The Dividend Cafe - Putting the Puzzle Pieces of the US Economy Together

Episode Date: March 15, 2019

Topics discussed: Obsessed with CAPEX Job Report Fears Tax Reform Bill is a Sizeable One Brexit Bonanza! Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello, welcome to this week's Dividend Cafe podcast. This is David Bonson and I am the Managing Partner, Chief Investment Officer of the Bonson Group. And we are bringing you our weekly market commentary. A strange week in markets because you've had kind of a nice positive move in market indices. At least as of the time here I'm recording, we've been up either a little bit or a lot most days. And yet that's in the backdrop of this kind of odd week in the news cycle. You have these airplane safety fears and this college admissions scandal,

and you got never-ending announcements of Democrat candidates for the presidential race. And so news cycle full, and yet markets kind of plugging along. And really, none of the news is necessarily good for markets. Maybe that's what's pushing markets higher, is that it's outside of the scope of what would be kind of market sensitive. But I'm going to get into the bigger picture issues this week that are not about what has happened in the market this week or last week or next week, but are what are really kind of the key pivotal issues that will drive the market and indeed overall economic health for the remainder of the year and perhaps longer.

And how a number of these different subjects we're going to touch on all kind of intersect with each other. So let's jump in to the Dividend Cafe. Yes, I am obsessed with CapEx. And as a matter of fact, the subject of CapEx, capital expenditures, you can now talk to your friends and use the fancy term CapEx and you'll sound like you're a real financier. But it is the shorthand term that we use all the time to talk about capital expenditures and business investment in the corporate economy. And the Advice and Insights podcast this week is dedicated

exclusively to that subject, in particular, some kind of nuances and a little deeper dive into things that we are seeing right now, trends and relevant aspects of the whole world of CapEx. But yeah, it's been a theme for over a year now, and it's because we have a thesis that this economic recovery, the expansion we've had from the post-crisis bottom, indeed the bull stock market, largely depends going forward on a resurgence of capital expenditures in corporate America. The thesis is that increased business investment will drive higher productivity, which will in turn create extended growth across the economy. When CapEx slows, you see industrial, energy, materials companies all suffer. They're highly cyclical and highly correlated to

basic business and capital investment. During the oil sell-off of 2015, we saw CapEx collapse across the industrial economy, and indeed the worst performing sectors were those three. Well, we're presently seeing highest level of CapEx spending in S&P 500 companies that we have seen in 25 years. That's the very good news. The bad news, by the way, is that that number is off in the last couple months from where it was about 9 to 12 months ago. But non-residential fixed investment, which is the category label within GDP growth for the

whole area I'm talking about, grew 7% in 2018, which was more than double the average rate we've seen for the last 20 years. Blackstone's recent CEO survey saw over half of respondents indicate plans to increase CapEx spending further from here. The need of the economy is greater efficiency and greater capacity utilization. With high levels of business confidence, the impetus is there for greater business investment, which will drive the economy towards those higher levels of efficiency. This drives productivity higher without driving wage and labor costs higher. But the thesis has plenty of risk to it, the trade war of 2018 being proof of that. We still believe

this forecast is needed, meaning what we're describing in the forecast is needed for economic health, and we believe the odds are better that it does play out than that it doesn't. Well, our thesis has been that capital expenditures have severely lagged what we have seen in past expansion cycles over the last 10 years. If CapEx were able to catch up to the levels seen in other periods, you know, meaning over the last 10 years, it would have been, it would have essentially pushed the GDP growth that was really muted and tepid out of the financial crisis to the more average levels we had seen. What held that GDP growth back below its normal recovery averages was the suffering business investment. You know, you have a chart at DividendCafe.com this week that basically lays out the CapEx spending growth in the quarters after various economic troughs.

And it goes back to the 40s. I mean, it covers literally, you know, five decades worth of these periods. And we kind of chart out what that CapEx spending growth has looked like. And then at the very bottom of those lines is the capital expenditure growth in our current expansion. And even though the expansion itself is now 43, 44 quarters long, the CapEx spending has trailed every other period that the chart is highlighting. So that's the historical context for it, and it continues to be a big issue. We point you to our Advice and Insights podcast for some more unpacking of this subject this week. Now let's talk about last week's jobs report. You had this blowout number in January,

