The Dividend Cafe - Inflation vs. Recession vs. Investing Common Sense

Episode Date: July 8, 2022

The fundamental tension in the economy today, and less directly so, in markets themselves, is really simple: Is a recession coming that slows down price inflation? That question is simple to identify as the economic tension point of the moment, but it is not simple to answer. One reason for this complexity is that some of the premises brought to the question are not to be taken for granted. And this is the subject of today’s Dividend Cafe – what do we know about current economic conditions, potential economic developments, and eventual economic results? What do some think they know that could be wrong? And what is an investor to do through all of this? I have some thoughts to share that can hopefully bring clarity to much of this, and some of those thoughts are merely clarifying, while others may be non-consensus views. Either way, convictions run deep at The Bahnsen Group, as does humility. That is another “tension” that we hold gladly. Let’s jump into 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 another edition of the Dividend Cafe. I'm excited to be with you. I hope you all had a wonderful kind of shortened week after the 4th of July holiday. I really did enjoy the Independence Day edition of Dividend Cafe last week. And I've actually been out here in East Hampton all week where we own a home and we spend a lot of time over the summer. I'm with my whole family. But I did struggle to come up with the topic for today's Dividend Cafe because I had not, sometimes you struggle because you don't know what you want to write about. And this was more like, how do I limit what I want to write about? Because there's certain

elements of the current inflation conversation, elements of the recession talk, investment implications of both those things, and a lot of other derivatives around it that are all really on my mind this week, and more so because of how much reading I ended up doing this week. And what I've done and what I want to talk to you about today is try to synthesize a lot of this together. I really don't believe that these are three, four, five, six different topics. I understand that I could kind of go really narrow and granular with some of them as separate and distinct from the others. But truth be told, I think there is sort of a singular topic around this quote unquote tension between inflation and recession. So, you know, the markets have mostly been up this week as I'm sitting here recording

midday on Friday, the market's been kind of all over the place. But the reason is, you know, bright and early this morning, we got the unemployment report for June. Futures had been up. They were up. The markets had been up throughout the week. And then the unemployment number was really good, meaning we created more jobs than expected. 377,000.

They're expecting 200, 250. And so naturally, when you get more people working, more people making money, more jobs being created, then markets go down, right? Well, this is the asininity of what we're dealing with right now, is that people do believe that there is a sort of tension between inflation and recession. But of course, both those things are negative. The belief, by the way, that I refer to as asinine, is the belief that job growth is inflationary. That isn't true. It's never been true, by the way. But when markets go down because of good job growth, they're not even stating that they believe job growth is inflationary. Markets are stating

what they believe the Fed believes, which is that interest rates have to keep going higher until we see job growth suffer. And so it's more an investment into what the belief is around people like policymakers, central bankers, to some degree politicians acting on this tension point. So the tension point between inflation and recession is what I want to talk to you about today. And the first, I think, question one has to ask is whether or not a recession itself is coming. If you had a crystal ball, you may say recession's not coming, inflation's going to keep growing higher, and that would be a negative thing for all the reasons we've talked about. Higher inflation means higher prices,

which means lower P-E ratios. It could be negative for stocks. It could be negative for bonds. It could be problematic in a certain way, but at least it would tell you what the problem was so you can invest around it. There's certainly some investments that are more anti-inflationary than others. And if what you knew was no, in fact, inflation is about to subside, you looked at the commodity price data and saw that even though commodity prices are all universally elevated from their levels of 2018 and 19, they're all way lower than they were from some of their peaks of recent months. And you see copper prices down 30% or lumber prices down 60%. And you could say, okay, well, maybe the inflation thing is starting to turn. But before I go down that path,

