The Dividend Cafe - The Great Debate - Part 2

Episode Date: January 22, 2021

In this episode, the point I am making is more than just “politics is overrated in evaluating market conditions” (even though that is very true). I not only believe this subject of Inflation vs. Deflation is more important than anything else in understanding the 3-year, 5-year, and 10-year state of financial markets, I also believe it is a welcome reprieve from what is just overdone, over-covered, over-saturated, and ready for a break. Inflation vs. Deflation Part II – jump on in to the Dividend Cafe. 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. Those of you listening on the podcast and watching the video, we are sitting here recording in beautiful, a Friday morning in beautiful midtown Manhattan. And this week's Dividend Cafe has a bit of a doozy. It's kind of a two-parter. So I guess that makes the, it's the second part of a two-parter. I guess that makes the two put together really a doozy. But I am kind of happy with this week's Dividend Cafe. I, for one thing, just got done writing it about 45 minutes ago and then walked straight from my apartment here to the office to record this. It's all kind of fresh in my mind and I've been working on writing it since literally

about 3.30 in the morning. And I believe that it captures in a number of different ways the major theme that is macroeconomic in our country right now and that investors will contend with in the years ahead. And it sort of, I'm striving with this topic to bring together, synthesize a lot of different things that are happening at once. Because a lot of people talk to me about the national debt. We talk a lot about how low interest rates are. We talk about the activity of the Fed, interventions into credit markets, interventions into asset prices, how it impacts real estate, how it impacts stocks. And all of these things, we talk about the dollar and weakness or strength of the currency. So all of these things, I believe in specific context, sometimes come to me as questions that are kind of individual or independent of one another and yet all of them are very much interconnected and that's sort of my job as an investment

strategist to bring these things together and apply them in a way that is sensible and coherent and opportunistic for our clients. And yet it requires certain understandings, certain presuppositions about basic economics that not everyone shares. And so it is by no means easy or simple task.

And yet I've tried my best in this week's Dividend Cafe I'm going to share with you now. Basically, our approach to how we got here and where we go going forward. One of the major issues that the economy faces that can be articulated like this. No one denies that we have a lot of ingenuity in America. We have an

American population that is mostly very willing and eager to work and work productively, not entirely unfortunately, but we don't lack for a population that is able to produce. We're not an overly aging population. We're not an overly feeble population. We're not an undereducated population yet. And so there's a lot of ability in our production capacity as an economy. And we most certainly are not a population that lacks for desire to consume.

And we have a great appetite for consumption. So in theory, the laws of economics are such that America is in a very healthy position because there is idea generation, there's innovation, there's invention, there's technology, there's education, there's immigration, there's diversity. There's just a lot of great things. And all of that is baked on top of what is, albeit imperfect, a really robust free enterprise system. Relatively speaking, compared to the rest of the world. a robust free enterprise system, relatively speaking, compared to the rest of the world. America's founded on basic principles of freedom that lend themselves to the achievement of prosperity and wealth creation. That's all the good stuff.

But then what we have is cyclical realities take place in in economy where there will be recessionary events, contractionary activities in the economy. And since the kind of mid part of the 20th century, the school of thought has been, well, then that's when the government step in and intervene to help soften the blow of those things. And a lot of it was kind of the byproduct of the Great Depression. That was such an incredibly severe period that we thought, hey, we can't let that kind of thing happen again. So what can government do? And there's different schools of thought that were prevalent in the middle 20th century, Keynesianism, monetarism, and kind of different contexts, classical economics, that all had different suggestions as to how we go about that. Well, it's very baked into the fabric of the country now that we're going to come in and try to do something.

And so I'm not here to debate that point. I have opinions about it. I think there's things that we can do that are good. There's things we can do that are bad. There's things we shouldn't do that we do do. There's things we don't do that we should do. I have all that stuff, but that's just not what I'm here to talk about right now. What I'm here to talk about is the reality of the fact that in addition to interventions into the economy, such as the ones that we saw last year in the COVID

moment, and in fact just passed another intervention, a $906 billion stimulus package a couple weeks ago. There's now a proposal out from the new administration for another $1.9 trillion. So just from the COVID moment alone, let's assume for sake of argument that the new bill were to get passed, we would have passed three bills that represent put together over $5 trillion of additional spending stimulus relief. And again, for the sake of argument, just assume some of that was really, really necessary, really good, legitimate.

