The Dividend Cafe - Market Optimism, Brexit, and Freedom

Episode Date: January 18, 2019

Topics discussed: Are Markets Turning Optimistic? What to Make of the Brexit Drama 3.Separating The Taxed from the Untaxed 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. I am recording just after the market is open on Thursday morning, the 17th of January. We're moving right along through the new year and as it stands now on the week, with still plenty of time to go here on Thursday and all day Friday, this week appears to be another positive week in the market. Not hugely so, but, you know, a higher on the year in the S&P 500. More than that on a percentage basis since the market low was hit on Christmas Eve. And so, yeah, market's feeling a little bit more positive.

And here we are. I'm going to cover as much as I can here today until I run out of time. And hopefully that won't happen, but it's a pretty long Dividend Cafe this week, and I feel good about what we have done at DividendCafe.com. A couple of different charts, not a ton there, but if you want to catch some of it in written form, we certainly always recommend it. Well, let's address that issue about market optimism just to start us off here today. Are markets, in fact, turning optimistic? The fact of the matter is that the fundamentals were not pessimistic last month either. What

happened last month was pessimistic sentiment combined with timing, technical factors, combined with timing, technical factors, totally kept buyers out. And it went too far too fast, which is often prone to do. But with no news at all, the sentiment has reversed, at least for now. It's what markets are about, unpredictable sentiment that can move on a dime. It's why sentiment is uninvestable as far as we're concerned. The fundamentals are good, earnings growth, U.S. economic backdrop, but there are certainly headwinds that can't be ignored. What are the positive and negative elements in the current market environment?

Well, the first sort of negative headwind that lingers out there is the potential for a Federal Reserve that will extract so much dollar liquidity out of the economy that it will starve credit markets. Another negative is the trade war that is still, as of now, not resolved. By the way, not just with China, but the potential of auto import tariffs out of the European Union. Not only that it does not get resolved, but in fact could escalate. Now, putting aside all the politics or the belief that it's about time someone stand up to China and those types of things, just purely from an objective market standpoint, if we think that this cannot get worse and that there is not any risk to the economy out of where things stand in the trade war, we're living in a fantasy world. Then I guess the other negative headwind dovetails very much with the other two I just mentioned, and that is that up against the

constrained, the potentially constrained credit markets and the potential suppression of global trade would be the risk of business investment, business spending, capital expenditures reverting to the Obama era levels. This would tank productivity, increase unit labor costs, and it would suppress earnings growth into the future. So then what is a positive element that has a somewhat constructive on markets, even if cautiously or neutral level so? The positive is that all those negatives may very well not happen. And in fact, that actually is our forecast, albeit a cautious one. When we talk about the credit markets, I never do pass up an attempt to tout the benefits of dividend growth, equity investing, especially for defensively

minded investors who want income, who are looking for a solution through some of the tensions that investors often face. And at the top of the list of concerns in capital markets right now are credit concerns. It's funny, we view municipal bonds as safe. Investors often view municipal bonds as safe when the payers in those cases are often running at the most distressed balance sheet and income statement realities that we've ever seen. And we view corporate bonds as safe when indebtedness has grown, financial ratios have deteriorated, and we're obviously in some version of a late ending of the cycle. Well, that's not to say these debt instruments are on the verge of default. They're not.

It's just that investors are likely not appreciating the reality of risk there. But in the equity camp, it's particularly important that investors take seriously the balance sheet of companies that they own. Most companies do not get into existential trouble over earnings. They get into trouble when their balance sheet is vulnerable. Our dividend growth focus requires us to care about net cash, cash versus debt. It requires us to care about debt versus income, about free cash flow, about debt to assets, about the overall nuances in the capital structure of the companies that we own. There are companies and also states and counties with credit quality concerns to be aware of as an investor. But it's our dividend growth equity

philosophy that's tailored towards taking this very seriously. What to make of the Brexit drama? It's kind of hard to miss what's going on in the news right now. A continued uncertainty narrative, not just out of Brexit, but out of Europe at large, I remain overwhelmingly pro-Brexit and am certain that if the will of the voters were executed, it would enhance trade and enhance access to markets. I will rephrase that to say I am highly confident, but all the while recalibrating appropriate national sovereignty. When in world history has more freedom been bad for markets? But all the while recalibrating appropriate national sovereignty.

