Dear Valued Clients and Friends,
So you may have seen in yesterday’s DC Today that my plans for an out-of-country few days with my wife this week, unplugged from work and electronics, was foiled yet again, this time by Hurricane Franklin. We have a running list over the last nearly 25 years of that which has prevented such an “unplugging,” and truth-be-told, we just are what we are. It seems to be a bigger focus to others that we “relax” and “take it easy” than it is to us. We accept this is a full-time job.
But yes, it was not the week we had thought was coming. This week’s Dividend Cafe is the Dividend Cafe I thought was coming, though. A long list of really thoughtful questions is worked through covering such topics as the Fed, private credit, growth investing, the U.S. dollar, Saudi Arabia, the 2024 election, municipal bonds, and so much more. It is a lot of fun and sure to offer something for everyone.
So jump on into the Dividend Cafe. There may be a hurricane in Bermuda, but there is clarity, perspective and answers, in this place where we belong.
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No Fed?
“If the Fed were abolished, would interest rates be managed by market forces?”
First of all, it is entirely possible (and as far as I am concerned, optimal) that rates be managed by market forces without the Fed being abolished. How rates would be managed without a central bank depends entirely on what replaced it, and suffice it to say that is not exactly on the table on the moment (I see more people pushing the Fed to take over climate policy, diversity policy, payments, and school cafeteria menu formation than I do looking to abolish the Fed). But there is no reason that market forces could not drive interest rates even with a central bank. We do not have that now, but we certainly could. Rates set by rules, with rules being themselves the prices revealed in markets, is the need of the hour. That does not require the abolition of the Fed; it requires the restoration of its proper function – that as a lender of last resort.
Private Credit
“What would reverse the trend of private credit gaining market share? Or is private credit here to stay regardless of what happens in the bond market and/or Fed?”
Well, in theory, really low interest rates with banks receiving a lot of incentive to lend into more risky ventures and encouraged to do so by regulators would cut into the market share of private credit. But in theory the discovery that fast food is good for you and that exercise causes you to gain weight would help a lot of people lose weight, too, it still isn’t going to happen.
Essentially, the door for private credit was opened by the post-GFC regulatory regime that wanted commercial banks to take less risk with their own balance sheets. Now, as I have written before, this is a by-product of the structure and math of the model – where depositor funds are sometimes but not always a good funding mechanism for credit needs. Private credit is a great solution for many but not all funding needs, and rates dropping and the Fed loosening policy will not impede that – and may very well advance it even further.
Growth Enhancement
“Why ‘enhance growth’ with things like small cap and emerging markets investing?”
First of all, I am not sure that one should do anything of the sort. We run a “growth enhancement” sleeve of a client portfolio where a client has the timeline, risk tolerance, and objectives to supplement the growth that their core investment strategy – dividend growth – generates. Our growth enhancements seek a higher rate of growth with a higher level of volatility, but do so in more nuanced asset classes than the ways we see most investors chase growth (i.e., shiny objects, praying over-valued assets become more over-valued, etc.). So with that said:
- Growth “enhancements” are just that – they are a willingness to ENHANCE risk & volatility in the portion of the portfolio for the potential of ENHANCED returns outside of our normal core dividend approach
- Small-cap and emerging markets are the two strategies we are using right now, viewing U.S. big-cap growth and big-cap tech as grossly overvalued
- Small-cap (as we invest in it) is extremely BOTTOM-UP. 50% of the index LOSES money – we want profitable companies that are growing at double the rate of most public small and mid-cap companies. We use a manager here with a 35-year track record of identifying management teams that know how to grow and operate companies, and have catalysts for doing so.
- Emerging markets (as we invest in it) is, you guessed it, extremely BOTTOM-UP. The focus is not on a country or a sector but COMPANIES that are growing at faster rates with lower valuations. We take on currency risk and geopolitical risk for the growth at a lower price we are buying. We do not want to lever up global cyclicality but rather buy domestic growth on the cheap – where demographics and embrace of a market economy is not yet reflected in their public capital markets. The growing consumer, growing embrace of technology, and growing GDP characteristics relative to the rest of the world make this a long-term opportunity that few adequately appreciate. Add in a U.S. dollar that may be declining, and there is real octane.
