The Dividend Cafe - When Doves Cry

Episode Date: July 19, 2019

As we enter the middle part of the summer, we also enter the beginning of Q2 earnings season, and this all adds up to fun times. The equity markets puttered around a bit this week and between the "wait and see" on a China trade deal and the "wait and see" on Fed accommodation, earnings ought to be the major story for the next couple of weeks. In the meantime, I really tried to use this week's Dividend Cafe to unpack some foundational things about the U.S. economy. What does the yield curve tell us about a recession? Why has the Fed become so accommodative to capital markets (there is an answer!)? What would make someone want our Fed to not be independent? What do pension funds tell us about the future of asset allocation? What can government spending tell us about the state of economic growth? If all of these questions are addressed this week, and they are, plus a few MLP and Brexit comments to boot, can you see why I am so excited to have you join me in the Dividend Cafe? Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. bringing you a really action-packed message this week sitting here in New York City where it is very hot, very humid, and more so than the markets themselves which are neither hot nor cold this week. Kind of buying a little time as we get ready here for earnings season. Some days that were modestly up, some days were modestly down, at least as I'm recording, not a whole lot of drama or action this week. Not really unsurprising given that there was no expected Fed news this week. We're right in the very beginning of earnings season. We get more into the action of earnings season next week. And then we had, you know, very little action politically as well this week, at least that would be market relevant quite a bit, I suppose, in the broader political sense, but not that would be market sensitive.

So I am going to take advantage of this week to really delve into some very, very fun things. And by fun, of course, I mean the yield curve. I mean the Fed. I mean the pension fund situation around our country, what that tells us about asset allocation, government spending. I mean, if these topics don't get you excited, I don't know what will. So let me delve into it. Well, I will go ahead and get it out of the way early instead of waiting till the end. If you like what you hear, then I'd love for you to rate us on your Apple podcast, throw some stars at us or what have you.

And however you listen to this podcast, we prefer that you subscribe versus just sort of accessing it. Because by subscribing, it helps the algorithm on these silly little podcast players. And it gives us a better rating and ranking and whatever they do. So there's a reason for it all. and I hate having to ask each week, but that's what I'm supposed to do. Okay, time to talk. Yield curve. Look, we've been talking about it a lot, and I guess, don't look now,

but the three-month bond yield and the 10-year bond yield, the spread between the two, they've been inverted for quite some time where the three-month yield has been higher than the 10-year yield and that inversion has nearly disappeared not completely but as i'm talking it's only about six or seven basis points and just two weeks ago it was a full quarter point 25 basis points wide and the two-year versus the 10-year it got about as flat as could be, but it stubbornly refused to invert. And I do think that this is a case of the Fed guidance or their indications are a policy tool in and of themselves, not just pointing to policy tools. In other words, just the Fed sort of jawboning about lowering the short-term rate becomes a tool to remedy inversion as opposed to actually lowering the yield itself.

Now, our view is that the Fed's dovish switch, you know, how they went from being such a hawkish central bank last year to now, you know really significantly switching their kind of posture it's going to anchor the short part of the yield curve down and that any basic modest improvement and growth outlook will push the longer part of the curve up a tad so we should experience a steepening yield curve for the remainder of 2019. Now, there are precedents with this chain of events. Ended up working out very well. 1998's the most historically interesting example. It most certainly extended not only the stock market rally,

but it arguably added several years to the economic expansion. But there's precedents where the recession ended up coming afterwards as well. So history is not clear how this particular situation will play out. I do think you'll find interesting a chart I put at DividendCafe.com showing the last seven times that the yield curve had been inverted. And then when the Fed took action, what ended up being the result? And you'll notice it's kind of a different thing in different situations. And so it's hard to draw a normative assumption out of it. Quick question for you. Did you know that the median assumed return for state pension funds is 7.5% per year across all 50 states.

And when I say median, that means that there are obviously some that are using a higher assumed return rate than 7.5. And did you know that the 10-year treasury yield right now is 2%? Okay, so any money in bonds in the multi-trillion dollar pension system in our country is forcing them to need a higher return from their stock and alternatives portfolio to average 7.5%. Since you can't will your way to a certain return in risk assets, what options exist for pension managers who need a 7.5% return to meet expectations? Simply put, it forces them to move money out of bonds into stocks and alternatives as the present asset allocation will not facilitate the returns they have to get.

Now, stocks may not achieve it either, but at least they have a chance. They know the yield on bonds. The math requires more money into stocks. And this is the United States pension system where we do have some positive yield in our bond market. There's $13 trillion in global bonds around the world with a negative yield. How do they get to their discount rate, their needed return rate, with a negative carry in bonds? This may prove to be the biggest driver

of equity valuations for years to come. The pension realities here in the United States and around the globe attach to the math of lower negative bond yields, forcing money into stocks. I want to talk a second about the Fed independent, and I don't really want to make it a political thing for me. I mean, I actually am kind of turned off personally by President Trump's jawboning of the Fed on Twitter and elsewhere. And I certainly don't ever have any problem publicly saying so when I believe the president's wrong about something or when I think he's right about something. But in this case, even though I disagree with the methodology,

I do think it's necessary to point out the Fed has never been all that independent of political pressure here in the United States, although obviously other politicos were more subtle about it. But I do think you have to understand, pretty much no other nation even pretends that their central bank is independent of the political system. Our Fed is not fully independent, but certainly no one else's is. And that matters right now. The European Central Bank is about to re-ramp up quantitative easing. I mentioned previously $13 trillion of assets around the globe presently traded in negative yield. Global central banks tied to the hip of their political leaders have found new monetary policy tools that were previously thought to be incomprehensible.

