The Dividend Cafe - Stock Market Says, "What Government Shutdown?"

Episode Date: January 26, 2018

This week, Chief Investment Officer David Bahnsen covers Topics discussed: The slippery mess of understanding oil A primer on equity market risk The potential game-changer at the Fed Links mentioned in this episode: www.DividendCafe.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 at the Bonson Group. And we have quite a lot of things to cover this week. I titled this week's talk, The Stock Market Says What Government Shut Down, and we'll have kind of a lot to unpack as it relates to market movement, the state of Washington, and a handful of other things. It's actually a pretty action-packed week and a lot of good content, I think. So what do you expect me to say? If I create the content, I'm usually going to say I think it's good content, although maybe not always.

I am relieved no client emailed over the weekend or on Monday saying, oh, no, what will the market do about this government shutdown? The press did all they could to make it a news event, you know, but, I mean, there's not much you can do to make something a market event these days. The people weren't biting on it. And frankly, they weren't biting on it as a news event or a market event. The market shrugged those silly little incident off. And as best I can tell, most people did too. Is there a political statement in this? I don't think so. Rather, it is a clear market statement. Markets have tuned out Washington, D.C.'s dysfunction and are so monolithically focused on earnings and fundamentals right now. We shouldn't be surprised by any of this. Those things that do drive markets are what this week's Dividend Cafe is about. And so we're going to kind of cover inflation talk, equity risk premium, the Fed,

stock buybacks, the market's correlation of the dollar, and more. Let's get into it. If a government shutdown doesn't hurt markets, what will? Well, let's take the non-event of last weekend's embarrassing government shutdown and its non-impact on markets is a symbolic furtherance of the crucial principle at play right now and was on display all of last year. Markets respond to earnings. Markets ignore Washington, D.C. becomes what will the impact be? What impact will market earnings have on their value that could change? In other words, sentiment, valuation, momentum, what is likely to impact earnings to an extent that it does change the values in the market? The economic cyclicality seems to have further room to go for expansion and perhaps a lot of room. So therefore, the likely catalyst at some point would not be global growth slowing, and thereby earnings slowing with it,

as much as monetary tightening, the eventual calling for a repricing in risk assets as the risk-free rate grows, the interest rate, and therefore compresses valuation of risk assets. To inflate or not inflate, part, I've lost count. Look, a reasonable, though I think an accurate, view of tax reform and inflation is that the onset of fiscal stimulus coming in the form of new personal and business tax cuts at a period of basic full employment will drive consumer spending into an inflationary breakout and deficit spending will exacerbate this. As we've argued before, most recessions are caused by the actions the central bankers have to take to cool down an inflating economy.

But it's important to point out the possibility that the consequences of tax reform will be more productive capacity and that the growth generated will be anything but inflationary. Mnuchin says what? Yes, that was the Treasury Secretary of the United States of America saying this week in Davos, Switzerland at the World Economic Forum that a weak dollar is good for us. Now one could be pleased with the honesty of what he said and that we all know they think it anyways. Competitiveness with global trading partners trumps actual sound money for these people, and it has for a long time. But it is bad policy long term, and is even more confusing when they acknowledge it. They will say, well, short term,

we like a weak dollar, but long term, we like a strong dollar. What exactly is the timing of short term versus long term here you may wonder? When does it become convenient to switch what we like from weak to strong? I want to be very clear Secretary Mnuchin's statement was unprecedented and sort of shocking but it represents nothing new in actual policy in action. For 15 years or longer, policymakers have acted this way. We just said it out loud. For our purposes, we actually stand with Alexander Hamilton on this issue. But don't expect other countries to just take what Treasury Secretary Mnuchin said lying down. Two can play at the game of currency weakening, or three, or four, etc. The slippery mess of understanding oil.

I want to join the cause of arguing for supply-demand factors as the primary driver in oil prices. And indeed, supply-demand factors are the primary driver of oil prices and indeed supply-demand factors are the primary driver of oil prices ultimately whether we adequately understand all the complexities they're not but one thing that drove our opinion in 2014 and 2015 when an acceleration of Saudi production pushed prices even lower on the back of excess supply was that if Saudi objectives were trying to drive the market then, and we would argue unsuccessfully so, a reversal of those same Saudi objectives would also play in the other end of all this.

