The Dividend Cafe - Top Five Questions of Summer 2022

Episode Date: August 18, 2022

We have a fun Dividend Cafe for you this week, with by far the most important things on my mind in the summer of 2022 getting all of the attention. This is a short, easy read, and easily digestible for anyone looking to make heads or tails of the current market conditions. I will spare you further introduction and jump right into 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. Hello and welcome to another edition of the Dividend Cafe. So excited to be with you, actually sitting in our studio here in Newport Beach. And I want to do something a little bit fun today. I hope you listening to the podcast and watching the video will enjoy this format. What I sat down this morning to write Dividend Cafe and had a number of different topics I wanted to address that to me were kind of the low-hanging fruit of the summer. And I'm kind of in that mode right now of the summer wrapping up. I have kids getting ready to start school again and sports practices have already started.

And I'm very much thinking about USC football starting. And so you get this kind of like summer's almost over, fall's almost here vibe. And, you know, it's been an incredibly stimulating summer intellectually. Like there's been a lot of things that I've been working through, projects, challenges, and just, you know, a kind of framework of portfolio thinking that I think in a lot of ways are obvious. The macroeconomic questions that everyone's talking about and we've written about, I think we have a different touch that we put on it, but the question about recession and inflation and those things. But look, there's a few different things that are kind of primary subjects and we get a lot

of questions about them. So I just thought, why don't I give you the five things that are kind of most on our mind, our thought process here as we wrap up the summer 2022. And so what I want to do is just go straight from the Dividend Cafe, address these topics and give you a little commentary on them. And of course, invite more questions going forward. First and foremost, which I think does play into other things that we're going to talk about regarding the Fed and the market, but that broad question of what to expect from inflation next. And we know that the CPI number that was released a couple weeks ago for the month of July went from being up 9.1% year over year in June to being up 8.5% year over year in July. And the kind of confusion, you know, it's not really confusion.

President Biden either misspoke or was purposely misleading. But where this 0% nonsense comes from was that the inflation from June to July didn't move higher, but the year over year prices are much higher. It's just they're not as higher as they were the month before. And so it's kind of semantics there. But it is a rate of growth of inflation that for one entire month went down. I've talked about a lot that in goods inflation, went down. I've talked about a lot that in goods inflation, it's been going down. And what had really pushed things higher in the spring and early summer was food and energy, energy most notably. And it was the energy prices coming down on the month. OK, just for the month of July, they were down 4.6 percent. That pretty much caused everything else to come down because

food prices were up 1.1% on the month. Services were up 0.4% on the month. Now, look, it's entirely possible energy prices end up reversing, of course. But my point is that there was always some lumpiness in some of the inflation data, and you get lumpiness pushing some things higher. You're going to get lumpiness pushing it lower, meaning it's more idiosyncratic or kind of outlier things. Fundamentally, when the question is what to expect from inflation next, my view is that the rate of inflation is coming lower and and I want to give you a few different reasons for that a lot of which I've been writing about but I think that they're important and the supply chain issues that have been I believe at the heart of inflation since

let's call it early and certainly mid 2021 up until the very early part of 2022, there has been a lot of relief, a lot of improvement in supply chain challenges. They're not fully cured, though. There's been material improvement, but there remains room for more improvement, which also means room for more disinflation. Energy inflation, number two, has for now subsided. It was a substantial contribution and it was on the supply side. We had inadequate production meeting what was really status quo demand. And so the incredible amounts of pressure that existed to get production higher,

both in the U.S., we exported the most ever last month. There's also an increase in production, OPEC Plus and whatnot. The Russia-Europe deal remains a challenge. But energy prices have been able to come down because for now we've at least started to do some of what we should have done a long, long time ago, increase the production side. It's not where I want it to be, and it's not going to get to where I want it to be, but it's better than it was. Another aspect of why I think the rate of inflation will be coming lower is even though there's a big lag in the data, housing prices are either coming down or not going up or not going up as much as they were. And that translates into what rent prices would be as well. So you could pick which of those three you think it is, but it's

