The Dividend Cafe - A Hearing on Spending and Recessions

Episode Date: July 26, 2019

Markets appear to be up a tad on the week, with little volatility to show for it (as of press time, anyway). Earnings season is off to a really strong start, but I want to wait one more week to begin "report carding" earnings season (partially to not jinx it, and partially because it is a tad premature). I took advantage of this week's slow news week (sorry, Mueller) to talk about the broad economy and my perspective on where we are in the macroeconomic cycle, and what it means for all of us at this stage in the game. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. commentary we are sitting here recording the middle of the day on Thursday and at this point market's up a tad on the week it's giving some of that back today so I don't know if we're going to end up flat or up a hundred we're around that range now and of course you never know what Friday holds but I'm going to use this week's podcast to kind of focus a little bit more on some macro things because I want to talk about earnings season. I want to talk about companies are doing and, and we do, you know, we're in the earnings season. It's we're about 10 days in now. It's just that, first of all, I joke in the commentary that I don't want to jinx it because it's really actually started off quite strongly. Um,

particularly for a lot of the holdings that we care about at the Bonson Group. But it's early enough. And so I want to avoid the jinx. And I also want to avoid any kind of false signals. I really do think we're going to need another week to get a better feel on how revenues are being reported relative to expectations, how profits are being reported relative to expectations, and then, of course, guidance into the future so we're going to talk more about earnings season next week but right now i'm taking advantage of this you know

you could say like it's been a really busy week in the news cycle and there's all this hubbub around the muller report yesterday and i actually got to sit on set at fox business and kind of guest host with stewart varney uh becauseney because they were planning to just broadcast the whole Mueller report live. And then at the last second, they decided to not do that. Fox News Channel was broadcasting live the whole report. So they had to kind of still go forward and do all their normal couple hours of broadcasting. And because I was going to be appearing for a few minutes to talk about the market, they

asked me just to stay. And it was interesting. It's sort of a news event for political people, I suppose. I don't really think that either, but I'll pretend I do. But it was such an incredible non-event for markets, and it was sort of this poetic manifestation of how the markets have thought about the entire escapade, which is now roughly 27 months, 26 months old. If you go back to when the special counsel was originally appointed and then you kind of look through the ebbs and flows and developments and new news and old news and fake news and everything that's come out of it. and old news and fake news and everything that's come out of it,

the fact of the matter is that the report has never, and the allegations and the kind of whole thing, has never really generated much hubbub in the markets. And naturally, the person who was behind it, the head special counsel, testifying to Congress, simply repeating the things he had already put into a 400-page report a couple months ago, wasn't going to be moving markets much either, and in fact, did not. And yet, as I'm sitting there on the set, we're talking about a whole lot of things that kind of do matter.

You know, stuff with the Department of Justice, the Federal Trade Commission ramping up some of their antagonism against big tech, individual company results that came. These things, you know, you're talking about the fear of a recession, the health of the economy, expected growth in U.S. economy. We had the International Monetary Fund this week in their quarterly estimates for global growth. They actually ticked down the total global growth estimate for GDP by 0.1%. But within their ingredients that make up global growth, they ticked up their expectations of U.S. growth from 2.3% to 2.4% up to 2.6% for this next quarter on an annualized basis. And that's got very little news attention. I'm not sure that would have gotten news attention even if the Mueller thing wasn't going on because I think that negative news gets a lot more attention than positive news.

And I'm also not even sure how positive that news is because the IMF is not the greatest economic forecasters in the world. But my point being that there are things I think that matter, markets, things that don't. And also there are things that matter short term, but maybe not long term. And there are things that matter long term and maybe not short term. I'm going to be focusing a couple of comments here on this podcast in that latter category. Things that I think are a bit more important longer term, intermediate term, maybe or maybe not short term. The first is the thing that is most important to me right now because I don't have an answer. I don't know how it's going to play out. I have a fear that I could define for you. I have a hunch that I could define, but I don't have an outlook because there isn't enough visibility just yet. And that has to do with the impact that the trade war may or may not have already had on business expansion.

