The Dividend Cafe - A Sigh of Relief

Episode Date: July 13, 2018

This week, David discusses this week in markets..... Topics discussed: Trade war With China Bond Market Jobs and more Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Let me do just a couple of quick housekeeping things before I get into the content. This is a really good week to listen to our advice and insights podcast because I do a full kind of year to date summary through the first half of the year. Look at what the highlights of the year to date activity and investment markets has been the low lights and kind of offer a little refreshed perspective on the year ahead. The remainder of the year that is. So advice and insights, a little longer podcast. I'd really encourage you to check that out. As far as this week's Dividend Cafe, let's kind of get into it.

I mean, the market this week, I think it's reasonable as to why some people reached out and said, don't you think that the markets are going to be struggling in response to what feels like an elevated trade disruption with China? And the fact of the matter is that the trade talk really kind of subsided a bit this week. And what I mean by that is the U.S. announced intentions to retaliate late last week. And then nothing really was said over the weekend. And China's foreign minister came out talking about how they really want to cooperate. And the markets rallied substantially on Monday and Tuesday. Well, the U.S. announced intention to tariff $200 billion more of imports from China. And on Wednesday, markets dropped a bit.

But then now on Thursday, the markets are rallying. We're in the middle of the market day. So, you know, who knows what happens. But as of now, Thursday is already made up for all of the downside from Wednesday. And you have the full rally from earlier in the week. So where we are now, it's been a rather robust week in investment markets. I think some of that could be looking ahead to earnings season, which is getting ready to start here tomorrow, going in the weekend. And then next week and the two weeks thereafter, you have the vast majority of S&P 500 companies reporting their Q2 results.

And there may be some people optimistically getting positioned in front of that. But the issue on the trade side is that the U.S. this week announced $200 billion of products being imported that would be tariffed. They did not announce $200 billion of taxes. In fact, the tariff rate they're assessing on these products, if it all goes through, will be 10%. That's $20 billion. And I think that it's sort of started to occur to me that the way the media is reporting it, which is not dishonest, but it's a little confusing, is leading to some of the misunderstanding. When we say we're announcing tariffs on $40 billion a product, that isn't the tax impact. That's the gross value of trade of what would be coming in and then being tariffed at whatever tariff rate is assessed.

There is a grand total of $8.5 billion of tariffs in our $4 trillion, $3 trillion economy that have actually gone into effect. That is 25% on $34 billion. That's an $8.5 billion level. China's retaliated basically tit for tat with the same level. So then even if they do go forward now with this $200 billion at a 10% rate, that's another $20 billion. I hate all of it. I think all of it's bad policy. I think the uncertainty around everything is the source of the volatility in markets. But my point being that the fiscal impact has actually been reasonably constrained, and hopefully it stays that way. But that kind of gives you an explanation as to why things have not reacted even worse. Now, why were the tariffs that they

announced this week at a 10% rate when the prior announcement is a 25% rate? I think it does point to some political calculus that there are some voices and names in the Trump economic administration that understand this next batch of products are largely consumer products. And so effectively, this tariff is a direct tax on U.S. consumers. And that politically, that is a much different issue than when you're taxing, say, an industrial producer. than when you're taxing, say, an industrial producer. So you probably see some soft peddling and yet still trying to jockey and flex a little bit in terms of the posturing. That's what they want to get.

They want to get China on the negotiating table and work out a deal around intellectual property theft. And part of the thing is China says they're going to go tit for tat with the U.S. but they only import 190 billion dollars from us and so in order to keep it equal in this trade war back and forth they effectively have to raise the tariff rate from what we're doing in order to keep the dollar impact reciprocal so this this is a messy deal and and. And to bottom line it for you, I believe that some outcome is coming. And I don't think it's in a week or three weeks, but I think it's in

two months or six months. I don't know. But something like that, like a few months away, where there will be some sort of political victory that everybody gets to claim. I think that more than likely for President Trump, it will end up being some renegotiated NAFTA deal, some improvement in the terms of our arrangement with Mexico and Canada, more so than with China. I think that maybe they get some kind of headline thing out of the imports of cars from the European Union. thing out of the imports of cars from the European Union. But more or less, the China thing, I think they're trying to get to an arrangement where they can deal with the intellectual property side. And along the way, the trade tariffs are how they've chosen to go about doing it.