one of those three. And that then means disinflation because the rate of growth in renting and the rate of growth in purchasing was so high that now it having come down when that gets captured into the the cpi data um it's going to make a big difference and then and then finally the thing i talk about all the time massive debt levels um have left loan demand very muted loan demand muted does mean a declining velocity and that means uh that the money in circulation not turning over allows for almost deflationary pressure to overwhelm inflationary pressure over time. And so I think the aforementioned factors around energy, supply chain, housing, as they come down and this unfortunate velocity characteristic comes in, you get a paradigmatic shift. And we've talked about that a lot. The chart of the week for the first time ever in the history of Dividend Cafe, I purposely pulled it up from the bottom of Dividend Cafe

to the middle because I wanted it to be right there in the addressing of this question, what to expect from inflation next. And that is a chart of the actual M2 money supply. And I point out a couple of things. First of all, that money supply went way higher post-financial crisis and inflation went lower. And it lasted that way for 10 years. And I didn't waste your time with a chart showing the same thing in Japan for 30 years, but I talk about all the time. with a chart showing the same thing in Japan for 30 years, but I talk about all the time. But then, of course, we know that money supply skyrocketed higher out of the COVID moment, and inflation obviously a year or so later did come up. But if one believes the reason that inflation went higher was from the additional money supply generated in the aftermath of the

$2 trillion CARES Act, the $900 billion lame duck stimulus bill that was passed late 2020. And then, of course, the Biden bill that was passed in spring of 21, which was almost another $2 trillion. You basically had $5 trillion of spending on those three bills. And the sort of viewpoint was, well, money supply went way higher as a result of those bills. was when money supply went way higher as a result of those bills. And my point in the chart is that money supply has now come all the way back down. So if the inflation rate was post-hoc from the money supply increase, then one has to believe the inflation rate now comes down as that money supply growth has totally, completely evaporated.

But do check out that chart, though. I think it's a really important point. Okay, so that's our view on what to expect from inflation. The bad news, I don't think it gets there quickly. I don't think it gets to the Fed target quickly. I think inflation expectations are already pretty close to the Fed's target, but the actual print that people will see quarter over quarter

and what people are paying in various price levels stays elevated. But the rate of that growth comes down from here. That would be our forecast. And of course, it's been my forecast now for a while. So what will the Fed do about rates? This is the kind of second big issue that a lot of people are talking about. Let me recap for you what's gone on so far. It would have been in April that the Fed first raised rates. So that was over two years since they went down to zero at the COVID moment. And in April, they raised a whopping quarter of a point. And you go, for good reason, wow, we're back to this post-crisis, you know, slow walking of normalizing rates a quarter point at a time.

And it was only the political pressures around inflation rate that caused the Fed to start moving at a bigger level. So they moved a quarter in April and 50 in May. And then they moved 75 in June and 75 in July. 75 in June and 75 in July. So where we got to the 225 to 250 basis point, you know, two and a quarter to 2.5% Fed funds rate we have now is from four rate hikes that were one quarter, two quarters, three quarters, three quarters. You follow me? So the question is, what are they going to do next? In my view is that September will be a 50 basis point rate hike that'll bring us up to three percent and then we are excuse me 275 to 300 and then we're looking at no Fed meeting in