And that theme I've been talking about for a long time now, the need for capital expenditures to increase, to add innings to this business expansion, this business cycle. You know, you could get a palatable conclusion in the trade war with China at this point. And yet, I think some impact in nominal growth has already surfaced. You see the manufacturing survey pointing to a decline in new orders. The market hasn't cared yet. Corporate profits have still been strong. Consumers fine, all that kind of stuff.

But I think that aside from the Fed boosting valuations with their kind of enhanced dovishness this year, you really do want to see that that economic addition that has existed under the Trump administration, which is non-residential fixed investment, that corporate activity, new orders, durable goods, manufacturing, industrial production, the long-term investment from capital into capital projects. And if that has already been impeded by the trade war, then I'm concerned about that. I don't trust my analysis in the sense that A, the data is still coming, so I'm analyzing things that are not yet complete, and B,

I want the trade war. I want to believe the trade war did not disrupt capital expenditures. I want to believe the trade war is coming to an end. And you always worry about wishful thinking getting in the way. So here's where we stand. If the trade war has suppressed confidence enough to stall and stunt projects that are needed for further enhancement to productivity, further enhancement to growth that would accelerate economic activity, that would accelerate economic activity. If the trade war has already impeded that, then I think it will accelerate the end of the economic expansion.

Now, the best case is that a little evidence right now in the present of slowing activity is temporal, and it will not show a slip-through to the whole economy, giving things time for a trade resolution to happen and then take hold. But I do think that clock's ticking, and that's something I'm watching very closely. There's a chart at DividendCafe.com this week that shows the peak in economic activity, and it's broken out by category from manufacturing to construction, labor activity, the consumer. And that peak was February 2018, which, by the way, is the month that,

at the end of the month, that the president launched the trade war. Now, labor growth has stayed steady. Manufacturing and construction side has still been growing, but its rate of growth has contracted or slowed quite significantly as of late. And that's where we need to see where things head. Check out that chart. The pattern, the trend is rather clear. Switching gears, the worst argument for recession ever. There's one commonly uttered piece of what I'm calling anti-intellectual nonsense that the longer the recovery has been, the more likely a recession is. And that isn't

anti-intellectual because it's untrue. It's anti-intellectual because it's so ridiculously obvious. It's a tautology. It goes without saying. It's self-evident. It's true by its vocabulary. In the base, it's true by its vocabulary. In the basic sense that the more days that have gone by, the less there are to go. Okay, there you go. Very true. I don't think that's very helpful information. It says nothing whatsoever about the timing of a recovery ending. It doesn't say anything about the timing of a recession starting.

It merely tells you that yesterday was one day ago. So it is not an argument for portfolio positioning changes. It is not an argument for anything relevant in economic commentary. In terms of the economic kind of milieu, I'm going to go through a number of different topics, some of which are a little more complicated than others. I am intrigued by the fact that the euro is stubbornly sitting around $1.11 or $1.12 in its exchange rate to the U.S. dollar, with so much presumed dovishness existing about the future of European monetary policy. And there would have been no expectation that that would reverse with the announcement of Christine Lagarde becoming the replacement to Mario Draghi at the European Central Bank.

Lagarde is the former head of the IMF, International Monetary Fund, and perhaps is the only candidate that they could have found who would be more dovish than Draghi proved to be. My view is that the euro is running in place, not because of anything about the euro, but because of the dollar. of anything about the euro, but because of the dollar. In other words, if the Fed was in a 2018 hawkish state of mind versus this uber-dubbish euro landscape, it would be pushing the euro far lower. But with the Fed now joining the party and trying to weaken their own currency, the market stuck with two currencies, and three if you want to count the yen, that are trying to jockey for superiority in weakening their own currency.

And that's why I mean a race to the bottom. They're all fighting each other for who can have last place in the strength of their own currency. And it's holding the euro flat when otherwise I think the euro would be declining. I think the euro would be declining. Speaking of the dollar, on a trade-weighted basis, the dollar is currently as strong as it's been since the early 2000s. Why do we want to evaluate it this way, meaning on a trade-weighted basis? index, which is also showing strength but not as strong as the trade way did going back that far, leaves out emerging markets countries. And it's fair to say that our dollars comparison to countries like China and Mexico matters

in evaluating our overall economic health. Our view, and this ties into our short-term view of emerging markets pricing, is that the dollar is overvalued. And it will need to demonstrate such against the emerging markets currency world, not merely against Europe and Japan. chart at dividendcafe.com showing you a 25-year history of the trade-weighted dollar and then the just dollar index on a spot basis. And you can see the big move up that we've had in the dollar and where the trade-weighted dollar is actually so much stronger than the dollar index and why that might be deceiving the data a little bit. Something has got to change at the FDA. This is a bottom-up comment, those of us invested in the drug sector.

