The Dividend Cafe - The Fed Talks My Book

Episode Date: December 17, 2021

Markets followed up their monstrous week by dropping a bit to start this week, then rallying back to even mid-week, to sit somewhere between flat on the week and down ~100 points or so as I prepare to go to press. The Nasdaq, though, didn’t fare so well on the week, dropping -600 points (-4%) as of press time and warranting a distinction in this week’s Dividend Cafe on how one may want to think about their assets in the Fed regime ahead. This one week aside, and the never-ending obsession with the Federal Reserve well-baked into our societal financial fabric, there is a lot to say about a changing of the guard at the Fed, and this week’s Dividend Cafe is devoted to just that. Some things are, no doubt, changing, but other things, as you will soon see, are not changing at all. Understanding all this may be the best Christmas gift I can offer you this glorious holiday season. Slide down the chimney into this week’s 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 another Dividend Cafe. And I guess, to be honest, I'm pretty sure this will be the last one we do in 2021 because I'm not going to do one next week as it is Christmas weekend and then the following week I'm going to be off and working on the annual white paper which will summarize the whole year in review of 2021 and provide all of our forecast for 2022 and yet because the year doesn't actually end until after that Friday, and then we have the New Year's weekend and that Monday, the market and the world reopen as 2022 New Year, January 3rd, the way the calendar flies that Friday, I won't be doing a year in review

version yet because the year won't be done and I want all the final data. So unless something comes up, I would assume this is the last dividend cafe. We will be doing a DC today on Monday, this coming Monday, the 20th. We have the holiday week and then that final week between both holiday remnant and just not wanting to do it. And then, of course, this white paper preparation, which is rather substantial, to be honest. That's kind of how the calendar and schedule and priorities have come together for the end of this year. But this Dividend Cafe today is actually not focused on year end per se, or there's no special holiday theme or

you know end of the year thing or blah blah blah um i want to talk about the thing that is by far the most uh in the news this week probably by far the most in the news by news i mean financial news specifically most of the year um and that is the Fed. And it is hardly something that I avoid talking about. It's a very, very prominent subject of my attention or my studies. And part of our formation of client portfolios centers around a lot of our view of the Fed, both past, present, and future. And so I do think that there is some benefit into me kind of providing a little commentary on what took place this week and what we see coming in the months, more importantly, the years ahead, and applying that to the present

state of affairs for investors. And I hope this is something you'll listen to. As I always say, I'm generally recording this podcast and video somewhere between 15 minutes and four hours after I finish the writing of the Dividend Cafe. hoarding. And I always do recommend that people, even those who are really rigorous listeners of the podcast, and we certainly appreciate all of you and are grateful for our explosion in traffic in our podcast medium. And those of you who watch the video, same thing, very grateful for you. We've also had a big percentage increase in the video medium as well. And yet, you know, there is a part of me that just is such a fan of the written word and the charts that can go there with that. I always like to say to video watchers and podcast listeners that I recommend you go to dividendcafe.com. In this particular case this week, which is the norm, I probably won't be covering right now everything I do in the written version, but is the norm, I probably won't be covering right now everything

I do in the written version, but maybe I will because I don't remember every single thing I wrote four hours ago, whatever it was when I submitted it. I do know this, though. The Fed this week did exactly what everybody in the world knew they were going to do, exactly what everybody in the world knew they were going to do. And the market rallied hundreds of points in the immediate aftermath. And so there are a lot of people saying, I don't get it. The Fed is raising. They announced they're probably going to be raising rates three times next year. And they announced that instead of tapering, going to the end of June, they're going to cut it off by the end of March or early April, wouldn't the market have responded negatively? And of course, the answer there is universally true about all things that are news inputs to market pricing, which is that markets are discounting mechanisms. And so news only moves

markets if market hadn't already priced in news. But in this particular case with the Fed, there is an aggressive amount of front running, an aggressive amount of financial actors pricing in what they expect is going to be coming. And in the case of the Fed, they just happen to have one of the most unsurprising actors on the planet. In other words, you have very little risk of getting it wrong when you're trying to discount these things in ahead of time because the Fed spends months and months and months telling you what you're trying to discount these things in ahead of time because the Fed spends months and months and months telling you what they're going to do and what they're going to say. And so this is the world that we're in and this is the world we've been in for a long time.

