Dear Valued Clients and Friends,
I always fear my ability to jinx things when I type what I am about to type, but as of press time, it really has been a very low volatility week in the markets. Now, with time remaining here in the week we never know what will end up, but we are literally right now, in the middle of the fourth market day of the week, exactly where we were to start the week. Imagine just two months ago me saying that there would be two days of Federal Reserve chair testimony in front of Congress, a failed North Korea summit, and more drama with the clown show in DC, and that markets wouldn’t move an inch in either direction around any of it. Such is the state of affairs when Fed dovishness has been baked into markets – it neuters so much other noise!
That said, a lot does need to be said right now to investors about the changing paradigm in our national economic intentions around inflation. I dedicate this week’s entire Advice & Insights podcast to that subject this week, and I discuss it a great deal inside this week’s Dividend Cafe commentary. So click on in and let’s talk inflation, the Fed, all of my expectations for the China trade deal, tax refunds, GDP growth, and so much more.
Dividend Café Video
Dividend Café Podcast
My diatribe on inflation
The Fed has explicitly stated they want a 2% inflation rate in recent years and have been frustrated at the challenges in creating such. Truth be told, I have always found the admission that a body tasked with a sound and stable currency is admitting to being willing to deteriorate purchasing power in the society by 50% every 36 years (I hope you follow my math there). The accurate price inflation target should be 0%, even if that proves unrealistic or difficult. That is not the same thing as saying there should be no increase in the monetary base – there should be more money in circulation as an economy grows! But to “target” 2% inflation is, I believe, unfair to consumers and citizens, and codifies the need for investors to overcome that annual 2% tax on their portfolios. (I would add that dividend growth investing is the best way I have seen to overcome the inflation burden, as annual dividend growth of 5-8% overpowers annual inflation of 2-3%).
I would also add that most “inflationistas” (those permanently fretting about the risk of inflation in the economy) are more concerned about the highly unlikely predicament of “hyper-inflation” (5-10% levels), and not nearly worried enough about the very, very, very likely predicament of “regular inflation” (which is perhaps more damaging because of the complacency that exists in confronting it).
Chairman Powell talks inflation
Fed Chair, Jerome Powell, testified in front of the Senate on Tuesday and in front of the House on Wednesday. It was mostly uneventful, but I would like to focus on a couple of important takeaways. The Fed appears focused on changing the way they target inflation. The nuances of what is being discussed would bore you to pieces, but I have to sort of try. The Fed is engaged in a debate on how to target the inflation they want. Right now, the policy objective is achieving an annual 2% rate. One year the inflation rate may be 1.4%, but the next year, the Fed’s objective is still 2%. A “price level targeting” would call for a target of a price level in the economy in line with annual movement of 2%, so that if the inflation rate ran below 2% for a year (or more), it would allow the Fed to let inflation run hot for a while so as to maintain that long term trend-line of 2% (not a per year rate targeting, but rather a long term price level targeting).
Say what about inflation?
I know that I lost most of you already, but here is the bottom line of what I just said: Technical, logistical processes are being considered that would effectively empower the Fed to let inflation run hotter than prior mandates called for, which would have a potentially profound impact on markets, interest rates, and policy. The way in which they effect this change will matter to their credibility (and I should add, nothing in the Chairman’s testimony or other governor comments we have monitored suggests this policy adjustment is a foregone conclusion). This just provides yet another aspect of monetary policy to monitor and its implications on investors.
What else did the Fed say?
The most important line of the week: “We are close to agreeing to a plan which would light the way to the end of the process [of reducing our balance sheet]. We expect the reduction to end sometime later this year.”
The Fed has reduced $448 billion off its balance sheet so far (undoing that much of the quantitative easing that had been done post-crisis), and currently sits on $3.8 trillion of assets. Bank reserves have contracted over $1 trillion.
Is the trade deal baked in?
President Trump tweeted on Sunday night:
“I am pleased to report that the U.S. has made substantial progress in our trade talks with China on important structural issues including intellectual property protection, technology transfer, agriculture, services, currency, and many other issues. As a result of these very productive talks, I will be delaying the U.S. increase in tariffs now scheduled for March 1. Assuming both sides make additional progress, we will be planning a Summit for President Xi and myself, at Mar-a-Lago, to conclude an agreement. A very good weekend for U.S. & China!”
Markets advanced 60 points on Monday, a modest but still upward move. My view continues to be that the market expects some deal to get done that keeps the current tariff levels from escalating further. The details will have relevance in certain pockets and particulars, but the broad macro issue most are looking to is really nothing more than whether or not some permanent de-escalation can be found (and that carries with it the presumption that there was some political face-saving that took place as well for both sides).
The most likely components of a pending trade deal from our perspective:
- Chinese commitment of U.S. soybean purchases
- Chinese commitment of other U.S. agricultural purchases
- Chinese commitment of U.S. semiconductor purchases
- Chinese commitment to not weaponize currency depreciation (this could rally Chinese renminbi and push the U.S. dollar lower)
- A potential reduction of the 10% tariffs implemented last year (this would perhaps be the most significant step not priced in)
- Chinese commitment to aggressively purchase U.S. oil and gas
- A non-binding, loosey-goosey commitment to “addressing/reducing intellectual property theft.”
