit up our usual rotation of topics.

Global harmony. We're not about to get world peace or world unity, but we certainly are seeing plenty of global harmony if one looks to 2017's economic landscape. The term many in our business are using is synchronicity, meaning across virtually all domestic, developed, and emerging economies, we're seeing year-over-year earnings growth, improving secular economic conditions, and top-line revenue growth. Synchronized economies are the exception, not the rule. It doesn't happen very often. They represent a very hard-to-quantify level of opportunity for risk asset investors. Hard- quantify because there's so many ancillary

benefits as globalized customers and producers feed off of each other. But global harmony on one side can be global angst on the other. The caveat to what I'm saying is that what's soft for the goose is soft for the gander. Positive global conditions can drive markets higher, but various global headwinds in a highly coordinated economy can be damaging. An example of where we can see this global synchronicity, which as discussed has been an asset reversing direction, is with global bond yields. We believe the anchor of low yields around the world, particularly in Europe, has held US bond yields low. So effectively, let's put it this way, when

European yields inevitably climb higher, when the European Central Bank tapers off of their excessive quantitative easing, we think that that will very likely result in higher US.S. bond yields as well, and not necessarily all proportionally, maybe even more so. So let me kind of phrase this in a way easier to understand. Europe's version of the Fed, the ECB, they've pushed yields lower by buying bonds. And when they announce that they're done doing that, rates will move higher. bonds, and when they announce that they're done doing that, rates will move higher, and then therefore we think the anchor of low rates in the U.S. will rise a few notches as well. The zero-bound risk-free rate. Forgive the seemingly complex vocabulary around this section.

I promise you the concept is actually quite simple. While many laypeople celebrate the low cost of money that low interest rates provide and holders of risk assets do the same, one very simple law plays out. Assets that have a risk premium see their expected return drop as well as the reality of a zero percent risk-free rate sinks in. This isn't a mere possibility, it's a law. Now that spread, that premium that a risk asset offers over a risk-free one may still be attractive, but the reality is that the gross return inevitably declines when it's competing against 0% instead of 2% or 4%. It should be understood by readers and clients that saying

an asset class may end up offering a lower rate of return for a period of time from a higher starting point of valuation is quite different than being bearish or, God forbid, trying to time around such a decision. We acknowledge the futility and, in fact, the destructiveness of such and instead offer valuation- based active allocation as the prudent solution we do implement alternatives which use manager risk over beta which is market risk to some part of a client portfolio we accept the imperfections of receiving less than a hundred percent of an class's return in exchange for taking on less than 100% of its volatility. See how easy this all is? While this next economic law I'm going to get into for a second is totally unrelated from what we were just discussing, as long as we're on the subject of economic vocabulary and law,

the disastrous hurricane season has been inviting the need to revisit one of the staples of economic coherence, the avoidance of the broken window fallacy. It's hard enough to see the human devastation these monstrous disasters have created, but to then be subjected to the most absurd economic analysis in history, that while tragic, the rebuild from the hurricanes will at least create economic activity that will be stimulating and beneficial. Friedrich Bastiat pillaged this thinking in the 19th century and the great Henry Hazlitt repopularized the folly, critiquing the folly of this thinking in the mid-20th century.

Simply put, this broken window thinking that celebrates hooligans breaking a window of a shop because the glassmaker will get business in repairing the damage, but ignoring the tailor who is going to make a new suit with the dollars used to repair the window. And again, you can use whatever analogy you want. Well, that was the broken window fallacy. But we never see it on a fuller display than with hurricanes and natural disasters and things. Yes, it's true. These awful hurricanes will create economic activity for construction and raw materials and repair and so forth. But the dollars used to invest into a rebuild are dollars that will now not be used for fill in the blank.

The most efficient allocation of capital would not be repairing a damaged building. That's only being done because it has to be as a result of the tragedy. If we're not for the hurricane, that capital would be allocated elsewhere and presumably better. The cleanup is going to be messy and a lot has to be done to bring restoration to these affected communities. In no sense is this an economic blessing and that thinking is not only morally confused but ideologically absurd. In the first week of the Harvey aftermath I alluded to the lack of investable application from the tragedy. I read a study this week that evaluated the impact on interest rates, treasury bonds, and municipal bonds after the worst 12 hurricanes and natural disasters

of the last 30 years. And guess what? Half of the time, interest rates were up three months later, and half of the time they were up six months later, and half of the time they were down three months later, half of the time they were down six months later. Well, how's that for clear investable application? A European version of deja vu. It's fascinating to see the euro rallying so much this year before Draghi and the ECB have done anything to lift rates or churn down their quantitative easing. The same phenomena was at play here in the United States in 2014 and 15 when the mere talk of Fed interest rate hikes caused the dollar to rally, essentially doing much of the tightening for the Fed. Currencies are the ultimate discounting mechanisms in this regard.