Maybe some of it was not. But my point being, that is the mentality that exists in the country to come intervene at points of slowdown or points in the COVID case crisis. There's extreme things going on too. But then that is on top of the fact that we kind of permanently run deficits, that we have a spending structure

in the federal government that is in perpetual excess of its revenues. And some of that came out of the Cold War, where there was a huge increase in defense spending. A lot of that then came down post-Cold War, and we were able to, for a very short period of time, actually balance the budget. But then we have an incredibly high transfer payments overhead in the country. What I mean by that is the combined amount that we spend in entitlements for Medicare, healthcare, and social security. Those three together equal over 50% of total federal government outlays. We have a fairly

high amount of discretionary spending. And a lot of that, I candidly admit, I would not really agree with or approve of, but that is actually small ball in the grand scheme of things. And so is, by the way, the interest on our debt as a percentage of total outweighs. So you have all these expenditures. They are not things that are done against the will of the people. They're done because of the will of the people.

And we can sort of substantiate that by the fact that the politicians who vote for all this stuff have re-elected the politicians who vote for it or who did it. There's no tyranny going on here. This is representative form of government vote for it or who did it okay there's no there's no you know tyranny going on here this is representative form of government for good or for bad right so then you take the interventions of the economy that we feel are there to buffer slowdown they cost a lot of money and you take the perpetual state of spending when we have and even though it is not quite like the welfare state of much of democratic Europe, it is a social overhead that's very expensive.

Obviously, there were wars that took place post 9-11. I mentioned Cold War spending back post-World War II up through the Reagan years. So we've had various things, and a lot of people have opinions as to which ones of those expenditures we liked and which ones we didn't. But at the end of the day, we now have this belief that is accurate, it's indisputable, that economic growth has slowed down in America post-financial crisis and that the rate of growth is sub-trend, that we are in below-trend growth, not just coming out of a recession where we were used to really robust growth,

but that coming out of the great financial crisis, we really didn't even get back up to trendline growth, let alone above-trendline growth, sort of offset some of that. And by growth, I refer to real GDP growth, meaning net of inflation. So the nominal component is not even important, even net of inflation.

So the debate exists as to what needs to be done about that. And along the way, the Federal Reserve, the central bank of the country, their role in our economy has been totally reconstituted in my adult lifetime. Beginning in the late 90s when I think there was more and more of a desire to see the central bank protect risk asset investors, but then throughout some of the significant crises of the new century, starting off with what was one of the biggest nothing burgers of a crisis of all time, but Greenspan using Y2K as a reason for a lot of Fed activity in money supply and liquidity.

But then after that with 9-11, a recession that ensued after the technology crash, and then, of course, the great financial crisis in which entirely new facilities and new conventions were put into existence out of the central bank as a means of buffering a lot of the economic damage and trying to buffer the impact of what were zombie assets or dead assets. what were zombie assets, so were dead assets. You had over-leverage, and instead of just sort of the hangover effect, we tried to buffer that, and a lot of the things the Fed did were really effective. Some of them have nasty side effects, but my point being, you know, most people would look at kind of how things have gone post-crisis and say, okay, well, so far it sort of seems to be working, and for my purposes right now, it's all fair enough. But what you have is a lot of questions that exist as to whether or not the actions of the fiscal side, the U.S. government, are going to generate the growth we need as an economy to get back to trendline growth and whether or not the Federal Reserve interventions are potentially going to be inflationary.

interventions are potentially going to be inflationary. And along those two kind of different debates, the fulcrum of which on the fiscal side is what the good upside potential is out of those actions and what the bad could be or downside. And same on the monetary. There are two different axes that we have to look at. There's a lot of different opinions as to where the inflation may come or the deflation may come, all those type of things. And I believe that one's opinions

and the conclusions one draws around those two issues, all of which are impacted by debt levels and all of which are impacted by our economic now dependency on the Federal Reserve's interventions, that they will formulate a foundation that's very important into one's investment policy. And there's certainly very much at the core of what we're doing with client capital.