October and in November in December I think they get another 50 done whether that is 25 and 25 or 50 and zero or what have you. I think they end up the year at about 3.5 percent. And this is where things get very interesting. And I really hope you'll take note of this. I want you to understand the three options that exist for rates going into 2023, which is what markets are looking to now. Markets don't care if they do 50 now and 75 the next month. It's the point being that they're getting to some number. What is that number? And then what they're going to do after that. And there's debate as to whether or not it's three and a half or three and three quarters

or some may even say lower. And do they get there in November orober in november or december or whatever this stuff's meaningless the terminal rate where they end up kind of pausing and where where that number is and when they get there not how they get there okay i would suggest that at that point the pause could mean that they actually end up pausing for a bit and then having to hike further. And I don't think there's even a 10% probability of this. There is the chance that they get there and then have to start cutting rates rather quickly. And I would put about a 30% chance on that going into 2023. And so obviously that leaves you about a 60% chance

of what I'm forecasting, which is that they literally kind of sit still for a little while. So what are the different scenarios? Well, look, what would make them have to hike rates from getting to that 3.5 that I think they're going to go into the new year with is that the inflation rate is actually staying above 8.5%, 9%. And at the same time, the unemployment rate is staying as low as 3.5%, 3.6%. Now, the Fed knows that they don't really have that much impact on the CPI rate. But they have to pretend they do, and the political pressure is there, and God knows the media won't stop talking about it. So the Fed has to act as if, well, yeah, we've got to really hike rates,

inflation's high, and that's fine. They don't really believe that, in my opinion, but they've got to do it. But if the unemployment rate starts coming up, they have cover. But if the unemployment rate stays very low, they really do believe that there's a trade-off between employment and inflation in this Phillips curve thinking. So again, there's things they wrongly believe that they really believe. There's things they wrongly believe they don't really believe. Then there's the stuff that they might

rightly believe or that I think I rightly believe. I'm referring here to what they wrongly pretend to believe, which is that the Fed funds rate is going to be a factor for the CPI number coming down next year. They don't really believe it, but they pretend and they're wrong. They really do wrongly believe that the unemployment rate being low is inflationary. And by the way, the unemployment rate being high is antiary. And by the way, the unemployment rate being high is anti-inflationary, both of which are untrue. So I don't anticipate either of those scenarios, that unemployment stays at 3.5 and that the CPI stays at 8.5 to 9. I think that both unemployment will be a bit higher and CPI will be a bit lower, which gives the Fed all the cover to not do what this 10% probability is. But if those two things are there, I think that will be a factor that makes the Fed hike even more.

And I'm telling you not a whiff of that is priced into markets. No market actor in fixed income or equity is acting as if that is a scenario. And so that could end up being very market disruptive if it were to happen. It's obviously a very low probability outcome in my mind. Then the issue of what would make them actually start cutting rates as early as early 23, which a lot of people don't believe is very likely. But what could make them do it? Well, it's if the unemployment rate is moving really higher and the CPI number is moving

really lower and then financial markets, financial conditions tighten substantially. At that point, then everything kind of reverses. And then the Fed says, OK, we wanted to create a little tiny recession to soft land this. But oh, my gosh, it's left the station. tiny recession to soft land this, but oh my gosh, it's left the station. We got to get this under control. And that can cause some rapid fire cuts. That could be, by the way, one of the worst things that will happen. You might think everyone loves it because everyone thinks they all love low rates. But that kind of blow to credibility, that addition to instability that we dramatically hike and then dramatically

cut, it's just not good. So the scenario that is maybe the most likely, 50, 60 percent, and certainly the one the Fed is playing for, is that they get to their three and a half-ish and sit still. What causes them to be able to sit still? Well, you know, the CPI number is coming lower, but not rapidly. I think that's very likely in both fronts, lower but not rapidly. And then that the unemployment numbers don't skyrocket higher, the financial conditions don't tighten dramatically, that it's just kind of not too hot, not too cold. That's the scenario that they end up sort of sitting still, at least for a little while.

That very well could happen. It can't happen forever. It can't happen as long as anyone would want it to. But it could buy them enough time in 23 that we sit with a stable rate. And then, you know, a rate sitting still, let's say a 3.5% Fed funds rate, which I actually really like that number a lot. a three and a half percent Fed funds rate, which I actually really like that number a lot. Well, I don't know what people will do with themselves if the rate's not going real high, a lot higher, a lot lower, and taking away the narrative that the Fed is the sole influencer of all things economic. It could be pretty boring, but we'll see.

