The Dividend Cafe - The Fed in a Post-COVID World

Episode Date: August 28, 2020

In this week’s Dividend Cafe we will: • Review the week that was in markets • Really spend the time we need looking at what the Fed has done, will do, and will never, ever do • Provide five key investment implications to the monetary regime we now live in • Do a “Euro”pean history lesson for you, and look at what that means for investors now • Provide an explanation of how business investment works, what the hold-up has been, and why it matters • Politics and Money – a look at this week’s Republican convention • Chart of the Week Let’s jump in, to 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. Well, hello and welcome to this week's Dividend Cafe. This is David Bonson. I'm the Chief Investment Officer and Managing Partner at the Bonson Group. And I have a fun one for us today all you listening to the podcast and those of you watch on the video. I'm hoping both camps here podcast listeners and video watchers are enjoying a better quality sound and look. We have our studio all set up in in the New York office and so it's kind of fun to be able to just hit a button and be able to record and make things so easy and hopefully

higher quality. I can't even count how many different ways I've done this over the last several months. Although I listen to a lot of podcasts, particularly when I'm here in New York City and I'm walking from my apartment to my office and it gives me more time for podcast listening. I hear a ton of people I listen to talk about how they've recorded in their car. I've never done that. So I assume they're in transit and have to record and they pull over and record or something. I don't know. But it feels like I've done it a lot of different ways and I hope this will be a good one. The Dividend Cafe today is I'm going to discipline myself to focus on the two major topics that I have. And that's because both of them are substantial and there's a lot I want

to say about them. And yet there are a number of other topics I could easily kind of go off into. I'm going to avoid all the election oriented stuff and political stuff because we're going to get so deep into that after Labor Day. We have a white paper coming out. The Republican Convention just wrapped up last night. There's more polling that will be coming out. And we're going to do a national video call on Zoom on September 14th at our normal Monday time, which is 11 a.m. Pacific, 2 p.m. Eastern, and we'll unpack all of the political stuff, you know, in that kind of second week of September timeframe going into the middle of the month, which gives two full months before the election to hopefully make some sense of things political.

But the big theme this week, you know, markets up, as I'm sitting here talking right now, about 600 points on the week, pretty low volatility day by day. And you had the Fed announcement from Jackson Hole that they are formally crafting this 2% inflation target that they've had for a number of years around an average 2% inflation. And so there's a lot I want to say about that. And I also, before the Fed kind of events of the week, had already done in my Dividend Cafe preparation a pretty significant amount of stuff about Europe. And I don't really want podcast listeners or video watchers to not get some of the European coverage that I provide at DividendCafe.com, so I'm going to try to cover some of that

too, mostly because I just think it's interesting to kind of go through the history of the Euro and what it means going forward. But really, for everybody listening, I think that there is a lot of practical application around our views of the Fed. And when I talk about the Fed having, I'm holding, by the way, the printed out version of Dividend Cafe this week. You know, not a ton of charts this week, actually. Wow, very few.

I'm pretty proud of that. Sometimes I just get carried away with the charts. But I still, you know, the chart of the week, there is another chart on the economic data. There's some stuff that I really want you to listen to. But I've given up on the believe. I recognize a lot of podcast listeners only listen to podcasts. They're not going to go to the written, and that's all good. Everybody's preferences are what they are. But here's the thing on the Fed that is getting most attention for me right now, and I think has the most significance for you.

The Fed did not do anything or say anything this week that you should interpret as new. They crystallized something that has been the case for a long time. It is not like the Fed saying, hey, we're going to run above 2% inflation to average 2% inflation, it is not like there's been a time where they would have been doing that previously, but because they hadn't yet crystallized this policy, have not. They have not been able to get to 2% inflation, let alone run above 2% to average it. So there has been no practical difference in the last, let's call it 12 years, post-financial crisis realm of monetary policy from what they're doing now. I have read so much commentary in the last 24 hours from rather melodramatic economists about this paradigm shift and the Fed taking a bold stance into the future and all these things.

