The Dividend Cafe - The DC Today - Monday, October 2, 2023

Episode Date: October 2, 2023

Today's Post - https://bahnsen.co/3F3CrAp Ask David “A couple weeks ago in your ‘What to Look for in an Advisor‘ Dividend Cafe, you pointed out that most advisors outsource portfolio management and asset allocation, and you expressed your disagreement with that trend. I agree with you, but I was wondering if you could unpack the specific reasons for why you disagree with outsourcing the investment process and why there is merit in direct portfolio management by advisors.” ~ Nathan I really don’t feel strongly that most advisors should be managing capital directly, and in fact, for a significant amount of advisors I have met, considering their work ethic and intellectual capacity, I am glad they don’t. But I do feel that TBG should because we consider it our calling, part of our authentic skill set, and a huge part of our value proposition. What I believe is more universal, though, is that all advisors should have some baseline competence in capital markets, even if they do not practice security selection or portfolio management directly. And that they should be accountable for who they outsource to and not use third-party partners as mitigation of their own decision-making. Links mentioned in this episode: TheDCToday.com DividendCafe.com TheBahnsenGroup.com

Welcome to the DC Today, your daily market synopsis of the Dividend Cafe, brought to you every Monday through Thursday to bring you up-to-date information and perspective on financial markets. Well, hello and welcome to the special Monday edition of the DC Today. We are officially into the fourth quarter. For a while today, it just felt like things were picking right back up where they left off in the third quarter. What's kind of interesting is the third quarter, it wasn't as bad as it sort of feels because September was pretty bad for broad market results. But we forget that July had actually been up quite a bit and August was down a little. So it definitely got a lot worse for some of the junkier stuff. Energy did real well in the quarter. And there were a few other things that hung in there in the financial side. For clients, I'm going to do a video in the normal weekly bulletin that will come out Wednesday,

summarizing our specific activity, going through actual positions and portfolios and things. But just at a broader level, I think everyone knows it ended up being a very challenging month for risk assets. But again, the real story isn't on the stock market side. And I say that partially because I just expect that stock market investors understand that type of volatility is extremely common. What's rare is when it doesn't happen. But the bond side just got walloped. And so when you have a kind of 60-40 type portfolio and the 40 side is not offsetting the 60 side, it tends to exacerbate the pain. That was largely the story of 2022.

Now, of course, yields going from 1 to 5 has a lot more pain than yields going from 4.5 to 5 or 4 to 4.5 or what have you. So, yes, bonds were down in September as global bond yields have all moved to the upside, particularly on the longer end of the curve, which is what I'm about to talk about here in a moment. But the math of it is very different because you just simply don't have the same movement higher as a percentage in yields, which of course brings prices down inversely. All right. So let me kind of get into it because I do want to talk about the shutdown that wasn't in some of the other things over the weekend. The DCtoday.com today is a very long one just because it was one of those weekends where I had travel, I had time to myself, and what do normal people do to fill their weekend time? But, right, DC Today. So that's what I did.

There's a lot there. So futures last night actually opened up 120 points, I think that it largely was related to some belief that there'd be market relief in the shutdown being averted, as we're about to talk about from Saturday's news headlines. And I think by the time I went to bed last night, futures were up 160 or 170. And then this morning, very early, futures were down already. So whatever hope there was of some shutdown aversion story went away. But the market opened down 70 points and it closed down 70 points. But it got down 300 in between and then really kind of in the second half of the day sort of rallied back. And even with that said, that's with the S&P being dead flat on the day. I mean,

totally, completely flat. And then the NASDAQ was actually up 67 bps. And so it was a very mixed day. You know, just to give you an example, let me see here. The communication services were up almost one and a half percent. But utilities, which again is one of the lowest weighted sectors in the S&P, but utilities were down 4.72% today. I mean, that's one of the worst days I've ever seen in the sector. And it was the worst day since I think June of 2022. But it also comes off of a week like last week where utilities were down 7% on the week. So utilities being a more bond proxy-like equity sector are getting hammered as yields are going higher. And if one didn't care about timing, which I don't know why one would, and one believed that there is some point here at which these yields begin to reverse,

there's probably significant opportunity in utilities. What keeps people, including very smart money or fast money, from taking that trade? Because they don't know when the top on bond yields is found, and they don't know when the reversal of bond yields will come and will play out. So it isn't necessarily a trade. It isn't necessarily something that can be done without regard for patience. Luckily, patience is a virtue at the Monson Group. All right, what do I want to go through here today? So the 10-year today closed at 4.69%, highest in a very long time. That was up 12 bps today.

