The Dividend Cafe - Looming Problems

Episode Date: August 25, 2023

Today's Post - https://bahnsen.co/3Pe4vqK The right thing to do with Dividend Cafe the weekend USC football season is beginning is just replay last year’s edition over and over again, one of my favorite Dividend Cafes of all time … But alas, I have never rehashed old material for a Dividend Cafe since this weekly writing began in September of 2008 and I won’t start now. Fresh and new every week is the commitment, so fresh and new you shall receive (no matters how much Fight On it sometimes entails). You may have heard that tbere are other things happening in the world besides USC’s imminent kickoff to their season. As I type Fed Chair, Jerome Powell, is preparing to speak at Jackson Hole, Wyoming. In the last 15 months or so he has raised the federal funds target rate over 5%, something nearly 100% of economists would have predicted would break the back of the economy a year ago. Here we are a year later, and not only is the economy not broken, but markets are not all that distraught, either. They aren’t great. And economic growth is tepid. But nothing has broken. Yet. But we are not exactly out of the woods, either. And in fact one could argue that the damage done from the Fed’s tightening has surfaced (or is about to surface) in less obvious ways. And that is the subject of this week’s Dividend Cafe. Maybe the Fed wants to create 7% unemployment (because, you know, more people unemployed brings down prices). Maybe a lot of economists predict that will happen (and were predicting it 18 months ago). But whether economic recession should happen (it shouldn’t) or will happen (TBD), there are certainly other looming problems that warrant discussion. And for that discussion, you will want to jump in to this week’s Dividend Cafe! Links mentioned in this episode: TheDCToday.com 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. Hello and welcome to this Friday's Dividend Cafe, recording the day before USC football starts and unfortunately not providing a Dividend Cafe this year as I did last year when the USC football season was starting where I actually talk about the correlation between SC football and markets. It was by far the greatest dividend cafe ever written and I decided very early this morning to not do a repeat of last year's masterpiece, but instead actually address a new current relevant topic. And that topic this week is going to have to do with the Fed tightening cycle that we're in

and what some of the aftermath of that may be, has been so far and could be into the future. From the time I started writing Dividend Cafe very early this morning to the time I'm recording right now, Jay Powell's speech at Jackson Hole has already happened. And so it really was sort of a nothing burger and the markets were not down or up a lot right away. And then now they've kind of gone higher. But it's still so early in the morning that anything can happen in a few hours. And so I don't want to predict where the market will close today. But whatever it does, it wasn't a big market moving speech that Powell gave. And it was kind of a repeat of where we've been for a little while of, you know, oh, we could still have to go higher, but maybe we won't. And we're data dependent and, you know, we really want to beat

inflation. But on the other hand, we want to take a look at how things are going and all that kind of stuff. So we'll update what market expectations are on Monday and the D.C. today in terms of Fed futures. But yeah, as far as just the broader narrative, it wasn't like something happened in the last few hours that makes this dividend cafe already obsolete. Where we are is where we are, which is that the Fed in the last 15 months plus change has tightened the Fed funds rate by over 5%. And that was from basically the zero bound up to a five and a quarter to 550 Fed funds range right now. And in a normalized environment, that would be utterly surreal for financial markets to digest.

And I think that outside of financial markets, just in terms of the economic impact, if you had asked 100 out of 100 economists at the beginning of 2022, if the Fed were to raise rates over 5%, would the economy go into recession? That first, you would have had 100 say they're not going to do that, and they have. And second, you would have said, and of course, it would put the economy into recession and it has not. And so one of the things that I am most interested by right now is the difference between the immediate impact from what the Fed has done in tightening. I've talked about credit a few times. We've talked about China recently. There's a lot of stuff that we know and things that have happened in the last year. I want

to review some of those things. But then there's this idea of kind of going back to Milton Friedman's notion of a lag in monetary policy, that sometimes the action happens and the reaction can take place much later. And so I read a piece from my friend Louis Gov this week. Louis is the chief macroeconomist at GovCal Research. I read their material every single day of my life. Louis in particular is a very proficient economist, writer, thinker. I really enjoy what I learned from him. And he had a piece that had an analogy in it that I don't totally understand, not being a man of the sea, if you will. But it makes sense to me as it pertains to the analogy into financial markets. We talked about the idea of a whale coming up to the surface that if there was a bunch of dynamite that you put underwater, you'd almost immediately

see a lot of dead fishes. A lot of the smaller creatures of the sea immediately come up to the top from an explosion underneath the surface. But that it would take a while from the underwater explosion for some of the bigger things to come up. and that it might be a couple of weeks or what have you until some of the whales surfaced so that the event has an immediate impact to the smaller things, but that the longer impact might take, the larger impact might take longer to surface. And so what all that means in terms of marine life, I have no idea. And so what all that means in terms of marine life, I have no idea. But it generally makes sense to me.

And I think there's a good analogy in there into financial markets. And you say, OK, well, what are the fishes here? What are the small things in this analogy? And I think that that's really what 2022 was, that there was a sense in which there are shiny objects that I've talked about so many times. that there was a sense in which there are shiny objects that I've talked about so many times. And I believe that if the Fed hadn't tightened, if the Fed never tightened, these things were still going to get their comeuppance. They were still going to get re-rated. They were still going to get walloped because they were just simply beanie baby valuations.

