The Dividend Cafe - The Right Question to Ask in the Prediction Business

Episode Date: February 18, 2022

There was plenty of talk about Russia/Ukraine in DC Today this week as well in the unreliable news cycle, and there really isn’t any “new news” to report. I am not sure we will be talking about Russia/Ukraine in six months, but I am very sure we will be talking about inflation, the Fed, and interest rates in six months. I want to do my best to make those six months (and more) of conversations be as worthwhile as possible. The Dividend Cafe is here to help that effort. We are going to look at what some of the right questions are to ask today and let it go from there. I believe this discussion will give you some better information then you might find elsewhere, but it also puts me out on a limb with some actual forecasts. The very concept of forecasting bothers me, usually because those who do it are charlatans and grifters. But I have nothing to gain in these forecasts; rather I am trying to point us towards a context and understanding that will likely not prove exactly right in the details, but I think more helpful than thinking about 2021’s battles during 2023’s war. Jump on in to the 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 week of the Dividend Cafe, getting ready to go into a little holiday weekend. I am sitting in the New York office where I will tell you it's been very odd weather this week. We had several 12 degree mornings and then all of a sudden it got like up into the 60s and felt like it was 80 and so it's interesting to see the kind of weather shifts but But nevertheless, this is what happens this time of year in the winters of New York. And I believe that things have been kind of the opposite in my other coast, where last week, Southern California was having a dramatic heat wave. So we have up and down weather conditions, and we continue to have up and down market conditions.

But I am going to save you the boredom of talking more and more about volatility. And actually, it's probably not boredom, but I'm also going to save you from yet another conversation about Russia, Ukraine, where it's been discussed each day in the DC Today, our daily market bulletin, which I hope all of you subscribe to, thedctoday.com for those who don't. And it's obviously being discussed ad nauseum in the press. Now, look, the bullet points that I offer on the subject each day with market specificity and implication hopefully aren't boring, but regardless, they're at least, I can promise you, accurate and shared in good faith and coming from a perspective of trying

to give honest commentary for the purpose of understanding and clarity and market application, where a lot of the information I think that you may get in other sources, some of it may be right. I wouldn't take that for granted, but it could be. But, you know, it is agenda and why it's being shared. And so we're here to try to be neutral presenters of information and yet not neutral in where we apply. You know, how we have a point of view as to how we believe investment perspective ought to be carried out on behalf of clients' financial goals. So the Russia-Ukraine thing continues, but

I make the comment in DividendCafe.com today that I don't think we're going to be talking about it in six months. I'm not totally sure we're going to be talking about it in six weeks, but I'm less I'm not totally sure we're going to be talking about it in six weeks, but I'm less sure of that than I feel on the six month side. Where the thing I want to get into a little bit today, inflation, interest rates, the Fed. I believe we're going to be talking about that in six weeks, six months, six years. And with a lot of ebb and flow around the way. But this is the topic that is far more relevant to me right now in the way in which we allocate client capital. And I think that the way I worded it in Dividend Cafe is the way I want to start our conversation right now for the podcast listeners and video watchers. What is the question to be asking? I've probably done a little

more than I've needed to about trying to point out the nuances and particularities of the backward looking inflation rate. So I do think it's relevant and I do think it's noteworthy when I point out, you know, you get a 7.1 CPI and 29% in used car sales. And what does that look like in terms of understanding the inflation that we've had, price escalations from 2021? But if someone were to say, hey, Dave, you got to make some investment decisions for the future. What do you think about last year's inflation? I'm not sure that would be the right question. And one of the reasons is I can most certainly assure you it's not the questions the Fed is asking. And for those who believe that what the Fed ends up doing has some sort of relevance, they are asking, what will inflation be in a year? And I think that

this is important for a couple of reasons. It is important because I think it's what the Fed's looking to do. It is important because it makes a bigger difference to me and how I think that this is important for a couple of reasons. It is important because I think it's what the Fed's looking to. It is important because it makes a bigger difference to me in how I think about forward-looking capital allocation, interest rates, the valuation around assets, things like that. But I also think that it acknowledges the just unbelievably clear reality that there is some noise in the inflation data that is very likely to get less noisy a year from now. Gone altogether, I don't know how much of the current inflation is related to the noise.

I don't know that either. how much of the current inflation is related to the noise. I don't know that either. But it seems to me someone has to be either dishonest, which is very common, or uninformed, which might be pretty common too, to act as if there's no import from the noise of the supply chain disruptions, the port closures or delays or inefficiencies, the truck driver shortages, the labor inadequacies. I don't know what the bottlenecks mean to price escalations in a quantifiable sense. But there is one, I guess I'll say there's two

numbers that I can rule out as to what their level of relevance is. 0% at 100%. Okay. So I'll take both of those theses out. But I think that when people are talking about the 7% inflation rate and the highest is this and that and the other, and not when they know better, when they're not looking to a forward-looking expectation, I think they're missing an opportunity. Because my view is that if you have 3% to 4% inflation, that is double the Fed's target.

