The Dividend Cafe - Getting Fed Matters Right

Episode Date: February 11, 2022

Long-time readers know that I have strong opinions about the Fed, about monetary policy, about its relevance to economic conditions, and of course about its implications for investment decision-making. Today we have enough misinformation out there about the Fed that it may be a chance to actually use that word appropriately. And this misinformation comes in a period of elevated interest. The stakes are high. This week in the Dividend Cafe we are going to see if we can’t make more sense of what the risks are and are not around current Fed actions. And in so doing it will allow us (force us?) to touch on a handful of peripheral subjects that matter. It’s an easy read, digestible, and actionable. So jump on in to the Dividend Cafe … Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to the Dividend Cafe. I am so excited to be back here in my New York office studio to record. It's been a whirlwind week, travel and things things and looking forward to a Super Bowl weekend I think that most listeners and viewers and readers are aware or maybe suspect that I am not a big sleeper but this week has been like one for the record books even for me for a number of reasons and so I'm looking forward to the weekend but not really as much as I'm looking forward to sharing with you right now a couple things that are on my mind about the Fed. I talk about the Fed a lot. The Fed is being discussed a lot and right now there is a narrative that it doesn't seem to be being noticed by people

that the Dow is like barely really moved. It's still sitting there very near, not at, but very near all time highs. And we're talking about the potentially catastrophic circumstances of the Fed raising rates to something near or at a whopping 1% and what that could mean to risk takers. And I want to share with you a view on the Fed and their rate policy that is wrong, which is kind of what the one you hear all the time. And then I think one that is right. And it is not one that says all is rosy. It's one that shares a risk and shares, I think, a realistic approach to thinking about risk-taking and the implications on risk-taking from monetary policy.

But I think it does so more intelligently and with a little more information. That's what my goal is today in this sleep deprived version of the Dividend Cafe. Let me basically just say this to start, okay? The Fed's great benefit to markets and to risk takers for the last 25 years, it's not a myth. There has been a benefit to those taking risk in credit, in equities, obviously the stock market, and real estate, and in commercial real estate, and levered loans. Okay, I could come up with examples of risk asset categories, and I will not tell you that the Fed has not benefited those. Now, I do not believe, I will push back on the idea that that's all there's been. That like

you take the Fed out of the mix and you go to bed in 1995 and you wake up in 2022 and risk assets wouldn't have been up at all if it weren't for the Fed. It's a just preposterous notion that is lacking in an understanding of economics and ultimately what drives economics, the human action, the incentives, the profit motive, the sophistication of self-interest that is embodied in the talent and innovation of the modern economies company capability. There is a corporate capability that is profit making at a scale that we don't really even fully appreciate or fathom. And on the margin, you could argue that a low cost of capital and excess liquidity, those things make a difference.

Strip the Fed out of it, you still have wildly successful risk assets in this day and age of price efficiencies and of greater productivity and globalization and whatever other dynamics you think have been at play for 25 to 30 years, okay? But the Fed has made a difference, and I want to explain what that difference is because it is not merely the cost of capital. It is, I believe, the notion that investors right now, I'm going to say two things. They do something and I'm going to say that they do it rationally. They do it correctly, meaning they're not wrong about what it is they're doing. And what they're doing is investing with the belief that the Fed is there as a backstop,

that the Fed is there as a put option, that some of what we call in our business left tail risk, okay, multiple standard deviation events to the downside. Your 9-11s, financial crises, Asian crises, long-term capital management implosions, COVID pandemics, European currency crisis, Greek bond default, all these things that have happened basically since I was a very young man. In each of these cases, the Fed has come in as a backstop of these various implosions and helped to bail out risk takers. And one of the things that boosts risk premiums, and we talked last week, that means lowers valuation, is the belief that the Fed would not be there. It would boost risk premiums if left tail risk was more necessary to price in. And to the extent, regardless of where you think the Fed is playing into left tail risk,

severe, low probability, high impact events, to the extent you think the Fed is there mitigating that risk, then you're lowering risk premium. Okay. And that's what we've been living through for a very long time. So I will make a counterintuitive argument for you right now that the dumbest thing an equity investor could want is the Fed to keep interest rates at zero. Because what mitigation of left tail risk does the Fed offer you if they stay at zero and then another bad event really does happen? Because guess what? Right now, I know there's bad events, meaning that lumber prices have gone up and down a lot and used car sales are way too high. And the potential risk of bad policies in the aftermath of COVID has been out there.

that been out there. But what you really have is GDP growth that has gotten back up to four or five percent to recover from COVID, but is still averaging around one and a half to three percent and unemployment that is below four percent. You basically have an economy where everyone who wants a job can have one or is skilled enough to have a job can have one. And you have economic growth that is positive, even net of inflation. It's not it's not a great economy. It's not something that though is called left tail risk, where there's this severe distress event. And so if the Fed is staying at zero for years in a rather sanguine economy, what bet what can they do next time there is one of these aforementioned type events? They can't do anything.

