The Dividend Cafe - Stocks Vs Bonds

Episode Date: June 21, 2019

Topics discussed: What stocks and bonds are saying to markets The Fed and Credit Markets 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. I am the Chief Investment Officer of the Bonson Group and we are thrilled to be bringing you this week's investment commentary as succinctly and hopefully as substantively as we can. We encourage you always to check out DividendCafe.com where this podcast content can be found in written form, our weekly commentary alongside all sorts of other charts and so forth. I will spare you all the normal housekeeping stuff and I'll wait till the end of the podcast to ask you to rate us and subscribe to us and give us stars and thumbs ups and likes and things like that.

I'll hold that thought and get into it because I think there's a chance this is the most economic I've ever gotten in the dividend cafe. And that's probably not a great hook to keep you listening. But I actually do believe that the unpacking of truly pivotal economic understandings is right now one of the most beneficial things an investor can be doing. And ourselves at the Bonson Group as fiduciary advisors to clients, and I think particularly myself as the chief investment officer of the company, feel a real moral responsibility to counteract some of the nonsense that people hear in the financial media, which is often just a breeding ground of simplicity and even outright fallacy. And that can lead to really negative outcomes and behaviors for investors. So bear with me through some of the jargon this week, but hopefully you'll find some

clarity on the great economic questions of our day. It was rally mode on Wall Street this week. As of the time I am talking, right now this second, about halfway through the market trading session on Thursday, the fact of the matter is that the S&P 500 has made a new intraday high. So fact of the matter is that the S&P 500 has made a new intraday high. We don't know how that will finish. But it's just important to understand why the things that are happening are happening.

And so that's what we're going to try to get into is the why of all the big picture things. And then we'll talk a little bit about the what, what we ought to be doing and so forth. So we'll get into it. Okay, listen. Stocks versus bonds are in right now what I would call a battle for the ages. And I think that the message of the stock market, which it has been for some time, is that the economy is growing, that earnings are great, that economic expansion is not likely to falter anytime soon, despite occasional trade hiccups. Whereas the message of the bond market right now, and it also has been for quite some time,

is that long-term economic growth is not on the horizon, that global economic headwinds are dramatic, and that secular forces persist. That represents a long-term drag for economic growth and for investors at large. The 10-year U.S. bond yield is presently right around 2%, and it was 3.3% just nine months ago. It was 2.6% when President Trump was elected. So who is right? Mr. Stock market or Mr. Bond market? And is it possible that stocks are right in one time frame, but bonds are right for another? Well, the answer is, as you might have guessed, complicated. Of course, the easy answer is no one knows yet, and that's certainly true, but it's also true that the two indicators are more intersected than one may believe.

Let me unpack it further. Do stocks like low interest rates or do they like high interest rates? And the answer to this question is yes. But the answer also can be no. It all depends on circumstances. The answer can never be that they like low or that they like high because they can like either one or dislike either one depending on particular circumstances. A low growth environment that pushes government borrowing rates down but pushes corporate borrowing rates up is about as negative for equities as one could imagine. The market rate of interest, the level at which companies borrow, must be lower than the natural rate at which they are growing. In that sense, the market rate can be high or low, but it all depends on what the rate is

relative to the return on capital. So if the spread between the return on capital and the cost of capital is positive, then that environment, whether rates are high or low, then that environment, whether rates are high or low, is positive for stocks. And if that spread is negative, it can be very bad for stocks. And so again, I'm just going to repeat real quick. The issue is the market rate, the cost of capital, being either lower than the return on capital or higher than the return on capital. If the market rate at which companies borrow is lower than what they can get out of the capital they're deploying, then that is positive. And if the opposite is the case, that they

have a negative return on capital relative to their cost, then they obviously will slow down and it creates a negative feedback loop. Because companies will use their cash to pay down debt, they won't invest in new projects, economic activity dries up, and so it's that negative feedback loop. And out of that is what we generally call recessions. Now in this sense, the money it costs a large government like the United States or Germany to borrow money is not the key variable. American companies have done very well when treasury rates were 2%

and they have done very well when treasury rates were over 5%. The key is that spread between government yields and corporate yields. And the last time these two numbers really went in the wrong direction, meaning corporate borrowing rates were widening versus the government yields, was the Great Recession of 2008. Well, in late 2018, it began to happen. And in early 2016, it began to happen. And in mid-2015, it began to happen. And in mid-2011, it began to happen. But none of those head fakes played out.

In each case, either a central bank intervention or some other market force reversed the concern. And the healthy environment of companies' return on capital exceeding their cost of capital resumed. So where are we now? The question I must obsess over is whether or not the Fed will be successful in their desire to extend the cycle of companies generating a higher return on capital than their cost of capital. But the Fed cannot help the return on capital. Only innovation, technology, competition, organic growth, healthy market forces can do that. So the Fed has tried to help on the other side of the equation by keeping the cost of capital down.