When in world history has more freedom been bad for markets? But see, we're not talking about that now. This is about the uncertainty of how this dumpster fire of a situation plays out. Europe at large remains unattractive on a risk-reward basis, as this uncertainty, combined with German economic recession, combined with Italian debt bomb, all lead to a story we just don't want to touch. If they treat it with more fiscal stimulus, it will make things worse. If they treat it with yet more monetary stimulus, it will create a short-lived sugar high rally and kick the can. No thank you. I've become pretty obsessed, by the way, studying the modern European Union largely out of my fear for certain social, cultural,

political, economic mistakes being repeated in the United States, but also because it represents a pivotal turning point in so much of modern society. I subscribe to the thesis that German reunification in the early 1990s caused many other European countries to panic at what was really a very positive development in civilization. And then they opted for a heavy centralization and forfeiture of national sovereignty as a means of competing with what they thought would be an economically indomitable Germany. The vision for a European super state came after two world wars, but it wasn't advanced in the form of a shared currency until after German reunification. Well, let's fast forward 20 years, and I'll just say mildly, softly, that Germany's

disproportionate influence, control, competitive edge was not exactly reined in by the behemoth of a European Union and currency. In fact, it's grown on steroids. The stated promises of those who delivered a strong centralized control of Europe have badly failed, and Brexit represents what will surely be the first of other attempts to unwind the failed and unnecessary experiment. is for the Fed in 2019, so I may as well answer. The caveat to my rate forecast is that I'm completely stealing it from the present state of the Fed futures market. I have no rate forecast of my own. I work off the belief, fallible as it may be, though I don't think so, that the Fed will not shock the markets, perhaps ever again. And the Fed funds futures are saying what I am saying in my 2019 Fed forecast. No hikes, no cuts.

Think about the year 2016, one of our big themes of this year. As for balance sheet reduction, what is called quantitative tightening, $50 billion a month, I think, will prove too aggressive for credit markets to swallow. I think if they go back to $10 to $20 billion a month, it would rally markets.

And if they were to eliminate that roll off altogether, I think it would be the biggest capitulation in Federal Reserve history. I did find fascinating transcripts that were released this week of the 2012 and early 2013 Federal Open Market Committee policy meetings, wherein then Fed Governor, now Fed Chairman Jay Powell, spoke of fears that quantitative easing would create a, quote, sharp and painful correction, end quote, in corporate finance. He voted for the famous QE3 bond buying initiative of 2012. It lasted through 2014. But in 2013, he warned that such transactions should be cut before bubble-like terms surfaced.

He said, I would take the next opportunity to taper. He even made reference to how it could be done in a way that didn't shock markets. Well, by 2015, well before he was a candidate to replace Janet Yellen, he had changed his mind. He commented that though the concerns people like him had were appropriate, they hadn't surfaced and neither inflation nor asset bubbles had become an issue. But perhaps this is the quote from Chairman Powell that's proven more prescient than all. Quote, long periods of suppressed volatility can lead to the buildup of risks and to a disruptive ending. The idea that monetary policy can ignore that is not

credible to me. Words from Jay Powell in October of 2013. Fascinating stuff considering the landscape in which we find ourselves. Separating the taxed from the untaxed. It's always a good idea to separate the broad discussion of bonds from the specific discussion of municipal bonds. Treasuries, corporate bonds, municipal bonds, all are impacted by prevalent interest rates, yet all three do have potentially different supply and demand characteristics from one another. Supply, of course, comes from issuance. And in theory, if the federal treasury deficits expand, there will be a higher supply of treasury bonds in the marketplace. And inversely, if issuance of new municipal debt is a net negative,

more bonds are maturing than are being issued, you would face less supply of municipals in the overall marketplace. Okay, not rocket science here. Both categories of bonds get their demand in a low-rate environment from those seeking a safe haven asset class. That strikes me as unlikely to go away anytime soon. So you have pretty constant demand, but then different variations around supply. Well, if municipal bonds are going to have a net negative supply relative to 2018, I think that that ought to bode well. And that the total return for 2019 will be most impacted by broad interest rate movement. But there is a big school of thought that believes supply is likely to pick up in municipals in 2019 relative to 18. So it's a very complicated landscape in terms of measuring supply-demand characteristic around different categories of fixed income instruments. The other factor that will

