The Dividend Cafe - Some "R" Words are Worse than Others

Episode Date: April 29, 2022

Recession.  The dreaded word, “recession.”  For those who have lost their job in one, it can feel like a depression.  For those who kept their own job in one but saw their portfolios drop, or saw neighbors or loved ones lose their jobs, or experienced a decline in income or business revenue, it may not have had the existential punch that it did for others, but it generates unpleasant memories of unpleasant times. There is a lot of talk about a recession right now, some of it imbecilic, some of it overtly political, and some of it, quite substantive and important.  But if the Dividend Cafe exists to bring simplicity and honesty to topics that are often spoken of with too much complexity and/or abundant dishonesty, the task at hand is readily apparent. And so we will look at recession reality in current times, when, what, and why, and unpack the investment implications on all of it.  I will always do my best at the simplicity part (I know I miss the mark there sometimes).  I will be unrelenting in the honesty part.  But as far as the pleasant part of it all, well, let’s just say my focus is on the honesty part. Jump on into the Dividend Cafe … Links mentioned in this episode: 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 another Dividend Cafe rallying a bit, really just a little volatile and unpredictable, and that's the way things go. And as is the case, each and every week at Divin Cafe, I'm going to spend basically no time at all talking about any of that. I want those of you listening to the podcast, those of you watching the video, to hear from me today on a topic that is absolutely a topic that will matter in another quarter and in another three years and in another three decades. It's the way that we think about recessions. Now, the reason I'm bringing the topic up now

is you're going to just hear this R word over and over again. And the recession word right now is coming up because I think there is a greater chance of tipping into recession when a central bank is tightening monetary policy, pulling credit out of the economy than when they're not. That generally speaking, we think of monetary expansion as anti-recessionary. And in theory, credit contraction can be recessionary. So it's understandable that we're looking at it that way. But I have to say, first of all, there's a lot of people throwing the recession word out because they're another R word, and that is Republican. And you always want to make the economy look bad or cast aspersions on economic prospects when the other party is in power. The Democrats would absolutely do it.

Republicans will look at the job status or what's going on with the market. You look at how the economy was contracting during COVID and how that was obviously a big political thing. So this isn't something I say as like a negative on either party. I just say it is the way the world works. But it isn't completely sinister right now in the way that it's the politicization is a byproduct of the fact that there are legitimate questions about our inflationary pressure is going to create a Fed response to then tips and recession. And what's that going to mean to people, middle class and all this kind of stuff, jobs, wages,

economic growth, all fair enough. However, I will say that there is a need for some clarification on basic vocabulary and a bit more honesty in the way these things are understood. And also a difference between those who talk about the present and the future. You do not ever need to ask the question, are we in a recession? And the analogy I would use is, you know, is there a storm outside? Well, just look out the window. No one needs to tell you if there's a storm. You know that there's a storm. That's not a relevant question. The relevant question is, is a storm coming?

Have we prepared? What makes us think it is or isn't? Or if it's going to come, when? And what's it going to look like? It's future-looking, forward-looking, preparatory. It is not present tense because that's asinine. By the time the storm has come, it's come. It makes no sense. So when someone says, oh, I think we're in recession. And I go, well, no, we're not. And they say, how could you

say we're not in recession? Things are going to get horrible. And I say, you just changed the conversation. But also it is not merely dishonest to equivocate between present tense and future tense, which is dishonest and, like I said, an equivocation. But the other thing will happen is people will say, I think that we're in a recession. And I'll say, no, we're not. And they'll go, well, there's high inflation. Or they'll point to another economic issue that is negative. And I'll say, no, no, no, you Or they'll point to another economic issue that is negative. And I'll say, no, no, no, you're right. There's negative economic things we have to watch here that are problematic now that can become more problematic later.