And I don't agree with it, but it doesn't matter what I think. The fact of the matter is that I don't see how market volatility can come back down when this still lingers. There's still uncertainty about how severe it could get, how good it could get. I mean, you could end up in a much better situation. So the fact that we're right now about 1,500 points off of the low that we've been at over the last few months and still 1,000 points or so off of the more recent high, you're in that range. And you see it in year-to-date market activity. You know, the market, the Dow was down 1% year-to-date, and the S&P was up 1% or 2%. So that's the range we're in. Everything's hugging around the zero mark. Nothing's getting killed, and nothing's rallying in terms of broad market indices. Obviously, there's individual things that have

had very negative outcomes or very positive, but the broad market summaries are all right around that zero level. And that, to me, is a byproduct of the uncertainty of the trade issues. And then the volatility is elevated also around the trade issues and the Fed normalization. So in dividendcafe.com this week, I also break down the bond market. Very interesting to me how the municipal bond market has performed so much better than taxable bond market year to date. And of course, they're both interest rate sensitive. You know, if you have a 10-year muni bond and a 10-year treasury bond and the 10-year yield goes higher, the price should be coming down. And in a perfect world, they'd come down about the same for both. But they don't.

And the reason is a supply and demand play in. Demand is not for municipal bonds, for investors needing tax-free income. Demand has not dropped, and yet supply has dropped. That creates a little bid under the muni bond market. Very low supply issuance of new municipal bonds as states have gotten a little bit more fiscally responsible in the last eight, nine years. Not every state, but some. Counties, cities. Also, really high demand for high yield municipal bonds where you have pretty low default rates and double tax free or single tax free, depending on the state income from riskier credits, but still ones with very low default history, more appetite for some of that. So it's helped the whole municipal bond space. Treasuries dropped just

in concert with interest rates moving. So overall, the bond market down about 2% on the year. And the 10-year yields, the 30-year yields have not really moved in months. And so as the short term rates find some kind of ceiling, you probably end up with a positive return in bonds going forward. We would never try to guarantee that. There's so many things that you have to factor in. But that's kind of our perspective is that maybe in the short term, some of the worst outcomes for bond pricing is already set. Now in terms of the unemployment report from last week, very interesting, 220,000 jobs created above expectations.

And I would argue that the quote-unquote bad news, the unemployment rate went from 3.8% to 4% is actually the best news of the week. Well, how does the unemployment rate go up when more jobs were created? Because the labor participation force, which serves as the denominator, which is all people with a job and all people who want a job, all people looking for a job, that number increased. So we've been in this rather tragic, secular, long-term decline of our labor participation force, somewhat around demographics in our country, and certainly somewhat around people who get frustrated, give up, and then take themselves out of a job search. Well, that number peaked up a bit, which meant that even with new jobs, when you divide the numerator into the denominator, you got an unemployment rate

that was somewhat higher. So if they somehow can see that labor participation force continue to move higher, I don't think that there's anything better we could ask for culturally within the economy. And we continue to watch that. A quick comment. I'm going to jump all over the map here for the rest of our time together. Stock buybacks. Fascinating stat I read this week. 57% of the companies in the S&P 500 that have bought back stock this year are performing worse than the overall market. That's the highest percentage of companies underperforming the market that are engaged in stock buybacks since the financial crisis. That doesn't mean much around a market indicator. It means something about how we value stock buybacks. They are not as valuable to investors as people believe them to be. How could that be? It automatically dilutes earnings. So much of stock buybacks is done

