The Dividend Cafe - The War Between Tax Reform and Tariffs

Episode Date: June 22, 2018

This week, David covers from trade stuff, to capex, to Japan, to so much more..... Topics discussed: China's retaliation against US tariffs Small Business CAPEX on the rise! US moves up to #2 in world oil production much more Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson, the managing partner, chief investment officer of the Bonson Group. And we're coming to you with our weekly commentary this week covering so much around the trade and tariff wars, tax reform, and even going around the world to talk Europe and Japan and all that kind of stuff. Markets predictably resumed downward pressure this week as the U.S. tit-for-tat tariff war with China exacerbated. Markets do remain well over 1, thousand points higher than they were a couple months ago, when arguably the trade war had not yet even grown as bad as it has now. So that is a testament, I think, to how strong other economic news has been, apart from this

unforced trade war error. But there's a lot more to be said. Let's get into it. In terms of this tariff terror, what must surely be one of the least surprising things ever, the Chinese retaliated against the U.S. declaration of tariffs, $50 billion worth. And that provoked President Trump to say he will retaliate against the retaliation, so forth and so on. I'll spare you kind of the inner details as to where these various tariffs are being applied, what sectors exactly and what products and then what percentages are being waged on different things and so forth and so on. It's hard to play out where it will all go from here. The consensus view and the hopeful one is that there's plenty of posturing and flexing and negotiating behind all of this and that the actual impact on prices and consumers via these voluntary tax hikes will be minimal.

The problem, of course, is that no one knows exactly how this plays out or in what timeline. There's a game of chicken going on and investors are wise to not like it. The underlying market volatility we're experiencing now is highly unlikely to subside as long as this issue lingers. The president's bet is that the economy is strong enough that he has wiggle room to play this out and see how much of an impact a trade war has. Skeptics say that to launch such an experiment with, let's say, 3% to 4% anticipated GDP growth risks losing much of the lift that led to that 3% to 4% GDP growth potential. My own view is that the most likely thing to reverse course from this

desired path in trade and tariff discussion will be a meaningful drop in equity prices. That hasn't happened, and so we continue in this directionless limbo. The tariffs are creeping higher, the retaliations are moving into more and more sectors, and then retaliations are being launched against retaliations. The market's not loving it, but the market is not panicking yet. We'll talk about this more a little bit later. Investing by valuation. We like to avoid overvalued securities. We like to buy undervalued securities, but maybe that's not as obvious a routine as it may sound. Many feel like undervalued stocks get more undervalued. They often do. And overvalued ones get more overvalued, they certainly often do,

until they don't. We don't view the momentum trend-driven approach as viable due to the violence and rapidity with which trends can be broken and momentum disrupted. We liken that approach to gambling, and we feel strongly that investing should be done with more rationality and coherence. But being valuation conscious does beg the question as to how one can identify what is over or undervalued. It's a fair point. Our argument has always been, borrowing from the value legend Benjamin Graham, that we don't need to guess exact weight to know what is overweight, and we don't have to know exact age to know if one is old or young, etc. Yes, a lot of middle ground exists, and much investment controversy and difficulty can exist in that gray area of valuation,

but broad labels are possible and warranted, even apart from exact weight and age. By the way, a great chart you have to see at DividendCafe.com this week about small business CapEx taking off. The survey of the National Federation of Independent Business on what smaller-sized businesses are doing in their own capital expenditures since tax reform, seeing a real breakout in that regard. You're hearing it from me here in the podcast. View it at DividendCafe.com.

Hey, why aren't long-term rates going higher? Has the Fed has slowly but surely increased the short-term interest rate higher over the last 18 months? We've seen the 10-year bond yield creep from 2.6% to just 2.9% or so, and we've barely seen the 30-year bond yield move at all. The result is obviously, and just plain mathematically, a flatter yield curve. But with economic growth so much better and supposed inflation fears, why are long-term rates not, in fact, moving higher? My thesis has long been that the bond market doesn't believe the inflation theme, that whether or not headline or transitory inflation chatter increases in the short term, a pickup in structural inflation is simply not believed in the bond market,

evidenced by the low long-term rates. However, another factoid that really warrants more consideration in the overall milieu of this macroeconomic context is that our long rates are being held down by Europe. Challenged growth and heavy monetary intervention has anchored their rates down, and it's hard to believe the U.S. bond yields could widen much with Germany anchored so low. And I would add, you know, Japan deserves an honorable mention there as well. So in terms of our fixed income bond market update, we are looking right now to increase emerging debt in our bond portfolio just on a valuation basis. We see it as having gotten undervalued relative to the overall opportunity set in the fixed income universe. We're probably going to take that increase from