Okay, so then speaking of 2023 and things getting kind of boring, a lot of people want to know what the midterm election results are going to play with markets. I went out on a limb here in D.C. today, this week, and offered my forecast. I kind of think the Republicans taking back the Senate is now off the table. And obviously it could change. And people say, well, you're just looking at the polls. And I always say, well, of course, I'm looking at the polls. And yet I don't ever assume the polls are scientifically set or perfect.

I don't look at one poll. You want to look at big averages. You want to look at blends. And to think that all the polls are for sure going to be totally wrong is not generally accurate, but some polls can most definitely be wrong. And you can have things that end up escaping the pollsters. And, you know, some polls may be biased to the left and others could be biased to the right. That's why you look at averages. But, you know, they're wrong, they're wrong. But I look at more just the polls. I look at the inside campaign polls where I have access to some of that information. There's no bias in what campaign is polling on their own to tell them about their campaign. That idea that was very probable in the early part of 22 and even into the second quarter of the Republicans getting a net one, net two or net three, you know, where the gain in the Senate after the midterms is very, very, very unlikely at this point.

There's still a path to a break even Senate and there's still a path where the Democrats could take as many as three net, like end up at a 53 percent, 53 to 47 Senate. And there's still a path where the Democrats could take as many as three net, like end up at a 53 to 47 Senate. And it could be 52, 51. But I think that's the range you're talking about. Somewhere from 50-50 Dems to 53-47 Dems. That's my guess based on a number of factors as how things have played out with some of the candidates that won primaries in this election. And if I'm wrong, I'm wrong, because that's always a possibility of politics. Anyone can be wrong. Most people's opinions are based on what they want to be, and mine are not. And I'm just calling balls and strikes here. But I do believe the House is going to obviously flip, and I don't believe it will be by the margin some were talking about earlier in the year,

but that kind of doesn't matter for markets. Let's just get off politics. If the House is Republican majority, you're going to get gridlock for the next two years. You're going to have a Democrat in the White House, I believe a Democrat-controlled Senate, and a Republican House is enough to keep anything from passing legislatively. And so markets like gridlock. And I've talked about this for 20-plus years. So I don't think that there's a big factor there. But, you know, on the margin, the control of the Senate does affect who runs some committees. It has a regulatory impact. But I got to say, the biggest aspect to markets is what tone it sets for the 2024 presidential election. I think that if you had a certain scenario that really forecasted a high probability of a pro-market, pro-economic growth kind of agenda going into the future, markets could have started to discount that. But I think

that there's going to be a lot of ambiguity about where things are going, who the candidates are going to be, and who the winners are going to be, and what's going to happen. And 22 could have given some foreshadowing to 24 that could have been market impactful. But I very much doubt that 22 will give market forecast for 24. I just don't see that coming now. And that would be our takeaway on that point. I'll leave that there. If you're mad at anything I just said, there's a good chance it's because it's true. Okay. Number four, I'm getting this question a lot. We're talking about it a lot. Is de-globalization real? Is it a game changer? Is it a negative factor for markets going forward?

What's my take on it? I really only gave this a couple paragraphs of treatment in Dividend Cafe because I need to do a whole Dividend Cafe on it. There's no question it's real. There's no question that it has some negative and positive components to it. I think that both politically and in the interest of national security and in the interest of other agendas, that there is a lot of positives about the idea of less reliance on China and our supply chain, certain aspects of national security and prominent manufacturing coming onshore or being regionalized in North America. Those things, I think, could be positives. And yet this increasing disinterest in the international order from America is what people are talking about when they say deglobalization.

And I understand that trend and I understand the rhetoric and emotion behind it. But my view is mixed on it because I ultimately believe it could be very negative for the international order and for markets. But I also don't believe it's really going to happen. I think that it is temporal. I think that the healthy parts of deglobalization and a healthy move towards regionalization could be very productive. But this wholesale idea that the U.S. is somewhat disengaged from much of the world, I think may very well happen. And I'd say that negatively until it doesn't, because I think that as soon as it creates pain, that there would be a reversal.