let me just reiterate, the same is true in the recession talk. I put a chart in DividendCafe.com illustrating the most inconvenient factoid around the recession thesis is job openings. 3.6% unemployment, wage growth has been steady. But just the mere existence of this, you know, 10 million ish unfilled job openings. It's totally unprecedented. Not only that it would be that high, even if it were much lower, just the fact that directionally, it's going the way it's going. When you're going into recession, you see job openings collapse. You don't just see terminations, but before you see terminations, you see positions get removed. Employers first quit looking to hire new people, then they start looking to fire old people in tough times. This seems incredibly logical to me. And we don't see that yet. Now, again, if it comes, it comes. If it happens, it happens. But I'm not going to accept this 90% odds of a recession thesis when there is that staring us in the face. And then this other kind of inconvenient reality, which is real bond yields. We've never, ever, ever had a recession where real bond yields were negative. We've actually never had one when they were even as low as 1%.

So when you look at the bond yield minus the inflation rate, excuse me, the bond yield minus the inflation rate, and you have a negative number, which is what we're dealing with now, it's incredibly hard to talk about a recession coming. Now, the argument people make against this is that that can flip, that you could see the inflation number come lower and the bond yields go higher. And that's very true. But I got to tell you, I have a very hard time stretching the numbers to a point where you even get to 1%. I mean, you could say you think the 10-year bond yield is going to go up to 4%. I do not. But it could do that. And you could say that the inflation rate's going to come

all the way down to three. But then you're looking at 1% of a real yield, and that assumes the most optimistic expectation for growth. That's not inflationary. And if the inflation rates come down that much, I guess what I'm saying is you're not supposed to be doing this analysis by looking forward to where those rates are. This is based on where they start when you start talking about a recession indicator, where they are, not where they're going. And so fundamentally, I am not totally convinced it's coming or at least coming imminently. But again, as I've written about quite a bit in Diving Cafe, they can deteriorate credit conditions enough that it ends up happening. We do have a lot of leverage in the economy

that could quickly spill over into the labor market. There are scenarios by which it could happen, but I don't believe one ought to formulate an investment strategy around something much more than about 50-50 on the recession talk. But then you kind of look and we put in a chart at differentcafe.com that's like a decision tree. Like, will there be a recession or not? And then if there is a recession, is the Fed going to keep tightening or are they going to stop tightening? And so you have different scenarios. There's two questions there. So therefore four scenarios, right? You can say yes and no, or yes and yes, or no and no and no and yes. You got me? You got to look at the chart to follow. But in none of those scenarios,

Fed tightening or not, recession coming or not, do I think it makes a ton of sense to be coming back into very expensive growth assets? I think it's possible that growth ends up getting some kind of a bid, certainly higher quality growth, that people just really, again, there's a popularity and a dependability that people decide they want to come back in. But again, as I've written about before, both valuations and earnings momentum itself, I think speak against this. And then when you look at lower quality growth, it just doesn't strike me as even remotely sensible that in an environment where everything was ideal and companies couldn't turn a profit, couldn't establish pricing power in optimal conditions for us to believe that all of a sudden they right the ship and have better economics and better fundamentals when valuations are strained,

when access to capital markets is strained, when you're potentially in recessionary conditions, economic contraction, those are all bad things. Why does that become better for some of these companies than the ideal circumstances they had before? So when you look at this inflation recession axis and say, okay, we don't know exactly where inflation is going. We don't know exactly where recession is going. And yet we want to be invested in generating a return on capital for our ultimate financial objectives. I think it's a fair paradigm to say that if you think there's going to be a little bit more of the recession narrative and less recession narrative, you're going to benefit from being more invested in credit on the fixed income side and less on duration.

