The Dividend Cafe - More Financial Food For Thought

Episode Date: May 25, 2018

This week, David covers a variety of things effecting markets ..... Topics discussed: Interest rates Yield curve (and how it could effect the 2020 Presidential Election) Oil prices Oil and Natural Gas Pipelines Dollar rally Trade deals and much more. 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. This is David Bonson, Managing Partner and Chief Investment Officer of the Bonson Group. As we head into a long holiday weekend, markets have been given a lot of chance to react this week to more and more news catalysts, improvements in the trade talks with China, a fallback in the trade talks with China, a step forward in North Korea, a big step backward and now canceled Korea's summit. Political ire, conspiracy theory, this auto imports investigation, Fed dovishness permeating the May meeting minutes. Now, some of these things we've long discussed how they really aren't catalysts to market movements because the markets just don't care. Others not only have been catalysts, but were so this week. We had a big up Monday.

We had a big up Monday. We had a big down Thursday. And with all this and more, we appear to be headed, at least as of my recording time right now, towards a modestly down, maybe flat week. We were modestly up a couple hours ago. So it's kind of moving around a little bit. The directionlessness theme may be continuing. And yet I would add equity markets are up substantially in May, although there will be a few trading days to go next week by the time you're listening to this. You should also note, by the way, that effectively these things that we're going to be discussing here today that are politically related are of interest to listeners. They have market repercussions on occasion. They sometimes have no meaningful

market repercussions but are portrayed as having such. So therefore, it's still meaning portrayed that way by the media or what have you, pundits, things like that. So it's necessary for me to attention it and cover it just so that there is perhaps more enlightened understanding. At least that's how I would feel about it. But at the end of the day, a lot of the beltway discussion that takes place around markets is banter. It can be interesting.

If you're a political junkie, you may even really enjoy it. As a matter of fact, at DividendCafe.com, we're doing a separate section now called Politics Meets Markets, just to kind of highlight those different things that are sort of driven out of K Street, out of the Beltway, and have economic or market potential pertinence. and have economic or market potential pertinence. But the consistent theme of the markets being driven always and forever by earnings is never going to change. But if I had a section doing a cafe called earnings meets markets, it would be a little redundant or silly. You get my drift. All right, let's get into it. Economic vocabulary and investment policy.

into it. Economic vocabulary and investment policy. One great fallacy in media coverage and casual conversation about the present state of affairs is this, the inability or unwillingness to delineate between short-term rates and long-term rates. We talk about interest rates going higher as if they're the exact same thing, short-term and long-term rates. We talk about interest rates going higher as if they're the exact same thing, short-term and long-term rates, when really they are anything but. As all the talk about the yield curve makes clear, and later on I'm going to be doing more kind of discussion about the hubbub of yield curve inversion, there is not one rate, but rather relationships between rates, short-term, intermediate, long-term rates that matter. And we want you to understand this. Most of your economic activity centers around some form of the short rate.

Credit lines are usually hitched to things like the federal funds rate or the LIBOR 30-day rate. Credit cards usually are as well. Business bank borrowing, too. rate. Credit cards usually are as well. Business bank borrowing too. The short-term rate in the market should be thought of as the proxy for practical borrowing costs. Corporations, cities, states, individuals, and even the Treasury Department, you know, federal borrowing, rarely lock up their financing costs to a long-dated maturity. Now those rare and glorious 15-year or 30-year homebuyers can be the most common exception. So the short rate matters because it impacts borrowing costs for all economic actors who borrow. But the long rates matter because they're

a proxy for the actual anticipated economic growth rate. So if a 10-year treasury bond is at 2%, let's say, which right now, by the way, it's a little below 3%. But if it were at 2%, it's an extraordinarily low rate for a 10-year treasury bond. It's not an indication of what borrowers are paying. It's an indication that structural growth in the economy is anticipated to be awful. If the 10-year bond yield is at 8%, this is an anticipation of severe inflation expectations. The worst place for investors is if borrowing cost short rates are flying higher, which is impacting corporate profits and overhead and things like that, and yet the 10-year and 30-year rates are staying flat or even going down, meaning no growth is expected.

The pace of change between the different rates matters. The relationship between the two rates matter. But what interest rates are doing cannot be believed to have practical efficacy to it. The sentence itself, the question itself doesn't provide enough information. We're going to talk a bit about energy. Midstream energy MLPs are very well back in the focus. They've rallied over 15% in the last month and brought the oil and gas pipeline sector into positive territory on the year, which is stunning many who long ago left the sector for dead. The thesis behind pipelines has always been, always will be volume. We need more oil and gas

flowing through the pipelines. Rig counts are up 150% since mid-2016, and despite 45% of those rigs being in the Permian Basin, we're still way, way under rigged and under piped, even in the Permian Basin. The yields in this space compared to high yield bonds, not to mention investment grade bonds, are extraordinary. Spreads are a valuation metric and spreads indicate this space is anything but rich. There's a wonderful chart, by the way, showing the growth of production taking place with crude oil, with natural gas, dry and liquid. And you can just see how that production is moving even higher and higher. Well, let's talk about the whole movement of oil prices and so forth and how it's playing out across the energy sector, the reality

is the relative performance of how the energy sector is doing versus the whole market has not only trended violently better the last six weeks or so, it's actually gone into net positive for the first time in a very long time. So is all this oil stuff good news or bad news? I mean, should we be rooting for a higher oil price or a lower oil price? Fair question. I wish I could give you an economically coherent answer, and I wish even more that other pundits would answer with some competent understanding of history.