So no one who's talking about there being 3% to 4% inflation is talking down anything. They're referring to the fact that for various reasons that weren't unpacking, if there was three to four percent inflation, there would be dramatically higher inflation than we had pre-COVID and that we have targeted as a matter of monetary policy at the Federal Reserve. And yet by going to the seven number backward looking instead of a yet still higher number forward looking, I think that we are setting up a narrative change. And that narrative change is going to be relevant to actual Fed policy. And this is what I mean. The pressure, I start out at Diving Cafe today. Well, okay, I'm going to back up if you don't mind. I believe that politicians love inflation. I do not believe politicians worry about inflation. I do not believe politicians are concerned when prices are going higher and it's hurting constituents.

I believe they worry about inflation and start talking about it when it gets so high that their constituents notice. And I think there's some number at which people live with it. And it does damage to them. And it's not good. And sometimes the policies that created are unfair. But nevertheless, the slowness of it, the minimal gravity of it enables people to just sort of live with it. And let's say that number is between one and three percent of an annualized inflation rate. Still, I would point out is halving purchasing power. It's cutting in half purchasing power every 25 to 35 years,

if it's somewhere between 2% and 3%. So I think that that's a significant reality of financial planning, but I don't think politicians care, and I don't think the people care enough to make politicians care. So then now, why is there all this noise around inflation? Well, because the numbers have gotten so much higher coming out of COVID, the massive demand surge, the supply chain shortages. We know that there was a whole lot of government spending put on and people figured that plays

in somewhere. They're not exactly sure how. And I have thoughts on that. And then, of course, the monetary side of it. But here's the thing. If the inflation rate is at 3% next year or three and a half, you tell me what you think the headline is going to be. Inflation double what it had been pre-COVID or inflation half of what it was a year ago. This is where I believe Fed policy is going to come from, is that the uproar over elevated inflation by focusing on the sensationalistic aspects of a seven handle backward looking

instead of where we could still see elevated price inflation in housing and rents, potentially still in food, but I hope those food shortages end, and then I expect still in the energy side. And instead of focusing on that, by focusing on the backward looking side, on that, by focusing on the backward looking side where there are these noisy contributors to it, I think we're setting the stage to take focus off of inflation. And then what will happen is a Federal Reserve, who I do not believe wants to tighten monetary policy above and beyond the minimum level needed to achieve a couple things, then we'll have the cover to hit the pause button. And yet this requires like three things happening at once. They're trying to thread a needle. They have to get off the zero bound. I'd like it to be closer to 2%. I'd take one and a half,

but I think they're going to have to end up being content at around 1%. Maybe I'm wrong. Maybe it's a little higher, but I still feel comfortable saying something with a one handle at the most. Okay. And they need to get a few trillion off their balance sheet. The number is probably about three trillion. If you look at what they've added to the balance sheet, less the reverse repos, I think that they would feel like they had at least gotten to some equivalent of pre-COVID in a three trillion reduction. But the Fed is not unaware of the leverage in our financial system, the amount of M&A transactions and leverage buyouts that have taken place with a low cost of capital in mind, heavy degree of liquidity in the financial markets.

The Fed's not unaware of the volume of levered loans, of the quality of companies that have been able to access the high yield bond market. And if all of that leverage is then undermined as credit markets tighten, it forces the Fed's hand. And I know people say, well, yeah, well, then they're just going to press further. I don't believe it. I don't believe it. The Fed does not want to be politically engaged. And it doesn't matter what party it is. If you are going through that kind of a period where you're voluntarily forcing pain upon the markets, and that is obviously, in that case, going to be significantly recessionary, it doesn't matter if it's

Republican or Democrat in office. The Fed is going to be blamed regardless of who it is. And that's not the role they want to play. They want this sort of institutional credibility, institutional independence thing. And so I feel very strongly that they have a threshold of how much they can push this. And if all the stars are aligned for them, they would be very happy if they could get a couple trillion off the balance sheet, if they could get the Fed funds rate up to one and a half, one, somewhere higher than zero. And then right at that time that inflation, the rate of which is lowered, then they can say, OK, well, now we kind of need to take a pause before the credit

markets end up rebelling. That to me is the timeline of where we're headed. So if you look forward and you see a three or four inflation rate, you do not see something in a year from now that should be thought of as a wonderfully low inflation rate. But however, I believe that's how it'll be perceived relative to six or seven because of all the conversation and noise now. And then the Fed will be able to use that to pivot off of a policy that is pushing them to inverting the yield curve, drive recession, drive credit market revulsion, and then back off and become the coddler of risk assets yet again. That's where they'd like it to go. Any number of things could throw off that chain of events. But these are the questions

that I think need to be asked. These are the ways I recommend people view these things. And having a forward-looking view to prices helps And having a forward-looking view to prices helps one formulate a forward-looking view to interest rates and therefore asset prices and therefore Fed policy and therefore macroeconomic conditions, so forth and so on. And I think it's a lot more useful than the backward-looking narrative that is less useful in the here and now. I've given you enough to chew on there. I absolutely recommend you read Dividend Cafe today. The written version is always different than what I'm saying here in the podcast or the video. More charts, more elaboration, and I'm a fan of the written word, and so I hope you all will be as well. But you know what? Not everyone is a fan

of the written word these days. A lot of people love the podcast medium and will take that as well. But if you're going to love the podcast medium, please subscribe, put it in your feed. It helps us and hopefully helps you. Thanks for listening to and watching the Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Thank you. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice. The Bonser Group and Hightower shall not in any way be liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced.

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