Well, if you did not know before yesterday that the Fed was willing to create inflation or wanting to create inflation as a counteract to disinflation, then I cannot help you. And I'm talking to economists and people that are supposed to know about this stuff. This is the most vanilla statement about monetary policy and the central command of the economy that I could possibly offer in the last 12 years and probably longer. The Fed is in a very difficult position. I do not blame the central bank for this. The Fed is left with an excessive amount of debt in the economy. Then the realities of the debt, the future growth that has been brought into the present by that debt

requires them to do things to counteract the impact of that. Lower rates, more liquidity, more credit, more stimulus. The results of that more credit, more stimulus, lower rates is more of this future growth being brought into the present. When it's government borrowing, it will be unproductive debt. And when it is private sector borrowing, it might be productive debt and it might be reckless debt. And the point is it's distorted by the Federal Reserve activities. But this is the thing. Inflation is 500 years of a policy of how to deal with excessive debt. If you just forget politics, forget history, forget governments, make this as simple as could be. forget governments, make this as simple as could be.

If you could borrow $100 from somebody and pay them back with something worth $50, wouldn't you love to do that? The issue is that generally the person you're paying back wants to be paid back with something equal to what they loaned you. back wants to be paid back with something equal to what they loaned you. With inflation, you take away the ability for the borrower to have any say in that. You were lent $100 because the bill said $100 on it, and you're going to get paid back with a bill that

says $100 on it. And if that, via the mechanism of inflation, means that 100 is worth less over time, sorry. Okay? That's why inflation exists, to deflate the burden of debt. And the reality is that the Federal Reserve did not create the debt. And I'm not even really, by the way, see in the Diven Cafe, I flat out said I'm going to veer into a little section here of me telling you what I personally believe, not just kind of how we manage it, practically speaking. So I should give you that warning now. What I'm saying right now is my personal opinion on what ought to be the case.

It's irrelevant to how I manage money because I have to manage money on what is and what I believe is going to be, not what I would do if they made me king for a day. However, I believe that most inflation comes about because of the people. The citizens of a given state want certain things, the politicians deliver it, and then it needs to try to be inflated away over time. You can always test my theory about humans' appetite for inflation. They go, we don't want inflation. It's not fair an ice cream cone costs more than it did for my grandparents. It's not fair that my kid's college education is so preposterously overpriced. Don't even get me started on that one right now. It's not right that these vacations keep going higher, hotel costs

keep going higher, you know, so forth and so on. But you can always test someone's appetite for inflation. I learned this from Milton Friedman when asked them about their house price. Do they want house price inflation in their house price or not? See, we have pretty much codified into the national ethos the cult of rising housing prices. I've written a book on it. The financial crisis largely took place around that. There's a lot of other factors that played in, obviously. So inflation becomes something that's very selectively hated or not hated. And then you get the politicos that deliver the policies that create inflation, and you get the Federal Reserve that says, okay, what are we going to do here?

But the whole point now to get back to economics and back to portfolio management is the Fed's desire to use inflation in the way I've kind of outlined here today doesn't mean that they have the ability to do it. The problem is the Fed can, through monetary policy, create a lot of reserves that go to the banks and sit in the financial machinery. And they work their way into securities markets. They work their way into credit markets.

