The Dividend Cafe - What to Watch in the U.S. and China

Episode Date: January 25, 2019

Topics discussed: Current state of the market Chinese economic growth & their credit markets US corporate debt and monetary normalization Housing Market 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 video and podcast. We're going to record both at the same time here today just because the content I wanted to deliver is basically very similar for both. And that is just to kind of give you a weekly rundown. There's a number of different topics we're going to go through this week around China, around U.S. economic growth, and kind of a broad recession watch. I want to talk a little bit about housing, housing market, and a few other fun things. So let's get started with just where we are this week in the markets. We're recording middle of the day on Thursday, and you'll recall that Monday was a holiday with Martin Luther King Day, so it's kind

of a short market week. Market was actually down 300 points on Tuesday, and it's really been almost a straight line up all year. So you had a little bit of a points on Tuesday and it's really been almost a straight line up all year so you had a little bit of a correction on on Tuesday but at one point we were down 450 points it came back near the end and then it was up 170 on Wednesday so not really down much at all in the week and as I sit here recording now it's up about 30 points it's been down it's been up so today is kind of a flattish day. So it looks like this week may end up finishing kind of flat, but of course I, you know, these days and any other day never really know how that will all play out by the time you're listening or watching.

But what I want to kind of delve into, I mean we already know that January has been a really big month up in the markets. And we know that December was a bloodbath in the markets. But the things that we are looking to that are driving a lot of the conversation, and ultimately that will be the decision makers and how markets perform in 2019 for investors, are things like China and things like U.S. economic growth. And I think there's a couple of misnomers that ought to be cleared up. There's no question that a lot of the weakness that we're seeing in China is a direct result of President Trump putting the screws to them as it pertains to this trade war. So a lot of the sentiment took a move down after the trade war kind of was instigated. But additionally, you just already had a sort of backdrop of economic weakness.

And one of the things I put a really helpful chart in Dividend Cafe this week, a lot of what's really happening there, and it isn't totally separate from trade war, dovetails with all of it, but really preceded the challenges that they have in China, even before the trade war, is a really significant decline in credit growth. And that's a purposeful decline in credit growth. They were in a really unhealthy credit bubble, largely out of what we would call the shadow banking system, a lot of sort of unconventional financial instrumentation. And the Chinese regulators, authorities were in a desperate aspiration of suppressing a lot of that. And whether it be through regulation or cutoff from capital markets, by cutting

that out and then trying to replace more into the bank market or whatnot, you've ended up with about a 30% drop in Chinese credit growth. And it's somewhat incomprehensible to think that that wouldn't have an economic repercussion. So China's economy, for a whole lot of reasons, continues to grow, but the growth is slowing dramatically, and that's what's causing a lot of the angst. It's what's giving President Trump a lot of leverage in this particular trade war issue. But I think it's very important that if we're going to understand China, understand China's role in everything going on,

that we understand the nature of their credit markets. Because if I'm going to talk so much of how our credit markets are pivotal to what's going on with the Federal Reserve, we want to understand the same thing in China. Now, that brings me to the issue with the United States and why I believe that a recession is not imminent, but what the tension points are economically as it pertains to the Fed. So I've kind of beaten the dead horse and I'm supposed to never worry about

doing that. I'm supposed to just keep saying really important things over and over again, because it helps it sink in and there's always new people listening. And so, look, I won't tire of saying that the fear from potential overreach from the Fed is a result of the leverage that's built up in the corporate aspect of American economy. The corporate sector has added significant debt and leverage, and an unwinding of that or a cutoff of access to credit represents the real threat out of Federal Reserve monetary normalization. But I want to put it a little differently because this is a broader and somewhat timeless economic truism that I want you to be able to understand. Fundamentally, the return on invested capital that corporate America can count on minus the cost of borrowed capital. It represents the delta that has to be achieved for us to measure economic health. To the extent

that the cost of borrowed capital were to exceed the return on invested capital across an economy, that's what you call a recession. That's what leads to a recession. So it signifies one and creates a vicious cycle thereabouts. At this point, the return on invested capital is very high in the American corporate sector. The cost of bond capital has increased, may increase more, but that delta represents what we want to kind of look to. And for the time being, it is a pretty significant delta, a very healthy one, but the expansion of that spread could take place in 2019, not the contraction.

If cost of our capital stays about the same and the return on invested capital were to go even higher, that's where you kind of get to the sweet spot of potential extension of this economic recovery post-financial crisis. The opposite is if the return on invested capital comes down, economic slowdown, economic economic headwinds and at the same time cost of borrowed capital is going higher so this is a somewhat simple framework it's one that i've believed in for over 20 years economically but i i think it helps to kind of create the construct for how you want to measure both sides of what takes place in the economy where we go this year. You may recall that one of our themes in 2019 is an expectation of a garden variety

correction in housing prices. Nothing significant, nothing earth shattering, but we do believe that A, there will be a correction in house prices. In fact, we think it's already taking place now. But B, that that'll be a healthy thing, not a concerning thing, that restoring some degree of affordability in the housing sector will be a good thing for the economy. We have a chart in Dividend Cafe this week. First, let me tell you just some of the stats that I'm providing that just came out real recently as it pertains to December, which admittedly was a somewhat anomalous month based on just the kind of drastic sell-off that was taking place in risk assets that month. But sales on existing homes fell

