The Dividend Cafe - Dividends, Dollars, and Central Bankers

Episode Date: December 16, 2016

Dividends, Dollars, and Central Bankers by The Bahnsen Group

Welcome to this week's Dividend Cafe podcast. Please forgive my voice this week. I'm getting over a little bit of a cold, so the volume may not be as loud as normal, but hopefully the content will be beneficial. 20,000 this week. Couldn't quite get over the finish line, but certainly very close. The Fed raised rates for the second time in 10 years, which also happens to be the second time in one year. The dollar has continued to rally. More Trump cabinet picks have surfaced. So in this week's Cafe Podcast, we'll chew it all up and give you our feedback. A little context, please. How bad was the month of November for the municipal bond marketplace? It was the worst month in total return since September of 2008, which many will remember was the month in which the world was ending. That was not necessarily something we expected to ever see again,

in the sense that such a violent move in a quick period of time, and especially a period of time in which, unlike September of 2008, overall economic conditions and broad market sentiment was actually quite good. The bulk of the move was related to broad market interest rates moving higher, the yield on a 10-year treasury going from 1.8% to 2.4%. But credit spreads within municipals blew out as well. So much of the move down for bonds in November was a self-fulfilling prophecy of the initial move down. Stocks were rallying, bonds were dropping, so naturally investors decided to sell more bonds at lower prices and buy more stocks at higher prices. Weird. Fundamentally, the next move for bond

yields will depend on inflation expectations and inflation expectations are capable of confounding so-called experts for years at a time. Our approach to the bond market overall is very important right now. We want to keep our exposures modestly underweight to normalized levels and within those exposures keep duration lower than normal, meaning how much our portfolio would be impacted by a move in interest rates, shorter maturities and call dates and things like that. Benefits will take place to our bond portfolio when rates rise if we have a lower duration or even negative duration as bonds can be reinvested at higher rates. We want to take credit risk but not duration risk and we want to monitor even those credit risks very carefully.

That all sounds very simple, right? What the municipal bond crowd does may be useful. Municipal bonds have one particular reality about them that really make it a very unique asset class, especially when it comes to crowd behavior. It's an asset class almost entirely owned by individual investors. Pensions, endowments, sovereign wealth funds, 401k plans, all sorts of institutional ownership structures did not buy muni bonds. So this is primarily an asset class subject to the whims of individual investors who, frankly, happen to be, generally speaking, a more emotional bunch than many institutional investors.

Therefore, muni bonds are heavily owned in mutual funds, and mutual funds are heavily subject to the redemption whims of their owners, which means muni bond prices are subject to the same. There's a long and consistent tradition of heavy outflows from muni bond funds being a contrarian indicator for where muni bond prices will be a year later. For example, let's just say that the outflow of funds from muni bond funds this last month has been extraordinary. Fed versus Trump round one. Well, not really. The Fed did raise interest rates by a quarter of a point for the only time in 2016, adding to the one and only quarter point increase they did in 2015, together which make up for the only increases in the Fed funds rate since 2006.

This rate hike, like the one a year ago, has been totally and completely and thoroughly telegraphed to the markets for six weeks or so before it happened. They projected up to three rate hikes in 2017 as well, though we would remind you that a year ago they telegraphed four to six hikes this year. We only got one. We suspect that the Fed may very well hike next year with more intentionality as they're no longer held back by an election year and may very well see their agenda as one of dampening the stimulus that fiscal policy may create out of a new Trump administration. The tension between the Fed and the Trump White House might, it just might, prove to be the story of 2017 in the markets.