That's not the same thing as saying we're in a recession. And now, gee, I use in DividendCafe.com today, which I made up while I was writing and I'm not going to delete it, is that if somebody says it's raining outside and I say, no, it's not. And they say, well, I'm having a bad day and there's traffic. And I spilled coffee on myself in the car and I got dunked on in a pickup basketball game and McDonald's forgot to give my Egg McMuffin in the drive-thru. So yes, it is. I would again point out that maybe they're the one missing the point. Because all I'm saying is it's either raining or it's not. And we're either in a recession or we're not. And that has nothing to do with A, if other bad things are happening,

and B, if we're going to go into recession. The distinction between present and future tense matters. And so, David, it sounds like you're pretty optimistic everything's okay. Well, I didn't say any of that. I believe there is an enhanced recession risk in the future. I just kind of want you to understand where that is coming from for me, how I think about this,

because I'm not sure that it's the same as the way it's being presented in the media. If someone says, and if this is being said as almost kind of a consensus view, I think the Fed's going to tighten monetary policy so much, rates come up enough, and then it's going to cause such a contraction in housing, and that will be a big negative. I would say I agree with everything you just said until the very final sentence. I don't care a whiff if the Fed raises rates so much that people stop overpaying for overpriced houses. I hope that happens. There is nothing good about a distortion, a mispricing, a malinvestment.

That is not a good thing. And people go, yeah, but then, you know, people's house values will be lower or whatever. We've gone through this, haven't we? It is not helpful for someone to overpay just because it's helping to employ certain people in that ecosystem or whatnot. Markets have to clear activity.

All right. That's what markets do is they clear transactions in wages between buyers and sellers and prices and asset markets. That's what markets do. And markets cannot clear something that is inefficiently priced forever. And so I'm sorry, that is not to me what a recession will be is when we finally get a right pricing, a repricing, a right sizing of housing, for example.

Nor am I really particularly worried about the ability of Americans to continue loading up their food and beverage bill each month, more vacations, more TVs, this and that. I love all of it. Buy things, produce, and then consume. I mean, that's the sequence. First produce, then consume. All of that I'm fine with. But to the extent that people say, oh, consumption can come down. Do you think there's someone out there spending their credit card to buy something that says if the interest rate of my credit card is 15%, I'll do it, but if it's 18%, I won't? Because I'm just going to tell you that there's not. It never has been. Now, what can cut off

consumption is when the credit card is maxed out and they can't get another one. Okay, so the cessation of credit can limit consumption. The inability to get an auto loan can keep someone from buying an auto. Tighter credit can have an impact downstream. But the tighter credit that I would be worried about leading to recessionary impact is just not on the consumption side. Because generally speaking, if consumption tightens, it's because consumption should tighten. Because savings is too low, wages are too low, or spending relative to productivity has gotten out of whack as a ratio. So the notion that we need greater spending without any comprehension of the other economic data points around it is silly. It can also be immoral, but that's not even the point I'm making right now. So where is my concern, negativity, foreshadowing, looking ahead? Where is my contemplation on this

coming from? It's do we get to a point where the Fed, in an effort to purge out the inefficiencies that they've helped to exacerbate in the economy with excessive accommodation and excessive monetary easy policy in the course of shifting the pendulum the other way into tightening will we then see credit contract to a point where it strips away business investment capital expenditures forward-looking projects that are necessary for productive growth in the economy. I talk about this theme all the time. I also talk about the number one biggest disincentive to productivity being the fears about the return on the productive endeavor that has excessive indebtedness taken away from economic opportunity, from output potential in the economy.

That's this long-term fear that I tie into our Japanification thesis I talk about all the time. But can there be a point in six months, 12 months, 18 months, 24 months, where we see credit tighten enough that reflation that our economy has gotten kind of dependent on in the corporate sector reverses. I think it can, and I frankly think it probably will. I also think the whites of those eyes will be what causes the Fed to end up capitulating, but they simply, like turning around a battleship or like lights that are on a dimmer, have no ability to turn it off quickly. Okay, they can now say we're going to reverse course. But just like right now things have gotten too excessive on the monetary side, their ability to kind of perfectly manage this is either dependent upon luck. And you can imagine

how I feel luck ought to play into an investment strategy or stewardship of economic affairs. And B, it more than likely leads from a mistake to be getting another mistake that then leads to another mistake. There becomes a negative feedback loop. I can't help that right now. That's not my subject matter at hand. It is quite frequently. I don't like this idea that they're constantly playing whack-a-mole with the American economy and that we more or less have, both in the fiscal and monetary side,

a constant hair-of-the the dog management of the economy, a constantly insatiable need to feed a hangover with more booze. But that part has all kinds of problems embedded in it, and yet it doesn't speak to the immediacy of a recession. of a recession. And my argument is that a recession where we get two quarters in a row of real negative GDP growth that the economy contracts, and then around that, there is unemployment that follows, wage declines that follow, obviously a general productivity and output decline that follows. Those are all the consequences of the recession, but we measure it academically or formally