They work their way into asset prices, risk assets. But in order to create inflation in the economy, banks have to take those reserves and lend them out. to take those reserves and lend them out. And then the people who receive the loans deposit them for the use of the loan in their business or personal use. And then those new deposits go into the bank and get lent out again. And then that becomes inflationary

as you get that velocity, that turn on the money. Lending dollars becoming deposit dollars that then become lending dollars. This is the cycle of inflation. And the Fed has nothing to do with any part of that other than initially creating that money supply. Well, what generates the demand for loans? It's not the Fed. It's organic. It's the economy. It's businesses and individuals that are wanting to borrow more money. And in order to want to borrow more money, they have to believe they can pay it back. So there has to be uses of debt that are productive. Okay. This to me is the entire issue we're dealing with. The Fed can't create the inflation they set out to create,

yet they've made very clear they're going to try. So I am a professional investment manager responsible at this point in time for hundreds of households and $2.5 billion of client capital. And I hear a Fed saying, we're going to run even hotter than we said. We want to work even harder to create inflation. And I see interest rates at 0% on the lower bound and pretty much 0% on the higher bound, right? I mean, really, even at a 10-year treasury at 0.5%, 0.6%. And I say, what does this mean for what I'm going to do for my clients whom I love, that I'm responsible for the fiduciary and fiscal manager of their affairs. So what I've done in Diving Cafe today is suggest to you five practical takeaways for the monetary regime in which we are living.

First of all, if you believe that the Fed's going to be successful in creating consumer price inflation, I heartily suggest that you be invested in things that have pricing power, that have the ability to pass on the impact of that inflation to their consumers so that their profit margins are not stunted by the impact of inflation. The great examples here, I won't get into specific names right now, but are generally consumer staple type companies. As the price of cheeseburgers, as the price of coffee, as the price of laundry detergent goes higher, that's consumers paying it, not the underlying maker who is dealing with the reality of inflation in the society. the reality of inflation in the society. Beyond that, I will say to what affects essentially trillions of dollars of investors and maybe 20 percent up to 60 percent of many, many,

many client portfolios is your bond allocations have got to be completely rethought. The Bonson Group is right now in the final month of what has been a since COVID process. We began this intellectual journey in March. We intend to unleash it in October. And one of the great implications of this sort of portfolio reconstruction is separating as entirely different asset classes, bonds that act like bonds and credit. Why? Because what is generated return for bonds that act like bonds is the coupon of the underlying bond, which is now at zero, or the lowering of the interest rate, which gives a price appreciation to the bond,

which now the interest rate being at zero means it can't go lower. appreciation to the bond, which now the interest rate being at zero means it can't go lower. Then the other component of credit is risk. It spreads. It's pro-cyclical. It is not the inflation hedge that, excuse me, it is not the risk hedge that so many expect and want. hedge that so many expect and want. And so I really do believe that credit is so risk reward, both in where it gets its risk and where it will get its reward. So now categorically different from bonds, athletic bonds, we're separating out the asset class. Cash, money market, CDs, treasuries will have a negative real rate of return. What I mean is whatever the rate of return is, which is going to be very, very close to zero,

minus the impact of inflation, that real rate will be negative. And I think it's going to be such for a long time. Therefore, we have to think differently about how we are constructing bond portfolios. But then beyond bond portfolios, you have to think about your usage of bond portfolios, not just what their composition is going to be, but what their actual application will be. Because traditionally you want bonds as a diversifier to equities, as a mitigator of risk. bonds as a diversifier to equities, as a mitigator of risk. And I believe that you cannot build what is essentially going to be an equity-centric portfolio. We're dividend growth investors. That's the core centerpiece of our client portfolio solution. And then we want to mitigate

risk around it, diversify risk around it. And that bonds that act like bonds are not going to do it the same way, which leads to an increased need either for credit, which can become very highly correlated to equities at times, or for alternatives. This is the great burden that I think investors have for the next 10 years. They're so used to thinking of alternatives as either an equity amplifier or an equity diversifier. And they have to understand that using alternatives as an almost bond replacement is going to become a very, very important part of an asset allocation going forward. Okay, recapping real quick, I'm sorry. Pricing power would be important in how you look at equities. Bonds act like bonds and credit have to become two different asset classes because of the impact of what all this means to the bond market.