Why do I think the Fed may be more handcuffed than people think? The white line, excuse me, we have a chart in Dividend Cafe this week, and you're going to have to look at the chart to understand. But essentially, the chart is reflecting the German bond yields for their two-year maturity is going straight down for three years in a row. And now our two-year Treasury yield has recently bursted out. And really, we could put up a chart comparing the German bond yields to the dollar or Japanese to the dollar, to U.S. Treasury, or any other European country, et cetera, et cetera. My point being, it's a tremendous divergence between the US and the rest

of the global economy that's a real challenge for Yellen and the Fed. Now our central bank could continue to allow this divergence but fundamentally there would be a real currency challenge if the divergence blows out much more and that could threaten competition and market normalcy. We are so used to talking about interest rates in macroeconomic terms as part of a conversation about growth rates, inflation, the yield curve, currency, we sometimes ignore the most practical aspect of the world of interest rates. While mortgage rates and securities-based lending facilities may be the most obvious impact of rates on our own clients, there's a significant group of consumers in the

public marketplace who are affected in different ways by interest rates. Those with credit card balances, the ultimate variable rate. Delinquency rates have been pretty benign for several years. We put a chart up at Dividfe.com this week, kind of showing how that delinquency rate is starting a little bit to work its way back up. I guess the question is, will a slightly higher rate impact consumer spending? You know, for those wondering, we'll kind of tell you our take. We think that the long and short of it is that there's very little evidence that credit card interest expense provokes such a radical thing as consumer responsibility. On the margin, there may be a slight impact, but systemically, society's commitment to consumption is pretty serious. Real quickly, I want to say something about our dividend growth philosophy, and then I'm going to have to wrap it up this week, not only because we'll be close to out of time, but because I don't want to talk much further.

Whenever I hear someone say that a company paying a dividend out to a shareholder is immaterial as to the value of the company or the investor return, you know, they're thinking being the company paying the dividend is poorer as a company since it then parted ways with the cash. So the shareholder is a little bit richer, but the company is a little bit poorer. And so all things are sort of just equal. I'm reminded how important it is when I hear this, that we spread our message to the world. Yes, a company growing at the same percentage with the same level of earnings and retaining those earnings is theoretically just as valuable as one in the exact same boat but paying out some earnings to us, the shareholders. But what this analysis misses is, well, a lot. Number one, the continued extension of risk that the retention of earnings represents. Consistent, generous dividends reward

shareholders now. Retention of those earnings simply delays monetization to us and therefore, as is the case with all investment realities, increases the natural risk of time. Number two, everything makes sense in theory but in practice not so much. And in practice, companies with long, impressive records of dividend payments and dividend growth have historically featured higher quality earnings, lower volatility, and a management culture more aligned with shareholders. 3. Dividends are their own accounting proof. Retention means extended faith in their accounting, which again, may be good in theory, but not always in practice. Number three, the mechanics matter to shareholders. An investor living off their investments,

partially or otherwise, needs to withdraw whether the company paid a dividend from earnings or retained it. If the company retains earnings, the shareholder becomes forced to withdraw at unattractive prices during inevitable market downturns. And then number four, dividends change timing risk. Are there investors out there who believe they know when to sell share prices at optimal prices and when not, dividends smooth out this process in a more

reliable and rational manner. So a couple other sections in this week's DividendCafe.com that I would encourage you to read deal with a big difference between this bond sell-off here in November, December of 2016 and the last time we had one in June of 2013, the so-called taper tantrum. I'd read about that if I were you. A quick hint, a lot of things have been very similar, but the VIX, the measure of fear in the market, is a huge difference. We also have a nice chart about MLPs and the seasonal calendar traditions of how their returns go and what that may mean to you. A few more things about Trump as well. So please do check out dividendcafe.com.

And we do hope that you've benefited from the podcast this week. I again apologize for the weakness in my voice. But with December now halfway done, we can't forecast how the last two weeks of the year will end. Let's put it this way there's poetry in that as the first 50 weeks of 2016 have not really gone according to script it's very possible the last two weeks won't either. It's not been a good year for timers those who didn't believe asset allocation works have been punished. The abandonment of asset allocation disciplines probably led to outsized drops in periods like January, February, and then inadequate returns when markets rallied in March or July. So right now it is easy to pile on bonds, but it's a

bridge too far. You know, with the S&P trading at 18 times forward earnings to say you want 100% of your money in a stock index going forward. Selectivity in one's investment allocation is pivotal right now, but so is the robust discipline of asset allocation, of not swinging for the fences. With that closing comment for the week, enjoy your last pre-Christmas weekend of 2016 and tis the season. We look forward to coming back to you next week.