The Dividend Cafe - Human Nature and Twenty More Years of Debt

Episode Date: May 24, 2019

Topics discussed: Financial Advice vs Human Nature China Trade War Sovereign Debt Fed and Interest Rates Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson. I am the Chief Investment Officer, Managing Partner of the Bonson Group, and we have a lot to cover today. This is one of my favorite Dividend Cafe commentaries that I have written a long time. You know, I write it every single week, and I always like them. I mean, I guess I think some are better than others, but there was just something about the content this week, the subject matters and, and the way that some of them juxtapose together

that I really enjoyed. And, and I hope you'll find it valuable and I hope it translates here into our podcast in a, in a good way. Just, you know, in terms of the market on the week, we I'm recording right now on Thursday morning. We're a couple hours into trading already. We're down 300 points on the Dow. We had been down 400. We opened down 200. So we're right kind of in the middle of the high and the low on the day. But we are now negative on the week. We had been positive on the week coming into today. So this is just absolutely nothing new and nothing that's going to stop anytime soon. The trading volatility around the uncertainty that this unfinished China trade war business represents is real and likely to persist.

is real and likely to persist. And so we're going to talk a little bit more about that later. And you'll find that some of the topics we address this week are both time sensitive and ad hoc to what's happening in the markets, and yet also evergreen and timeless and more principle based. And so I hope you'll get a lot out of it. And, and as always, we welcome your questions and comments and feedback. We want to make the podcast as valuable for as many of you as possible. And to the extent you find it valuable, we hope you'll subscribe. We hope you'll throw us some stars and thumbs ups and shares and whatever in the world it is that people are

supposed to do that helps us kind of increase our podcast traffic. So let's get into it. All right. Human nature is a more powerful force than good advice. Let me explain this, okay? One of the reasons that the entire financial advisor profession exists is, and I would say at least as far as this fiduciary advisor is concerned, is the primary reason is to manage the behavioral tendencies of human beings who are subject to human nature. Whatever one thinks about investment management, portfolio construction, cash flow mechanics, financial planning, tax minimization, estate strategies, and any of the plethora of services and roles that are generally a part of a financial advisory relationship, there's one primary function that is eminently relational, non-commoditizable, and value-additive, and that is the management of an investor's behavior. The management function is not needed because human beings naturally do what is right.

It is needed because left to the devices of nature, human beings have a strong and natural proclivity to do what is wrong. From the wishful thinking belief in easy or free money from an investment to capitulations to fear that dominate during bouts of market volatility, the shift from greed to fear and fear to greed is unending and it is natural, but it is to that end which we work to help manage the behavior around that natural and yet ill-advised aspect of human nature. Now, the issues I'm about to talk about here, okay, I refer to it as my continued epiphany. And I don't think epiphany is actually the right word because this concept does not come to me.

It's something I've been studying and grappling with and becoming more and more convinced of through a lot of research and analysis. For some time, it's been sort of an intellectual homework assignment. Sometime it's been sort of an intellectual homework assignment. But it's important because I think that so many simplistic understandings suggest an opposite conclusion. And the subject is that of the impact of greater government spending, greater government debt on interest rates. We know that when a company borrows more and more money, they become a riskier company to lend to, and the interest rate for their debt goes higher as investors demand more return to compensate for the risk of lending to them. That's not rocket science. Many assume the same should work for the government, and it's certainly true at first glance. But we have seen bond yields drop as

government spending accelerated, and we've seen it all over the world. And many assume it's just central bank intervention that's caused it. But I no longer believe that's solely the case. If you believe that the government's spending and debt overhang crowds out private investment, which it does, and ultimately creates weaker economic conditions, which it does, then it follows that loan demand would be reduced, putting downward pressure on rates. Well, why does this matter? Because it suggests a very long-term period of relatively low interest rates until such time that the private sector recaptures the portion of the economy that government debt overtook, which usually is never. can always create the results we want. Excuse me. Monetary intervention cannot always create the results we want in a free market as free market actors are too smart and too willing to be manipulated. If one believes that excessive sovereign indebtedness

ultimately puts downward pressure on long-term interest rates, as I am now convinced of, it behooves us to ask if we believe sovereign indebtedness of an excessive nature is likely to persist. One argument is that excessive current debt means that future debt has to come down via austerity. And it is certainly true that mathematically appropriate fiscal policy, pro-growth measures that increase revenue and spending discipline that decreases expenses, would lead to reduced indebtedness. But this is not about math. It's about politics. And there are very few nations on earth, including ours, where the political will and national appetite is there

to reduce spending. Are you personally against the high levels of debt? I bet you are. Are you willing to cut $500 billion out of the national budget? If so, what will you cut? And are you going to tell everyone what you're cutting? See, now you get the idea. The people have not yet said they actually want particular spending cuts, just abstract spending cuts. So economically, I have to presume that the debt will continue until some economic force makes it stop. And this is where investors need to listen up. Ultimately, excessive debt has to be inflated away, yet debt burdens are inerrantly deflationary, which leads to a vicious cycle of central bank interventions. These interventions have been my primary macro focus for over 20 years,