So this violent move higher in global bond yields continues on the long end of the curve. So I'm going to end up spending most of our time here on the podcast talking about that. I'm going to suggest four or five reasons, five reasons. And I think they're kind of in order of magnitude, but I don't know that for sure. This is my subjective assessment. I am very convinced that the biggest factor is the quantitative tightening chickens coming home to roost, very much taking a toll on the long end of the curve. In the past, you had three major rounds of quantitative easing after the financial crisis. And all three times when the easing ended, bond yields that you would expect would have gone back higher came lower. And there's a contrarian reality to that I've explained before. Same thing happened here as

the quantitative tightening picked up. Yields did not initially go higher. They came lower, they consolidated. But at this point right now, I am convinced that they got a trillion dollars off of their balance sheet at the Fed pretty easily and that they will not get another trillion off very easily. And that's what you're seeing right now is some of the support that had existed in the market as the Fed would roll over maturities. It wasn't full-blown yield curve control like you see in Japan, but it was some form of a twist of their own duration, okay, What they were wanting to see happen in the duration of their balance sheet. And it was

used, especially back in the Bernanke days, to the benefit of the long end of the curve to hold those longer yields down. And as they have released some of that support. Things have reversed quite a bit. And so I suspect that will hasten the moment at which quantitative tightening pauses and perhaps even reverses back into quantitative easing, which is actually my real prediction, but I'm staying humble. The second is obviously a surprise addition, the budget deficit. Markets price in what they know. So you could say if you know

there's going to be a $3 trillion deficit, bonds price that in. And yet if you believe there'll be a $1.5 trillion deficit, it ends up being two. Two may be a lot less than three, but it's the surprise factor. And the fact that tax revenues and tax receipts and the overall rollout here of this fiscal year budget, there's absolutely no question that has resulted in a greater issuance, which has pushed yields higher. It is not, though, the same as just because we're running high deficits. Because remember, bond yields were incredibly low, lowest in history, for the 10 years where they were running the biggest deficits in history. So I can't stand seeing people almost purposely twist this narrative.

The issue is not the news. It is the delta between the news and the expectation. Number three, the U.S. did not go into a recession yet, as so many had predicted. Bond yields collapse in a recession. Bond yields are also financial market mechanisms. They're pricing in ahead of time, some form of expectation. There had been an expectation of a recession coming. That has alleviated to some degree. Perhaps it comes back, and if so, it will most certainly violently reverse bond yields. But right now you do have the double whammy, which we're already up to a triple at this point, between quantitative tightening, higher-than-expected budget deficits, lower-than-expected recession odds.

All of those things put upward pressure on bond yields. Then fourth and fifth, you know what, I have six here. You know I don't see well, so I'm trying to keep up my own bullet points. You're talking about Japan alleviating its own yield curve control to some degree. Now, what are we referring to? A 50 basis point, half of 1% cap. What they wanted their 10-year at, they had moved up to 1%. So obviously, it's a very insignificant amount and a real low absolute yield, but it was the direction, the directional movement with Japan pushing that yield higher, albeit at a very, very low level, was a factor

in all global bond yields as a reference moving. But then I think the fifth factor that I want to mention, which may belong even higher in the list, is declining Chinese exports. What does Chinese economic weakness have to do with our treasury yield? Well, a lot. Because what does China do when they export? They get paid in dollars. And what does China do with the dollars? They get paid in dollars. And what does China do with the dollars?

