The Dividend Cafe - The Fed, North Korea, and Stuff the Market Cares About

Episode Date: June 15, 2018

This week, David covers what was a busy "big news" week, yet markets barely moved (as of recording time) ..... Topics discussed: Singapore summit w/ North Korea Fed interest rate hike Much more 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. What an interesting, fascinating week it has been. The G7 summit last weekend ending with verbal fights and accusations amongst allies. In Singapore on Tuesday, you saw the dictator of North Korea and the President of the United States meet face-to-face, laying out a rough plan for working together. Wednesday, the Fed raised interest rates and announced plans for more rate hikes. Thursday, the European Central Bank confirmed the end of their quantitative easing, their bond buying program by the end of this year. And yet through all this,

the markets have barely moved a whisker. So in this week's podcast, we're going to kind of unpack why markets haven't really cared about a lot of these rather significant news events and hopefully delve into the things the markets do care about. So here we go. Look, the Fed is not ahead, as was 100% priced into markets ahead of time. The Fed raised rates a quarter point on Wednesday. They telegraphed another two rate hikes this year. The market had already nearly fully priced in one of those two future hikes.

And the futures market right now sits about 50% odds of a second hike in December. And that's the same 50% or so it was at even before the Fed announcement. It's tough to forecast five months in advance. But what we believe at the Bonson Group is not related to what they will or will not do, but rather the fact that whatever they do will be well, well telegraphed to markets plenty in advance. The Fed is forecasting GDP growth that we believe is much lower than it will end up being. And yet ultimately, what markets care about is the pace of their tightening, not the direction of it.

The market is a discounting mechanism, and for markets to be truly disrupted by normalization of monetary policy, it will have to be because the policy gets ahead of the discounting. We watch this vigorously. So as far as the yield curve, the 10-year bond yield has not moved much in months, and yet short-term rates have continued their move higher this entire time. The two-year treasury this week hit 2.56 percent, higher than the 10-year was about a year ago. So that increases the flatness of the yield curve.

And I actually have to say I was intrigued by Chairman Powell, his comments about longer rates, being somewhat confounded by the fact that the term structure is not moving higher, meaning the longer-term rates are not moving higher in concert with the short term rates. The curve is flattening, and it's not just because the short term rates are moving higher. It's because the longer rates are not cooperating by moving higher with them, and that is because the bond market is saying we don't believe that inflation is coming. we don't believe that inflation is coming. The bond market does not believe the Fed will sustain this policy normalization. Well, do we know the bond market is wrong? No. Do we know it's right? No. But I do know this. History has not generally been kind to people betting against the bond

market. If you get healthy, non-inflationary, but productive growth, we not only would expect long-term rates to go higher, we would want it to happen. But while this fight plays out, I would say the Fed is focused on economic models, while the bond market's focused on actors who have skin in the game. And for our money, we continue to believe global conditions and disinflationary forces will not let rates move much higher, certainly not in a secular sense. Why didn't the market respond to the North Korea summit? Even in the height of the tension last summer, the bond spreads in South Korea were tight as can be. In other words, real risk markets were never

anticipating actual day-to-day risk from the North Korea noise. The North Korea risk, nuclear conflict, elevated military action, is what we call a tail risk, meaning it's a very low probability and very high effect type event. Tail risk doesn't get priced in and out of the markets day to day because it's tail risk. The unlikely bad things that could happen come and go, but they never go all the way. So much tail risk persists, and even as this one improves, others remain. The real day-to-day issues of the market remain the continued tug-of-war between a very strong economy and earnings environment, largely brought on by tax reform and deregulation, versus the new monetary landscape of a normalizing Fed.

We do believe the bulls are going to win, but volatility and directionlessness will persist until it doesn't. I would say here's a more important story to be talking about. The Energy Information Administration, the EIA, updated production forecasts for oil and gas this week. Oil, 10.8 million barrels per day in 2018, and 11.8 million barrels per day in 2019, it was 9.4 million barrels last year. So 15% growth year over year, 9.3% growth into next year. And natural gas production continuing to grow as well. And natural gas power plants will be responsible for 34% of electricity generation next year,

more than coal, more than nuclear, more than all the other generators of electricity production. The story for midstream pipeline assets has always been contingent upon these two things. There will be increasing need for the liquids that flow through the pipelines, and there will be increasing production of the liquids that flow through the pipelines. I see this playing out on both fronts right now. How's tax reform going? Year to date, there's been 196 dividend increases in the S&P 500. 996 dividend increases in the S&P 500. Last year at this time, only 167.

Their estimates right now on a global basis are for $1.36 trillion of dividends to be paid this year globally. That's an 8.5% increase year over year. So global dividends rising, U.S. dividends rising, and we think so much of this is related to the positive economic impact and obvious increase in after-tax-free cash flow generated by tax reform. $296 billion of cash, by the way, was repatriated in the first quarter. So early innings of that cash coming back on shore story, and you're already near $300 billion. One of the reasons that we show clients the standard deviation results of their portfolio, the volatility around their portfolio return, not to mention their asset allocation,

the percentages of different asset classes they own, the drawdown, how much downward movement from a peak to a trough they may incur, is that we want our clients to be aware of risk, and we want them to be aware of the emotional realities of what they've been theoretically exposed to. But the fact of the matter is that often returns are generated, and the risks, the potential for downside volatility didn't come to fruition. So it can numb investors or spoil them regarding the reality of said risk. It's difficult to be concerned about risks that don't bite.

So the numbness or complacency builds and then voila, when least expected or prepared, real risks hit. This is something we defend against with podcasts, with Dividend Cafe, with meetings, with communications, with weekly updates. Constant communication, constant truth-telling, constant education. There's no free lunch. Return premiums have a cost. To pretend otherwise is not something we will ever do. Moving to the politics and money beltway bulls and bears section, the president did make some extraordinary headlines last weekend around the G7 talks ending in a big Twitter fight with Canada

and so forth. Look, the market didn't respond, and I guess I'd be lying if I said this didn't surprise me a little bit. But I do want to give just some factoids around the trade relationship with the country of Canada to our north. $341 billion was exported by the U.S. to Canada last year, and we imported from them $333 billion. So the U.S. has a trade surplus with Canada, albeit a small one. And yet, whenever we talk about China, we talk about the trade deficit being the big reason why there's such a problem. So now we're told we have a huge issue with Canada, and yet, actually, Canada has a trade deficit with us. Look, the problem here is not that it is good with China or it's bad with Canada or vice versa. It's just that it strikes us as utterly bizarre to hold out Canada as a national security

threat when you're talking about our trade relationship. The truth is that I suspect most of this is continued negotiating and posturing and that a deal will end up getting struck. But along the way, the importance of understanding the top priority when it comes to trade in a global economy, what markets care about, can't be ignored. We care about more trade, total trade. The more trade, the better in an economy of voluntary exchange. The way in which those trade balances move is not nearly as significant as the fact that there be economic activity, the hallmark of economic growth. Okay, I've already kind of explained why North Korea didn't move markets much.

I have a wonderful chart, by the way, at DividendCafe.com this week explaining why we believe active managers are now due for a run in this different landscape that we face. I encourage you to check that out and what its connection to Federal Reserve balance sheet management might be. So a crazy week, but not so crazy in the markets. Maybe you're enjoying that. Reach out with any questions.

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