Saudi Arabia had $750 billion of reserves in 2014. That number is down to $350 billion, a loss of $400 billion in less than four years. They will burn through another $50 billion this year, even with oil prices firmly above $60. Their current fiscal necessities combined with the preparation of this Amarco IPO, the state oil industry spinning off to private markets, caused us then and causes us now to forecast a combined bias in their supply policy towards the boosting of oil prices. Game changer at the Fed. One of my big themes in late Q3 and early Q4 of 2017 was the impact that a changing of the guard at the Fed could create.

At the time, the chatter was heavy that the replacement of Janet Yellen could represent a pretty severe break from the Neo-Keynesian interventionism of the Yellen-Bernanke school of thought. Kevin Warris, John Taylor, etc. were being discussed as possible replacements. I was excited about the possibility, but well aware that it could create, and would have created probably, a certain volatility if markets had to digest uncertainty or radical transformation at the Fed. But that didn't happen.

The replacement ended up being Jerome Powell, a smart and seasoned banker and economist. But largely he was in the same school of thought as Janet Yellen. We stand by our call that a very slow pace of normalization and a status quo framework on Phillips curve, model driven, wealth effect sensitive, it's highly accommodative to monetary policy in the short term and is likely to rule the day. With that said, there apparently is a conversation right now about abandoning the current 2% inflation targeting and even maybe the possibility of overall price level targeting going away. But there's a conversation about changing the way they do it, and I imagine the selection of vice chairman could represent some influence on this thinking.

some influence on this thinking. It's possible that the Fed gets some sort of rules-based thinking like Warsh and Taylor, but more in a vice chairman role. I wouldn't bet on it, but I wouldn't mind it. If nothing else, it's encouraging to think that the present Fed chair would not be open, excuse me, that the future Fed chair will not be open to intellectual inquiry driving the Fed instead of sound policy. A primer on equity market risk. Should bond yields move from 2.6% of the 10-year bond yield to 3% or higher, it's hard to believe that equity markets would not suffer. But the major category of risk in equity markets for over a decade now has been deflationary pressures. Pressures that are effectively hedged with long duration bonds.

But rising bond yields in response to economic growth are anything but deflationary. And in that case, the proper diversifier are inflationary hedges, like commodities or tips. These are bizarre paragraphs to type, because it's the polar opposite of what has been the risk and conversation for so many years. But these conversations are going to become more common in 2018. A bull market for me but not for thee. One of the possibilities I'm trying to keep my arms around is the

possibility that we all enter the rest of 2018 that it excuse me the end of a risk on risk off paradigm in 2018 that whole way of markets moving goes away. And we've really been there more or less since the financial crisis ended. So we've seen periods of all risk assets rallying together, and we've seen periods of all of them retreating together, but not so much various risk assets moving in different directions against one another. And it's been understandable. You have globalized monetary accommodation begging for synchronized behavior of risk assets. And most periods of downward pressure were contagion-driven fears of a systemic slowdown.

Let's say, for example, the European crisis in 2011, the Chinese crisis in August of 2015. Differentiation amongst macro environments and drivers has been hard to come by. And what we call risk on, risk off, has become very familiar to asset allocators like us. But what is, maybe, just maybe, but what if the paradigm is about to change? Is it remotely possible that the U.S. bull market will peter out, but emerging markets will just be getting started? Yeah, it's possible. Could Europe resume headwinds just as the U.S. market is rallying, or even Japan?

Do you think these possibilities are real and if nothing else warrant asset allocators thinking differently than they have since 2009. Not so fast on small cap. The counter argument to our tactical call in favor of small cap stocks starting off in 2018 is that many small cap stocks are heavily correlated to interest rates due to their newfound indebtedness. Many are trading at multiples not seen before, and as I pointed out in this year's white paper, many are not profitable at all. All of these things, the indebtedness, the different market multiples, the indebted factor leverage ratios, and basically, at the end of the day, the valuation.

Very different company by company. And it's why we favor active management, a more selective and concentrated approach to small-cap investing. We just think it is, in this environment, far better suited for active versus passive index approach. Well, I'm going to leave it there. There's a couple other paragraphs at DividendCafe.com and certainly our chart of the week, which you have to see to understand the correlation between the dollar and energy stocks. It's fascinating.

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