In the most basic sense, it stands to reason that oil is a commodity price and represents an input cost for many companies, but overhead for a consumer, therefore functions as sort of tax and leaves less money in the pockets of people who spend money in oil-related items. Oil-related items, fair enough. We would traditionally think of this as a negative, right? Well, this cannot be said emphatically enough. All the rage throughout the oil malaise of 2014 through 2016 was that the low oil price meant Armageddon for the economy and the stock market. It meant bond defaults, bank stress, and indicated weak demand in the global economy.

So certainly people cannot have it both ways. It cannot be a sign of bad things when it drops and a sign of bad things when it rises. The more cogent approach is this. It means different things at different times, whether high or low, depending on many other circumstances, supply and demand, geopolitical landscape, the forces that are pushing supply and demand, etc. All of these things matter. When something happens that never happens. Well, actually, what we're describing here does sometimes happen, and it's happening right now. It's pretty rare, but over the last five weeks, the U.S. dollar has appreciated quite a bit, and yet oil has risen

substantially as well. We are used to oil and the dollar trading inversely to one another for the obvious reason that the world oil price is denominated in US dollar. If this relationship were to sustain itself, a rising dollar and rising oil prices at the same time, it would have a profound impact on emerging markets and commodity prices. and commodity prices. There's very little reason for us to believe the dollar will in fact continue this rise, which by the way has been an interruption from a 16-month dollar decline period. But because many emerging markets countries have financed their debt in U.S. dollars, especially in their corporate sector, a rising dollar raises the cost of servicing that debt. And it also forces emerging markets countries to hike their own domestic rates to fight off effectively what would be imported inflation,

thus making their own local currency debt, because it's financed, because it's denominated an outside currency, tougher to service. So does all of that macro currency, dollar, inflation, rate stuff matter for an individual growing company with strong competitive advantages and great metrics and great management? No, it really does not. Pricing power overcomes a lot of stuff. But in the short term, price movements in emerging markets can be very

driven by such things, and it behooves a disciplined emerging markets investor to be aware of this reality. We happen to not believe the dollar rally will continue like this for very much longer, but if it is geared up for a longer rally than we've anticipated, short-term headwinds in emerging markets pricing is likely. We don't care, but we are aware. But the yield curve is flattening. One of my favorite things I deal with in my profession is when a whole lot of people in the media begin using a term that they do not understand, and it becomes contagious, allowing a whole lot of other people to begin using a term that they also do not understand. We are living this out in real time right now with the expression flattening yield curve. Now let me elaborate.

A flat yield curve is when short-term interest rates and longer-term interest rates are the same. So a flattening yield curve is when they are headed that direction, either because short-term rates are rising or long-term rates are dropping or both. Even that actually is somewhat inaccurate because it could happen by both short-term rates and long-term rates rising, but with short-term rates rising more than long-term rates do. Of course, or vice versa, both dropping at different paces. Now, this is what happened in the last several months. Short-term rates have risen a lot quicker than long-term rates have risen, although they've both risen.

An inverted yield curve is when short rates are actually higher than those longer rates. That is very often predicted a recession. We do not have an inverted yield curve in the United States, but we certainly have a flatter one. There are all sorts of reasons for this, ranging from the Fed's short-term rate movement to the lack of inflationary pressures on the long end. The talk that a flattening curve is necessarily bearish or predictive is a history-hating one. From 1994 to 1998, few would refer to that equity market as troubled, and yet we went for years with a pretty flat yield curve. A comprehensive understanding of monetary policy, rate markets, money supply, money flows are all necessary to understand the lay of the land in capital markets. But understanding something wrongly is worse than not understanding it at all.

So could the yield curve invert? Well, absolutely. Will it? I'm sure it will at some point. When? Well, it could be late this year. I suspect it'll be 2019. But will recession happen when it inverts? A recession rarely happens when it inverts, but rather after it inverts, often a year or two later.

It can be less. So I'm going to go and leave it there for this week. I don't want the podcast to go on 15, 25 minutes, something like that. And there is a whole section of politics meets markets, talking about the trade issues, talking about the imports on automobiles. It's kind of the newest thing we're dealing with is the discussion of import tariffs, even though there's not a lot of activity that would generate the real tariffs happening. But again, it forces conversation and increases volatility. Look, there's some issues this week that are worth reading about. Dividendcafe.com, how politics affected markets, things like that.

As far as those really wondering where interest rates are going, I wish I could on the podcast illustrate for you our chart of the week, but you just have to see it. You've got to go look at a chart going back 35 years of the way the 10-year bond yield has dropped and dropped and dropped, and yet there has been so many different times where it's kind of moved up along the way before falling again, but staying in a very consistent downward trend, something we believe is very likely to happen again here this time. So I will leave it there. I wish you and yours a very, very happy Memorial Day weekend. I really want you to listen to the Advice and Insights podcast this week. I did a lengthy interview with Ron Barron, industry legend, growth investor, small cap investor. We use his Barron growth strategy heavily at the Bonson Group for our client short term,

excuse me, small cap exposure. And so we would love for you to listen to the Advice and Insights podcast. Subscribe away, review away, say good things about us, forward to your friend, do whatever you want to do. You know what? I don't have any idea who's listening and who's liking it. I want all your feedback. But in the meantime, I'm just going to keep doing what I do, which is trying to provide these podcasts and the written commentaries and other things we do for your benefit and hopefully you're finding it rewarding. But thank you for listening to this week's Dividend Cafe, financial food for thought. FINRA and SIPC and with Hightower Advisors LLC, a registered investment advisor of 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 and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinion, news, research, analyses, prices, or other information contained in this research is provided as general market commentary. It does not constitute investment advice. The team at Hightower should not be in any way

liable for claims and make no express 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 opinion is expressed solely those of the team and do not represent those of Hightower Advisors LLC or any of its affiliates.