Asset price inflation and consumer price inflation would be two different things. The Fed can control asset price inflation. It cannot control consumer price inflation. It can control asset price inflation. It cannot control consumer price inflation. And then I talked about diversifier coming from alternatives versus the traditional use of bonds. And then finally, high dollar-denominated debt and a strong U.S. dollar with a U.S. central bank that has been relatively tighter than other emerging market central banks or especially other developed market central banks. All of those things have been a headwind

for emerging markets for at least six, seven years. As those circumstances are all changing or have changed, they become a tailwind, or at least that's our outlook. They become a tailwind to emerging markets. And I believe that that is the regime we're living through now. I could come up with 10 or 15 investment implications. I'm starting with these basic five categories. They're all restated for you at dividendcafe.com. So that's our view on what the Fed's doing, what the Fed's not doing, what the Fed wants to do, what the Fed can't do,

and how we have to think about it going forward. I think it's a lot, but I hope it's useful. As far as the European history side of things, I will go back on my promise and ask you to go to dividendcafe.com to get the broader story of it all. The bottom line is that the euro came into effect in 1999. And and I think it is utterly fascinating that a dollar 18 exchange rate that's more or less where we started at. OK, now we the exchange rate came way below the dollar.

It got down to parity and then got to 81 cents to the dollar, which is all-time low in late 2001. And then you saw a violent bounce in the euro, and the euro almost doubled. I believe the all-time high was about $1.59. And we right now sit at $1.18. In 21 years, since the beginning of the euro, we've gone full circle. And the dollar and the euro are trading at the exact same exchange rate as they were 1999

when it started, with a lot of movement around and a lot of geopolitical reasons for that and post-crisis reasons for that, and as is the case with so much of what I'm talking about, the major factors that have affected the movement of the euro since the financial crisis are debt-related. So now we sit here and are in a quandary where the European Central Bank has said that they're all in, they'll do whatever it takes to protect the euro, that they're all in, they'll do whatever it takes to protect the euro, and investors have to figure out what that means to the varying European economies. So read that little history, and I

think from an economic standpoint, you'll understand why we have the application that we do about it all. So market's up a bit on the week. I'm really interested in where CapEx goes. Like most people, I'm reasonably surprised that not just markets have done as well as they've done through the COVID moment, but that the economic data, there are numbers one could look to that are a tragedy. And as I've said, they really are very limited in the scope of who they're hurting. And that is a big deal. That is a big deal as a human being. It's a big deal socially, big deal culturally. And the economic impact is clearly not as broad as if it were affecting multiple deciles of wage earners and of economic actors.

I would have expected, though, that even with that limited impact, primarily in the hospitality sector of lower wage employees that have been really, really thrown out here in this COVID situation, I would have thought that there would be a bigger impact to CapEx industrial production because of just this overall business confidence issue, holding back business investment. And that is still a real risk. That's not something I want to take any victory lap on yet as we come to the end of Q3 and then go into Q4. But I will say the data we see so far is encouraging. And there's some charts to that effect at dividendcafe.com.

Finally, the charts of the week. You just have to go see what's going on in this market right now. As we talk about the market being at a new high, the market recovering, all true as certain things go. the market recovering all true as certain things go but when you see the difference between the top five companies in the S&P 500 and the bottom 495 companies and the percentage delta in return between five companies and 495 it puts so many things into perspective not just about what's happened but the way people really need to prudently think about where we're going from here

so I will leave it there I really appreciate you listening to Diving Cafe on the podcast, watching the video I would love for you to rate us, subscribe rather than just listen in your in the website or manually if you

somehow get it automatically to feed to you from your player of choice, that helps us. And obviously we appreciate any reviews you would like to give. If you send us a review of Divin Cafe that you post at any of the Apple iTunes or Spotify or Google or whatever it is, then we will send you a complimentary copy of any one of my three books.

You can pick which one. But with that said, thank you very much. Enjoy your weekends. And we'll come back to you next week with yet another Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities Thank you. statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal

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