Or at least they have to do something even more wild and more creative and more adventurous, ergo more risky. So the policy tool of them being able to impact cost of capital and liquidity via the Fed funds rate, you put that back in their toolbox when you get off the zero bound. That's good for equity investors because of the whole thing I'm talking about, about markets wanting to know and investors in markets wanting to know that the Fed has leeway. And so I do not accept the notion that the big risk we have right now as investors is a higher cost of capital this year when I know and I hope you know that going to a higher cost of capital is needed and healthy and normal and it's not going to go that high. So you say, well, David, you just told us last week that with a higher discount rate, you have a lower value when you value risk assets like equities. As you put a valuation on the future cash flows to a discount rate, the higher the discount rate, the lower the value. That's exactly right.

But that doesn't mean that you want that manipulated. All you do there is just create a false scale telling you that you weigh less than you do. At some point, you're going to go on the blind date and the person's going to see you weigh more than you said you did. I just made that up right now. I think that analogy works. I'll have to think about it. It's always dangerous for someone who's been married over 20 years to come out on the spot with some dating analogy because I don't even know what I'm talking about. But I think you get the point that falsely measuring something doesn't make it more valuable or what have you. So a discount rate that has a short-term impact, I don't care about those who are speculating on what speculators are going to do. I don't care about algorithmic traders, front runners, people trying to front run what the Fed

will do. Those things are what they are. And I understand that exacerbates volatility. And I just don't care. And none of my clients should care at all. But if we're talking about what really matters to equities, this five and 10 and 15 and 25 year cycles, markets like the Fed put. And I'm sorry, but I'm unwilling to invest as if I think the Fed put has gone away. I'm totally willing to intellectually engage whether or not it should be there. Should the Fed be not merely a lender of last resort in a liquidity crisis like the late 19th century and early 20th century created. I happen to believe, by the way, they should be. But should the Fed actually be there to go mitigate from those severe impact events? I'm probably not surprising you to say that I really don't. However, I do think they are. And that's what I have to do in

the way I invest your capital, my client's capital, that is, is invest for what is. And that is, I think, the bigger issue that would face markets. Is the Fed leaving its backstop? No. So in the meantime, what are we talking about? We're talking about them pulling a couple billion off the, excuse me, trillion off the balance sheet that they never should have put on to begin with and doing it in a very modest and telegraphed and slow and orderly way. And by the way, you say, yeah, what if credit markets rebel? Well, here's my answer. I think they're going to stop if credit markets rebel. You go, well, what if inflation gets so bad they have to tighten more? If inflation gets to a point, does not come down, which I believe it's going to, the rate of inflation,

because of the things I've talked over and over again about what are actually causing it, if it was at a point where politically and the narrative and messaging made it bad for them to not kind of address it, I really don't think it would matter. Because with debt to GDP, when Volcker was raising rates was about 30 percent. It's now about 120 percent. OK, not just that the overall debt level is is about 32 times higher, but the percentage of debt to GDP as a ratio is four times higher. So what are they going to do?

They would create an implosion of the ability of the government to service its fiscal recklessness. So I think they're handcuffed on that side, not the other side. But regardless, the last thing I'm going to care about is a 10-year at 2 percent a Fed funds rate at one percent and the notion of them trying to get a couple trillion off the balance sheet I think those things that everyone's worried about are are actually positives and the things that could be really severe negatives are not in reality that's my take on the Fed that's my closing sentence there are a couple other pieces in DividendCafe.com this week that I am not getting into here on the podcast or the video

in the interest of time and focus, but I want you to read it and see some charts to hear this argument that is not a prediction, but it's a kind of possible scenario about China and emerging markets and how some of that risk taking can play out this year. And then just a little bit more understanding about FANG and why the one thing we'd be very cautious of with FANG is the belief that it belongs in a safe haven category, like the dollar and treasury bonds. And I want to make an argument for how FANG investing can work when one reconsiders their mentality around it.

So those things are divinitycafe.com. I'm going to leave the video and podcast here. With that, hopefully, I think more enlightened understanding of what to be thinking about the Fed. Thank you for listening to Dividend Cafe. Thank you for watching the video. Hit your subscribe button, give us stars, ratings, reviews. And as always, thank you for being a part of the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, and with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC.

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