The Dividend Cafe - What To Expect for the Rest of the Year - July 8, 2016

Episode Date: July 8, 2016

What To Expect for the Rest of the Year - July 8, 2016 by The Bahnsen Group

Dear valued clients and friends, welcome to this week's Dividend Cafe podcast. As we get ready to roll here middle of Friday morning, the markets are meaningfully higher behind a shockingly strong jobs number. Friday, we had a large drop in oil prices. Markets have rallied quite a bit here on Friday morning. In this week's Dividend Cafe, we attempt to tell you the two things that we think are at the crux of what is driving capital markets right now and what we believe will determine investor outcomes for the remainder of the year. It is, in my opinion, one of the more important commentaries of the year. A little look back at the first half of the year will hopefully grab your attention as well. So with that said, let's get into it. Never forget that at our YouTube channel, we also have a weekly video commentary with different comments and content. And then of course, the written version of this very podcast with charts

and so forth is available at Dividendcafe.com. By way of executive summary, markets rallied strong Friday morning behind a huge jobs number, 287,000 new jobs in the month of June, and really the accompanying feeling that maybe Goldilocks is alive and well, an economy strong enough to avoid recession for now, but not strong enough to get the Fed to do anything about interest rates. We feel that the danger in safety piece that we wrote this week at DividendCafe.com is one of the more important assessments of current market conditions and our present portfolio strategy that we've written, we strongly encourage you to check out that piece regarding the crowding effect that is coming into safer or allegedly

safer dividend yielding parts of the stock market. In the news this week, FBI Director James Comey announced that they will not be recommending criminal charges against Secretary Clinton, but did acknowledge multiple laws were broken and security was severely breached. In the UK, the largest insurer, Standard Life, blocked redemptions from some of their illiquid property funds, funds invested in commercial real estate holdings. Basically, the reason is that the redemptions they were getting could not be met because of the illiquid nature of the underlying assets. Could bode well, could bode not well, I should say, for other real estate fund positions we're watching closely. Of course, by now many of you know of the vicious mass police killing that left five Dallas police officers dead on Thursday night in a just despicable coordinated attack.

Ongoing social unrest is becoming a much bigger phenomena than I think economists and market pundits understand. Moving on to review the first half of 2016, let's start with China. There's no question that in the beginning of 2016, China fears were really the story of the markets. Having experienced a second bout of large capital outflows, the second being in December, January, the first being in July, August of last year, China's finance policymakers depreciated the yuan further to once again soften the blow of a slowing economy. Fears of contagion rippled around the globe and markets were smashed in January.

It was the worst January in the history of the stock market. As things settled in China late February and early March, so did things settle in other capital markets. But now this issue of the ongoing yuan currency depreciation to our dollar, it's dripping lower instead of collapsing lower, but it continues to be an issue we're watching based on those events of August last year, January this year. We have a chart at DividendCafe.com noting the correlation between the U.S. stock market and the yuan exchange rate over the last year and how it's only been the last few weeks where our stock market has continued to go higher but the yuan is depreciated lower. That correlation

has recently broken apart and we think that's very interesting. But we did get word this week that China's foreign exchange reserves increased by $20 billion in June, and expectations were for a $20 billion decrease. So not coincidentally, in my opinion, the stock market kind of reversed on Tuesday when it had been down, as we think that news started leaking through to trading desks. route of trading desks. Even as the week progressed, we do right now see a won at its lowest spot relative to the U.S. dollar in six years. So we think the market has not been responding negatively to this depreciation the way it previously has, because this time the currency depreciation was really not as unexpected. And in the past bouts, it was really

a big shock. Excuse me. So China is definitely the biggest thing that we're watching in the second half of 2016 that market pundits are not thinking about the way they once were. market pundits are not thinking about the way they once were. Let's move on to a discussion of oil. If we are going to posit China as the leading story of Q1 then we certainly have to put oil right up there as a very close second. More particularly China was probably the big story of January and then oil the story of February. As you likely know, oil dropped from $45 at the beginning of the year to $26 in mid-February, but then rallied up almost 100% to a high of about $52 a few weeks ago. We're now sitting at about the $45 to $46 level. It has sold off this week about 5%. But while no major oil producer has really cut production yet at all, well, besides the United States, that is,