Dollars to Oil
“If Saudi Arabia comes into the BRICS will they drop the USD as the petrodollar? Does it matter?”
No, Saudi will not drop the dollar for petro transactions if they take a larger role in the BRICS. The recent decision by Brazil, Russia, India, China, and South Africa to invite Saudi Arabia, Iran, Egypt, Argentina, and Ethiopia into their currency bloc does combine large energy producers with large energy consumers, and certainly enhances, on the margin, the ability to do more energy transactions in alternative currencies. But “dropping” the dollar is just not remotely on the table, and the economics of it all cannot be replaced easily. The currency of a third-world country does not become strong by other countries wishing it so. Currencies become strong when countries become strong, and I do not think Saudi wants to sell Ethiopia oil for the privilege of receiving Ethiopian currency any time soon.
The key distinction that is consistently missed by most in this conversation is the distinction between a trading currency and a reserve currency. If one believes, as I do, that more permission structures are being opened for energy transactions to take place outside of the dollar, those repercussions can be discussed. But to argue that these countries have other options for reserve currency in terms of size, strength, global use, convertibility, and more is not a serious position at this point in time.
The expanded BRICS bloc includes a lot of population. It also includes dysfunction, frequent insolvency, geopolitical instability, and rank third-world vulnerabilities. I have no doubt that many countries would like to pursue de-dollarization. I also have no doubt that you can’t beat something with nothing.
2024 Election
“Will markets do better under a President Trump or a President Biden after the next election?”
Of course, this hypothetical question contains premises that I do not accept as necessarily true – that the next President will be one of these two men. I see ample scenarios by which one or both will not be their party’s nominee. However, with both the present lead in their respective parties, I will take on the question as intended.
If there is one thing we know from history, it is that what party is in the White House is substantially overrated as a factor driving stock market returns. To the extent there is partisan relevance to market returns, it has far more to do with the blend of House/Senate electoral realities with the White House than it does the White House in isolation.
All that to say, if President Biden were elected and had a sufficient majority in the House and Senate to pass some extreme legislation he has sought to pass, yes, I believe markets would suffer a great deal. But as we saw in 2021, the beauty of divided government often keeps things that could crush markets from happening. Separation of powers is a great friend to investors! (h/t James Madison)
President Trump’s work on tax reform was very useful in his first term economically, and had a profound impact on market returns. So if a binary answer was required I would say Trump would be a better outcome to markets than Biden, but without knowing the state of the House and Senate in either situation, it really is impossible to answer. There are plenty of things either President could do that would be short-term problematic, and that is a highly bipartisan reality.
And speaking of bipartisan realities, longer term, if you accept my belief that the greatest threat to multi-decade economic growth is excessive indebtedness, I cannot say with a straight face that either candidate has a good track record here, or produces any optimism for me about the future on that front.
The Problem With Flawed Economics
“What makes smart Wall Street people embrace flawed ideas like Keynesian economics, and what makes academically trained economists continue to embrace the Phillips Curve error about trade-offs between employment and inflation?”
Well, these really are two different questions that require two different answers. In the case of why Wall Street firms or Wall Street thinkers embrace Keynesian economics, I would say the following:
- The best and brightest on Wall Street do not embrace Keynesianism. Most hedge funds, for example, operate out of a very micro, not macro, set of assessments, and trade client capital (and their own capital) on what is, not what ought to be. Therefore, they are ideologically agnostic in what they believe, and just play the cards they are dealt.
- When you read more generic macro research of a Keynesian bend from Wall Street behemoths like the one I used to work for, they are just trying to hug consensus views as much possible, and leave as little risk on the table as they can as far as a variation from what others believe. Consensus is formed in academia, social circles, and proximity to policymakers, and in that sense, they are all products of where they went to college and of a high aversion to intellectual risk. But they are not running real capital – they are window-dressing.
- Where you find Wall Street folks (real advisors, traders, managers, and dealmakers who do actually have an economic worldview), I think Keynesianism is counter-intuitive and not common. The problem is that you do not meet worldview-minded Wall Streeters much.