A significant amount of investing right now has nothing to do with the organic financial activity that comes out of the environment we're in, out of company innovation, and out of even the landscape and economic results that come from a Fed, they have to do what people are trying to front run the Fed and guess ahead of time what they're going to be doing. The things I would say to you are that one of the reasons the market went higher this week in the immediate aftermath of the Fed is because the market doesn't believe the Fed is going to raise rates six times over the next two years. Now, that part may not be true. That part may be believable enough. But then immediately after that, and I put the chart in Dividend Cafe, the disconnect between what the federal funds futures market, people that are betting forward contracts in the futures market on future levels, depending on lower rates than what the Fed is showing you and what

they call their dot plot and what the Fed is anticipating. But this has been the case forever. And the Fed's own dot plot has proven to be above what yields actually ended up being for every period since the financial crisis. And the Fed futures market has proven to be a far more predictive tool than the Fed's own forecast of what the Fed themselves is going to do. Well, what does that tell you? You know, the thing they say about certain spouses and the way some parents are with their kids, sometimes you can know somebody maybe better than they know themselves. And I think the market does know the Fed better than the Fed knows itself. And it's not because I'm saying that the Fed is lying. It's because I'm saying the Fed can have these intentions right now, but the Fed has a way

of being taken off of their best intentions by various events that have an incredible influence in the way they think about things. So on one hand, we do have a disconnect between what could happen with interest rates in the future, what the market's saying. But we also just simply have the reality that the Fed has a $9 trillion balance sheet right now, and they entered COVID with a $4 trillion balance sheet. And now there are about $2 trillion of what's called reverse repo agreements. And it's fair for our purposes to take that off of the calculation, because this is essentially money in, money out that kind of washes itself out in these repurchase agreements with people that for whatever reason need to get cash or hold cash. It goes back and forth. It's very complicated. And all I want to

get to is that with 2 trillion reverse RPs for now, we're going to pretend that the real number that they would like to get to is about 66 trillion. And so that would mean that's $4 trillion that they had before COVID and $2 trillion in reverse repos. And they're at $9 trillion. So to get from $9 trillion to $6 trillion, they would have to take about $3 trillion off their balance sheet. The Fed is not talking right now about tightening at all. They're not. In other words, tapering means that they will slow down the pace at which they're adding to the balance sheet every month. And that'll kind of wrap up by the end of March. And as I've said many times, I would have been perfectly fine if they didn't taper at all, if they just stopped, just stopped quantitative

easing right now. So they're slowing it down a little bit and then they accelerated the pace of that slowdown. And then I'm of the opinion that the time is coming where they will need to actually quantitatively tighten, which means not buying bonds doesn't do you any good. It holds you in place. But to reduce down to a state of balance sheet that is more in line with where they want to be for a number of policy objectives, they're going to have to do quite a state of balance sheet that is more in line with where they want to be for a number of policy objectives, they're going to have to do quite a bit of tightening. Well, what happened in 2018, last time they did that tightening? First of all, they started the tightening in 2017 and nothing happened.

And it was the lowest volatility year in the history of the stock market and one of the highest performing years. Capital markets are working. Economic growth had a great year. So all those things were kind of humming along. And then in 18, they accelerated the level at which they were increasing interest rates while they were modestly tightening, while they were reducing the size of the balance sheet. And the markets threw up. And I've talked about this a lot. I don't think it was the stock market. The stock market dropped to 1.19.8% in the fourth quarter

of 2018. I remember it very well. It had a huge role on my Christmas Eve that year. Markets kind of recovered a bit in the very final couple of days of that year, but it was it was not good for the stock market. But no, what caused J-PAL a couple of days later in 2019 to say, we're done quantitatively tightening and we're done hiking interest rates. And in fact, we're going to start cutting interest rates, which they did throughout 2019, and it created a gangbuster year in financial markets. As you have the two headed monster of the trade war kind of subsiding and the Fed becoming an accomplice to markets, what happened at Spook J-PAL was credit markets tightening up.

And for a while, they weren't. But then when you got the dual policy activity of rising rates and quantitative tightening, all of a sudden, it became very hard for corporate America to roll over debt for high yield for a lot of credit sensitive sectors of the market. And this is a very, very financially levered economy. And so this had profound impact into small business, midsize business, commercial real estate, residential real estate. And that degree of credit markets seizing up is kind of the one thing like the central bank just can't allow to happen. So they reverse course. How do we reconcile these things with the Fed dealing with the trauma of what

happened in 2018 and then now them needing to maybe revisit a similar looking policy prescription. My own belief is that they will get rates up to where they're comfortably off of the zero bound. So that could be six increases in two years and they could end up at 150 basis point Fed funds rate. And that would still be a negative real rate. So we're hardly, it would still be 75 basis points below what it was pre-COVID. And that itself is not for two years out. So let's say they get there. I don't think it's a foregone conclusion they will, but I'm willing to pretend because it wouldn't surprise me if they do. But then what I think would happen is they would pause on additional rate hikes