They often buy treasuries. So less exports from China to the U.S. equals less dollars repatriating into our shores. This is an inconvenient economic fact for 20 plus years. And it is largely the result of Chinese economic weakness right now resulting in fewer exports. And then finally is something called the basis trade. It is more confusing, but it is a big deal where hedge funds are attempting to sell short treasury in the futures market and buy the same treasury long in the cash market, where they find a very tiny amount of inefficiency between the pricing of treasuries in futures and cash. And it was a big deal going into COVID. A lot of that volume had ramped back up. And I think that pair trade has effectively

hurt as repo market activity is declining. As that unwinds, it puts upward pressure on bond yields. There's six reasons right there as to why I believe bond yields have gone higher. You say, well, Dave, you mentioned inflation. Well, that's right. Inflation has done nothing but go lower. The PCE on Friday was lower than expected. You have right now an inflation rate. Someone can argue if they think it's 2%, 3%, or 4%. Let's say it's somewhere in the 3s. It's nowhere near when it was in the 7s, 8s, and 9s, and bond yields are much higher now than they were then. So I don't know how it can be more obvious that the bond yield action is not related to inflation.

And of course, we don't have to take my word for it because we can go to real financial markets and look at the inflation expectations priced in the TIP market. TIP spreads, Treasury Inflation Protected Securities that are literally priced in, basically pricing in what the inflation rate they expect to be. And the price of those bonds implies an inflation expectation. That's what real people are getting paid for in terms of real yields around future inflation. That's sitting at around 2.5%, not 4.5%, 4.7%, et cetera. The bulk of the movement, maybe about 30 basis points has had to do with higher inflation expectations, not 200 basis points. I got to start skipping over some stuff, which first of

all, hopefully pushes you to the DC today, but also saves you the agonizing time of having to listen to this. And for you poor video watchers, look at me. I did mention in Friday's Dividend Cafe and Long-Term Capital Management implosion that there was this sense in which that giant hedge fund back in 1998, there were a lot of smaller funds that were mimicking their trades. And so then you get weakness, you get distress, and that forces their prices to be marked down. But then their weakness and markdown prices force others to have to sell. And as those smaller players are having forced liquidation, as they're getting margin called out, then that puts more downward pressure on the marked prices for long term capital. And it was this kind of spiraling drain effect. Now, I was thinking about this over

the weekend. Long term capital management had something in the range of $125 billion at its levered total self of assets. And at the time, J.P. Morgan had like $250 billion of assets. So that's how large that hedge fund was compared to this major global investment bank. It was about half of the size of their assets. Right now, J.P. Morgan has like $3.9 trillion of assets. has like $3.9 trillion of assets. So you've seen these large commercial behemoths go up 10x or more than 10x in the last 25 years. And so I don't think that the hedge fund size and magnitude relative to the whole financial system can compare to long-term capital. But I most certainly do believe that crowding out effect is still a very big deal where trades just get crowded. And then you get forced selling because

there are leverage players. I referred to the month of March of 2020 many times as a national margin call, that you had a lot of these pair trades, relative value trades, global macro, where everybody was kind of lined up on one side. And when something gets over levered and has to face forced liquidation, more players follow. I think that dynamic is still very real. But I wanted to draw those contrasts between the state of financial markets now versus 1998. All right.

So Dianne Feinstein passed away, a senator here in the state of California, age of 90, Friday morning. Governor Newsom has announced LaFonza Butler to be the interim replacement. A funky thing in California, the way this will work, because that seat was actually up at the end of the 24 year, and then a new senator would go in in January 25. So they're actually doing two elections at once for this seat. The interim stays there at the governor's appointment from now, which is what, October. So you have 13 months. Then in November of 24, there'll be a special election for that person to finish the seat, the term, but the term is only two more months. It will just be November to January.

And then there will also be the normal election there would have been for that seat, which presumably would be the same person that the voters elect for that special two-month period. You follow me? And very likely California will end up being two Democrats running against each other because California has what's called a jungle primary where the top two vote-getters in the primary run against each other in the general. So you have an interim candidate now that Governor Newsom has appointed, doesn't require any approval, that will go in for the next 13 months. Then you have a special election for someone who will run for two months, and then very likely the same person will end up running then a six-year term after that. But Senator Feinstein's activity in various committees and so forth was so diminished recently around her health and age and whatnot

that there isn't a big market issue here. But one thing I want to bring up on the public policy side before we get to the shutdown on the market side is spring court new terms started today. And I'm no friend of the Consumer Financial Protection Bureau. The constitutionality of the way the Bureau has been funded, this is an old Obama administration issue. I will be surprised if the Supreme Court rules that the Bureau is structured constitutionally. I think it kind of clearly is not. And they may very well provide relief as to how that is to get rectified. But it is possible they will rule that everything the Bureau has done in recent years, all actions they've taken are null and void, are mitigated