by two consecutive quarters of real GDP contraction. We're not going to get that Q1 to Q2 in my forecast. I think this negative 1.4% print that came this week for Q1 is very clearly around some temporary technical factors that are actually going to reverse next quarter. Perhaps even the other way, where right now we had an increase in imports in Q1 because we had 3.6 million people call in sick in January. Normally we have about 1 million. There's Omicron and all that stuff. And I think now on the import side, China and their COVID lockdowns, we're probably going to have a reversal on the margins of import activity and then export activity, which was somewhat constricted. We had less workers creating less things to export, especially the beginning of Q1. I think Q2 is going to see a pretty big increase in exports,

if nothing else, on the energy side. We're at record levels right now of exporting crude oil and exporting natural gas. I think that's a good thing. That'll show up more in the Q2 data. But see, those types of things that kind of filter in to the GDP formula, they're not the sort of sustainable levels. Inventories are another example that are subject to anomalies in the data quarter over quarter. What you have to look to is, everyone talks about how important consumption is there. I agree it's important formulaically, but I always believe it from a chicken or egg standpoint. It is following production, not creating production.

But that's an economic difference between me and the Keynesian school. But from the supply side, are we going to have what GDP formula calls non-residential fixed investment, the business investment that will be necessary to keep us in positive economic growth. And if we don't, what will be the reason? Sometimes it happens because you run out. Why do we have such low business investment in non-recessionary times post-crisis? Because there was very low business optimism, very heavy skepticism about economic growth, concerns about coming back into recessionary periods, obviously a lot of extraction of capital and resources. The allocation of resources was not optimal when you have such incredibly excessive indebtedness that we were taking on.

So those things are a bit more long-term and secular, and I continue to have grave concern about that. Not necessarily that it goes negative, but that it just stays stagnant, that it's subpar, that it's below capacity. I hate that reality, both morally and economically. However, in the shorter term, what could tip it into negative that then brings GDP growth down is a contraction of credit, a cost of capital that gets so high that when one views their cost of capital as greater than their return on invested capital. That business says pump the brakes. This is not a particularly complicated concept.

If I start talking about the Wixilian framework and some of the Austrian economic foundation to this, which is really how I learned this, I guess I could make it complicated. But let me just say it again the way I just said it. When the cost of capital is higher than the return on invested capital, businesses contract activity. What would you do? That's not a good thing. Consequently, or I should say inversely, when one's anticipated return on invested capital is higher than the cost of capital, it produces the incentive to go produce. You know, there's other complexities and nuances that fit into this, but all I'm getting at is what would tip us in a recession, perhaps late 23, early 24. Beware of any charlatan who tells you exactly when it's going to happen.

Beware of anyone who has predicted 10 of the last two recessions. Everyone likes to be smart forecasting doom and gloom. It's a scam. I'm not here to scam with clickbait, doom and gloom nonsense. I think that we can go into a negative, probably a shallow recession, but a recession nonetheless in a year, year and a half, if indeed the Fed properly recalibrates. So then this is the very ironic thing I would say. Only for investors, not for those who might actually lose their job in a recession. You're not going to catch me becoming unhuman about the impact recessions have. Recessions hurt lower wage earners, less skilled employees,

people who have less of a balance sheet, middle class folks, all far more than they impact people that are wealthier. I'm well aware of that. I'm not insensitive to what a recession does. I'm merely talking right now to investors. I'm talking to clients because this is my job to kind of apply into an investment portfolio these realities that we're talking about. My view would be that a recession would end up being healthy

if it allows some of the excesses to be purged out, if it allows a normalization of monetary policy that can reset the Fed's emergency levers that they surrendered post-COVID. Things that happen like a pandemic, a war, a bubble bursting, an unexpected geopolitical event, China throwing a curveball at you, Japan, global affairs. There's all the things that have caused recessions throughout my lifetime. And we could go back through history and talk about others. But when those things happen, including just run-of-the-mill cyclical recessions,

you know, inventories build up too much, there needs to be a slowdown, we can go back to Austrian business cycle if you want. I love that topic. All I'm saying is that recessions have to purge out malinvestments. And generally speaking, the time that it feels worse to invest is in a recession, and the time that it is best to invest is in a recession. The amount of money that we make post-recession because of better pricing and so forth is more or less a huge part of return an investor generates throughout decades, a long-term cycle of investing. generates throughout decades, a long-term cycle of investing. So when one gets this wrong, they end up with the other R word that is not recession, and that's regret. And that kills investors. It kills investing success. Because then they get on a hamster wheel of constantly timing everything wrong. I got out too early, and then I came back in too late and then I'm mad at myself so I'm going to try to make up for it with another dumb move that backfires. Rinse and repeat.

