Dear Valued Clients and Friends,
The month of July is now behind us and we enter August next week which represented the worst month of 2015. I loathe superstitious calendar correlations posing as real market analysis, but I certainly have not forgotten the serious challenges that August of last year represented. (We were coming out of a Greek drama and then entered a China one.) This week we review the July that was and talk a bit about August and beyond. There is a lot to it, so let’s get into it …
Watch this week’s Video Executive Summary at this link (unique content).
Listen to this week’s Dividend Café podcast at this SoundCloud link or this iTunes link (same content as this writing).
- July is set to end as another strong month for equities, though a weak one for oil prices. The issue with oil is the U.S. dollar, and how oil dropped as the dollar rallied earlier in the month, but did not move higher as the dollar sold off this week.
- The stock market performance in an election year impacts the election a lot. The election generally doesn’t impact the market.
- Emerging markets have really turned (for the better), and present great growth opportunities for the future (but are vulnerable to external shocks, particularly if any central bank decides to become tighter than expected). But the currency matters!
- The disconnect between the global GDP growth trendline and actual GDP growth the last decade is the source of a lot of political angst.
In the News This Week
- The Democratic party officially nominated Hillary Clinton as their candidate for President this week and the DNC convention finished up in Philadelphia Thursday evening.
- The Federal Reserve announced on Wednesday that they were keeping interest rates flat yet again, and basically stayed status quo in their outlook.
- China – Corporate profits have been much stronger than expected this year, as the consumer sector has gradually grown, and the industrial sector has rapidly grown (mostly in response to their ongoing housing boom). This bodes well for 2016 but not for 2017.
- Oil – If I only had one thing to watch in formulating my views around oil, it would be the U.S. dollar. Ultimately, it is supply and demand (always and forever) that drive oil prices, but supply and demand metrics are highly dynamic, volatile, unpredictable, and with OPEC, often unreliable. To the extent that oil is a global commodity denominated in U.S. dollars, this correlation is hard to break (that is, the inverse of the dollar, and oil prices). The chart below says it all.
July was an interesting month because the dollar did indeed strengthen against the Yen and Euro (the two most dominant currencies in the world besides the dollar), but depreciated against many emerging markets currencies. This story regarding the dollar and oil remains in flux.
- Recession – While the economy is not strong enough to get the Fed to raise rates even a quarter of a point, they did say in their report this week that “near term risks to the economic outlook have diminished.” The muddle-through economy continues.
- Earnings – With essentially 50% of the S&P 500 having reported Q2 earnings results, 74% have beaten their earnings projections, and 52% have beaten their top-line revenue projections (Zacks Research, July 28, 2016). So far, the strongest “surprises” have been in the Financials sector.
- Election – The Democrats hosted their convention in Philadelphia, suffering a lot of the same commotion (and then some) that the GOP experienced the week before. The dissatisfaction with both candidates in both parties is palpable This feels more like a protest election year and anti-establishment year than any election I have studied. Of course, Huey Long and William Jennings Bryant never became President, but the point is that this is a year like no other, and prognosticators are wise to respect the uncertainty of things.
Questions from Readers
- Do we want our currency to go up or down to help the value of our investments? I’m confused.
I assure you that you’re not as confused by this as the media. Yes, it can be a confusing situation, but it is important to understand. When you use U.S. dollars to buy a foreign investment, the return on that investment will be: a) the amount the investment goes up or down; plus, b) the amount the currency of that country goes up or down. So if an emerging markets stock is up 5%, but the currency of that country is down 5%, when we sell that investment and convert back to U.S. dollars, we are at a 0% return. Make sense so far? The more a foreign investment sees its currency go up vs. the currency we bought from, the higher the return. If one believes the investment is good but the currency bad, they generally may want to hedge out the currency risk (there are ETFs that do just this). Well, the reality is that over the years much of the return of overseas markets has indeed involved currency appreciation. It is incumbent upon investment managers like us to take these things into account in our decision-making process.
- What is it economically that has made this a year of voter angst so far (Trump’s nomination, Brexit, etc.)?
My friends at Strategas Research have a highly plausible theory that in this chart we essentially see the source of voter angst:
Source: Strategas Research, 2016 July
We are off the trend line of GDP growth –- meaning, we are below it – and in that gap you see between the red line and the dark blue line, you find the wage stall, the tepid growth, the middle class frustration, etc.
Deep End of the Pool
We have very faithfully reminded clients and readers for many years that, despite what we believe is mostly good intentions, the real problem with an artificially “easy” monetary policy (i.e., lower interest rates than are appropriate given a certain level of economy; more money supply creation than economic growth warrants; etc.) is the “malinvestment” it creates. Put differently, monetary distortions cause a distortion of risk and create decisions that otherwise would not be made. Case in point: $450 billion (with a B) has been issued in corporate debt this year alone, not even counting “high yield” (i.e., poor credit). Of that $450 billion of “investment grade” credit, 44% of the investment grade (highly rated) universe is now BBB-rated, vs. 10% several decades ago (Gluskin Sheff Research, July 27, 2016). BBB is the lowest credit rating that still falls in the “good quality” classification, meaning we have a few hundred billion on the knife’s edge of becoming “junk rated.” This is a direct result of a borrowing binge and capability brought on by an artificial low rate environment. The danger is in trying to forecast exactly how this will play out. There isn’t a lot of danger in forecasting that, one way or the other, it will not end well.