And in some cases, beanie baby value that needed to be corrected. And so there was a significant correction that was quickened by the Fed repricing risk assets. technology companies, a lot of SPACs, a lot of faddish investments from plant-based meat to work from home to electric vehicle or solar. I mean, there's all these different categories of it, and we've gone through it all in different phases quite a bit. So you had a lot of these things get decimated, and I think that they were to the fishes. It wasn't systemic. It wasn't contagious. Risk takers got hit. No one else really did. It didn't spread to other aspects of the fishes. It wasn't systemic. It wasn't contagious. Risk takers got hit. No one else really did. It didn't spread to other aspects of the economy.

Why am I not mentioning crypto in that list right now? Well, that's a little tougher in the sense that I definitely think the Fed repricing and then crypto getting walloped exposed crypto that it was actually correlated with traditional risk like NASDAQ and tech and not reverse correlated or contrarian as a lot of crypto investors may have wanted to believe that they were sort of outside the vein of what many traditional investors were doing when in fact it was very correlated and in fact levered. It wasn't just that it had a high beta to that space. It had a higher than one beta to that space.

But first of all, I don't want to call it a fish because there was a thought last year it could have been a whale. It was over a trillion dollars of losses. And yet we do now know that as bad as the losses were, they weren't contagious because they didn't leak into the banking system. They didn't cut off credit into the economy. A lot of money got lost by a lot of people who took speculative risk, but there was not a contagion effect. And also, it clearly was not merely a byproduct last year of Fed activity. There was other grift and corruption and NFTs that had to get kind of wiped out. And then, of course, the issues with some of these crypto exchanges and scams and things that are right now under indictment and arrest and SEC and DOJ and whatever.

So that kind of invites other issues as well. But there were a lot of fishes that immediately when the Fed raised rates, it just kind of said, OK, well, this didn't go. So what are these whales? What are the bigger issues that we're still maybe waiting for that could be consequential as a result of what is obviously a very dramatic and significant Federal Reserve tightening? I think the biggest false alarm we got was the regional banks, that you legitimately had an issue that could have become very contagious, that looked in fact like it might be, and that wasn't small ball stuff. You were talking about good size banks. Silicon Valley was large, but very niche. Signature was less large and also very niche, more crypto,

Silicon Valley, more VC. And then you had First Republic, which was much more traditional, a lot of real estate, residential and whatnot and various problems there. But see, in each case, it was contained. And people could agree or disagree with some of the things that happened. Agree or disagree with some of the things that happened, but I think the FDIC backstop and the JP Morgan rescue of First Republic, not rescuing it, but taking it on after it was left for dead. And then even though it's a separate subject, let's not forget Credit Suisse was a major global financial player going down in March and UBS, orchestrated by the Swiss National Bank, taking on the Credit

Swiss deal. So like a number of different things could have spread and just didn't, maybe for different reasons, idiosyncratically in each case. And so when the fear of a freeze-up of regional banks sort of subsided, then that think, disqualified that as the likely whale in this whole mess. One of the elements I alluded to last week is some of the things happening in China right now. And you go, what does U.S. rate policy have to do with problems in China? And I think that there's a fair argument to say not much, that I don't think China's property sector problems are related to the Fed tightening rates. But I do believe that the limits to what the Chinese policymakers can do about it is related to the Fed's rate policy.

As I talked about last week, they have a currency that's depreciated 15% already, and their sort of logical aspiration to loosen monetary policy to help in this property sector weakening is less possible because they cannot see their currency weaken much more. And yet, if they intervene to strengthen, it has the effect of tightening monetary policy. And so they need the Fed to do it for them, effectively let the Fed by tightening, excuse me, by weakening or loosening monetary policy, weakening the dollar that would help the yuan strengthen and give them more leeway on their monetary policy side. I'm not sure I worded that as articulately as I want, but I think you get the idea. The Fed could help China,

but they're not. And that is leaving China in a precarious position. I'm not suggesting the Fed should in that sense. I do believe the Fed is overly tight. But my concern here is not how it's impacting China. I'm just pointing out the way that the interconnectedness of monetary policy and the global economy works is that there is other side effects and other things under the ocean water that could cause certain whales to surface and an unforeseen and unintended impact to China's property sector and thereby the rest of China's economy and thereby the global economy is certainly a candidate here. Now, Louie mentioned the possibility of the sell-off in treasury bonds as a possible whale. And I want to explain why I

don't agree. Anyone holding bonds that they bought at 10 years when the yields were one and a half percent has these bonds priced lower right now. But you're still talking about something that is not bought with borrowed money, that is fully principal protected at maturity, just going to be a lower rate of return than other people who bought bonds later would get. And that whatever mark to market price impairment exists now could be rectified in a moment. Because just by definition, what we call a tautology, if they loosen rates right now, if they lower rates, some of the damage done to other things isn't going to be reversed. It's already done.