And you're going to benefit from owning more value on the equity side and less growth. And then to the extent if you do get less inflation and more recession, you're certainly not going to want credit. And probably in that environment, on a relative basis, growth looks better than value. And certainly less inflation, more recession, you know, is going to pull down the short term rate and probably benefit in terms of longer duration in your bond portfolio. My thesis is that I don't think an investor has to make that decision. I think that we don't know what's going to happen with inflation. We don't think an investor has to make that decision. I think that we don't know what's going to happen with inflation. We don't know what's going to happen with recession in a short-term period. And we have formulated an entire investment strategy at the Bonson Group where we want to be

neutral about those things, not only right now when it's particularly hard, but in any other environment. I think dividend growth is more all weather. That you are naturally going to have things that are somewhat pro-cyclical. We have an energy overweight, and I'm going to talk about that in a moment. There's no question that energy is a pro-cyclical investment. The financials, generally you would think, if you're going to go into recession, that financials hurt as lending, loan demand comes down and things like that. But I will say this. I believe that when you look, I'm going to use

those two sectors as an example. Energy, I believe, benefits from inflation. And I think that the PE ratios are already pretty darn low if you end up going into recession. Financials do better with higher interest rates when you're talking about like banks and insurance companies. And I think their valuations right now have already seen a lot of valuing in, you know, pricing in the possibility of recession. So I'm not convinced that those sectors really suffer if that's the way these things play out. Now, on the energy front, energy got hit hard near the end of June. There are still big returns on the year, but they definitely have come down. Are we looking at a scenario where the energy bull market of the last 18 months has all of a sudden ended?

Let me just throw out four quick things. I wrote a big list two weeks ago as to why I still saw a lot of opportunity in U.S. energy, particularly midstream assets. effort to keep certain large pockets of their population locked down around the futile goal of avoiding COVID infections. But I know it's coming at some point, either because they figured out what the rest of the world already figured out, or everyone ends up getting COVID and the herd immunity comes and they go on, or maybe they actually vax the population. I don't know. COVID and the herd immunity comes and they go on, or maybe they actually vax the population. I don't know. I don't know what happens. All I'm saying is at some point that does happen. And I certainly would not want to be short energy when China goes into a full reopening mode. Right now, I would argue European supply issues are still heavily constrained. And I don't think they're about to go kiss and make up with Vladimir Putin. I don't think they're going to go pay the Saudis through the nose to

help remedy situations. I think they could end up turning to coal for a moment, but environmentally, I don't think that's their sustainable long-term solution. So I think supply constraints in Europe, the reality of eventual demand increase from China reopening, the continued instability geopolitically right now that focuses mostly at Russia, NATO, Ukraine. And then just you see the way that policies are being formulated to treat it. They're all basically in the form of subsidy, either direct payments to people to help offset high gas prices or trying to cut taxes on gas prices, but they're not focused on the supply or demand side. And I don't know what they can do to cool demand. I don't know why they'd want to cool demand, but they're not doing that. And they're not doing

anything to increase the supply. And so all of those dynamics fundamentally seem to me to suggest that inflation or no inflation, recession inflation and recession, which, again, I believe both of them have a certain transitory element to it, that this is not the conversation we'll be having for the next decade. I think Jay Powell unfortunately caused the word transitory when we talk about inflation to be thought of and utilized in the wrong context. to talk about inflation to be thought of and utilized in the wrong context. But my point is that from an investor standpoint right now, making decisions around this axis of doubt as to what will happen between inflation versus recession, that will go away. But I accept that there are certain pieces of deglobalization and other consequences of that that are really, truly paradigmatic. And what I mean by that is I fully expect a significant changing of the guard. You can call it the Trump effect with tariffs and a lot of the kind of attention around helping U.S. manufacturers, a sort of protectionism, if you will, and local nationalism. But far more than that was COVID.

It was attention brought to national security concerns, strained relationships with China. tension brought to national security concerns, strained relationships with China. There's just a lot of factors that have played into this idea that intense globalization has slowed and some level of de-globalization is coming. And I've been reading more and more about how that could indeed impact equity investors. And the thesis goes something like this. And I got to say, I vehemently disagree with it. But the thesis is that companies will have to use more CapEx in the future and that more capital expenditures as investments into productivity means lower earnings. It hurts bottom line as they have to divert monies from free cash flow

into more expenditures. And the particular caveat around that is they're doing so into something that's less profitable than what they had before. You had offshoring that had a certain cost benefit. Now you're doing onshoring, it's going to be more expensive. And I really have to say that the notion of capital expenditures as an investment in productivity being bad for productivity doesn't make any sense to me. And the notion of an investment in productivity being bad for profits really doesn't make any sense to me. And the notion of an investment in productivity being bad for profits really doesn't make sense to me.