That can be very beneficial for a season, but it also can lead to bad investment decisions, unhealthy debt buildup, excessive risk in the economy. And right now, the bond market is saying that the economy is going to weaken in the future. And right now, stocks are saying that companies have a healthy spread over their borrowing cost, that their ability to generate earnings supersedes various economic question marks. So let me now, of all this kind of setup, and I hope you haven't fallen asleep and that you're following me, but this is sort of a summary I want to leave for you. Our take at the Bonson Group, the debate will not be settled by machinations around the cost of

capital. No Fed maneuverings in the cost of capital are going to settle this, but rather it will be the return on capital generated by America's best and brightest. Monetary intervention buys time, it impacts valuation, and it generally puts a backstop in risk assets. But the long-term answer that neither the stock market nor the bond market know at this time will come down to whether or not organic growth can be found that keeps the cycle going. Well, it does beg a question. What is it bond markets are reacting to? Why are German bond yields negative? Why are U.S. Treasury yields making new lows? Global growth is the most obvious answer. Bond markets are prepped for a sustained period of low growth in Europe and Asia. Fears

abound that credit can continue to grow. And there is at bare minimum some question out there as to what impact the trade war may have on global economic activity. The European Union's banking system is in disarray. It's very solvency is in question. So all sorts of culprits can be found that are forcing, that are putting pressure on global bond yields. Ultimately, my contention is the bond yields are low because excessive debt is deflationary and pushes bond rates lower. Central bank interventions complicate things but ultimately reinforce the narrative. Central banks want inflation if for no other reason

that they live in utter horror at the prospects of deflation. But central banks cannot wave a wand and create inflation, try as they may. In a lot of ways, the long-term interest rate environment is the market's way of saying they don't believe the central banks of the world have any power here. So what does this mean for investors? Are we to believe that the Fed can't move markets in the here and now? Well, absolutely not. They can, they have, and they will. This is where the challenge lies. There are long-term forces fighting the big fight about debt, deflation, and economic growth. And they coexist with shorter term forces dealing with the cost of capital versus return on capital. The Fed is engaged in

that second fight. The bond market is pointing to that first fight. And somewhere in all of these two things, an investor has to formulate an investment policy for themselves. So one option is to develop a conviction about how it will all play out. Predict what will happen and when and attempt to time your way through those evolutions. That's likely the surest fire way to blow up. Markets are dynamic, unpredictable, and attempt to time your way through those evolutions. That's likely the surest fire way to blow up. Markets are dynamic, unpredictable, and inherently unknowable. The volume of inputs one would have to understand to get this right is beyond any mortal's comprehensible skill set. But the other approach is to make long-term strategic decisions around one's goals

and expectations for major asset classes. This involves a worldview of macroeconomics, but not the ability to navigate the specific nuances and details each step of the way. And then making some midterm tactical decisions within that plan around more transitory matters like the Fed, earnings and such that align one's portfolio with their risk tolerance and return needs as one's own financial goals dictate. The construction, strategic planning in the context of investor goals, this is the need of all investors. Now, speaking of the Fed, they did not raise rates this week, but stocks rallied around

the message that said or unsaid, they all but promised they would be doing so next month. There's debate as to whether or not they cut a quarter point or a half point at the next meeting. Will they cut more beyond that? But there's little debate in the Fed futures market that rate cuts are coming. The Fed's message right now is this sort of bizarre mix of perfection for risk assets. Everything is great, but risks are growing and we're there to help and in fact will help sooner than later. In other words, growth is good, but inflation is low so we can act preemptively. There's a contradiction in the message. It's

unavoidable no matter what anyone wants the Fed to do. My assessment is that the Fed regrets their last rate hike or maybe two of them, but they can never say we went too far last year, and the economic climate is allowing them to unwind and save face all at once. I do question that they actually believe a deflationary disaster is around the corner. I mean, why would they wait if so? But I'm confident that they fear deflationary issues at large and the challenge of the debt hovering above all else. that a tightening monetary policy revealed,

all point to a very tough road for the Fed to ever unwind the accommodations of the last 10 years. So I am going to leave it there because I think I've given you a lot to chew on around the kind of economic paradigm, the message of the stock market versus bond market, where things stand. The DividendCafe.com does have a couple other comments on the trade war update. We know President Trump and President Xi are now officially scheduled to meet next week, which I would say at least improves the odds that they will not be going forward with this new round of tariffs on $300 billion of products. on $300 billion of products. There's also a politics and money section in this week's Dividend Cafe

and then a really wonderful chart of the week from my friends at Strategas Research that give our little bull market checklist, just kind of updating where things stand across about nine different criteria relative to where those things were at the last couple bull market endings. And I think you'll find it very interesting. I'm going to leave it there.

We very much encourage you to reach out with any questions and forward this to anybody you would like. We thank you for listening to the Dividend Cafe podcast. We thank you for the nice little rating and subscription you'll give us now if you're so inclined. And we look forward to coming back to you next week with more of a trip inside the Dividend Cafe. Thank you for listening to the Dividend Cafe, financial food for thought. 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 and 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 and does not constitute investment advice. The team at Hightower should not be in any way liable for Thank you for watching.