But if they loosen, have lower rates, treasury bonds, by definition, move higher. And by the way, it's also true that with the quantitative tightening, that they could stop tightening and thereby allow for downward pressure on yields at the longer end of the curve. So I don't agree that that becomes a whale there. I just think that I'm not really sure what the consequences are. On a mark-to-market basis, people holding on dated bonds show statement prices that are lower, but I don't think that's a contagious thing. Now you could say, what about Silicon Valley Bank? Well, that's right. The regional bank thing could be. But that's not a problem in and of itself with treasury bonds. It's treasury bonds potentially causing a problem in the balance sheet of banks, which you've already talked about how that's been rectified,

allowing them to hold those in their balance sheet and receive liquidity from the Fed at full par pricing for these money good assets in the balance sheet to deal with the hold to maturity value versus the mark to market value. So the banks have that issue reasonably rectified. And I think from an investor standpoint, it's just not a levered asset class that has that contagious risk. Other things like alternative energy, you know, is down 50% basically globally from 2020. But again, I think that's a more shiny object. About half of that drop took place before the Fed started tightening. And those were things that just as a non-profitable asset class, I think was going to go down whether or not the Fed had tightened rates. So

I really believe the most likely candidate is the one everyone's talking about, which makes it least likely to really be what everyone's talking about. Because in my entire life as a professional investor, I've never seen everyone talking about something be right. Never once. And what is effectively going on right now is a lot of people talk about commercial real estate as if it's a foregone conclusion that the Fed tightening is blowing it all up and that it's all one big thing. And not only do I want to make the argument that there's a difference between self-storage and data center and industrial and office and retail and multifamily, and that there's a difference between San Francisco and Austin, and that there's a difference between high-quality office in Manhattan and low-quality office in Manhattan. So some would say, well, look, feds raise rates, and then you got a lot of people

working from home. And first of all, that whole thesis has blown to smithereens as company after company after company has brought people back to work. And the notion of businesses not having folks in the office anymore has proven to be comical other than a couple isolated cities struggling from other political and social epidemics. But then even in a market like Manhattan, which is very overbuilt for office and has a lot of vacancy, you're paying the highest rents ever for high quality office space. It's just that there's a lot of old and lower quality office space. And so you could have things like hotels in San Francisco, the two

largest hotels in San Francisco, give their keys back to the bank. And yet, by and large, record levels of revenue and occupancy for the hotel industry around the country. So all that means is we're saying, well, bad stuff is doing bad and good stuff is doing good. Well, that's not a statement about a monolithic asset class. That's a statement you can say any day, any year about anything. The good is doing well and bad is doing poorly. So I believe that what we're really talking about is new development, that there is a freeze up of credit, that private lenders are available, private credit is available when we're talking about, when we're talking about incumbent assets that have stabilized. But from a development standpoint or a build, that's where there's risk.

That there is not the credit available to roll when there was short-term financing that is needing to convert and even just getting the financing needed from the build. And that if this were to go on longer, I think this becomes your whale. And I'm not sure that people fully appreciate those distinctions. Even then, I think it's solvable by a simple correction in a flawed policy from the Fed. I do not think they have to go from five and a quarter Fed funds to two, 1, or 0. But just merely getting a downward trajectory in the coming months, headed to 4, headed to 3.5, something in that range could very well stabilize even new development in commercial real estate. But maybe they've already gone on too long. Too much dynamite

has already blown up under the surface, and we're going to see some whales come up to the water. Thank you, Louie, for your analogy. And hopefully you listeners, readers, viewers understand where I'm going with this. That's kind of where we are. A lot of the immediate damage from Fed tightening we saw last year. In the meantime, talking about financial markets and investors, these are some of the things that are on the table and I think potential risks that come. This is different than the conversation about the impact into jobs, wages, and corporate profits.

I've talked about that plenty. Today, we're talking about the impact for investors and various aspects of financial markets. Okay, real quickly, by way of housekeeping, you will see me live Dividend Cafe next Friday because I will return on Thursday from being out of the country with my wife. But I will not be doing the DC Today Monday through Thursday and will not be checking email. For the first time in my adult life, first time in my marriage,

we are going to go away and I get over a thousand emails a day and I cannot do an out of office and just check them all when I get back and have three, four thousand emails waiting. So I will be dark and then you can resend me anything upon my return. But I wanted to let clients know about this ahead of time. But I am committed for the first time in my vacationing travel with my wife ever to unplugging for a couple of days out of country. But I will be bringing you Dividend Cafe. We have at this point a lot of questions that have built up and I want to do another Ask David version of Dividend Cafe next Friday to get up to speed with some very thoughtful questions that have come in. In the meantime, USC will start their football season tomorrow. Next week, I will be gone a few days, and we will be back with you next Friday going into Labor Day weekend as we get

ready for the greatest time of year, fall football season. Back to school, all the fun things. I hope all you parents are excited, and I hope this Dividend Cafe was helpful in understanding the lay of the land we're in in this unprecedented period of Fed tightening. Thanks for listening. Thanks for watching. And thank you for reading The Dividend Cafe. The Bonson Group is a group of investment professionals

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