As far as the incentive structure that promotes Phillips Curve thinking in academic economics (which means Phillips Curve thinking in Fed economists since they are always and forever straight from academia), my own belief has been for some time that Keynesianism, econometric (quantitative) analytic economics, and model-driven Phillips Curvism all flow into central planning. Nothing says “we need central planning” more than saying, “we need a model that smart planners create which will solve everything.” Their commitments are not really to a given model – or a flawed theory underlying a model – but rather, to the idea of a model – a fatal conceit that says enlightened central planners can theoretically achieve something they cannot actually achieve. It is a full employment act for academics, which I guess sounds inflationary?
Municipal Bonds
“Is an investment in high-yield municipal bonds more of a judgment about rates or credit quality (or both)?”
In a nutshell, the value in high-yield muni is much more about SPREADS than either RATES or CREDIT. We know with a highly diversified high-yield muni strategy that credit as measured by defaults is very, very low, even in extreme stress conditions. Regardless of where RATES are, it tends to trade up and down around SPREADS to rates, and higher spreads create serious price value in advance of inevitable spread compression.
“When it comes to municipal bond investing, what is your view of the trend in fiscal soundness in the state and local issuing authorities? Is it positive?”
Unfortunately, I am sad to say that my opinions about the “fiscal soundness” of states is actually not all that relevant to my opinion of the likelihood of states performing in principal and interest payment of muni bonds. My opinion of the former is quite negative. My opinion of the latter is near perfect certainty.
Defining Deflation
“Would you be willing to define the word ‘deflation’ for us?”
As a matter of basic vocabulary, it simply means a decline in the general price level. Inversely, inflation simply means a general increase in the aggregate price level. Now, people like deflated prices for their consumer goods (especially electronics), but do not like deflated wages and profits. Entrepreneurs and risk-takers have a hard time doing economic calculation when the revenues they project they need to invest capital in a project face deflation. Paying off debt with dollars that buys more things (deflation) is less attractive than paying off debt with dollars that buys less things (inflation).
Deflation that comes from increased productivity is a good thing. Deflation that comes from contracting money supply and credit can be a very challenging thing. Borrowers hate deflation. Lenders love it, assuming the borrower stays solvent, which they usually don’t.
FedNotNow
“Can you help explain what the Fed is trying to achieve with FedNow and what the actual repercussions are likely to be?”
It is merely a payments system, is not a currency, is not a legal tender, and represents no new currency. I do not believe there will be repercussions other than a central bank that struggles to do basic blocking and tackling, taking on another pet project without the needed expertise to do it well and at scale. It is not for consumers or businesses, but rather for banks (who can pass along the infrastructure to customers if and when that is deemed advantageous for the bank and its customers). We have had wire services and ACH services that banks use with their customers for years, and FedNow is just a newer payments system. The hype is unwarranted (for good and for bad).
Chart of the Week
Though federal debt as a percentage of GDP has exploded to World War II levels, interest expense as a percentage of revenue remains low (just below 10%, up from the 6-7% it was a few years ago, but well below the 10-17% it routinely averaged in the 80’s and 90’s when interest rates were much higher). But as old debt at low rates comes due and is rolled into new rates, the picture changes. Well, it changes if they let it change.
Quote of the Week
“I want to spend a minute on an interesting question: Which is worse, buying at the top or selling at the bottom? For me the answer is easy: the latter. If you buy at what turns out to have been a market top, you’ll suffer a downward fluctuation. But that isn’t cause for concern if the long-term thesis remains intact. And anyway, the next top is usually higher than the last top, meaning you’re likely to be ahead eventually. But if you sell at a market bottom, you render the downward fluctuation permanent, and, even more importantly, you get off the escalator of a rising economy and rising markets that has made so many long-term investors rich. This is why I describe selling at the bottom as the cardinal sin in investing.”
~ Howard Marks
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Well, that was a fun one. I hope it scratched the itches that were behind the questions posed and that the rest of you got something out of it all.
I cannot wait to be back in the Los Angeles Memorial Coliseum tomorrow for my first USC home game of the 2023 season. And I hope you all are excited for a Labor Day weekend. Keep the questions coming, and I will keep the answers coming, and fight on!
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