And this just tends to be the way a lot of American policy gets set, is that these things go until they don't. And there's an old adage, I think it was Churchill, who said Americans can always be counted on doing the right thing after they've tried everything else. But I don't remember Churchill said that or not. More or less, I think that's a play here. It's not this simple. There's more nuance here. But I think that there are both positives and negatives out of what is a real trend. The intensifying globalization of 2000 to 2018 or so is definitely subsided. And elements of a deglobalization

will prove to be a mixed bag for U.S. economic interest. OK. And then finally, I want to close with what is and I love this topic, the criteria for quality from public companies right now. People hear me critique all the time the notion of the PE ratio, the valuation as being the most important element of a company's stock price, a company's health. A growing, rising price-earnings ratio might speak to someone's hope. It might speak to someone's speculative mania. And it might speak to just really rational and deserved optimism. But it doesn't speak to the quality of the company. It speaks to perceptions that either prove right or wrong. The fundamental quality, I believe, is best measured by free cash flow. So what about balance sheet? A strong balance sheet for a company is quite important. It sure is. A strong balance sheet

is better than a weak balance sheet. But what if a company has a strong balance sheet and totally deteriorating free cash flow? All that means is they're going to light the money on fire that's in their balance sheet, right? They're going to be deteriorating assets is they're going to light the money on fire that's in their balance sheet. Right. They're going to be deteriorating assets because they're not generating cash flow for the future. Ideally, as dividend growth investors, we want a strong balance sheet and free cash flow. But you have to have the free cash flow. That is the element of a quality company. And the piece I want to add to it is free cash flow margin. In other words, how much, the rate at which revenue can be turned into profits. Because free cash flow then has a very capital intensive business. And we have a lot of CapEx intensive businesses. And I like CapEx

because I like investment and productivity. And I like growth. But there are some businesses that enable you to grow your cash flow that can translate into earnings that become distributable. And this is a very high quality position to be in, especially when cost of capital is going higher. Companies that can fund their own CapEx, companies that don't need to use a lot of their free cash flow for working capital, they're in a better position. So to me, this represents the definition of quality company. And of all the accounting metrics that exist, the one that I think most neutralizes the ability of very clever accountants to play games with the income statement is free cash flow. I think that what can take place on an earning statement around so many elements of goodwill

and intangibles, depreciation, amortization, they can distort a real picture and cash can't lie. And of course, then when you go to investment merits, you get to the real Bible of the Bonson Group's belief about investment, which is what really can't lie is the dividend from the free cash flow that they give you that we actually get to take and deposit. that we actually get to take and deposit. But before you look to the management philosophy and management operation around the investment methodology of dividend growth that comes to us, the quality nature of the business is defined by cash flow generation.

I can't say it enough, and I hope you understand that. It's a totally different way of looking at business versus shiny objects and say, oh, cash flow doesn't matter. But, whoa, we got this hot new technology. Well, hot new technology that generates no cash flow could end up being a massive gainer in the future. But it could also light money on fire. Most of them do.

And I know some go up 10 times and you say, well, who cared? They didn't have cash flow back then. That's fine. But that wasn't the question. The question is not where was the most speculative opportunity. It was where's the most quality to be found when one's evaluating company investment opportunity, free cash flow. Okay. A lot of categories today.

I loved going through this stuff. I hope you got a lot out of it. Thank you, as always, for listening to Dividend Cafe. Please reach out with questions you have. If you're not subscribed on YouTube, hit the subscribe button. If you've never liked us, throw a like on there.

I keep finding out more and more about how this stuff works. And so I'm just trying to prod a little to get those likes and subscribes at the podcast, at the ratings, at the video, at the things, and I'll leave it there.

Thank you for listening to and watching The Dividend Cafe. 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. I'm Matt Levin. performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this

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