The Dividend Cafe - The Week After: Morning in America

Episode Date: November 17, 2016

The Week After: Morning in America by The Bahnsen Group

Dear valued clients and friends, the first week after the election hardly represented a reprieve from politics, as all eyes are intensely on the formation of the Trump transition team. We're particularly focused on the formation of his economic team and what that will mean to investors. So this week's Dividend Cafe podcast covers the important parts of where this leadership transition has brought us in terms of markets and the economy, but it also delves into a few other areas we think you'll find particularly compelling. So let's get into it. Anyone paying attention knows the punditry class was expecting a stock market dip in the event of a Trump election. Our own forecast was that there would be typical and historically consistent volatility coming into the election, and indeed at one point the S&P was down nine days in a row, and that after the election we would see standard normalization as various fears of uncertainty and unknowns came off. The violence of this stock market rally is a bit of a surprise to us, but the general fact pattern is not. However, the key occurrence for diversified

investors since Trump was elected is not what is taking place in the stock market, but rather the bond market. Bond yields have jumped higher. We discuss more of that later, but that's pushed bond prices down about 2.5% across a core bond portfolio. And it's more than that, much more than that for long dated, long maturity bonds. agree that part of this is the market expectation that Trump will get past some of his pro-growth economic agenda and that there may be some accompanying deficits that matter to the bond market. But there is ample reason to not put this entire bond back up at the feet of his electoral feet. For one thing, bond yields were just insanely overdone, and from a valuation perspective, they reached levels this summer that no one could really rationalize. Secondly, just the doubling of oil prices since the beginning of the year represents a more realistic assessment of inflation expectations. Bond yields were assuming levels of inflation lower than any analysis could justify.

So do the infrastructure spending plans and proposed tax cuts of Team Trump explain some pressure on bond prices? Of course. But we've been in a secular bond bubble for quite some time regardless. Now we're just recalibrating. Net net, the global value of stocks has increased $1.3 trillion since the election, while the global value of bonds has decreased $1 trillion. It's only the second time in history bonds have seen that level of drop in just a week. The polls getting it wrong was just the beginning. We cannot actually blame the various pundits who predicted a Hillary Clinton victory because pretty much everyone predicted it and all of the statistical modeling analyses certainly forecasted it.

The polls were not all in on it together. They were all just sharing the same flawed assumptions about turnout and enthusiasm. We have more information about the nuances of this year's electoral realities we could share if you were interested, but the fact of the matter is that it was nearly a universal assumption that Hillary Clinton would win. Where we would point to an even bigger breakdown in forecasting accuracy, though, came from a small group of financial writers who were not content to assume that market volatility from a Trump win, not to, they were not content to assume normal market volatility from a Trump win, but instead actually forecasted a full-blown market collapse. RBC modeled a 12% decline if Trump were to win. Barclays foresaw a 14% drop. The Brookings

Institute spoke of a 15% drop. Ray Dalio at Bridgewater Associates, again regarded as one of the most astute hedge fund investors alive, forecasted a 10.4% drop. Pretty specific, isn't it? a 10.4% drop. Pretty specific, isn't it? Look, Doomsday ran amok and the response was just less bite than bark. The response was the biggest up week in the stock market in over five years. We say all the time that the market's biggest task is to make the biggest fools possible out of as many people as possible as often as it possibly can. Well, mission accomplished, Mr. Market. A growth agenda just in time for a bond bubble bust. At the risk of pouring any water on the bullish sentiment that is understandably circulating, and we say understandably because we agree that corporate tax reform, deregulation,

we agree that corporate tax reform, deregulation, foreign profit repatriation, full cash expensing for business investment and capex, and many of these other political initiatives are likely to be wildly bullish for stocks should they all come to fruition. But it should be pointed out that the bond market is responding in the exact opposite way. The interest rate on the 10-year treasury bond has been 1.5% a few months ago and had creeped up to 1.8% before the election. It is now blown out to 2.25%. Heavy duration sensitive bond investors sweating, leaving them sweating as their portfolio values have declined. Bond positioning that was more credit sensitive and less rate sensitive has benefited a great deal. Now beyond the noise of a one week or two week market response, should bond investors be concerned?