And so right now you will see a significant school of thought, and this is what I really devoted most of the Diving Cafe to today, to rebut that would suggest that the Fed's ramping up money supply and we face big inflation, that we're going to have bond yields go higher and you're going to get a lot of inflation and that that's going to push prices higher and then, of course, put P.E. ratios lower on stocks and so forth and so on. And the presupposition behind it is that government spending is increasing and that's going to create a lot of economic growth

and then the money supply is growing and that's going to then put those two forces together and become inflationary. And I think the money supply is growing and that's going to then to put those two forces together become inflationary and i think the entire argument is wrong and i think the entire argument is wrong um with a little bit of cheating on my part because it's very clearly wrong by testimony history and i allow uh i graciously allow for the idea that this time it could be different and that's fine but it most certainly has been the case for a long period of time that as our debt to GDP has gone higher, higher, higher, higher, and our money supply has gone higher, higher, higher,

that economic growth has not grown in tandem with that debt to GDP. And then inflation has not grown. A rate of inflation has not grown with the higher money supply. And we're not talking about over three years, although we are, but that's not merely what we're talking about. And we're not talking about merely about post-GFC either. This goes beyond just the great financial crisis period. We're talking about decades of this. And so I put some charts in Dividend Cafe to try to help make the case of what we're looking at in terms of debt as a percentage of GDP and the diminishing return we get from that debt over time.

And I make the argument that that's an inevitability, that it becomes more and more unproductive debt over time. It could have an important social function. It could have an important social function. It could have a legitimate military function. There's other aspects besides just economics. But I'm just simply making the case that for good or for bad, the economics of this are that we have a growing percentage of nonproductive debt that

is compressing debt by definition. This isn't an argument I have to make. This is a tautology. It's inherently true that what we are spending is money we are pulling into the present that is therefore not available into the future. So the easiest analogy to use is one of your own business or your own household. You have a bonus coming in a year, and that's going to be adding money to your income,

and it's going to be adding money to your balance sheet, and you spend the bonus now on a credit card to go buy new furniture. And then when you get the bonus, that growth you would have achieved you don't achieve because the money was already pulled forward. It's pretty basic, pretty simple stuff. Now, the huge caveat, and I'm not going down a rabbit trail here, this is an important caveat, is that, of course, there is such thing as productive debt.

And when a business goes and borrows money at 5% to go buy a business that's going to make them 20%, a high return on that capital, that is a productive use of debt. They're putting a little leverage on to get a growth of equity, a return on equity. The problem is even for a business, there's a diminishing return to it. There's not just infinite opportunity and infinite deployment of wise deployment of capital. And there's a diminishing return to how much can happen and yet as that return diminishes and the opportunity set diminishes and risk increases

through each thing you're doing the debt doesn't diminish it's just there hurting your balance sheet and hurting your cash flows as you service the debt kind of corporate finance 101 stuff but why is it any different with the United States government? Well, here's one thing that's different. I didn't know this, by the way, until about 4.15 this morning at the charts in Dividend Cafe. Our government has $27 trillion of debt and brings in about $3.4 trillion of revenue.

So a little over eight times debt to revenue. The S&P 500, all the companies put together generate about $11.5 trillion of revenue and has about $5.5 trillion of debt. It's a lot of debt, by the way. It's a high level of debt within the market index. So they have two times revenue to debt in public equity.

And the United States government has eight times debt to revenue, a 16 times differential between the two. And so what you have now is this problem of opportunity being taken out of the economy through the excessive debt, which, of course, has to be paid for through taxation. Even when you borrow to pay for it, the borrowing is just simply borrowing against future growth. OK, so then you have back to that desire to come fix things with interventions in the economy, monetary or fiscal. You now have a bigger problem because the thing you've done to create to solve the problem

is exacerbating it. And you get this pushing on a string effect. And that's where we are right now. And so my argument is that we do not face a period of sustained inflation coming out of robust growth from all this government activity. But in fact, the Japanification lesson we've seen from the only other developed country that has really gone through this for multiple decades. And then now the European Union is kind of coming alongside with us in the same sort of dynamic. We are in a better position in our ability to generate top line revenue than both our friends in Europe and our friends in Japan. But nevertheless,

we still face a similar economic problem of distorted ratios. The debt to GDP, the debt to assets, the debt to income creation is astray, and it puts a slowdown on economic growth. And so some will come and say, are you predicting a depression? I go, of course not. Japan hasn't gone into depression.