Do not allow regret to become the R word that dominates your response to recession. Recessions are inevitable. There are ways, and we can talk more about this in a different Dividend Cafe, to become a bit more, excuse me, not optimistic, but to become more prepared, to become more opportunistic is a word I was looking for. A lot of my clients have boring bonds in their portfolio for dry powder purposes into the future. Right now they see rates going up and the bonds are coming down, but then all of a sudden these things kind of roll through. You have a high capital preservation part of your portfolio,

and that represents some dry powder gets put to work later. But why not do more of that if you see a recession coming? For very simple reasons. People are wrong about predicting recessions all the time. It's the norm for people to be wrong. And it can't be timed. And there's a huge opportunity cost. If you say, I want to have more dry powder in advance of recession. If the recession comes in 60 days, maybe that works out real well. If the recession comes in 36 months, it doesn't work out so well. in 36 months doesn't work out so well. So my point is that there is an allocation and a tactical marginal component to how you handle this, but that fundamentally recessions provide opportunities

to buy great things at better prices because recessions do generally kind of purge the system. prices because recessions do generally kind of purge the system. This is different even than what we're already seeing purged right now. In a non-recessionary time, the stuff I think I've probably talked about this subject most on Dividend Cafe this year was the huge theme of my white paper. I was certainly talking about it well before it happened as well. It just took a while to happen, but it's happening. There was a lot of excess valuation in tech. There was a lot of excess valuation in FANG. There was a lot of ridiculous valuation in shiny objects. You know, you've seen crypto get smoked out. You've seen all those work from home stocks blow up. People just doing what they do. Human nature. Chasing a free buck. just doing what they do, human nature, chasing a free buck. Well, that repricing is going to happen and recessions are going to happen. Those are two different things. Sometimes they can correlate

together. But I guess what I would say is avoid regret by viewing the recession for what it is and do not get caught into the headlines about housing and consumption, very much look at the business investment side. I don't know when the Fed will capitulate. I do know that it is very hard for them to time this perfectly, and I don't think that they will, but I don't know, and nor does anyone else. So this is our version of a session watch Watch is to watch business investment and allow the data to pull through in GDP the way it does. On a human side, I hope my friends, loved ones keep their jobs. Right now, it's 3.6% unemployment. It's surreal.

We're talking about recession with unemployment this low. Generally, employers start laying people off when they see dark clouds ahead more than they start cutting other elements. Right. So the job losses usually lead. And that's not happening yet. If anything, we've talked about labor shortages. So maybe we have a ways to go. Don't let this be political. There's no need for that.

We can all have strong political opinions without trying to make up an economic forecast to fit a political narrative. Just allow this to play out and be flexible in a portfolio to where you understand that your allocation is designed to accommodate the fact that there can be recessions and unpredictable timings and that, in fact, on the other side of recession, will actually more than likely be better things for your portfolio, just maybe not for your cousin. So that's the part. I just, I can't stand when I get criticism that people think I'm being insensitive to the humanity of it while I'm specifically talking about the investment situation, because I don't want to be perceived that way.

So I hope you take my qualifiers to heart. I've gone on long enough. I hope you understand where we're coming from. Please do read DividendCafe.com. There's other charts, other commentary. I always prefer the written word in the way I articulate these things. And so this message is addressed at DividendCafe.com. Those of you watching the video, if you don't subscribe to our YouTube channel,

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Blah, blah, blah. I get tired of saying it every week, but I always have to say it because we have new listeners and viewers all the time. I love doing Dividend Cafe for you. I hope you've enjoyed listening. I will be off to New York, but actually back in California by next Friday. So we'll bring you another Dividend Cafe a week from today back here in our California studio.

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