We talk more about interest rates below. Emerging markets and the dollar. There's been a sell-off in emerging markets the last two weeks and there's little to explain it other than the stock answer that well the dollar is rallied. The chart that we have in DividendCafe.com this week shows and we'll just describe for you now that there has indeed been an incredible inverse correlation between the dollar and emerging market equities. Now Our belief though here is well documented. Good emerging market investing does not rely on a weak dollar, but rather fantastic operating companies with pricing power. Currency moves come and go and have little or no impact on what fantastic operators are doing to serve domestic markets. This is noise

and it always has been. Growth conquers all, but the timing matters. Our general viewpoint is that investors are caught in a tension right now between two forces, both real, both we believe somewhat predictable, and yet both on different timelines, so therefore hard to predict in terms of how these things will play out. On one hand, interest rates are rising even as the global economy has been weak, and on the other hand, we really do buy the argument that much of what we expect from the new political administration will be bullish for growth. But the tension comes because the impact of higher rates will be felt immediately, while the pro-growth policies we're talking about out of Washington, D.C. are months,

if not a year or more away. We are watching how high rates go and may be compelled to take a larger position in bonds if we feel they become valuable on a price basis or on a recessionary hedge basis. We still believe growth is the likely outcome here in the States, but this timing tension is real and somewhat unpredictable as far as how it exactly plays out. Bond yields are the number one macro thing we're watching now, and will stay such for the foreseeable future. now and will stay such for the foreseeable future. Well, since when do real estate developers like higher interest rates? Since one became president, I suppose? Actually, the story of bond yields blowing out since the election is quite simple. They were way, way too low prior to the election,

and I don't know, for the last six years maybe? Of course the market is reasonably expecting the Fed to begin some degree of rate hikes next month. The bigger issue that does delve into the political is that the market believes Trump has the political ammunition to get a large infrastructure spending bill into law, since it's its own party that would have to block it, and such spending commitments would add to deficits and push rates higher. The initial knee-jerk response of bond markets may not be fully thought through though, but there is some wisdom to it. Secretary Clinton may have wanted a big deficit spending package, but she would have faced congressional resistance. President-elect Trump will not.

So what do we expect out of interest rates? We have no opinion on the next 30 to 60 days. Generally speaking, we believe interest rates have been way, way too low for way, way too long. With that said, we think longer term rates stay generally lower than historical averages for a long time as global growth and global yields and global deflationary pressures anchor them lower. Trump may be able to generate some boost to growth with tax reform, but fundamentally the rates that have two issues for borrowers and investors to understand. One, the rate levels we've been in have been preposterously irrationally low, and two, even as they inevitably go higher, they can't go that much higher, knowing that global growth isn't producing enough demand for money. What's a contrarian supposed to do? Long-time

readers know that besides our deep commitment to investments that are continually growing their cash flow generation to investors, few principles are held more near and dear to the heart of the Bonson group than basic contrarianism. It's a fundamental tenet that timing fears notwithstanding, the crowds can generally be relied upon to do the wrong thing at the wrong time. This makes it tricky in those periods when the behaviors of the crowd are mostly logical and rational. Ultimately, contrarianism does not say that the crowd is wrong and that Trump will increase defense spending as a random example. Contrarianism just says that the crowd will overshoot.

In other words, what makes a contrarian thesis true is that often the crowd is doing the right thing at first, but then just plain overdoes it because of human nature. Greed goes too high, fear goes too high, etc. Right now we understand the crowd selling off what we call bond proxies, investments like utility stocks and REITs. But as interest rates in the bond market have risen and making the risk-adjusted returns of those investments somewhat less attractive, I guess our contrarian impulse says maybe we ought to take on some REIT exposure soon because we think the crowd has or soon will overdo their response. I'm going to go ahead and leave it there for this week. At the dividendcafe.com blog commentary entry, there is a few more sections that we don't have time to include into the podcast

dealing with China and a few other matters that might be of interest to you, particularly the chart of the week telling you a bit about the level of panic and fear that we see going into and out of political events through the VIX and how investors are so prone to get that wrong. But we will go ahead and leave it there. Thanksgiving is just around the corner. We hope you have a wonderful weekend. Thank you for listening to Dividend Cafe.