The Dividend Cafe - Is the Fed about to Break This?

Episode Date: June 17, 2022

Once again we find ourselves in the midst of a tumultuous week in the markets, and yet with bigger fish to fry in the Dividend Cafe? What could be bigger than a 1,400 point drop in the market on the week, and a 3,000 point drop in the last two weeks (note: I am hitting “send” on this before the market opens on Friday, and pre-market action Friday does appear to be to the upside right now, but you know how that goes)? Well, for one thing, I think most of the commentary I have to offer on the specific things taking place this week in markets was well-covered in each edition of The DC Today this week. If day-to-day market distress is distressing you, I hope you will turn to The DC Today as a resource. Reading it cannot make the market go up any more than my act of writing it can, but hopefully, it can provide clarity around where this volatility fits into expectations for investors who have real financial goals in their lives. So the bigger fish to fry I refer to are not about the specific Fed meeting of this week, or this most recent interest rate hike, or even my broader theme about the carnage in “shiny object” investing … It has to do with discussions around a potential deeper level of concern in financial markets, and what they may look like. I hope after reading this week’s Dividend Cafe you will feel a bit smarter, a bit more informed, and a bit more at peace. 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 Dividend Cafe. This time I love just changing venues around on you every week it seems. I'm actually recording in my apartment in New York City as I have to get straight to an appointment so couldn't get into the studio this morning. The market hasn't even opened yet on Friday morning and as promised last week I do have a particular topic I want to address this week but it will not be all that directly connected to the kind of turmoil that has been in this market week.

As I'm recording here, Friday morning pre-market, market was down 1,400 points on the week. It looks like it's set to open 200, 250 points this morning, but you know how that goes. But it was down significantly the week before as well. And so you're looking at a 3000 point drop in the market. It had prior to that been up a couple thousand points. And so, you know, this is downside pressure and a lot of volatility, and we know all those things. And I think, you know, in the DCt DC today.com every day, I try to write about what's causing it, what we're doing, what we think about it, what to expect. And, you know, each time the market has a period like this, there is a cause and there is particular circumstances. But also each time it happens, there is a kind of consistent best practice for investors. And so whether the cause of a market turmoil is a recession or is Fed tightening or is a war or whatever the various catalysts to market turmoil that have existed for hundreds of years,

whatever the particular catalyst may be, obviously we we write every week and with DC Today every day and have built a financial advisory group around the notion of emphasizing wise investor behavior. And so we want high quality alignment in a portfolio. We want goals and tolerance and personality and psychology and the very customized parameters of how one's own portfolio ought to be constructed. We want that to take place before there are hard times, not after. We want to avoid buying into insanity. And yet, during the difficulties that the assurance of which provide the risk premium that give investors return over time, we also want to behave and understand that in fact, downside volatility is a part of being an investor. So all that to say, I am so incredibly confident that we do those things for our clients at the Bonson Group that I do not feel the need to use

downturns in the market to wring my own hands about what should we be selling this or selling that or what have you. We want to get portfolio alignment correct to begin with. And then, of course, put our energy into holding hands of clients who themselves may not quite have the conviction and the metal that we are professionally expected to have and obligated to have. So there's a long intro to what has nothing to do with today's Dividend Cafe. I wrote last week about the reality of a further leg down of markets, a further systemic risk that could accompany what is right now a bear market in the S&P, or it has at least generated a lot of talk of recession. We haven't necessarily got there yet. And I brought up some of the potential culprits to kind of a black swan

event, another catalyst to economic contagion risk. And I said why I do not believe that some of the things that have broadly been discussed over the last decade, European bonds, municipals. I talked about a hedge fund imploding. We talked about the crypto space, how I didn't see those things as necessarily systemic events. And that now there's been a lot of talk around, well,

it's private equity, which has grown so much and has taken on certain differences in the way it's being invested in versus 20 years ago. Is that a space? And I shared why I don't believe that's the case. And I reiterate some of that in today's dividendcafe.com as well. I believe that there is always risk in underlying businesses being invested in. that there is always risk in underlying businesses being invested in. And yet, not only am I convinced in the existence of an illiquidity premium, I'm also convinced in the benefit of illiquidity keeping people from behaving badly. So what I left you with last week is the idea that there may be this other issue lingering out there, and that issue is a massive, I mean massive growth

in what some will call a shadow banking system, non-bank lenders that have taken on a significant role in being a liquidity provider, a credit provider in our economy. And so I refer to things like structured credit, which is largely backed by an underlying asset. It's lending against commercial property, residential property, other asset-backed vehicles, whether it's pools of credit card loans, car loans, student loans. There is an asset-backed realm of structured credit that the lenders are largely private actors, meaning hedge funds, special pools, or lenders that are formed that are not using deposit capital, bank capital, things like that. Apart from structured credit, there's been a huge explosion in cash flow-based lending.