the mere freeze at present production levels has caused prices to rebalance to some degree. Our contention throughout this whole oil debacle is basically that it's a supply glut issue, not a reflection of declining demand. And that is really held true. If all the remaining producers were to implement a slight production cut, we think oil prices would rally dramatically. But for now, the bleeding has stopped to this $45 to $50 range. It may last for a bit or it may not, but we are meaningfully off

of the really catastrophic lows of earlier in the year. I want to recap some things with MLPs for you real quick, because the suffering that MLP investors endured in 2015, that memory may not go away anytime soon, but the downturn in the prices sure has. The Elyrian MLP index was down 4.2% in Q1, but up 19.7% in Q2, resulting in an almost 15% net return for the index these first few months. The last four months have all been positive for MLPs, the longest win streak in MLP history. Eight months, the longest win streak in MLP history was for eight months from September of 09 through April of 010. Now that was the good old days in MLPs, but there actually was even a 15 month win streak back in October of 2002 on through December of 2003. I wasn't an MLP investor

then and the index was really quite different. But when we look at the MLP recovery more recently, it's important to note how impossible it is that this recovery has only been about oil prices coming back to the high 40s. I mean, $48 oil is a bigger positive for oil producers who use pipelines to transport their oil than $26 oil is. But last year, when oil came down to $48, instead of coming up to $48, which is done this year, it was anything but positive for the sector. So the issue is not the price of oil, but rather, A, the significantly improved financial picture for the high-quality pipeline companies, and B, the extraordinary volume of natural gas liquids that the pipeline companies are now transporting. Let me elaborate briefly on that latter point. The U.S. is now

exporting more propane than the four other largest exporters combined, almost a million barrels per day. We think that outlook will continue and we have a really fascinating chart about propane at DividendCafe.com. To further cover the first half of 2016 from a recap standpoint. The contrarian indicators we want to point out, net inflows of $25 billion into cash and money market funds in the second quarter. Gold funds had a huge $2 to $3 billion inflow. European equities had their biggest outflows in the second quarter

in European stock market history. Japanese equities had their biggest outflow since the second quarter in European stock market history. Japanese equities had their biggest outflow since the first quarter of 2008. High yield bonds saw $1.6 billion of outflows and then rallied 10% in the second quarter. Utilities are up there with cash and gold in terms of their level of inflows. So it's driving a lot of money into the space and we would argue creating a bit of a bubble condition in the utility sector. Our conclusion to draw from all this is that asset allocation works, chasing sentiment doesn't, and investors are sadly preconditioned to do exactly the wrong thing at the wrong time over and over again. Finally, recap as far as the

S&P 500 stock market goes. We have a chart of the way the quarter kind of moved around up and down at DividendCafe.com. The winners were no doubt the yield type sectors, consumer staples, utilities, and telecom. The only real loser was financials. It was down a little over 3%. and telecom. The only real loser was financials. It was down a little over 3%. Many pockets in technology struggled as well. The overall tech sector was about even, but that's with some big winners and big losers in there. The dispersion of returns is very high right now, which means active management has done much better than passive indexing. That, of course, assumes that the active management has been good. The next move in markets will largely depend on how Q2 earnings come in. Q2 earnings season will

start next week. Brexit is behind us. Global economies are highly vulnerable to other conditions. It's a very interesting time. So let's talk about quickly what we care about for the rest of 2016. I mean, the story that we are highlighting above all else is the interest rate conditions of global economies. And when you look at the U.S. interest rates, something has to give, okay? On one hand, the extended belief we have that the Fed will stay lower for longer has certainly pushed rates down a notch, but these rate levels are just insane. The 10-year Treasury right now at 1.38%, it hit 1.3% earlier in the week. The 2.14% 30-year Treasury, afforded with 2% earlier in the week. These are both all-time lows