They make policy implementation quite difficult. We don't speculate on currency at the Bronson Group, but the euro going the way of the dollar here, rallying right into the actual monetary tightening, and then selling off when the real news comes, would not at all surprise us. This is new territory for the historically more hawkish European monetary culture. we knew the Fed would soft pedal in a post-Volcker Federal Reserve from Greenspan to Bernanke to Yellen. Dovishness, meaning accommodation, has been their gospel, but in Europe it's going to be tricky. And speaking of Europe, besides the fact that we see the European monetary picnic entering cleanup mode soon, there does exist fundamental

and structural questions about the entire European model, particularly in terms of their shared currency that have nowhere near subsided. If an investor is wondering if there can be stock market rallies in Europe, even as they address the long-term mess that a shared currency has created, the answer is absolutely yes. But if an investor is wondering if the economic conditions the shared currency have cultivated are stabilizing or improving, the answer is totally different. At the end of the day, one may choose to invest in a part of Europe while shutting another part of Europe. But the hope of a monolithic Europe in a monolithic currency experiencing shared strength and productivity goes against all

analysis of the data and policy direction. With member countries experiencing such incredibly divergent action in terms of capital, labor, government, regulation, there seems to us to be no escaping the conclusion that a shared currency will be a benefit to some and a millstone to others, therefore destabilizing. Active versus passive. It would be so much more interesting if there was such thing as pure passive. I'm spending more and more time reading about this craze into passive investing. It's always struck me as naive to think that the prices of one's passive investments, the stocks that make up the index fund, are not set actively. While one may be passive in receiving the results of a market, the market itself is affected by the efforts of those actively managing in it. It also strikes me as ironic that active decisions have had to be made to set the methodology of how a passive index is priced or determined. But nonetheless, I understand the attraction of low-cost anything when everything's

going up in value, and inversely, I've seen in several cycles how much active management comes back into favor when markets become difficult. I guess those who believe market navigation is likely to be easy in the years to come may find the passive approach superior, but Behavioral Investing 101 tells us two things. Our behavior matters, and so does everyone else's. Passive investors will learn this too. A couple comments on Japan for the week. Their Q2 GDP growth came in at 4%. For the first half of the year, the figure was 2.4% annualized versus a consensus expectation of only 1.2%. So they doubled the expectation in the first half of the year.

GDP growth is subject to false positives in an economy being so monetarily manipulated as Japan. But the data bears watching as we do our research, especially when accompanied by the validation we're seeing in their strong industrial production growth. Higher oil prices maybe would drive retail investors back into midstream assets, the pipeline investments that we love so much. But higher volumes will be what validate the investment thesis, growing the distributable cash flows. New rigs came online, but working through the cycle is a work in progress. Maybe one even delayed a bit by Hurricane Harvey.

The stocks are cheap, but the volumes will be coming later, in our opinion. So we ask you, when's the time to invest? We'll answer for you if you want. We think it's now. Look, our 12th annual early October trip to the world's finance capital, known as New York City, is a couple weeks away. Both myself and my managing director in our investment solutions department, Deya Pranas, will be joining me. We'll be meeting with every money manager, hedge fund, and thought leader in our orbit, getting them on our calendar for a review of strategy, discussion of the asset class that they play in,

conversation about go-forward perspective. It's more than just a series of transactional meetings. It's sort of a mind alteration. We become extremely self-challenging of our own investment theses and introspective in that regard. We seek to examine from A to Z our own assumptions and ideas that drive our portfolio decisions. I'm a permanent value investor guy, and I confess to entering this year's trip wanting to believe that the risks have skewed and expected return levels diminished just as a byproduct of higher pricing across risk assets. So I could see this trip resulting in us increasing our defensiveness in our portfolio positioning, but I could see it resulting in something different too. So the key is we enter with tremendous intellectual humility and teachability.

Wonderful chart of the week that obviously you'll have to see at dividendcafe.com, just referencing the historical reality of S&P 500 drawdowns in the middle of the year and what this year has looked like. We'll leave it there. Thanks so much for listening to the Diving Cafe podcast. Subscribe to listen.

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