It is not our central bankers we look to to make sure we're globally competitive. It's our politicians, dear lord. So independence is a pipe dream, even if we do agree that the Twitter trolling might be unbecoming. So why did the Fed go dovish? Look, few topics have generated more attention than that since the early part of January this year, not only in the financial media, but even in my own Dividend Cafe podcast in writing. The Federal Reserve's significant about-face from hawkish tightening monetary policy to the total opposite, not just in their tone and rhetoric, but in their actions this year. And I think that that big hubbub around what they've done is explainable. And I believe the idea that inflation running beneath its targeted rate is not, in fact, the reason that the Fed has done their about-face.

I think this idea of an insurance cut is not necessarily the real reason. We know about the political pressures. So there's plenty of explanations and some of them could have some legitimacy to it and some certainly might be the ones that get used publicly or vocally. But there's nothing more clear to me than what happened in the credit markets late last year, 2018, that explains why the Fed needed to sort of rechannel their inner Bernanke and Yellen. Bond market liquidity dried up in the fourth quarter, and it got very little press, but I believe it scared the, you know what, out of central bankers. Bond issuance dried up, outflows from high yields skyrocketed, credit spreads rose. That milieu was, in my opinion,

the major factor driving the Fed's change of thinking. They got a look at what unwinding the post-crisis accommodation would mean to the U.S. economy, primarily in terms of corporate credit and how the economy has become addicted to it, and they chickened out. So what I've done is at Dividend Cafe, I put up a chart that shows what happened in the fourth quarter of spreads in the high yield bond market, in the investment grade bond market, in the leveraged loan market, and what happened to issuance of those three markets. And you see the results were clear as could be.

of those three markets. And you see the results were clear as could be. Credit markets were absolutely drying up. And immediately after, the Fed completely changed their posture. Let's talk valuations real quick. There's no question that risk assets have historical averages around how they trade, multiples of cash flow, multiples of earnings, etc. And these valuation metrics on an absolute basis and a relative basis do matter. And I've gone to great lengths here in the Dividend Cafe podcast to discuss valuation, what things mean, what things don't mean. So what I'm about to say, there's no room to interpret it as a suggestion that valuations do not matter because they do. But it's also equally true that evaluating valuations requires a reference, something the asset is being valued against. And financial markets have always framed valuations

around a comparison to a risk-free asset. Right now, we know that the P.E. ratio of the S&P 500 is roughly 17.6 times on a forward basis. But we also know that corporate bond yields and treasury bond yields are significantly below historical averages. Not merely suggesting, but frankly mandating, that risk assets warrant a premium to their historical valuations. Financial types come up with all sorts of ways to evaluate the earnings yield of the market relative to the bond market. The Fed has always loved the Fed model, where the bond yield is divided into the earnings yield of the market. Earnings divided by the price instead of the P.E. ratio, which is price divided by earnings.

This allows for some sort of comparative number where the earnings yield is evaluated by the number that frankly drives financial markets, U.S. bond yields. Well, and on that measure, that methodology, the market actually looks very cheap. Now, I don't want to rely on that. I just simply want to indicate that the absolute level may look a little pricey. The relative level does not. Let's see, what else do we want to cover here? I have a little tweak about how the tariffs might be succeeding a little bit in getting manufacturing out of China. Only problem is they don't seem to be moving it back to the United States. Only 5% of U.S. companies said that they considered moving their manufacturing back to the States because of the Chinese tariffs.

But 25% said they're looking at Southeast Asia and over 10% said Mexico. So I think you could have different globalism that comes out of the anti-globalist measures but um be that as it may brexit um i'd have a few comments there and and and i also do get into the um a little update at differentcafe.com this week on mlp's uh midstream sector of the energy market just got done having its sixth positive week in a row which is only done twice in the last five years. The sector is up over 20% year to date. And yet yield spreads are still way above historical averages. The financial metrics are still way below historical averages.

We think it's a great situation because not only have we had wonderful returns, but we're still at least on paper and a really valuable part of the market. And it's nice when you've done well in something to still think the good part is still to come as opposed to other areas where you've done well, but you think you're near the end of the opportunity set. Interest rates rising. Let me kind of get ready to close out with this. I understand that we believe the Fed is about to cut rates. We don't know exactly how much. But the notion that that then will lead to interest rates like, let's say, on a 10-year treasury bond or whatnot, or mortgage bonds for that matter, your mortgage that you take to borrow money going lower still, it doesn't

necessarily match up with history. The fact of the matter is, is that four out of the last four times that the Fed has cut rates, eight months later, the 10-year Treasury yield was higher, not lower. And the reason is because it's the eight months going into the rate cut, like the eight months we just got done with, where bond yields have dropped precipitously. So markets were discounting it ahead of time. And the whole point of it here is the Fed thinks if they cut the short-term rate, it might provoke a little expectation of higher inflation or higher growth and push the longer-term bond yield higher. That's their whole point is to steepen the yield curve.

So I just don't want listeners assuming the pedestrian idea that as the Fed cuts their short-term interest rate, all other interest rates will go down with it. It's not true economically. This is a case where both theory and practice might be on the same side here because in history and in economic theory, it's pointing to the same thing. Okay, quite a bit of charts at DividendCafe.com, including some history regarding Fed rate cuts and so forth. So go ahead and check that out. And I'm going to leave it there for the week.

Interesting things shaking up in the political space. But reach out to us with any questions. I do hope you've gotten a lot out of this week's podcast, and we look forward to coming back to you next week in the Dividend Cafe. Thank you for listening to the Dividend Cafe, financial food for thought. The Boston Group is registered with Hightower Securities LLC, a member of 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 Thank you. 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 opinion, news, research, analyses, prices, or other information contained in this research is provided as general market commentary. It does not constitute investment advice. The team at

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