The Dividend Cafe - The Fed Tightens Things Once Again

Episode Date: December 21, 2018

Topics discussed: The secret sauce in the Fed's actions and words Cost of capital vs. return on capital Will the market "yield" to the curve Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. conditions taking place in the market. Big sell-off this week on top of big sell-off last week, on top of big sell-off this month, on top of big sell-off this quarter. So you got a real negative environment and that's probably not the podcast you want to listen to going into your Christmas week. But what I'm going to do is just kind of highlight a couple of the things from this week's DividendCafe.com in the podcast, and then encourage you to go read the whole thing online or print it out and look at the different charts and so forth. From a time standpoint, I just can't go through the whole thing now, but there is some content I think is very important. I mean, it's a crazy year, and it's, of course, a crazy week as well. But overall, think about this. There's five market days left in 2018.

And so who knows what will happen to the interest rates and stocks and overall markets in the remainder of the year. But as of right now, stocks are obviously comfortably in a negative territory in the year. I do not see that changing. They will end the year with a negative total return. And barely, Treasury bonds are holding on to a negative return, although they have actually moved up quite a bit here in the last few weeks. But they've spent almost every single day of 2018 in negative territory. If the full year total return on both the S&P 500 and the 10-year Treasury bond ends up being negative for 2018, it will be the first time that has happened since 1969, basically 50 years ago. So like I said, we've got to wait for markets to close to analyze final data because it's entirely possible that that will be averted again because of the Treasury bond going positive.

that that'll be averted again because of the treasury bond going positive. But it is certainly not been a year where many asset classes provided an escape from either flat conditions or flat out negative ones. And even when the flat conditions are there, they were hardly flat throughout the year. In other words, a lot of volatility around the asset class that maybe ended up somewhat flat or slightly negative. If you're going to have a volatile year, you'd like to think you get more than a flat result out of it, generally speaking. Now, the one exception has been alternatives. And obviously, it depends on what alternative and what weighting in a portfolio. But this oft-derided world of hedge funds, private equity this year, will post their performance relative to high beta risk assets like stocks and bonds will probably be the best relative year in many years and on an

absolute basis our alternatives will be the only asset class that's delivered really attractive returns in 2018 but when we look at the market sell-off this week, 350 points on Wednesday. It was down, as I'm recording right this second, on Thursday, intraday, another 350. It was down going into the week. So, you know, you're just talking about a pile-on of sell-off. We were down 500 points last Friday. Here's the thing. The Fed increased rates, as expected, this week by one quarter a point. And it was the fourth rate hike in 2018.

And the Fed futures market had been pricing in about a 75% chance of that happening. So it wasn't a surprise to markets. They reiterated their intention to continue reducing their own balance sheet by about $50 billion per month. The Advice and Insights podcast is going to talk about that more. Our other podcast, listen to that for a little bit more granular dive into the Fed's quantitative tightening and why I actually think that's the real story in the market. They mildly reduced their expectations for economic growth in 2019, which really was just restoring their expectation to what it had been in June of

this year. They had previously forecasted three rate hikes for next year. They're now forecasting two hikes and again, only at a quarter point each. So look, it's not the president jawboning them. It's not the feds confusing their own messaging. Their fear, what's holding them up as to what, you know, do they want to really pull back or do they want to slightly pull back from where they were? The confusion and the sort of trepidation around which the Fed is trying to conduct monetary policy right now is their fear of inverting the yield curve. For the Fed to confidently see their policy normalized, they need to see the long end of the curve increase, a steepening of the curve, as continued normalization with a curve this flat increases, if not practically guarantees, the risk of inversion. But the long end of the curve is

not cooperated at all. And the Fed is choosing to try and control the curve versus letting the curve inform them. And I'm sure you're wondering and control the curve versus letting the curve inform them. And I'm sure you're wondering, what in the world does that mean? The issue is that the signal embedded in interest rates, on one hand, is the long end of the curve, meaning longer term bonds that are selling at very low yields are not forecasting inflationary growth that they think will eat away at future opportunity. But on the other hand is a short end of the curve, which is responding to the reality of a tighter Federal Reserve taking liquidity out of the system. If all maturities of interest rates were moving up in tandem,

it would be a different situation. But in this case, we have short-dated bonds rising, while longer bonds are not only not rising, they've come lower. So the signal of this flat yield curve freezes the Fed because it believes it sees data that warrants higher rate policy, but then they also don't want to be caught. And in addition to that, they don't want to be caught without a policy tool at the next economic slowdown. And yet they also know they have to respond to reality and the yield curve is speaking to that reality. So where are we? What does all this mean? Look, the Fed was more dovish this week.