for U.S. government bond yields. Ultimately, the major factor pushing our treasury bond prices up and our treasury yields down is the flood of global capital pouring into our treasury bond market. And that's due to the pitiful, often negative yields available around the globe. And secondly, the perception of safety in the United States relative to everywhere else. If indeed rates stay low because of relative strength in the U.S. dollar, U.S. economy, to other interest rate environments, then the next factor we're going to discuss will take over. But if our low rates prove to not be merely a byproduct of comparative conditions in Europe and Japan, but also a dying economy domestically, then economic and market conditions will turn south quickly here too. This week's jobs

report seems to indicate to us that we may have a little more time before that kicks in. So that leads me to the second story for the remainder of the year, which is global growth, economic growth outside the U.S. and what its impact on the United States will be. And our best guess continues to be that what will eventually tip the United States into recession will be the lack of a growth partner around the globe. But probably for the remainder of this year, the TINA factor will be on. TINA standing for there is no alternative, whereby the U.S. markets remain the beneficiary of unattractive conditions everywhere else.

The timing of when the slow global growth turns from a competitive advantage for the U.S. growth turns from a competitive advantage for the U.S. as money flows into our stock and bond markets to a drag because we're caught up in all of the other global growth slowdown, that timing is unknown. But I would say that odds are below 20% it'll be this year, and after this morning's jobs number, I'd say even below 10%. But we do believe the chances of tipping into recession in 2017 are north of 40% right now. We did have a question this week about the rough start that 2016 saw on hedge funds and wondering what we like in the current hedge fund environment. I want to quickly say that we are cautious of what we call hedge fund hotels, stocks that hedge fund after hedge fund pile into. And we're also cautious of these types of hedge funds that buy these stocks. This was the source

of most of the hedge fund problems in Q1. Just a crowding effect of alternative asset managers all buying the same thing. If you view alternatives as we do as a way to diversify your exposure to stock and bond asset classes, we think this current market environment lends itself to more market neutral strategies, particularly those of a relative value persuasion. for the foreseeable future, which basically means alternative strategies that are looking to benefit from mispriced relationships between securities, different than betting on the direction of stock markets. So we do like those relative value arbitrage type alternatives right now in this environment. What we don't like is crowded hedge fund hotels. In our deep end of the pool this week, let me just quickly say that the high yield bond market is a huge indicator for us. If indeed treasury bond yields are collapsing because of substantial economic weakness, then we think U.S. stocks will get caught up in it.

And the economic weakness will take down the high yield bond market too. But we haven't seen that yet. will take down the high yield bond market too, but we haven't seen that yet. So if the reason U.S. bond yields are dropping is just simply global capital pouring in, then high yield bond market may give us an indicator of such, but we want to watch that and see what it bodes for equities as well. So far, the behavior in high yield bonds has been very, very strong. strong. By way of a permanent investment principle, please check out the chart on dividendcafe.com to see how the FTSE 100, the UK stock market index, has done since the Brexit vote, just to get an idea of what we think about all the hysteria that exists out there in the media the hysteria that exists out there in the media and so forth. As far as the bullish thesis this week, we continue to like stocks as the new bonds where high quality dividends exist, but we're

cautious where the highest perception of safety is. Consumer staples, utilities, telecom investors pouring in there. We think that story will continue, but we think it is getting crowded and eventually will lead to greater risk. From a bearish standpoint, we can't say enough negative about Italy, the Italian banks, the Italian manufacturing sector, industrial production. The possibility of them putting a referendum could create even greater volatility overall we're very troubled by Europe's economic condition and that remains the the big negative over there so I will kind of sum things up here this week we'll let you look at a chart on dividend cafe calm that shows the massive inflow into precious metals in recent months

and let you draw your own conclusion from that. The second half of 2016 is off with a bang, and there's more questions than there are answers. My weekend reading list is just crazy. Our Investment Strategy Committee at the Bonson Group will be meeting Monday morning, and we are considering some tactical asset allocation changes. But in the meantime, our permanent goal of balancing risk and reward tradeoffs effectively for all of our clients is alive and well. Enjoy your weekend and thank a police officer today for all they do to keep law and order in our society.

We're living in just unbelievable times. I don't have a market comment to make about last night's events in Dallas. I just am, from a human standpoint, truly disgusted and fearful. So I don't want to end on a sour note. We do hope you have a wonderful weekend. We keep the families of the Dallas police officers in our thoughts and our prayers. God bless. Bye-bye.