They just have been kind of floating along for about 30 years. No real growth. That's not good. That's not the American way. Now, we've had growth since the financial crisis in our country, but we're all disappointed because it's been one and a half to 2% real growth. And we're used to, you know, 3% real growth, 3% to 4% real growth. We're going back to World War Two. And my view is that everything we're doing to solve for the low or no growth problem

is creating more of a low and no growth problem. That's the pickle we're in. So what's it mean to investors? First of all, you have to understand this talk about inflation does not mean nothing inflates. This is one of the greatest economic fallacies I've ever encountered, that there's such thing as a price level.

And there's just this aggregate blob of prices that all either go up inflation or down deflation together. Prices are applied to individual products and services based on individual supply demand characteristics. And I remember studying the myth of the price level about 30 years ago when I first began intently studying economics. And the analogy that stuck with me then, I didn't even golf back then. And for those who know me know I don't have time to golf now either, but back then I could still appreciate

the analogy. Talking to a golfer about aggregate rain levels, like, hey, throughout the year, there's this percentage of rain and this percentage of raindrops and so forth, it is completely meaningless to that golfer on that day in that city at that weekend tournament. And everyone knows that. So when I put a chart in showing housing prices are going up higher than the consumer price level, we shouldn't be surprised by that because inflation works off of individual supply-demand characteristics.

And my argument is that some overall threat to higher prices that drives interest rates higher is not the great economic threat of our day. The great economic threat of our day is that what they're doing is generating more money at lower rates that facilitates more borrowing that bids asset prices up, real estate, housing, stocks, et cetera, but doesn't generate wage growth.

That doesn't generate organic economic growth back to that GDP metric that we're trying to get. And so I have a lot of policy opinions on this stuff, but that's not what I'm sharing it with listeners to Dividend Cafe and let alone my own clients for. I'm sharing it because as investors, our relying on continuing growing valuations is dangerous because of the diminishing return and the ability of them to use market interventions effectively. Our decision to try to ramp up our portfolio towards all inflationary biases is dangerous because all of these forces are working against such a thing. There will be cyclical inflations,

there will be ad hoc inflations, but primarily what we see are asset prices that are currently being bid up that will lead to distortions. And I do not want to invest my client's capital on trying to bank on a distortion working to our favor and then getting out in time, playing a bubble, things like that. That reinforces the need to this inflation deflation debate and the realities of where we are with the monetary and fiscal side of the U.S. economy for fundamental investing that is free cash flow generative, that is based on real companies that are actually generating revenues with as much purchasing power and defensive characteristics as possible, sharing the growth of those free cash flows with you as shareholders. I think dividend growth becomes an imperfect and yet very sensible defensive and offensive reality in these

forces that are at play. And I'm trying to avoid, by the testimony of history and the economic outlook, extreme views that we go to NASDAQ 200,000 or that we go to a Great Depression. Neither of those things fit within the universe of reality. those things fit within the universe of reality. What we have in the universe of reality is low and slow growth that is exacerbated by the present policy environment that there is, at this point in time, no easy way out of whatsoever.

And that, therefore, makes it incumbent upon me to recognize the capacity for distortions that could create bubbles and not get sucked into a bubble being unaware of the fact that I'm in a bubble and to do my very best to find sensible investments that are cashflow generative that I'm not playing a valuation increase,

I'm playing a cashflow increase. I hope that makes sense. I gotta stop now. Read Dividend Cafe, some great charts. This is about the best I can do to try to take about five very complicated topics and bring them together. I really, really welcome all your questions and feedback. And I thank you from the bottom of my heart for listening to this week's Dividend Cafe. Have a great weekend. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC, a registered investment advisor with the SEC. Securities are offered through Hightower Securities LLC. Advisory services are offered through Hightower Advisors LLC.

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