because of the illegality or potential unconstitutionality of their funding. That could have some interesting market and economic impacts to some of the things that they've done, particularly in the financial system, more around consumer finance. So I'm watching that closely. I would say that I think it's 80%, 90% that they'll rule the Bureau is unconstitutionally funded,

but maybe only 40% that they will mitigate, that they will strike down past rulings and activities they've done. We'll see. So as quickly as I can, because most of the story is so utterly embarrassing to me, I don't want to spend a ton of time with it. But basically, Speaker McCarthy had a bill ready to go that would cut spending 8%. If you got a majority of the House, it would go to the Senate as is. And then the Senate would not accept it that way, but they'd start to poke down on it. And you'd end up with some form of spending reductions.

And that would avoid a continuing resolution to fund government. It would be a real bill. Everyone could go on. avoid a continuing resolution to fund government. It would be a real bill. Everyone could go on. But as we know, anywhere from four or five up to 10 particular people, it was not everyone in the House Freedom Caucus, but it's a certain number of them were just striking down anything McCarthy was doing. And so then what he had to do to get the votes is go to the Democrats with a bill that would not cut any spending, not increase. It didn't have Ukraine funding in there. There was a few things just to get another 45-day continuing resolution. And then that overwhelmingly passed.

And then the Senate, of course, passed it. So the government did not shut down. And he went a path that very, very few expected he would go. And it was politically dangerous for him, but politically quite smart to get it done. There was no way at that point the Democrats were going to be in a position to vote no on it. Now, Matt Gaetz is a congressman in the state of Florida, is saying he will process a motion to vacate that would at least put Speaker McCarthy's speakership up for grabs again. There's a lot of political handball as to what is going to happen with that.

So I can't make a prediction right now. My prediction is that Speaker McCarthy will survive for a little while. Another 45 days, I don't know. But in this week and in the weeks ahead, I don't think he has the votes. But there's so many moving parts and horse trading going on. I don't want to get into the weeds of it, but it's obviously going to be a market story and we'll see what happens. ISA manufacturing rose to 49 on the month. It had been 47 and a half last month. But remember, anything below 50 is still contraction.

So for what is I think the 11th month in a row, yes, 11th month in a row, U.S. manufacturing contracted, but it contracted a lot less last month than it had been. New orders actually were at their best level in over a year, but still nevertheless negative. There's now 25,000 UAW workers on strike. That's 17% of the membership of the union. And then Apartment List published their September report. Rents were down half a percent nationwide on the month and are down 1.2% year over year. 85 out of 100 cities in the survey saw a decline on the month. 71 out of 100 cities saw a decline on the year, year over year, trailing 12-month period.

So remember, the inflation data is quantifying in 34% of the CPI number that is up 7.5%. But the real number we're getting from real market current indicators is down 1-2%. I've talked about enough vacancies, by the way, at apartments where vacancies were up for the 23rd month in a row. I'm going to leave it alone there. I really do hope you'll go to DC Today for a chart we have about coal demand that I think is quite fascinating. I pulled out of a Bloomberg piece I read this morning just showing the collapse of demand and need for coal in the U.S. and even Europe, but how it is just inversely increased in China, India, so that total global use of coal isn't going down at all. U.S. and Europe lower, China, India higher. And there's sort of a principle

there around WTI crude I think is worthwhile. Speaking of which, crude was down 2% on the day but still hanging around there. It's technically right about $89, so right around that $90 mark. By the way, last week with that market sell-off, utilities, as I mentioned, were way down. MLPs were up yet again. They were down today, but midstream energy, including the upstream, by the way, last week, have all been kind of counter cyclical to the current market condition. Against doomsdayism and an Ask David question are in the written DC today.

I'm going to leave it alone there. I've gone on long enough, but it was a special Monday edition. I'll be back with you tomorrow on Tuesday and welcome your questions at thebonsongroup.com anytime. Thanks for listening. Thanks for watching. And thank you for reading the DC today. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory Thank you. The Bonson Group and Hightower shall not in any way be liable for claims and make no expressed 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.

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