Weekly Reinforcement of a Permanent Principle
Properly diversified investment strategies that have expected rates of return which surpass the “safe rate” (say, a short-term treasury or CD yield) will have volatility. In fact, the expectation for a rate of return higher than the “safe rate” is a by-product of that volatility. To confuse volatility with “risk” is a cardinal error, and results in all kinds of investment mistakes. We aim to manage client assets to avoid the permanent erosion of capital. We even manage client assets to somewhat limit volatility (for psychological reasons). However, we do not manage client assets to eliminate volatility. To do so would also mean eliminating the possibility of a return.
Comments from the Bull in Us (What We Like)
It is risky to be coming out in favor of Emerging Markets equity investments right now, as a significant amount of pundits believe EM is the space most vulnerable to a global growth slowdown, and most vulnerable to U.S. dollar strength. The space itself has already seen a 28% rally from its January bottom (FactSet, July 29, 2016). However, we are seeing significant increases in money entering the emerging markets, largely on the belief that central banks are going to remain accommodative as far as the eyes can see (Japan, Europe, U.S. Fed). There is certainly external shock risk, but the fundamentals in Emerging Markets, given the backdrop we presently have, are very attractive. The whole space is a risky bet. There remains strong commodity price dependency throughout many emerging markets companies, and earnings on an index level can be quite volatile. We are bullish on the backdrop of the whole EM space, but then executing it with our own company selection philosophy – one based on earnings growth, dividend payment, and pricing power..
Comments from the Bear in Us (What We Don’t Like)
We are having a harder time understanding why more attention is not being put on the situation with Italy. There is little dispute that their banks are on the verge of insolvency, and we see no option that doesn’t carry profound spillover possibilities. Italy conducting a domestic bailout would certainly mean massive debt levels, at ratios on par with Greece. If the ECB steps in, which is what we presume would happen, does a precedent get set for other countries? This reality, and the political uncertainty around their October referendum, all point to significant risk in Italy and its direct touch points (read: EU) for the next several months.
Switching Gears (Outside the World of Investments)
I want to direct readers to the Financial Concierge Services section of our website at this link.
We believe this platform is one of the extraordinary value-adds we offer clients in our family, and it speaks to our culture as a “family office” model for our clients. Clients needing some of these services should talk to their advisor any time about how to engage in some of these services, none of which involve any additional fees to The Bahnsen Group whatsoever.
Chart of the Week
We favor a very active, very intentional, very obsessive focus on only those companies that are paying attractive dividends, and then grow those dividends consistently and responsibly. So the chart below is sort of an understated representation of what we are going for, because within the S&P 500 you have 17% of the companies paying no dividend at all (Divcon, July 26, 2016), and a significant amount paying a paltry dividend, or offering little to no dividend growth. However, with that said, even the S&P 500 itself, with so many of its ingredients not adding any assist, note the unbelievable growth in income an index investor has seen over the last generation (from $3 to $45, despite the plethora of bear markets it has experienced along the way). No bear has ever been able to dispute this investment merit of growing income!
Quote of the Week
“The biggest business in America is not steel, autos, or television; it is the manufacturing, refinement, and distribution of anxiety.”
~ Eric Sevaried
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I am actually having to go to press before July has wrapped up but by the time you are reading this it likely has. It really has been an incredible month in the markets, and it strikes me as surreal that it was just one month ago (plus change) that so many were crying in their cups over the results of the Brexit vote. The market has snoozed off Brexit, it’s snoozing off this debacle of an election, and now well into Q2 earnings season is climbing quite nicely. Central banks can (and at some point will) throw water on this stock market party. In the meantime, prudent pruning makes sense, as does diligent client-by-client analysis of goals, risk appetite, and planning. To that end we work! Into August we go ….
Joleen and I have been building our dream house for over a year now, and just this week saw construction crews wrap things up. There is still plenty of clean-up, wrap-up and furniture delivery ahead. (I have blocked out six hours just to set up my ties, pocket squares, and cuff links in my new closet.) But within a week or two we will be sleeping in our new home. Besides launching this business a year and a half ago, building this house (Joleen did all the work), and working 14-16 hours per day in an extremely challenging market, there really hasn’t been much going on! =) You will find that Joleen is as gifted a home designer as she is wife and mother. Have a great weekend!
David L. Bahnsen, CFP®, CIMA®
Managing Director, Partner
Chief Investment Officer
Brian T. Szytel, CFP®
The Bahnsen Group, HighTower