They definitely backed down a little bit from some of the more hawkish rhetoric, but they weren't as dovish as the market had wanted them to be. And they didn't reference the housing market, which is clearly slowing, and a lot of data would suggest it's slowing dramatically. They said inflation expectations are little changed. And yet, you know, it's interesting to hear that when oil prices have dropped 35% in two months, if that's not disinflationary, I don't know what is. They referenced the potential need for still further gradual increases. So I cannot tell you if 2019 is going to produce one, two, or three more rate hikes and perhaps even zero. They were saying it would be three. They're now saying it's going to be two. Some have been forecasting it before. And right now,

I suspect that it could end up being one. And there's even an off chance it ends up being zero. If someone put a gun to my head and said, you have to bet what it will be, I would just tell them to pull the trigger because I have absolutely no idea. I do not believe we have any historical precedent for how the Fed will respond. I do at DividendCafe.com this week, quote, word for word verbatim, the Fed's announcement this week and their announcement at their December meeting in 2015 to give you an idea of how similar those elements that are weighing on market conditions are now as they were then. And in 2016, the Fed had forecasted four rate hikes. They ended up doing zero. So do I think they're at risk of a policy mistake by tightening more than economic conditions

warrant? I certainly do. Do I think they've done that yet? No. I think that they have been needing to normalize and get to a place of a neutral rate. But I would suspect that if their motive for doing so was fear of inflationary conditions, they're probably a lot closer by their own standard than anyone had been anticipating. Now, as far as the real issue that I think is disrupting markets about the Fed's balance sheet, this added level of tightening by them allowing bonds that are on their balance sheet to mature and not replace them, so it's a backdoor way of removing liquidity from the economy, listen to the Advice and Insights podcast. Let me close out this podcast with a kind of somewhat positive twist on things. The fact of the matter is asset allocation has held up

remarkably well in the last month or so. You have, you know, let's call it a 15% market drop from peak to trough in the broad U.S. equity index. Now in the year we're not down that much, but since our high level at late September, early October. Well, the fact of the matter is that while that's happened, U.S. treasury bonds have risen in value about 5%, restoring for the first time all year the more conventional inverse relationship between stocks and bonds. As I mentioned earlier, alternatives have largely done well in this period, certainly on a relative basis and often on an absolute basis. The chart I put at dividendcafe.com shows you the performance of different asset classes, including individual fixed income asset

classes on the year. And you can see how so many of the things that were down a few percent have now kind of reversed. And where equities are in the lead, they bounce the other way. But see, this is the thing. The same people who are now saying, why own stocks, were the ones earlier in the year saying, why own bonds? Asset allocation driven by what is most popular or sentimentally strong in a recent past is not asset allocation. It's destruction waiting to happen. Sensible, professional, adult, responsible asset allocation is driven by the humility of not knowing which asset class will pop next and the acknowledgement that various asset classes contain very particular blends of risk and reward outcomes.

asset classes contain very particular blends of risk and reward outcomes. And so from our vantage point, there's plenty of bright sides to consider going into 2019. I list all of those out at DivenCafe.com. I wish I had more time on this podcast to lay them out for you about oil prices, the fact that this is a fear-driven run on equities, which is categorically different than a reversal of fundamental strength. No part of this recent equity market drop has been related to underlying earnings dropping. It's entirely been about equity valuations dropping. Now, don't take that to mean that there's a timing lesson there. I don't know when that reverses. I don't know when sentiment changes. But I do know that when you're dealing with a sentiment-driven sell-off,

it's a categorically different thing. So please listen, excuse me, read DividendCafe.com. Nothing will warm the Christmas fires more than sitting down with your family, grabbing some eggnog, and reading David Bonson's commentary on the market. And if you don't want to do that, I forgive you. In fact, I kind of commend you. But I do believe if you would like just a little bit more comprehensive vibration around what's taking place here in the markets in this really awful December we're experiencing,

I think there's a lot of content at the market commentary worth reading. But I've got to end the podcast here now. Have a very Merry Christmas with you and your family. And we'll look forward to our next podcast, which I believe will be next week and maybe the week after. I don't know for sure. Okay. Talk soon. Thanks again. Reach out with any questions.

Thank you for listening to the Dividend Cafe, financial food for thought. investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC. This is not an offer to buy or sell securities. No investment process is free of risk and there's no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative. Current or future performance is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinion, news, research, analyses, prices, or other information contained in this research is provided as general market commentary. It does not constitute Thank you. 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 team and do not represent those of Hightower Advisors LLC or any of its affiliates.