Private credit against first lien positions in businesses that may not have underlying assets, maybe asset-light businesses, but are cash flow heavy, And that might have been way too small for the bond market, perhaps too big for bank loans, but have a sweet spot in a kind of middle markets lending that is largely securitized by the cash flows of the business. This has exploded in size, exploded in popularity and utility. It's been great for investors, great for companies that are borrowers, and frankly, great for lenders as well. So whether you're talking about syndicated loans, which often are generated by banks that are taking first lien positions and applying a floating rate to the credit they're extending to businesses and then pooling those

loans and often selling them off to institutional investors in the CLO space, collateralized loan obligations. Whether you're talking about those syndicated loans, whether you're talking about structured credit, which is largely asset backed, whether you're talking about private credit, which is largely cash flow backed. In all of these spaces, there is one huge thing in common, and that is they are not being lent out by the likes of your Lehman Brothers and Citi's and these kind of huge behemoths that we know from financial crisis. They're not commercial banks. They're not intertwined with depositor money. They are therefore separated in a P&L sense from the balance sheet of the American economy. Now they are a part of the American economy. And this is sort of the tension.

It is brand new. And I am very critical of a central banker who is doing something that's never been done before and says, no, no, no, this can't happen. Not because I think it will happen, but because that banker doesn't know. And I don't know either. I don't know that this interconnectedness of non-bank lenders in a downturn, that it can't become more contagious than I think. But what I am suggesting to you is that there is a benefit in non-bank lending, that this is not connected directly to that engine of commercial banking activity, that hub of American economy, that the systemic risks are different. I accept that there could very well be widening credit spreads, that there could be defaults. I happen to believe there will be great recoveries if there are defaults where lending has been well underwritten. But nevertheless, I don't know what the tentacles of all of it could be. The argument that because of that opacity, the risk is greater,

I think is fine. I think it's true to the extent that it's true. We don't exactly know where all the connectedness is. However, we know that the banks are dramatically more capitalized than they were pre-crisis, that there is much less leverage in that traditional aspect of the economy, and that where there is greater risk being taken in this quote-unquote shadow banking portion of the economy, I think that's where those risks should be taken. Whereby the possessor of the risk who is the possessor of the reward, they will own the profits and the losses. This privatization of P&L I see as a very positive thing. Now, will that interconnectedness end up leading to other slowdown, other halts in hiring, could it

exacerbate recessionary impact? It's very possible. But I do not believe that that risk is in any way, shape or form analogous to the pre-crisis risk, nor do I believe the mere sharing of numbers like, oh, there used to be a trillion in non-bank lending and now there's four trillion. Therefore, the risk is four times higher. That kind of linear argument is illogical. It discounts the existence of collateral. It discounts the existence of underwriting. It doesn't take into account that the leverage is different. The leverage that was on the traditional bank balance sheets pre-crisis was exponentially higher. And it discounts the fact that the risk that one may be taking is their risk, that there is not the shared risk in the way we

normally think about such contagion events. I know people are going to take this to say he's discounting or diminishing the possibility of a systemic event. What I'm saying is I do discount it more than some, but I acknowledge it exists. Should there be a deep enough recession and the way in which our private credit markets have underwritten the extension of liquidity and credit to the American economy over the last five to 10 years, should this prove to be a deeper event than I have anticipated, then I will stand corrected. I recognize it as a potential. And yet I believe it to be a superior

system as an arbiter of risk and reward as a distributor of capital than other alternatives. So this is the conclusion of today's Dividend Cafe, which may not leave you any more satisfied than you were when you started. We do not know how all these things with the non-bank lending, a shadow banking system will play out in a deeper recession. And yet I am not remotely convinced that we have a better alternative. I think this represents a positive evolution in American capital markets. And I think this represents a positive evolution in American capital markets. And I think that for the most part, deep losses being taken in a capitalistic system are painful to those who take losses.

But minimizing contagion risk from those losses ought to be our objective. And I think as an investor, we're in a better position that way than we've been. That doesn't mean we can avoid losses. But what we're talking about today is trying to avoid systemic losses, where one person's pain leads to another non-connected party's pain. And I do not believe we are sitting in such an environment. The recession could come, the bear market could worsen, but perhaps both of those things don't even happen. We don't know. But what I do believe is that many of the sort of black swan events people are looking to are wrong. And that is generally the case, that black swans are not the things people are looking to. They're the things they don't look to, which by the way, is the definition of a black swan. I need to run now

to get to a doctor appointment. And so I'm going to leave you there. I hope you've enjoyed the podcast, enjoyed the video, and I look forward to next week's Dividend Cafe. Please do reach out with any questions you have. And thank you as always for listening to and watching's Dividend Cafe. Please do reach out with any questions you have. And thank you, as always, 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 Securities LLC. Advisory services are offered through Hightower Advisors LLC.

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