So if you accept the sort of syllogism that you're investing in productivity and that that is there to generate productivity and that more productivity is to generate more profits, then I think you have to view that investment, the capital expenditures, as a positive, if indeed you view the fundamental objective of equity investing as investing alongside profit-making activities.

Earnings growth is bullish for equities, and that's what I expect to happen. So I don't believe that on the other side of this inflation recession talk is a deglobalization era that hurts corporate profits. And I earnestly hope it's one that can help profits. And I certainly hope it's one that helps GDP growth, that helps economic growth

and more productivity is the need of the hour. But that's a subject I'll save for another day. So kind of in conclusion, because I've been all over the map here today, there is very likely, in my opinion, going to come a time where not every central bank is doing the same thing. Not every central bank is going to say, hey, we have to really talk hawkish for a while, do some things in our policy that are tightening, even if they're not that much tightening, and then just kind of hope some force helps bring down pricing pressures. A recession is not a cure to inflation,

because an inflation is not caused by real economic growth. We're getting categories wrong here. And ultimately, from an investor standpoint, staying focused on why you invest to begin with. It could have an element of credit. You like the premium you get from investing in the debt of debt worthy endeavors. It could be focused on duration, meaning you like the stability you get from investing in high quality bonds, municipal, corporate, mortgage, or sovereign. It could be the risk you take in investing in operational enterprises. And yes, in a dividend growth portfolio as well, let alone an index or whatever else it is people are doing, you're going to have

some things that benefit more on the inflation side, more on the recession side. They're set up with different offensive and defensive characteristics. But my point is that the goal being not to guess right on a three-month or six-month macroeconomic dynamic, but to be invested alongside the cash flow generating activities of these companies, I think makes a lot more sense right now than waking up every day trying to guess what the recession will look like, when it will come, where inflation is going to be,

what the Fed's going to do about it. You invite multiple uncertainties and variables that cannot possibly be handicapped correctly. I think this offers more resolution, more conviction. And then here's the biggest thing I want to conclude with. You eventually get to be right. If you go all in on low quality tech stocks, thinking I know a recession is coming and that there's going to be this big multiple expansion and you go into this type of thesis, capital can be destroyed

where you don't get to benefit from mean reversion. There's a lot of people invested in certain things the last couple of years. I don't know that they're getting their money back. At some point, if all of a sudden inflation subsides or a recession comes or whatever these different things are, the types of things I'm talking about will pay eventually. You can have more volatility or less volatility depending on certain ways the cookies crumble, so to speak, but you want to be able to benefit from the eventuality of your thesis.

There's nothing in the thesis that I'm sharing today that is not eventual. It is. I hope this makes sense. I invite more questions to dig deeper into this subject and the various derivatives of this subject. I think it's fascinating stuff. I enjoy sharing it with you. Look forward to another Dividend Cafe. I think, let's see, next week I will be speaking at a conference in Las Vegas near the end of the week, and I'll be recording Dividend Cafe from Las Vegas. So look forward to that. In the meantime, reach out if you have any questions. Stay focused on prudence, humility, conviction. We're going to do the same here at the Bonson Group. Thank you for listening to and watching the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower

Securities LLC, member FINRA and SIPC. 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. This is not an offer to buy or sell securities. No investment process is free of risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. Thank you. is provided as general market commentary and does not constitute investment advice. The bonds to Groupon Hightower shall not in any way be liable for claims and make no expressed 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 are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Thank you.