and they will be for the next 20 years. The Treasury will ultimately look to the Federal Reserve, in my opinion, to monetize their debt. A macro view that fails to capture this framework in the decades ahead will make key errors in interest rate assumptions, growth expectations, and ultimately the asset allocation of a portfolio. Getting the framework right is the end to which we work. The other side to the coin in my trade war fear. My primary fear remains that an unresolved trade war holds business investment down long enough that it becomes too late,

that the CapEx renaissance needed to boost productivity into two or three more innings of economic expansion fails. But there also is a sense in which this perpetually soon but not yet trade resolution is ironically good for the markets and good for President Trump politically, because until a deal is struck, he can continue to bash China with political impunity. He scores well for that with his base. And until a trade resolution is found, markets have some floor in place because markets have to price in the potential of a deal coming. So a continuation of punting may actually hold markets in place for a bit, albeit with enhanced volatility, and it may serve the president politically. But that certainly does not mean it can be done

without damage to the global economy and without damage to the U.S. economy. One of the great coincident metrics to business investment in CapEx is what we are making in U.S. factories. We call it industrial production. It increased in a beautiful way throughout 2017 and the first half of 2018. And we saw the number peak last summer, right when, you guessed it, trade tensions began. It's steadily declined ever since and now sits at a two-year low. Of course, we're talking about the growth of industrial production slowing, not an actual contraction yet. But it's an example of the threat the trade war represents to the economic expansion.

Now, by the way, if someone wants to tease you with fear about the market right now, might I suggest that the trade deal with its expected volatility over the next few months is something I continue to believe will not be resolved until one of the sides or both sides pain points gets bad enough that it forces them back to the table. I don't know when that happens, but I don't think that we're due for some imminent resolution. But I would look at the European banking system as an example of something that, look, they've been punting for years. There's any number of things that the European Central Bank could do to continue punting or kicking the can down the road, if I can try to throw in as many overused cliches as possible. But here's the issue. You have what is literally a banking system down on

its last legs that's been taped together with very aggressive monetary policies outside of a fiscal union in the European culture. And I think it's very difficult to time what is going to happen, but the media is not talking about it. And if someone wanted to try to pick some kind of a surprise change, a catalyst for surprise change in markets in a few months, I think it's more likely to be something someone isn't talking about than something someone is. So all that to say, if you want to be fearful of something, it's not usually the best idea to be fearful of what everyone else is fearful of. I want to clarify something about equity returns. There's a misnomer about stock prices that I think should be clarified. It's actually something I implicitly address almost every week, and that's my constant reiteration that stock prices are discounting mechanisms,

that they're pricing in now what they believe about the future. However, it needs to be explicitly stated that for a stock price to surprise us to the upside, it does not suffice for the company to be great. It must be better than the greatness the stock price already discounted or already assumed. It can be said that a weak company which gets better will generate a better return than a great company that does great, because the stock price has already discounted what is great. As dividend growth investors, we want the stability and income generated from great companies, which is different than unexpected pops in stock price. We believe deep value can be revealed where a company has not yet discounted

an improvement story that is yet to play out. But management, with its dividend policy, is indicating their confidence in future execution. The moral of the story is not that a secret formula can be found for stocks that will pop in value. It cannot. Rather, it's to pour water on the idea that the best performing stocks will be the ones where everyone already knows of the company's greatness. Speaking of equity returns, by the way, earnings season is essentially behind us and earnings per share growth was indeed positive on the quarter versus a year ago. More importantly, revenue growth was up 5% year over year, stunning those who believe that the tax cuts were a transitory moment only

for the bottom line. 76% of companies beat earnings expectations. Earnings estimates had been revised downwards too much. 55% of companies beat their revenue estimates. At DividendCafe.com this week, I also have a section on where have all the high-flying IPOs gone, giving you some really important context and explanation as to why the big high-profile IPOs of late have not popped and represented this sort of free money, high-flyer environment, but how the whole world has changed since the late 1990s. Is a Fed rate coming? The Fed's minutes this week, by the way, did not say anything to increase or decrease those odds.

I do believe the odds are slowly increasing. The Fed is staking their argument for a kind of still position in monetary policy, no hikes and no cuts on the idea that, yeah, inflation's dropped, but you know what? It will be back up to 2% or so in short order because they think it's a transitory condition. I do not think it's why they're hesitant to cut. I get why they position it that way. But I think it's because they fear that a lower rate would just reaccelerate growth in the leveraged loan market, heightening sensitivity in the business sector to economic slowdown.

I certainly hope that's their concern because it should be. In the politics and money section of dividendcafe.com, I pillage the idea that it was the debt ceiling and debt downgrade issues of 2011 that caused the market disruption then. And a little update there on the legislative priorities of Congress as they try to work with the White House. In the chart of the week, we have a really good chart. I actually think I've used it before. I can't remember,

but it would have been a while. We've updated it to just show how long this current cycle of economic expansion has been going and yet how weak it has been cumulatively relative to the last seven or eight economic expansions we've gone through, and all of which are somewhat shorter but also a lot more profound. So it gives you something to think about there. I'm going to leave it there for the week. I hope you've gotten a lot out of this Dividend Cafe podcast. We thank you for listening. We welcome your questions and we do look forward to coming back to you next week as always. Thank you for listening to the Dividend Cafe podcast.

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