Look, this is not me talking my book here because, by the way, a lot of approvals that I am frustrated are not getting done at the FDA would be competition to companies that we might own. And perhaps there are approvals in companies we own that are also being delayed. My point being, at best case, it's an agnostic statement in terms of holdings that we would own at the Monson Group. I'm making a sector-wide comment, and it's really more about society than it is the investor element. There were 14 new drugs approved at the FDA so far this year. 14. So therefore on track for less than 28 on the year. It was 59 all of last year, and that

was the most ever in a single year. So we're on track to be less than half of what we were last year, and the bar is set at only 59 approvals a year out of thousands of potential medical items that get before the FDA for approval. You know, I don't know if you want to chalk it up as human genome sequencing or the improvements in research and development. But there are a significant amount of opportunities, and they're being slowed up in the bureaucracy of the FDA pipeline. And I think this has profound implications for investors in biotech and in pharmaceuticals, but also for the quality of human life. I read a report this week where someone, I'm not going to say who they were,

pretty prominent, and actually, by the way, I really like the analyst and really like the company that the analyst works for, but I don't know. I'm being a little critical here. The prediction was, you know, we want to get really fine-tuned. We think that the rest of the year, as we sit here now in late July, five months to go, the market will be somewhere between negative 5% and positive 5% from here.

So the prediction had a 10% bandwidth and then added, oh, and we think there will be volatility within that along the way. So much like the idea of saying in New York City it will be either rainy or sunny tomorrow and the possibility exists of both. Now, don't get me wrong. I'm not critical you can't predict the market. I'm critical that because I don't fault anyone for not knowing what the market will do by the end of the year. But I think forecasts that are applied to any short-term window are never very useful. And I think it calls for me reiterating our bold call for you, which is we don't know what the markets will do in the next five months. We're slowly and prudently harvesting some dry powder cash. Volatility has actually been very

low. So the smarter prediction, because volatility is a mean reverting force, is that it will elevate. But our clients expect long-term success out of their goals, and short-term errors undermine long-term realities. We favor the avoidance of huge drawdowns by using lower beta stocks and higher quality alternatives. And we think short-term market calls are for carnival barkers. Let's switch gears on national debt. I have a couple comments I want to make on this.

We'll start to wrap up in a little bit here. The size of the deficit is less worrisome than the amount of government spending. And you think those two things are correlated, and they are, but let me explain. A small deficit in an economy where government spending is a very small percentage of GDP is actually preferable economically than where there might be no deficit and government spending a huge percentage of GDP. Well, why? Because of Economics 101. The government can only spend where they've extracted from the private

sector either attacks and that they took money out of private sector or borrowing which is money that will have to be taxed in the future so it's either present movement of money or future moving to money from private sector government sector the government a large percentage of government spending means, especially with little or no deficits, means there's a very high tax state, you know, state of affairs. And that means a meager growth environment that limits economic and investment opportunity. The crowding out effect is real as high government spending mutes demand in the private sector over time. The United States faces existential economic issues to answer.

And maybe they'll do that when the environment is more conducive to resolution around spending, debt, annual deficits. Unfortunately, we're highly unlikely to answer these questions before the next recession. And if you think deficits are high now, wait until we enter a recession. Now, I find this just fascinating, but I want to give you a perspective on why pedestrian assumptions about debt and interest rates need to be repudiated. 30 years ago right now, the national debt was a whopping $2.8 trillion, and that represented 49% of GDP. The 10-year bond yield was 9.1%. Now today, we have $22 trillion of national debt, and that represents 106% of GDP.

Now the economy is a lot bigger, so the debt that goes therewith is a lot bigger. However, the ratio didn't hold. It doubled. It went from 49% of GDP, 106%. So you would think to yourself, well, there's more debt, more deficits, and a really concerning ratio of debt to GDP.