and begin some quantitative tightening. Now, there are plenty of things that could happen in between to interrupt this, a genuine recession from an extrinsic event that no one can foresee. I doubt that will happen, but it could. Geopolitical circumstances. Other things that kind of get in the way of the best laid plans. But what I don't think they'll do is quantitatively tightening and hike rates at the same time, again, knowing the heavy impact it has on the credit markets and the heavy credit sensitivity the Fed has created in our economy. heavy credit sensitivity the Fed has created in our economy. And so that is my best forecast, is that they end up beginning some quantitative tightening after they've increased rates comfortably off the zero bound, and that this all takes several years to play out. And this is a byproduct of incredible amount of sensitivity we have in the economy to what the Fed's doing with liquidity, with interest rates. And I've talked about that stuff quite a bit.

But what is the risk that from an investment standpoint that I talk about all the time with an overly accommodative and overly interventionist central bank is a misallocation of capital. That you could have malinvestment that takes place because interest rates take away, that you could have malinvestment that takes place because artificially low interest rates, artificially heavy liquidity, it takes away price discovery. It serves as kind of a distorter of optics and financial markets. And in that particular case, I think it is where we get a boom-bust cycle that we've been living in for several decades. And I put some academic research from central bankers, but as well as some commentary about this boom-bust cycle in Dividend Cafe today. But the thing I'll say to you for those listening now is that the Fed is not unaware of this. This is not like the Fed disagreeing with what I'm saying. It's the Fed

saying there's a possibility of that, but the alternative is worse. That if we take the risk of exacerbating a bubble, that is a better outcome than if we prematurely pop a bubble, if we falsely identify a bubble, or even if we just let a bubble burst, but right now, what the impact it would mean to price stability and to job creation. So I think that the Fed looks at it as a trade-off they're willing to endure. But see, for investors, most are not willing to go through these booms and busts and bubbles and then bursts and so forth. And so it becomes incumbent upon us to look at how we want to remedy that. And when you talk about the world that we're going into with very low rates and the need to start raising rates,

with concern about credit and what that means to overly leveraged financial investments, with clarity about what the price signal ought to be in the marketplace. You can go through all these different things that are jeopardized by current Fed policy, and I believe every single one of them is appropriately defended against or addressed or remedied with dividend growth equity. That you're going to still have volatility, but you would rather be, if I believe Fed actions in the years ahead necessarily have to exacerbate volatility, it behooves us to be in something of a lower volatility environment. If we believe that credit is going to be constrained, hopefully not to the degree it

was in 2018, but possibly, you want things that have less embedded leverage and less risky financial engineering. You want growing free cash flows, not static ones if they're raising rates against your investment instrument. So all of the different things that I could think of from greater defensiveness, greater non-cyclicality, greater financial reliability, lower financial risk, particularly in the sense of credit and leverage, I think dividend growth checks all those boxes. It doesn't do it perfectly. It doesn't do it without some volatility. It doesn't do it without execution and selection risk. Theoretically, it's a very, very attractive environment based on where we're going to be going. What is an unattractive environment?

Those things most susceptible to the boom-bust cycle. Now, maybe I'm wrong. Maybe Fed policy doesn't help exacerbate a boom cycle, a bubble. Maybe Fed policies to remedy the realities of today aren't going to burst the bubble. I think I'm right. And I'm not offering any timeline to it. But I believe that those things that are most susceptible to bubble-like conditions are the things to be most avoided right now for all the reasons I'm talking about regarding the Fed, how we got here and what they need to do from here and where we're going into the future.

So that is my view of the Fed right now, that they are trying their best to thread a needle that is very difficult to thread. And I would very much encourage you to embrace the idea of some boredom in your portfolio, some safety, some stability, not going to cash on the sideline. People still need a return. They're willing to take risk premium. They're willing to take exposure to volatility. And particularly for withdrawers, they not just want but need a positive cash flow.

So I'm not suggesting going to hide in cash, but I am suggesting the dividend growth right now has an incredible benefit for a variety of circumstances, all of which at the center of which is the Fed in all these different categories. So I hope that's helpful. I hope it's useful. Please read Dividend Cafe. Please review the podcast, write us stars, help us so that the podcast will be appropriately rated and easy to find for people. And please have yourself a very wonderful Christmas week. Thank you for listening to and watching the Dividend Cafe. Merry Christmas to you and yours. The Dividend Cafe, Merry Christmas to you and yours. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC,

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