The Dividend Cafe - The Economy, Fed, and You - May 27, 2016

Episode Date: May 26, 2016

Dividend Cafe - The Economy, Fed, and You - May 27, 2016

Dear valued clients and friends, welcome to the first ever podcast of our Dividend Cafe Weekly Bulletin. At press time, we're up 330 points on the week in the Dow, and maybe, just maybe, we will see markets end the month of May slightly positive for the month. We're going into a long weekend with a pretty good set of economic data having just come out and more and more questions about what the Fed will do. I will discuss the Fed this week as well as plenty more to chew on, so here we go. A big week up in the market as economic data surprised to the upside. The futures market is now pricing in just a 26% chance of a rate hike next month. It had been a 40% chance last week. So that was a big mover in the markets this

week. Our best guess on what the Fed does from here looks something like this. They seem to be doing what they did with both the last interest rate hike and the ending of QE3. A, hinting it will come sooner than people think. B, not doing it. And then C, doing it the next time, since they gave the markets a chance to absorb. This is not to say they won't raise in June, though we think they will not. And it is not to say they will raise in August, though that't surprise us but this is the pattern we're feeling it's played out with both the one and only rate hike thus far since the financial crisis and

it's played out when they tapered off of QE3 we think that they will telegraph not act and then at the next meeting, act. Number three in our executive summary, it's interesting to note that propane prices have hit a 52-week high, though natural gas liquids like propane and ethane and butane, they certainly don't get as much press coverage as crude oil obviously does. But we bring that up with propane because despite its ferocious rally of weight, it's still down 50% from its 2014 all-time high. And we just think the natural gas liquids are far more important to MLP exposures, oil and gas pipelines, than most realize. Number four, high yield bonds no longer are the attractive value they were a

few months back. Prices have come back to their early 2015 levels, but they are not expensive or at least recklessly priced here either. We're in a sort of high yield purgatory. Structured credit, on the other hand, looks like a decent risk rewardreward tradeoff for those that are investing in bonds. In the news this week, Greece secured a new debt deal on Wednesday. Although details from the Eurozone and International Monetary Fund were hard to come by, creditors described the deal as a breakthrough for Greece. Today, Thursday, presidential candidate Donald Trump gave a speech in North Dakota with significant details around a national energy policy calling for greater liberty for fracking with producers and oil drillers and such. And it's something to keep your eye on in the energy market if indeed Trump

is improving in the polls. With core, the China oil recession and election paradigm that we're using to describe current events, as it pertains to China, we would tell you that the recent dollar rally behind the talk of a Fed rate increase did bring the Chinese yuan down a tad, and the Chinese central bankers reacted as expected by softening their peg to the dollar. It's widely expected that if huge levels of dollar buying take place, China would again step in and alleviate the depreciation to their own currency. step in and alleviate the depreciation to their own currency. But what we want our clients to understand is that through all this rather complex currency talk is that China is short-term adversely affected by a stronger dollar and the Fed's actions have as much an impact on China as

they do domestically. It's the major domino catalyst in whether or not global markets behave short term as risk on or as risk off moving on to oil prices they exceeded 50 per barrel on thursday and there's a hearty debate amongst traders analysts and hedge funds and such as to whether or not 50 will prove to be a new floor for oil prices or a new ceiling. Those who believe OPEC has lost its ability to meaningfully impact the price argue that international players have lost their ability to coordinate with one another, Russia and Saudi Arabia recently, for example. If prices get set by the marginal cost of the least efficient producer,

If prices get set by the marginal cost of the least efficient producer, the oil bears say, well, that would create a lower ceiling for oil prices. That's certainly true enough. And if there's high demand, that wouldn't necessarily be a bad thing for U.S. shale producers. But what we think this thesis lacks the ability to really know is if OPEC and global production coordination really are obsolete. It's a profound enough call that we think time and prudence are required before actually making it. Additionally, one's view on oil prices may be couched in all sorts of rational explanation, but the inerrant unpredictability of supply and demand shifts means the prices are

more likely to be unpredictable than anything else. By way of recession, housing sales figures were strong in April, but we would argue a lot of that could be future sales that were pulled into the present by low interest rates and future higher interest rates. Manufacturing data has softened in recent weeks. However, company plans for capital expenditures, modestly disappointing, but then in the present, strong durables, good orders. So overall, pretty good economic data this week. As far as the election goes, the heat between the Hillary Clinton and Bernie Sanders camps continues to intensify, and it may very well end up being the Democrats, not the Republicans, that have a volatile convention this year. Very few believe

that Clinton's securing of the nomination is actually in doubt, but the low enthusiasm with which she has mathematically achieved this nomination is really unprecedented. A couple questions from readers this week, the first being one that we already addressed. Do you think the market will respond negatively if the Fed raises rates? And we want to point out that a very popular thesis that we're hearing right now is that earlier in the year when markets were sort of revolting after a Fed increase, it may very well have been the Fed's forecast of three or four more rate hikes that was causing the problems, where now a rate hike may be more palatable for markets if it's accompanied by a telegraphing of just one or maybe two more rate hikes. It's an interesting thesis and one we won't really know until the Fed does move higher