dilutes earnings. So much of stock buybacks is done in concert with the shares that are used in executive compensation. There isn't the same clarity and transparency. A lot of stock buyback authorizations are not executed. So there's a delta between those numbers. And of course, you can't eat a stock buyback. So this is our argument for why dividends represent a more tangible benefit to shareholders, transparency, clarity, and the fact that it de-risks every time you receive one. Someone should write a book about this sometime. Brexit, Europe, England, kind of a mess. I don't know what's going to play out out there. I think right now the soft Brexit is looking almost kind of guaranteed at this point. I'm not ready to throw in the towel and say it will end up being a Brexit in name only, but it's headed in that direction. Some

of the hardliner Brexiteers resigned this week. Theresa May's parliament is in kind of a bit of disarray. And I suspect that you're going to end up seeing a path that short term the markets like, certainly that the sterling pound will find room for appreciation in. I'm not sure it's the best thing for UK, but to the extent that the risk compression, excuse me, the volatility compression right now you're seeing is related to this view, the England trade in currency and equities looks like a very good one. We don't view it as a trade, though. So it's kind of an ironic thing. It sort of benefits us from the positions we have in the UK, but not for the reasons we want it to, which are long-term secular. And so there's a lot of analysis to be done there. I have a chart at

dividendcafe.com this week of the sterling pound since the Brexit discussions began. And it's somewhat stunning how brutal of a job trying to forecast currency is. It has not been one where the experts and pundits and analysts look like experts over the last couple of years. So, you know, politically this week, we talked about the trade side. I thought it was very interesting that 88 senators voted against the president's action around using Section 232, which is claiming national security criteria for imposing tariffs and including with Canadian aluminum as if anyone really believes there's a national security issue with Canada on it. So it's really the first time I can recall since the president was elected that a pretty significant portion of

his own party kind of said, come on, like even this is just a bridge too far. I wonder what it will end up meaning on a policy level. But the China stuff, trade stuff I already talked about, and then there was the announcement about a Supreme Court, Brent Kavanaugh, who I don't think markets care much about this to the extent there Kavanaugh, who I don't think markets care much about this to the extent there's some limited implication. I think, for example, the future of the Consumer Financial Protection Bureau is probably at stake. A lot was done in the way it was set up that has to question its constitutionality. And I would imagine that this judge or any other judge the president was going to nominate

were not going to find this to be constitutionally appropriate. So you'll see some impact around that. But, you know, it's going to take a while for him to get appointed. I think he will get approved, but that was kind of the other political news of the week. So I'm going to leave it there. We've covered kind of a lot of ground. As I always do, though, I'm going to point you back to Dividend Cafe. I really want you to see the chart of the week. And so DividendCafe.com, where you get kind

of the written version of all this and a few charts and things to pull it all together for you. S&P earnings growth are off the chart. You see in the chart of the week the growth last quarter, what we expect for this quarter. And that to me explains why there's still this positivity in markets. The trade issues we think get resolved at some point. The Fed normalization continues to be a short term factor in volatility, risk reward. But listen, longer term, it's other issues I'd be more worried about. Will there be a dollar liquidity shortage around the globe that becomes recessionary? Will there be economic turmoil in Europe like Italy and France that has a contagion effect? These are things you can't invest around

easily. There's things we could do to hedge it. Buying long dated bonds, then you take on interest rate risk. Buying yen, I think would be a great hedge against some of the stuff like that. But hedges aren't free. Hedges cost money too. So you say, well, what is your plan? How do you risk manage around these potential longer term events? I think you asset allocate. I think you diversify the portfolio around your appropriate comfort levels of up and down fluctuation and that we tactically try to maneuver to extract the best value around our perspective and outcome. But that in the whole point of asset allocation with stocks and with bonds and with different sub-asset classes they're in, with alternatives.

You mitigate a lot of that degree of risk and you accept that you're an investor who will take on volatility. Hedging these things can be done, but history's usually not been kind because asset allocation has worked so much better at creating a blended risk-reward experience that is palatable for investors at achieving their actual desired financial outcomes. That's the stuff we do all day. It's stuff I do all day. I do it in very long days, and I wouldn't have it any other way. I hope you have a wonderful weekend, and reach out, please, with any comments, any questions. Thank you for listening and watching The Dividend Cafe. Thank you for listening to The Dividend Cafe. Financial food for thought. This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable.

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