a slight decrease in floating rate bank loans, again, just on a valuation and a supply basis. Looking at some short-term tips, the inflation-protected treasuries, just based on the short-term level of headline inflation. And yeah, keeping duration short across our fixed income portfolio, but really not because of where we see long-term rates going, but just basically the opportunity for total return in the near term. Europe updated. What should we expect from European markets in the months ahead? Not just in their bond spreads, their economy, their equity markets, absolute yields, the whole deal. Well, my best guess, first of all, is it will not be monolithic in the months and quarters ahead. Germany's health will look

different than Italy's, et cetera. But I do believe investors should understand this. Over the last four years, the European Central Bank has purchased 2.4 trillion, with a T, euros of debt. 2.4 trillion euros of bonds have been bought by their central bank with money that doesn't exist. Now, they have not circulated that money into the money supply, which is why it has not been instantly inflationary. It's been more of a gimmick to hold yields down and stimulate economic activity that way. They've been slowly winding down those monthly bond purchases, and then they've announced they're going to stop altogether in September.

The question is whether or not the tepid economic growth they've had now with this bazooka of monetary stimulus will be hurt by the cessation of this aggressive monetary intervention, or will it help to be on the other side of monetary training wheels? Let's switch geographies from Europe going further east to Japan. One of my biggest frustrations is when people interpret my decision 20 years into my investing career to take a position in Japanese equity markets as me somehow believing that their monetary extremism in 2016 worked. In fact, I believe it made matters worse and that most of their monetary interventions over the years served to exacerbate the deflationary pressures that have pummeled Japan since the early 1990s.

pressures that have pummeled Japan since the early 1990s. That their corporate sector is loaded with cash, enjoys low valuations, and is in screaming need of creating value for their shareholders are all matters totally divorced from their sovereign finance state. The dividend payout ratio is incredibly low on a global basis, and we want to capture the secular reversal of that fact. As contrarians, we do not believe the space is loved or barely even liked. That makes us like it even more. In fact, the index trades down near where Colombia, Poland, and Russia trade in terms of their P.E. ratio, their market multiple. We don't see any justification for that. It's a long-term play. It's not related to negative interest rates or their central bank buying shares or any other market distorting shenanigan. It's a contrarian fundamental play given our thesis of Japan's

future corporate dividend growth. I'm going to push you to the website again for a chart on the biggest story in the American economy. It's not the iPhone. It's something else that's happened all in the last six years and entirely driven by American technology and innovation with profound implications for geopolitics and global economics and that we think will have third and fourth order effects that will drastically impact growth in our own economy. And of course, I refer to the fact that U.S. oil production has now surpassed Saudi oil production, putting us up as the number two oil producer in the world, very near Russia. Russia doesn't produce very good oil anyways. But I really want you to see the chart we have at Dividend Cafe.

Okay, so look, the rest of the Dividend Cafe this week, we go into our tactical explanation around asset allocation. Do asset allocators want to go make a strong prediction about what macro events are going to be? The dollar is going to do this. Interest rates are going to do that. The Fed's going to do this. GDP is going to do that. And then pick the right solutions to all those forecasts and then assume the market will respond the way they believe it will with their solutions that they think will be the right solutions to their forecast about macro events that they think will be the right way the macro events play out.

There is no sanity in such an approach to investing. People cannot get all those macro conditions right over and over in any short-term horizon, nor can they pick the right solutions to match up to their own forecast, nor can they anticipate how the market will respond even when their own forecasts do prove to be correct. The whole point of asset allocation is to capture zigs and zags simultaneously. So as an example, the dollar has rallied pretty dramatically in the last, let's call it three months, and you've seen small cap stocks do very well, substantially outperforming other equity markets,

largely because small cap is unaffected to a large degree by dollar movement, having a lot less multinational revenues. But then emerging markets have done poorly in that kind of expected short-term inverse correlation to the U.S. dollar. kind of expected short-term inverse correlation to the U.S. dollar. So here you have two growth-oriented asset classes that belong in any thoughtful long-term portfolio with different short-term responses, all part of asset allocation common sense. Hey, listen to our Advice and Insights podcast when you get a chance to hear more about the trade issues and our theory that there is a tension between tax reform and the trade war.

And then check out DividendCafe.com just because we really think there's all sorts of charts and other written material there. But the podcast has gone on a little long for the week and I'm gonna leave it here. We love you listening to this. We would love your feedback. Email us any suggestions, any time.

And then no matter how much it annoys you, please listen to me say that we would love for you to subscribe to whatever your player of your choice is, to write us a review, to write comments, and to send this out to others. The more traffic we can generate on the podcast, the better for us for a whole lot of reasons that are too complicated and boring to explain. And I would have to actually find out myself what it is. I'm just telling you what I'm told. Okay. Thank you for listening to Dividend Cafe. We look forward to coming to you next week. Thank you for listening to The Dividend Cafe, financial food for thought. LLC member FINRA and SIPC and with Hightower Advisors LLC a registered investment advisor of 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 is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance is not a guarantee. The investment opportunities referenced

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