certainly come into effect at some point is the cyclical economic health of particular states, counties, cities. You have to remember that the revenues backing most of these bonds have been very strong as we've been in a, you know, high tax revenue, high pro-cyclical economic expansion. At whatever point we end up suffering from some contraction, it could go the other way. As far as our view of tax-free bonds in 2019, we have moved to a more concentrated maturity structure. Rather than spreading out our bonds across a plethora of maturities from short-term to long-term. We've tried to be more targeted. The desired duration we have, higher concentration of bonds all around that maturity as opposed to averaging to that maturity with a wider ladder. We think

that that's important when the yield curve is flattening. And it's one of the great reasons why active management and municipal bonds is so important, especially in an asset class that doesn't promise a significant amount of return. The student debt fiasco is something that I get asked about from time to time. And I constantly refer to it as more of a cultural and a policy debacle within American higher education because of the fact that its funding mechanism, which is known as debt, continues to be just a bizarre story no one seems to want to talk about. 20 percent almost, not quite yet, but nearly 20 percent of the present one and a half trillion

dollars of student debt is in default. And that number is projected to get as high as 40 percent within five years. But see, the creditor in this situation is the government, almost entirely the government. So it doesn't offer a parallel to the financial crisis where the banking system was the creditor and therefore a gargantuan hole was created in the balance sheet of our national private economy. That empirical comment should not be interpreted as saying all is rosy. For those who believe in the insanity of permanently increasing housing prices, is there reason to believe that maybe $600 billion of student debt default might hinder some first-time homebuyers in the years ahead?

As is always the case in economics, it's never just what you see on the surface, but it is the second, third, and fourth order effects that have to be understood. Let me make a comment on the consumer staples sector. It's a sector we've been heavily invested in for many, many years. I love the idea on a bottom-up basis of high-quality companies with strong balance sheets that basically have to buy products for sale that pay out attractive dividends, the growing dividends to their investors. We certainly own several companies that meet that criteria in our portfolio, and we have for a long time. But it is incumbent upon me to point out in the

aftermath of portfolio rebalancing that we've done recently, valuations matter. We want our weightings of various companies to reflect value. And sometimes very good companies get expensive and have to be trimmed. And that doesn't contradict the underlying positive message. be trimmed, and that doesn't contradict the underlying positive message. As we get ready to close up here, active oil rigs up 18% year over year, active natural gas rigs up 9% year over year. Just a basic reminder that the more volume of production of liquid commodities, oil and gas, the greater revenue stream to those companies that have to transport and store such petroleum product. So more production equals more transit needed of the commodity itself. The rig count is going in the right direction in that sense. There's a great chart

at Dividend Cafe that I think speaks to the debate about active versus passive exposure in the small cap space and why there is such a high percentage of the index right now that is negative earnings as a company. And we've gotten back near all-time highs in that range after nearly 20 years. And I think that this speaks to the reality of active managers not being so leveraged to every single type of company under the sun, regardless of earnings profile, debt profile, etc. One thing I don't think about the December market sell-off that's gotten enough attention, that I don't think has gotten enough attention, is the collapse in longer term bond yields making a case for higher risk asset valuation. The 10-year bond yield essentially dropped from 3.25% to 2.65%. I mean, that's a massive move down. And yet at the same time, we now hear the Fed getting more dovish. So you have a

very likely more dovish Fed in 2019 in a lower rate environment. Look, these things are not just a benchmark for borrowing costs, although they certainly are that, but they're more than that. They're also a reference for the valuation of assets as risk assets are priced up against some risk-free rate. The lower these valuation benchmarks are, against some risk-free rate. The lower these valuation benchmarks are, the higher equity valuations can be found to be justifiable. The tension point is that a 2.5% to 3% yield on the 10-year treasury suggests underwhelming economic growth,

but it also suggests a market multiple in the S&P 500 or whatever the risk benchmark is that's higher than its own median. All right. Let me leave it there. Great chart of the week at dividendcafe.com about the history of yield curve inversion. I really hope you'll reach out with questions about the fourth quarter that is completed, about our posture going into the first quarter. We, you know, a lot of things going on right now at the Bonson Group and really significant portfolio rebalancing was done across our client accounts this week that we find to be very constructive. So we encourage questions, comments, and as far as this particular podcast goes,

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