The Dividend Cafe - The Markets are Happy and Well "Fed"

Episode Date: July 12, 2019

Topics discussed: Will the Fed Cut? Is a recession coming? A look at results of the tax reform bill Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Come up with our advice and insights and overall overview. All things that belong in the Dividend Cafe. And I'm titling this week's talk Fed Up, Rates Down. And that double entendre on Fed Up is very intentional. Because obviously the Fed is a very significant factor in things going on in the market right now, things going on in the macro economy, certainly things going on in the news cycle. And there is a sense where if I'm being very truthful, I am rather fed up with it. And that's not to say that there's this overwhelming disagreement with the policy, although there is some of that I'm going to get into in a moment.

But I'll kind of wrap up with a comment on this at the end. I just think overall that the market is so heavily dependent on macro right now, so heavily focused around macro, meaning big picture, top-down news, monetary policy, such as Federal Reserve machinations, and the Beltway, political developments, the trade deal, concerns about global trade around the China tensions. So these things have been such a significant factor in what's driving markets. And there's been so little around the kind of bottom-up considerations of, you know, like how companies are actually doing and company growth, company profits, company management, strategy, execution, the dividends companies are paying us. These are the things that really, really, really do drive stock prices for the long term. And it's been really buried for the last couple of months. And so we'll see as we get ready to go into earnings season,

what kind of changes out of that, what either positive or negative effect. What I expect will actually be both. There will be a high dispersion of results with some positive for some and negative for others. But it'll be fun hopefully to get the Fed a little out of the front page and company results back on it.

And we'll see how that goes. So now I'm going to violate everything I just got done saying and jump right into the Fed myself. As I'm sitting here recording, it's Thursday morning and Chairman Powell is actually now into his second day of testimony. The House Finance Committee, he spoke yesterday, is now into day two of that. And so I don't expect anything earth-shattering to come out of the second day. But if anything dramatically alters the shape of markets or content of what I say right now, it would be because he kind of says something in the next few hours that might surprise people. I'm not anticipating that.

But, you know, look, the Fed funds futures market right now is pricing, write this down, a 100% chance of a quarter point rate cut in July. There's a 33% chance priced into the futures market for a half point cut. So I would argue that the market is probably got this exactly right, that you're going to get a quarter point rate cut here in a couple of weeks from the Fed, and you're not going to get more than that. The inverted yield curve is not going to get a quarter point rate cut here in a couple weeks from the Fed, and you're not going to get more than that. The inverted yield curve is not going to be resolved by the long end going higher anytime soon. So the short end has to come lower. Now, the stunning 224,000 new jobs that were created in June

did add fuel to the fire of those saying the economy does not need a rate cut right now. And I frankly think that's hard to argue. But ultimately, in the face of impressive job growth and wage growth, one has to remember that the Fed really believes in their inflation target. And they really believe that they're failing to achieve it. And therefore, for their perspective, achieve it. And therefore, for their perspective, that calls for easier policy, not tighter. Now that the three month to the 10 year treasury curve has been inverted this long now, yet the two year to 10 year curve has not, is a pretty call for the Fed to cut. It suggests that the very ultra short term rate is too high. But I also do think it is somewhat evidentiary that a recession can be averted, that the analysts who are looking

at that saying the two-year is not acting like we're going to recession. It's just this three-month deal responding to aggressively tight Federal Reserve policy. Look, I'm more interested in what they will do than what they ought to do. I believe a quarter point is going to happen. I think a half point is not. But of course, I say that just knowing what the futures market is telling me. Now, what's fascinating about all this is that the Fed is saying they need to cut rates because they're worried about economic weakness surfacing. And we know that many times historically, not all, but many Fed rate cuts have preceded the onset of a recession. And yet right now, investors are just loving the news.

The Dow hitting 27,000, the S&P hitting 3,000. I believe the answer to that paradox was squarely addressed in the Dividend Cafe a couple weeks ago. Companies still enjoy a cost of capital that is lower than their return on invested capital. And until that changes, investors like what is happening. And I don't think you'll see a recession on the horizon. Now, I am in the one and done camp. The Fed will do this July cut, quarter point, and then they'll sit. And I'm sure a second cut in September is possible, but I don't think it's assured.