Yet the 10-year bond yield from 9.1% 30 years ago to 2.1% now. Why are investors demanding less money from government debt when the government is so much more leveraged than they were 30 years ago? The assumption is meant, or excuse me, the lesson is meant to be embedded in kind of a rhetorical question type of thing. Obviously, what we've been taught is untrue, that higher borrowing means it pushes interest rates up. The exact opposite has happened, and the reason is because I believe that there is a significant reality to suppression of demand and economic activity, the higher government spending grows.

And that pushes bond yields down, not higher. Okay, politics real quick. I'm going to speed things up a bit. The budget deal, woe and behold, they're not shutting down the government. They're not cats and dogs falling out of the sky. They're just increasing spending a measly $320 billion. Pretty soon you start talking about real money. And they agreed to get the debt ceiling punted out a couple years where they have to deal with that again.

So that widely expected compromise between the House, the Senate, the GOP, the Democrats, the President all came together. There is another batch of Democratic Party primary debates next week, two nights. I think it's Tuesday and Wednesday. It might be Wednesday and Thursday. I can't remember right now. But at their conclusion, I do plan to do a special Dividend Cafe podcast, which will recap the investor implications of the major economic platforms and policy positions coming out of the debate and the race.

By the way, I do think the announcement this week of a pending Department of Justice antitrust investigation into a cabal of leading big tech companies is a big deal. It's a bigger story than people believe. Not to mention the story of a $5 billion settlement with the Federal Trade Commission on other violations. This reshaping of a relationship between Silicon Valley and Washington, D.C. has been a significant theme of ours for two years now. It's playing out in significant ways right before our eyes. The major takeaway, I guess, is not that big tech is in trouble or not in trouble, as much as that very successful and growing companies that have bipartisan opposition against them

and a public sentiment shift against them are highly likely to see some angst visible in their market multiple valuation investors are willing to give. I'll wrap up this week by quickly teasing you towards the chart of the week at DividendCafe.com, one of my favorite ones I've put up in a long time. Look, there are plenty of reasons to believe a recession is going to come. And that's because it will,

because I don't think they've repealed the laws of business cycles. I don't know when it will come. I don't know what the magnitude will be when it does. But I'm not very impressed by event-driven arguments for the onset of recession. You know, Iran's going to do this, or the election will do that, or technology, or, you know. At the end of the day, generally, I think recessions come when a misallocation of capital hits an excess point, and the Fed has to go the other way to offset it.

And they end up being too late. And then you have contractual conditions that take over. So, yeah, there's unresolved questions, you know, about what could be a catalyst to an extra session. But I would just simply point out, you look at the chart I put at DivingCafe.com, simply point out, you look at the chart I put at drivencafe.com, you have over the last 10 years had no shortage of event-driven catalysts that people said could allegedly be a problem with recession, with QE's ending and Brexit and ISIS attacks and Japanese stimulus and negative bond yields and Benghazi and Hurricane Sandy and China issues and the Mueller investigation. And you get my point.

Event-driven arguments for recession are generally not very good. And when you put those up against the path of the markets, the path of economic growth, you have to get that habit out of your system that thinks a particular headline will be what one wants to invest around and rather understand the broader nature of the cycle, macro data, where valuations exist, where opportunities exist, and mean reverting assets, and be cash flow sensitive. Be an investor in operating companies. Be an investor in enterprises that generate profits. And that from those profits, which they are growing year over year, are paying a growing stream of dividends to you. I'm going to leave the DividendCafe.com podcast there for the week. We thank you for listening. We encourage you to reach out to us any time. Thank you for listening to the Dividend Cafe.

Please rate us, forward this to your friends, do whatever you would like to do, but subscribe and write us a review if you have good things to say. Thank you again. And we look forward to coming back to you next week with the Dividend Cafe. Thank you for listening to the Dividend Cafe. Financial food for thought. securities. No investment process is free of risk and there's no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinion, news, research, analyses, prices,

or other information contained in this research is provided as general market commentary. It does not constitute investment advice. The team in Hightower should not be in any way liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information or subjects change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the team and do not represent those of Hightower Advisors LLC or any of its affiliates.