300,000 plus new jobs. And then in February, you came back with only 20,000 jobs created. So at the heart of the challenge in the Bureau of Labor Statistics is this attempt to seasonally adjust numbers to a model. The model's long proven difficult and creating kind of an accurate and smooth monthly flow. The revisions that come in future months are rather significant this time of year, and I think a lot of that is because of the challenge in their adjustment models. But I've advocated for quite some time evaluating jobs data in three-month rolling averages to account for lumpiness in the numbers, both artificially high lumpiness and artificially low. By all such metrics, the jobs data has been hugely positive,

both the wage growth and increasing labor participation force and the declining underemployment rate, which is now down to the lowest level it's been since before the financial crisis. It really all speaks to increased productivity in the future. Now, so much of what's playing out in the economy comes down to what the impact of the tax reform bill is that was signed into law at the end of 2017. Growth projections have relevance to what deficit projections ought to be. And deficits have relevance for what interest rate projections will be, etc. The interconnectedness is extreme. For the fiscal year 2019, the White

House is assuming about 3% real GDP growth. On the other hand, many left-leaning economic think tanks are projecting 2% growth and some even lower. Our own forecast is if you took the low-end forecast and the high-end forecast and drew a line in the middle, the final number will end up being higher than the middle line for 2019. number will end up being higher than the middle line for 2019. Put differently, the rosier forecast may not be exactly right, but they are, in our mind, more right than the non-rosy forecast. As for the 2018 results, it's important to remember that the same detractors last year were forecasting numbers of 2.5% or lower, and again, in some cases worse than that, while the White House forecasted 3.1%, and they got, well, 3.1%.

If one wants to look at the total scoreboard to evaluate the lay of the land, it behooves us to also look at the details found in the box score. How does one end up with 3.1% real GDP growth for 2018? Well, $730 billion of repatriated assets is a good place to start. There was $1.7 trillion of U.S. corporate cash held overseas pre-tax reform. And seeing $730 billion of that come back in one year was every bit the stimulant many thought it would be. And frankly, the supply side benefits as such will play out for years to come. Yes, 38% of the repatriation went to stock buybacks and dividends. Both are, in our mind, legitimate and stimulative in capital formation. But an additional $500 billion of repatriation has gone into non-capital

return uses, reducing debt, mergers and acquisitions, CapEx, etc. The fourth largest increase in CapEx ever suggests that repatriation was a driving force in economic growth last year. Will the Q1 GDP number we get in a month or so reflect 2019 off to a good start? Probably not. Now, the government shutdown that lasted throughout January may have something to do with that. But the truth is that Q1 has lagged the other quarters of the calendar year for a decade now. And again, I think a lot of that comes back to the seasonal adjustments. But from 2010 to 2018, the first quarter has averaged 1.7% GDP growth, while the second quarter has averaged 3% and the third and fourth have averaged 2.2% to 2.3%. There's something about the first quarter that has lagged for many years now.

Well, what about earnings recessions? I wrote last week, I did not believe we would end up seeing negative earnings growth this year, but may very well see modest negativity in one quarter's earnings growth. And I think it's worth noting what happened last time earnings growth went negative. We did indeed go through a flat period in the markets. Not negative, but just barely positive. And by March of 2016, six months in advance of earnings growth acceleration, we began a two-year rally that saw over 30% growth in stock prices. In fact, in the 30 years since 1927 that earnings declined for the year, the market was up 23 of those 30 years. Put differently, what the earnings will exactly do is unpredictable. How long it will take is unpredictable. How markets will respond is unpredictable. But other than that,

it's very clear. Okay, let's talk Brexit. Look, it was no surprise to anyone Parliament again failed to pass Prime Minister May's latest Brexit proposal, one she surprisingly received approval from the European Union for, just not her own Parliament. A delay in the March 29th deadline looks most likely at this point, which is why markets have not responded as if a sudden or disorderly Brexit was imminent. The options going forward appear to be, number one, a very soft Brexit, whereas Britain's relationship to the European Union will look much like Norway's. Or number two, a new referendum vote altogether. This is probably the most politically dangerous.

vote altogether. This is probably the most politically dangerous. And then number three, a hardline Brexit after all, which does seem unlikely but not impossible at this time. That third option, by the way, I would argue would be the most volatility-inducing in markets and the most long-term beneficial for markets. For now, we watch the particulars of a likely extension and what position it leaves each side in to obtain leverage for the end objectives. But global markets continue to price in what we've long believed, that it is within the power of those driving this process to make it less disruptive than otherwise, and that Britain's real economic standing in the world is not remotely threatened by sovereign independence. A couple charts at Dividend Cafe this week I want to draw your attention to

about why I think the Fed waived the white towel in January. Tightening credit is the precursor to a recession. And the reason the Fed reversed course so substantially in the last two months as far as their tight monetary policy plans are really reflected in commercial and industrial loans, seeing tightening lending standards. We have provided for you the late year and early 2019 survey results of both small firms and middle market firms reporting greater difficulty in obtaining credit. And then in the spreads of loan rates over a bank's cost of funds near the end of last year as the Fed was doubling down on their tightening, you see those loan spreads blowing out. Again, indication of tighter credit. At the end of the day, I think that is the issue that is going to make or break markets in the short term and make or break the Fed's thinking.

