The Dividend Cafe - Mitigating Risk in an Unstable World

Episode Date: October 1, 2021

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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 another Dividend Cafe podcast and video. I think it's been a pretty adventurous week. I am recording in the middle of the day on Friday, and it's a little tough to tell where we're going to finish up. The futures had been down 200 points this morning, and now the market is up 250 points or so. So I don't know if we'll be down 1,000 points on the week or not, but we're going to be down something. There were a couple big down days in there and other days that went the other way. But the overall direction of the market is lower. And you have interest rates that have risen.

And you have a number of uncertainties lingering. And again, it just doesn't feel like enough to really give this correction that I think a lot of people, myself included, have been waiting for. And yet there's still enough kind of lingering out there where I don't think the market is going down because it is hoping to get the reconciliation bill. And I don't think the market is going down because it wants it. It doesn't want it as much as just the uncertainty lingering about those two bills. There's the upward pressure in yields. And then there's this forgotten thing in China. And I commented in Dividend Cafe this week,

I find it incredibly ironic that it was only a week and a half ago that we were told that the world was ending because of this real estate development company that can't pay its debts in China. And now you can't even find a story on it anymore. So I guess that's the way these things go. But the truth is, I think there are issues with China, not so much with the Zever Grande real estate company, but with geopolitical tensions with China, trade realities, global economic realities with China, that then combined with uncertainties in our own domestic political world and just the overall revolutionary story.

The economy is absolutely reopening. The COVID numbers are again getting to a point where I don't think anyone's going to be talking or thinking about it other than the professional doomsday class and that you have a lot of resurgence of economic activity that comes with that. And so that causes certain activity in the cyclical world that hopefully pushes bond yields higher. Why do I say hopefully, particularly for those people who have been trained to think that lower bond yields higher. Why do I say hopefully? Particularly for those people who have been trained to think that lower bond yields are good for stocks. Lower bond yields are not good for stocks.

They're good for borrowers for a certain period of time. But when lower bond yields are signifying low, slow, and no economic growth, that is not good. Now, I think we're stuck with that. Anyways, bond yields, if they get all the way up to 2%, are still signifying long-term economic growth of zero, basically. I mean, the real yield at that point would be negative, even if it got up another 50 basis points. down at 120, where depending on how you're measuring inflation, you might be as much as one whole percent negative on the real yield for 10 years, at least getting up to a point where the nominal yield leads to a real yield that is zero, but not negative. That might be a healthy thing,

wouldn't you say? So we're not there yet. But my point being, a lot of the conditions of earlier in the year where energy and financials were rallying and yields were going higher, a lot of that was in the anticipation of the vaccine and a lot of the reflationary healthy activity was taking place around reopening. And then some of the very high multiple, high growth, high PE stuff, particularly in technology, was getting hammered. And that's kind of come back on. Although tech had had a pretty good little run there in the summer. I don't know what happens on Monday. I certainly don't know what happens next week, next quarter. We're into the new quarter now. And we'll recap some of Q3

in DC today and next week. But the point I want to make today in Dimmick Cafe is that there are plenty of uncertainties that exist right now in the market. I want to talk a little bit about China, a little bit about inflation, and then kind of make some concluding thoughts. When it comes to the China issue, I think that some of the stuff I said in DC today last week is about as much as I have to say on the Evergrande story. When people unpack where the liabilities are and who holds the exposure and who's going to take a haircut, it becomes much harder to view this over-levered real estate development company as a contagious concern, certainly as a contagious concern in the United States. The Lehman moment,

I think, has some pretty key differences. And I'm appreciative of my friend Louis Goff for pointing some of this out. One of the major things that hammered markets when Lehman went down is that markets had been expecting the U.S. to deal with it, the Treasury Department to handle it, to kind of protect against it. They put Fannie and Freddie in conservatorship. Paulson went to Congress to ask for the bazooka. Of course, they spent that whole entire famous weekend trying to get either Bank of America or Barclays or someone to take on the liabilities of Lehman. In this particular case, it's sort of the opposite. China's Communist Party kind of wants Evergrande going away. They want to penalize these very over-levered real estate

development companies and allow these transactions individually that have debt levels and assets that secure them on a lot of local levels to kind of work themselves out. I have said some of this stuff before as it pertains to the overall situation in China. And I like continuing to say it because I'm really aware of the fact that some of my premises, my deeply held premises, is a dysfunctional government, country, economy, that I am particularly not fond of President Xi in the sense that I am not fond of communism. And he is a self-avowed Marxist leading the Communist Chinese Party. There is certainly different character to the totalitarianism today versus Mao Zedong's Communist Party. I recognize that.