The market is assessing a 59% probability to such right now. And I would be shocked if they dare to go beyond a total of 50 basis points, two rate cuts, if they even do that second. I don't much like the concept of what they're calling an insurance cut. But for those that are pricing a 38% chance that we're actually going to see three cuts by the end of the year and a 17% chance in the futures market that we're going to see four rate cuts, I will gently point out that in no way could those additional cuts be called an insurance cut. China talk. Let's kind of jump around a little bit. Be surprised if resolution or even

progress comes for quite some time but the talks have resumed that's really all we know at this time in the meantime supply chains are moving out of china and that's likely to continue happening until there is some resolution there i dedicate a good portion um in the dividendcafe.com this week to talk about stocks versus bonds and provide two charts for you to look at. The collapse of longer term bond yields in recent months, even as risk assets like stocks have made new highs, does point to a tension in global markets that I think will continue to play out in the second half of the year. And that is that equities are responding to healthy corporate earnings, the Fed's signaling of backstopping risk

assets, and the fact that we do have a healthy economy, full employment, robust wage growth, et cetera. But bonds are telling us that we're going to be in low growth and recessionary fears. The fact of the matter is that low bond yields reflect the expectation of low interest rates. If that sounds redundant, it's because it is. It's a self-reinforcing mechanism in finance. The Fed is not signaling easy monetary policy because the bond market is saying so. The bond market is saying so because it expects the Fed to affect easy monetary policy. The central banks of the world are doing politicians jobs for them, managing the burden of excessive debt. And the bond market does not believe these central banks have any gumption to buck that trend. So this leads to growing valuations for

risk assets and bond yields that necessarily reflect that reality. Now, am I worried? Well, there's a general unspoken sensation out there that a debt bomb is lingering over our economy and that one day it will explode and ruin the world. Those of us who do not believe the ending to the debt saga is going to be a certain explosive moment filled with cats and dogs raining from the sky are often accused of being complacent about debt issues that hang over the economy. When in fact, I got to say, I feel the more rational, thoughtful school of thought here

is more pessimistic than the doom and gloomers Now, let me explain that. There's a sensationalistic response to the debt crisis that lacks a real rooted view and reality of how these things play out. Believing that the debt to GDP ratio of our country will lead to long-term contraction and economic growth is not an apathetic view. It's a horrific one. Economies have always contended with cyclical woes, but this is a structural one that policymakers have thus far shown no aptitude for dealing with. In fact, Keynesian orthodoxy being what it is, policymakers tend to try to treat the low growth ailment caused by excessive debt with more debt. They have us in a negative feedback loop and seem utterly oblivious to the issue at hand.

The debt levels of today have not yet done great damage to the core U.S. economy because corporate America has been rising in productivity and earnings and because defaults have been minimal. But we must remember, post-crisis, the household sector in the U.S. has actually delevered substantially. And in reality, the government's leverage has flatlined for about six years now. It certainly levered up in the first several years after the crisis. But that forced sequester that House and Senate Republicans came up with in 2012 kept that government leveraging from continuing to grow. Even as the debt has grown, the ratio of debt to GDP is somewhat flatlined. It's the corporate sector that continues to lever up. Look, that's doing two things, okay? It's keeping

the party going, but it's raising the risks for when the party ends. Check out dividendcafe.com to see a chart of the way government debt has risen over the last 17 years versus corporate debt and versus household debt. Three different aspects of the economy telling three different stories. Is a trade deal going to happen to China? I've spent some time here in New York the last couple weeks with policymakers, analysts, trade officials, really trying to decipher their feel for where we're going to go post G20 and these China trade talks. And that a truce was called a couple weeks ago and the next round of tariffs are not being implemented is and has been a very good thing for markets. But it still seems that a further breakdown in talks is highly possible, and I might even say likely. And I do believe the next breakdown will

lead to the implementation of those tariffs, again, as a means of getting a deal. At that point, I think the results end up either being A, a comprehensive deal that gets reached in the months to follow, or B, the Trump administration choosing to purposely run on a standing up to China platform next year rather than cut a deal pre-election. A lot of gamesmanship going on in how this could play out. Much of this depends on how far off the two sides really are now. My skepticism that the very next step will be a final deal comes from the fact that I'm just not convinced

either side has created the leverage to get the other side where they want yet. As we have written about and talked about, kind of included in our various commentaries and messages for quite some time, our philosophy of engagement with the emerging markets is bottom up in focus. It's driven by earnings growth and demographics. So that said, three things need to be said in this present environment. One, oil prices have stabilized and even dropped a bit. And virtually every emerging markets nation is an importer of oil, meaning this is good.