10% in December. That is a three-year low and the housing sentiment number within that that monthly University of Michigan consumer confidence number the housing subsect was at its lowest level in 10 years so there's this sort of concern about confidence from the consumer in home purchases and then the volume of home sales declined 10%. Median prices nationwide have increased in between 5% and 7% per year since 2014. Last year, they increased 2.9%. So there's two things in there you got to pull out. They did increase. It was a positive number, but that rate of growth had substantially slowed last year. I wouldn't be surprised if construction levels pick up in 2019. They declined. New home starts were at a low level throughout

2018. There's a lot of reasons for that that are not very good. But I do think that we are not really suffering from an oversupply problem. I think that we are suffering from an overpriced problem and fundamentally a greater degree of supply could help bring prices down. I think you want more supply because we're undersupplied in the housing sector, both in terms of total available homes and new home construction. But also I think that it will help bring price levels down into a greater degree of affordability. So look at the chart in there that kind of matches up residential construction levels with the projected household growth. And you can kind of see the way those trends are matching up. All right, a few final things and we'll kind of close up. The annual chart that looks at all of the various major asset classes from large cap U.S.

stocks to mid cap or small cap to international, fixed income, commodities, etc. There's a sort of periodic table of these returns that is rather popular because of the simplicity of a graphic illustration it provides and the impossibility of guessing what asset class is going to outperform what asset class year over year. We listed a more comprehensive version of it in Dividend Cafe this week, courtesy of our friends at Fidelity. And I think you'll find it to be very informative. It has a lot of history to it. It goes back, let's see of history to it it goes back let's see the one we printed goes back 20 years so you get a lot of that

context over the last 20 years but also you see that last year was just an incredibly odd one as an asset allocator where every asset class suffered so much a few things I'll leave you with. The narrative around earnings growth is one we buy and do. It's one that is very necessary to defend an expanding stock market. The earnings are continuing to grow. And in fact, the United States grew at a clip that is really quite impressive. That rate of growth can begin to come down. But nevertheless, we are hitting all-time highs and expect to continue to at the level of earnings that corporate America is generating. We don't see any earnings contraction at all.

Well, I think that one threat to that thesis from a global equity standpoint is how true that is in terms of earnings growth around the world. Emerging markets, no question, very substantial earnings growth for a lot of obvious reasons by definition in the world of emerging economies. But you have the potential of an earnings contraction in Europe, and that's the earnings contraction from levels that were not very impressive to begin with, and in significant parts of Asia. So I think a fair question is where a global equity investor has to gauge the state of the earnings landscape when you look at the U.S. versus other domiciles. Oil prices, by the way, have moved up 19% so far on the year. And I think that that's important to the extent that it boosts the

profit levels that oil producers can expect, which incentivizes and creates more capex, which then creates the virtuous cycle of more productivity, more investment, feeds peripheral businesses, and so forth. And so the oil price itself being excessively high starts to pull money out of the economy when it serves as a tax on an investor, excuse me, on a consumer. But oil prices that are too low serve as a very difficult economic headwind when it de-incentivizes capital expenditures from the production and infrastructure side. A sweet spot in the low 50s to the mid 60s, maybe even into the 70s, I don't think a consumer is damaged at $70 oil the way they are at $90 oil. But that sweet spot where we've come back to after flirting with the low 40s now we're back to

the low 50s uh bodes well whether or not it sustains we'll see i'm not going to bore the podcast listeners or the video watchers with some of the stuff i haven't given cafe this week about how high yield bonds have really rallied here and And on a value proposition, the spread between levered loans, floating rate bank loans versus high yield, what kind of risk reward trade-offs we're seeing there. But there is some stuff for those of you that like to dive a little deeper into our analysis of credit markets and the bond market may find interesting. So I guess I'll leave you with the kind of overall summary. There's a lot of different things worth watching right now.

We're only about 15% of the way into earnings season. So we have a lot of meat on the bone coming up that we need to get to next week and the week after is the real meat of earnings season. So we're gonna be watching that carefully. Thus far, we're very encouraged by what we're seeing, particularly from companies that are important to us. But we think that there is modestly positive guidance for 2019 that companies are laying out there. And certainly the results for 2018 have not been a big surprise. But it's too early to really give you much analysis around that. But it's too early to really give you much analysis around that. So we're watching the government shutdown.

It's getting a little long in the tooth. I still don't believe it's had any impact on markets at all. Markets are up double digits since the shutdown began. But I think politically, both sides are beginning to feel a bit more pressure. I think that Alexandria Ocasio-Cortez being named to the Financial Services Committee this week was a shall we say interesting development and one I will refrain from further comment on but I don't know I don't really believe that right now the things that are most significant to markets for 2019 are the big headline events the Fed is not talking at this point we're not expecting any activity Things that are most significant to markets for 2019 are the big headline events.

The Fed is not talking at this point. We're not expecting any activity from the Fed anytime soon at all. Earnings season we need to get deeper into, as I say. And then the next kind of significant update on the trade discussions with China are probably about a month away. So I would be hesitant to direct you to follow the news cycle in financial media much in the weeks ahead. I think they're going to be grasping and trying to create stories out of things. But as far as our assessment of stuff, it's the fundamentals we're talking about here, the refresher around what really creates economic growth in a developed economy. We're going to be monitoring China and soon enough,

we even get more of an update as to where things stand in Brexit as well. So that's our take on the week. And we do hope you have a wonderful weekend. There's no NFL playoffs on college football is over. So I don't really know what you're going to do with your weekend. I have a conference I have to attend all weekend. I get to attend all weekend. And we'll be back with you next week sharing more from the Dividend Cafe.

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