But my point is that there is an entire philosophy and theology and political science in the country that is antithetical to what I believe. And yet with the various negatives that we could throw out at China right now, they are cracking down on their technology sector. There is an absolute sentiment and policy inaction that is not favorable to the entrepreneurial class in China. And then people say, OK, but then it looks like you're kind of bullish on their currency and their sovereign debt. And as long as people get those two terms right, don't include high yield debt, don't include

the equity sleeve, don't include their big picture role as superpower. China right now, for reasons I've laid out earlier, has a strategic imperative to be less reliant on the U.S. dollar. They are incredibly reliant on it now. One of the greatest ways to be less reliant on a competitor's currency is to strengthen your own currency. Of all the different things going on right now, it would be really opposed to China's best interest to bail out Evergrande. Now, there's backdoor bailouts. There's individual capital infusions. There's certain banks that are state owned where they have exposure. They can do all the crony things and so forth and so on.

But to the extent that when you look at the overall TARP legislation, the overall Federal Reserve response to our financial crisis. So those things lead to a weakening of bond yields. They lead to a weakening of currency, of dollar competitiveness. That is what China wants to avoid for other globally competitive reasons. Their desire to be able to re-denominate much of the global trade that most certainly has the second largest economy in the world, goes in and out of China into their own currency. Louie points out that it is China's dependency on U.S. semiconductors that is really behind much of what we're dealing with right now with all the supply chain disruptions that they don't like it and they're not shovel ready in the semi space. U.S. dependency on energy and then most certainly U.S.

dependency on the dollar. So I view this entire phenomena. First of all, the overall geopolitical relationship between China has not gotten better since President Trump left office. office. I think that it's just too intuitive that we have a problem adversarially with China that is not going to be resolved easily. There's not like a hawkish tone that hurts things or a dovish tone that helps things. There's substantive issues. And so the hypothesis I've put out there that there may be an anti-fragility, a safe haven role that is not available in treasuries in the United States right now, is not available in much of the developed world because of excessive indebtedness and because of governmental indebtedness and because of monetary policy that is very much driven towards weakened local currencies, it may very well be that with all of these issues regarding China, that those are completely compatible with the thesis of China's currency and sovereign debt representing that potential alternative in a U.S. investor's portfolio. So I want people that even apart from what happens

in that space with the Chinese government bond kind of question, I want people all over the world that care about the economy and finance, their own portfolio to understand they're very deeply tethered to China one way or the other. And if we don't like what they're doing in Macau and with the education sector and their technology sector, those things can be avoided. But what can't be avoided is the role in which it has in overall global trade. So you're going to have to hear a little bit more from me on this stuff as time goes on. But that is one example of something that I think lingers as a volatility, a risk creator in the marketplace. The notion about inflation is something that I'd like to offer another clarification on. I do think along with China, this is another issue I've written on quite a bit this year.

You know, my thesis on all of it is absolutely emboldened by the events of this year, not contradicted. My belief is first and foremost that excessive government spending and excessive government indebtedness and a monetary policy that becomes excessively accommodative are all anti-inflationary, disinflationary, and not the kind of commonly held belief that they are pro-inflationary. Now, that comment is empirically indisputable unless one believes that the last 30 years in Japan, the United States, Europe, and United Kingdom, that we have been fiscally and monetarily responsible. The debts have exploded in all these developed markets. The debt-to-GDP ratios have exploded. The monetary policy response has exploded. This is not a factually debatable issue. And so then the question becomes, well, is it now different? Okay, well, maybe it is. That's one thesis. But the other thesis is that when you see price levels increasing, that there are other circumstances driving them higher.

And I think we've seen that part of it was most certainly the base effect that prices were growing off of from 2020, middle of 2020, and what had been a very deflationary response to COVID-19. Now you all of a sudden have prices kind of seeking to normalize and it was making a higher percentage difference. Other parts were very, there were anomalies. Lumber prices exploded higher and then utterly collapsed, obviously around really unique supply circumstances.

But there's nothing right now affecting the price level in society more than semiconductor shortage. Where we lack the ability to generate necessary semis, it permeates into electronic products, automobiles, a whole lot of other aspects throughout the economy that then build up disruptions throughout the supply chain. So that's a story and it's a big story and it's impacting prices. And by the way, if you want to call it inflation or not it feels like inflation when someone's having to pay higher prices for things I'm completely on board with that but then that story is not isolated on its own then you add that to this labor shortage of 11 million job openings

with just over 8 million unemployed people and yet somehow we can't fill those jobs and I and I say this in all sincerity you You can blame it on government policy. You can blame it on a lack of necessary skills in the labor market. You can blame it on poor incentives. You can blame it on the work from home mentality that I think has come out of COVID for many. I think all of those things personally play in. Some people want to highlight on one versus the other. But the point is, when you end up with a supply disruption combined with a labor shortage that is exacerbating the problem of getting products into the marketplace, you get higher prices. And so the fact that I don't believe it is government spending and monetary policy driving the inflation, I think the government policy, the government spending, the government debt,

and the monetary policy are both doing negative things. I just don't believe those things they're doing are inflationary. I think long term, they're disinflationary, but they're anti-growth. And I think they're distortive. And I've talked about all this a lot. But the supply chain issues right now are a big deal. They come down to a semiconductor shortage combined with a labor shortage. And I think that clarification as to where prices are and why they are and so forth

is very important. So then this leads me to the conclusion about the subject of risk mitigation. You have China concerns out there. You have price level concerns. We already talked a bit about uncertainty on government policy. Are they going to go spend a few trillion more dollars? Are they not going to spend it? Is there a civil war in the Democrat Party? Or is there a kumbaya coming in the Democrat Party?