I did get some questions last week I want to address real quick about quantitative easing. I'd written an article that dealt with how we still have this kind of looming and lingering unknown that represents a certain risk in capital markets regarding the unwinding of quantitative easing. And people naturally want to know about other risks that have been there and the criticisms of QE and so forth. And I want to point out that I have not criticized QE for being inherently inflationary because it is not inflationary in and of itself. It is a form of digital money printing because it represents buying bonds with money that didn't exist, but that does not equate to money circulated. The velocity of money has been so low, that is the money that turns over in the economy. And so higher excess reserves have not resulted in inflation. Now, I agree quantitative easing took that risk because had

that money gotten off the bank shelves and into the economy, into circulation, it could very well with velocity have become inflationary. But in this case, Chairman Bernanke was proven right that QE would end up bringing long rates down without actually increasing the money supply. long rates down without actually increasing the money supply. Does that make me a fan or supporter of quantitative easing, of QE? It does not. What it means is that I'm trying to criticize it for the right reason, which is its buildup of embedded risk and malinvestment, not inflation. The active versus passive debate, part 3,000, we talk about all the time. Usually trying to reiterate how relevant the subject is in the grand scheme of things because A, behavioral commitments that fail, that undermine investor success don't really care if the strategy is active or passive. And also, secondly, because no one's ever really fully passive. Even if you're using passive strategies to fill in an investment portfolio,

some active decisions have to be made around underlying asset allocation, style, capitalization, et cetera. But I'll add to the conversation yet again that I really believe we are entering what will be a prolonged post-QE and post-zero interest rate era where those who believe there's no need for discernment in portfolio management will see how untrue that is when there is not a central bank assist to every risk asset under the sun. Investing is not and never has been hard science, and the results are not and never have been predictable, let alone repeatable. Human intelligence, experience, discernment, and interpretation matter, and the willingness to stray from consensus thinking will be an asset in the decade ahead. Let's talk yield curve interest rates real quick and then get ready to wrap up. The three

month treasury yield sits at about 2.45% and the 30 year treasury yield sits at 3%. So there's a whopping 55 basis points, 0.55% separating the annual reward for loaning the government your money for 90 days versus 30 years, 10,950 days. At a 2.62% level, the 10-year has dropped 10 basis points in the first half of March, widening its gap from the 10 to the 30-year, but tightening its gap from short-dated maturities. the 30-year, but tightening its gap from short-dated maturities. So the fact of the matter is that from one month to 10 years, we have a practically completely flat yield curve. And the cause is very simple. The Fed raised rates enough that the short end of the yield curve came up, and confidence in longer-term sustained growth is not high enough for longer-term yields to go higher. So remember the

CapEx stuff we talked about just moments ago. Well, that will be the issue that determines how the yield curve plays out. And if I'm being fair, confidence in global growth is so low that with global yields anchored down, it makes it very hard for U.S. yields to move much higher as well. makes it very hard for U.S. yields to move much higher as well. A lot at play here. All right, I will get ready here, close this out, because the chart of the week is one that you have to go to dividendcafe.com to look at. It shows you the average holding period for stocks in each of the last six decades. And boy, is it phenomenally interesting to see this most unfortunate trend for investors and the great opportunity that it does represent for people investing with great companies that are returning cash to shareholders year over year

to properly monetize the behavioral decisions of others. But we are living in an era where short-termism is in vogue, and I really commend you to look to the chart of the week at DividendCafe.com. I review us and direct your friends and so forth as the more that reviews we get and stars we get and the subscribers getting it through their feed, it enables other people to see the podcast. And that's just sort of the fancy little way they have this stuff set up out there. With that said, thanks for listening, and please do reach out to the Bonson Group for any questions, any time about your financial investment and portfolio needs. Thank you for listening to the Dividend Cafe, financial food for thought.

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