off the zero bound. If the Fed does raise rates in June, what will the reason be? Well, the polls are starting to show a much lower chance of a Brexit, the British exit from the Eurozone, happening. And in the short term, a Brexit probably would heighten economic volatility. I still want to remind you that we are fervently in favor of the Brexit from a policy standpoint. But if the Fed is not worried about the Brexit actually happening, that could cause them to act. The China debt crisis fears have subsided from their levels in January dramatically. Oil prices, as we've discussed, are up over 80% from their trough levels earlier this year. Some minor levels of inflationary pressures have picked

up. Ultimately, the reason the Fed wants to be higher is to give them wiggle room for when there's a real recessionary environment. The circumstances listed in this section here, well, they give a little bit of freedom to the Fed to be able to act, but we still suspect it will not prove to be next month. One reader asked, is the main thing you want from your alternatives for hedge funds to outperform, is it an advantage in information? Is that what you're looking for, is hedge funds that have this information advantage? Does their non-correlation to the market come from a sort of insider's access to valuable information type of deal? And we understand that there have been hedge funds in the past whose greatest value was their access to information, their ability to gather information,

including information that was hard to come by and gave them a significant advantage. We call this a knowledge advantage and we believe it's really overrated these days where technology, anti-insider information laws, and just overall democratization of information that feeds financial decisions has taken place. So what we want to see is what we call a judgment advantage where we believe the information may be somewhat level, but the ability of managers to judge the information and act on that judgment is the true source of value-added alpha. That's what we're looking for in the alternative managers that we

utilize. Why does allocating amongst asset classes, including some that have lower returns than others, result in a better return longer term? And this question is really at the heart of what we call modern portfolio theory. And the answer is because of the mathematical benefit of lower drawdowns. Basically, higher returning asset classes incur larger drops in value during bad periods, and so we're more susceptible to prolonged recovery times coming out of bad periods. But asset allocation across a variety of asset classes that helps to mute that volatility will mute the negative period results, not eliminate them, but soften, and then give mathematical support when it is time to recover.

So a series of great questions there. We hope you found those answers helpful. In the deep end of the pool this week, a lot of people are asking us about the home sales figure and many have argued there's still room to go for housing because new home sales levels are so muted compared to other historical periods. It's certainly true that the level of new home sales now is kind of just coming back to normal levels. But the only thing we'd point out is that that is basically a decade after the bubble that they had been in was so abnormal. It was so insane that it really leads to kind of distorted aftermath as well. And we have a chart to this effect on the website in this week's Dividend Cafe. A weekly reinforcement of a permanent principle,

especially for you clients, the fundamental foundation of the relationship we have with clients is based on trust. We seek to continually earn and maintain that integrity by telling the truth and in return ask clients to depend on or rely on us as it pertains to long term outcomes and strategies. We realize the basis on which we ask for your loyalty is not the assertion that we will always be right about a given investment decision, but rather that we will work tirelessly towards achieving the results we've committed to and that we have put your interest above all else. Comments from the bull in us this week. We're very fond of structured credit right here. One can only talk about the areas they like

in stocks for so long, and an asset allocator has to have convictions around fixed income and bonds as well. And we have fears around a lot of the credit markets, maybe more in the intermediate term than the short term. But we frankly think that the floating rate bank loan market is a great example right now of the right combination of circumstances for a buyer. Attractive fundamentals, but weak technicals. The weaker technicals keep prices lower than they otherwise would be, yet good earnings growth and low default rates suggest fundamentals will win out in the end. We like commercial mortgage-backed securities where there's strong demand but limited new issuance.

We wouldn't take anything in the bond world for granted when there's this kind of uncertainty around Fed rate policy. But with relative value hard to find in fixed income, structured credit pockets make sense. In terms of the bear in us, we would still caution against a broad market index, a stock market exposure that is non-selective. It isn't that we think the whole stock market is or isn't about to drop. It's just that we see a very high dispersion of value relative to all different sectors of the market. And we think this will be a challenging environment for the whole market, but with good selectivity, an opportunistic one for active management. There's a chart in the commentary on our website that might be of great interest to you, especially a lot of you parents, regarding the highest level on record of young adults now living at home, meaning it is the most common living arrangement.

That's never taken place. We're up to a full 32% of those 18 to 34 living at home, and we haven't seen that in quite some time. And as a percentage of other options, it's the highest on record. Look at the chart. It may tell you a lot about the present economic environment and frankly, the political environment. We'll leave you this week with a quote from Stephen Hawking,

the greatest enemy of knowledge is not ignorance, but rather the illusion of knowledge. Have a very happy Memorial Day weekend, and we look forward to more Dividend Cafe podcast.