Is President Biden weakened? Is he strengthened? Are taxes going higher? We already know, as I've said, all year long. I did not start saying this two weeks ago. I started saying it right after President Biden was inaugurated, that even if some spending issues get passed and some tax increases get passed, they were never going to be anywhere near what people had threatened, what people had talked about. We're going to get more info on details if there's going to be

details in the days and weeks ahead, potentially. But right now, the thing I would say is from the China level, which should be number one on the list, various concerns about price stability, concerns about price stability, and then the never-ending issues around public policy. The general things that drive severe, what we call left-tail risk, very uncommon events that are high impact. They're often affiliated with excessive valuations. The 2008 crisis came out of excessive valuations in real estate. And then you had a credit bubble that burst and it put us into a deep recession. And then an equity collapse followed. The 1990 issue in Japan was a multi-standard deviation event where, again, excessive valuation in real estate and in risk assets, but that bubble burst. There are other black swan events, unforeseeable, severe, you know,

type moments that are not valuation driven. 9-11, the COVID-19 crisis of just a year and a half ago. So there are different catalysts that can exist. But there is a lot of talk about how do we hedge against this risk. And the most common thing people do hedge against it is the dumbest thing ever done. And I just see people talking about it. I see people suggesting it. And God forbid, I even see some people doing it as a notion of market timing. And with market timing, of course, the problem with it is that you take a very low probability impact event and you turn it into a high impact event, and you turn it into a very high probability event, which is that you're going to screw something up, that you're going to miss a big portion of gains. You're going to miss time in

the bottom. You're going to reenter at the wrong gains. You're going to mistime the bottom. You're going to reenter at the wrong time. You're going to regret not reentering. You're going to then regret when you do reenter. You start a literal hamster wheel of bad decision making. It's the age-old issue of market timing. And the only people that don't seem to struggle from it are liars at a bar. Okay, so once you've ruled out market timing as an idea, people could bring up gold. The problem, of course, there is you have to own so much of it. And for such a long

period of time, and the drag it creates in the portfolio in all the normal good times that are not left tail risk events is so severe that it ends up being incredibly counterproductive. Right now, there's a movement of people saying, I'm so worried about all this excess liquidity, maybe crypto is the way to go. And I'm entirely sold on the notion that actually, crypto has been created by the excess liquidity, the speculative activity and behavior there is a byproduct of what the environment we're in. It's not a cure for the environment that we're in. There are people that talk about different hedges. They usually require a certain timing, but they most certainly require a cost.

There's a drag on the portfolio. The hedges may not, with volatility priced where it is, the hedges may not be good enough to really give a lot of that risk. The most common thing that people have done to deal with those events that they don't like is to set their asset allocation within a tolerance for them. And so they weight the risk assets in their portfolio and implement less risk-oriented assets, or a better way to put it is assets with less correlation to equities, so as to create an environment in a bad period of time that, while still negative, is tolerable and allow them to go through the period of time that may be shorter than expected, like COVID, or longer than expected, like the dot-com bust. But the point being of the various very negative

events that have happened in history, the investor survives it within their own tolerance for such difficult time period. I'm all open to the idea there's a better system out there than asset allocation. I'm very much of the mindset that within one's equity sleeve, people should be as sensible as possible at what equities they own. It's why we're dividend growth investors and not indexers that have an innate bias towards the most overvalued of the total stock market. But regardless, you're not going to get us to all of a sudden believe that anybody else or ourselves or you can time this. I am aware of the negative circumstances that persist. They're always there, even when you're not talking about them. That's another thing I

wish people understood better. We can talk about giving risks at a time period, but that does not make the market any more risky than it was or is in periods when we're not talking about it. Because there is a never-ending underlying risk and risk assets to unexpected events, to geopolitical disasters, to global health pandemics, to meteorological circumstances, to excessive asset behavior, bubbles, liquidity, monetary policy. You get the idea. If the media leaves it alone for a bit or you leave it alone for a bit or we all get distracted by Britney Spears conservatorship or something, it doesn't change the fact that the underlying conditions of markets are inherently risky, destabilizing, and most certainly unpredictable.

That Fed policy that has been baked in for quite some time, and not just Fed policy, but central bank policy all over the world, it adds to that dynamic. So you have to make a choice how you want to deal with it. And you hear from us over and over again how we choose to deal with it. China, price stability, policy coming out of Washington, D.C. Take your pick this week. But my point is next week and next year, our solutions are going to be the same as it pertains to risk mitigation. And those that have a risk mitigation strategy to sell you in the form of a product, you may as well be buying snake oil. That's all I have to say this week. Thank you for listening to the Dividend Cafe. We are into the fourth quarter. May you have

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