Two, lower interest rates in the U.S. and easier monetary policy reverse the concerns about tightening dollar liquidity, a major relief to the risk environment for emerging markets. Three, the dollar is stuck between a rock and a hard place. And this is quite correlated to the second point about interest rates. The dollar did finally soften a bit, which helped emerging markets last month. But since then, the dollar has retraced some of that move. It's anyone's guess right now. But few believe that a systematic and clear move higher, meaningfully higher, that is, in the U.S. dollar is fundamentally likely at this level. All that to say, there may be a macro backdrop that suits the bottom up story of emerging markets investors quite well in the months and quarters ahead.

The case for not buying the cool tech craze of this decade. I'm absolutely amazed by the lessons of market history, like the predominance of energy production companies as market leaders in 1980. They did not last as such until 1990, to put it mildly. In 1990, the majority of global leadership stocks were Japanese, a trend that didn't last for two years, let alone 10 years. In 2000, it was a fool's errand to bet against technology, telecom, media.

Many of those leadership names did not even survive the decade, let alone stay atop the world. In 2010, China was stay atop the world. In 2010, China was back atop the world. Commodity names were believed to be the story for the next decade as reflation was the predominant theme coming out of the financial crisis. That has not gone so well, certainly not sustained as a top performer. So now we sit here with mega cap tech names atop the world. Do I believe that they will stay atop the world for the next decade? I'd have to despise history to believe such.

A fiscal savior. All politics notwithstanding, there's an increasing school of thought, particularly in this year's Democratic primary, that one resolution for our fiscal challenges as a country may be in simply raising taxes on high earners. Besides the fact that the new spending programs being proposed are many multiples of the present national debt itself projected to reach $24 trillion in just a couple years, the top 1% of earners presently pay over 37% of all income taxes. At DividendCafe.com, I have a chart of the different levels of income versus the level of taxation that they pay. Speaking of accurately describing the tax picture, in 2017, the year before tax reform was passed, a grand total of $155 billion had been repatriated by U.S. companies, bringing offshore profits back into America. Well, in 2018, $800 billion was repatriated. But for quarter one of 2019 alone the figure was just over 100 billion it's expected to reach four to five hundred billion with a trillion dollars having come back to the united states and another

trillion still out there repatriation has got to be considered one of the more stimulative elements of the tax reform bill a couple comments on dividend growth and then i'll close out this week's podcast 83 of the companies in the S&P 500 pay some dividend, though it is a paltry dividend for a large percentage of those. Only 68% of mid-cap companies pay a dividend and 52% of small cap. And then those are even more paltry for a lot of the companies. But there were 62 dividends across the broad market were cut or suspended in the second quarter. Last year, we saw in the second quarter, $13 billion paid out from public companies in dividends, where this year the number was all the way down to $8.4 billion.

Point I want to make is that dividend growth cannot be managed passively. Now, of course, you could say I'm talking my own book here because I am. I mean, we manage dividend growth stocks actively. But my point is to use data to empirically substantiate that dividend growth cannot be indexed. It requires an active approach to consistently assess dividend sustainability and the outlook for dividend growth. And the testimony of history is clear here, this most recent quarter, but the decades before it as well. All right, we're keeping an eye on the federal, the president's nominees to the Federal Reserve Board, Judy Shelton and Christopher Waller, both of which I think are likely to get named.

Shelton in particular is an advocate for rules-based monetary policy. They're saying a number of things out in the press. They're not totally accurate. But either way, I think these are better selections than the last couple and more likely to get through. Chart of the week this week, a little refresher on entry-year market volatility. I'll make you look at it if you want to see it. But I'm going to leave it there, like I talked about.

Looking forward to getting the Fed out of our top stories and into the individual stocks that actually make up the stock market. In the meantime, reach out with any questions, any time. We would greatly appreciate it if you'd give us a five-star review on iTunes. If you'd subscribe in your player, whether it's Stitcher or Spotify or Apple, whatever you listen to, it helps us and we'll get to you more frequently. Our podcast, feel free to share it with anyone you would like. And then most importantly, reach out directly to me, the chief investment officer of the Bonson Group. With any questions you have any time, we love interacting with you. Thank you for listening to the Dividend Cafe.

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