As for that last point, there are mixed signals floating around out there right now that there could, in fact, be some legitimate enforcement structures in the deal.
Tax refund updates
The child tax credit was doubled from $1,000 to $2,000 in the new tax bill. The eligibility to receive this credit was changed from $100,000 or less of income to $400,000 or less, substantially increasing the amount who will receive this benefit. AMT (Alternative Minimum Tax) was effectively eliminated for almost all taxpayers (it was heavily slashed). None of these elements easily work their way into the withholding process, thereby impacting refunds. The impact is about $100 billion of tax savings that falls into 2019, not 2018.
Just doing math here …
Growing into growth
The Q4 real GDP growth number came in at 2.6% yesterday when only 1.8% had been anticipated. This follows a 3.4% growth number in Q3, and would mean a full-year 3.1% real growth number if it holds up when these preliminary figures are made final. This is a stunning reversal of the 1.5-2% real growth we had been getting for so many years. “Nonresidential fixed investment” (i.e. the crucial indication for business investment/capex) appears to have really reversed, but I am still trying to unpack all the specifics.
Never let a chance to talk about oil & gas pipelines go to waste
I have learned not to count chickens before they are hatched, but it is worth noting that the 15% return in the first two months of 2019 represents the best performance to start the year in the history of the MLP space. 2013 saw a 12.8% move through this period, and 2001 saw a 10.6% return, but the Year-to-Date performance we have seen here in this huge 2019 priority for us has been the best to date.
Adding to the story this year even beyond the fundamentals has been the really unexpected dynamic of insider buying and company stock buybacks, both really rare events in the MLP universe. Additionally, streamlined approval processes are giving the market confidence that the export of liquefied natural gas is coming.
The case for financials
The story of 2018 in this sector was all the forecasts around a steepening yield curve helping financials as long term interest rates went higher, and then all of the premises playing out the opposite of what was expected. In other words, the forecasts were not wrong because the conclusion failed to surface from the expected premises; the forecasts were wrong because the premises themselves did not play. Short term rates increased last year, but long term rates did not, decreasing the net interest margin of the banking sector, and compressing profit margins. The ten-year Treasury yield has not given much help to the financial sector for years.
So why make the case now? Simply put, if the Fed is on their hands, and if growth is going to be robust in the economy, the former should hold short term rates in place, even as the latter helps to push long term rates higher (yield curve steepening). The financial sector has very low/modest valuations, and out of this development should experience some favorable re-pricing. The new regulatory regime of this administration has been more favorable to the banks in their capital return programs.
* Strategas Research, Investment Strategy Report, Feb. 25, 2019
One other quick comment …
I have dedicated immense space in this publication for the last six months to the subject of the re-leveraging that has taken place in America’s corporate sector. It is important to point out that all of those data points, and there have been many, reference what is called the “non-financial” sector. In other words, the roughly $4 trillion of corporate borrowings (from the senior bank loan market to private middle markets to high yield bonds, etc.) have entirely taken place in non-financial companies. The fact of the matter is that our financial sector has dramatically de-levered since the financial crisis (obviously by necessity).
* Strategas Research, Investment Strategy Report, Feb. 25, 2019, p. 2
Politics & Money: Beltway Bulls and Bears
- The President walked away from the second North Korea summit and canceled plans for a “signing” meeting. On the same day, Michael Cohen spent hours testifying against the President in front of a House Committee. The markets were unfazed.
- I’ll have more on this next week as an extensive IRS report on this is due today, but the tax refund issue has self-corrected as expected in recent weeks
- We are watching to see if the collapse of the North Korea talks means anything for the trade talks with China …
Chart of the Week
How much is the market expecting a favorable outcome in the trade talks between the U.S. and China? Note the relative outperformance of companies with China revenue exposure vs. the overall S&P 500 … The lesson here: Markets are eagerly anticipating a favorable outcome in the China deal.
* Strategas Research, Policy Outlook, Feb. 19, 2019, p. 3
Quote of the Week
“A good decision is based on knowledge, not on numbers.”
~ Plato
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For those wondering, my beloved Pacifica Christian High School Tritons lost their CIF championship game last Saturday by three points, but advanced to the state playoffs on Tuesday night, where this happened (you really must watch). Now we are in the state regional playoffs and have a rematch against the team that beat us last Saturday! This is the school I serve on the Board of Trustees for and co-founded five years ago. My eldest son will attend as a freshman in the fall. Yes, I love this school and her vision and mission. And yes, I love basketball. Sorry – you’ll just have to bear with me.
I love capital markets, too, and this has been one heckuva a bizarre first couple months to the year. I think investors should be proud where they did not let behavioral decisions do damage to their portfolios in the aftermath of the December sell-off. But I also think investors should really take pause at how significant the central bank of our country has become in driving risk asset performance. The decisions made around liquidity in the economy drive far more than they ever have, as the last three months show us (in both directions).
What to do about such a reality? Well, my upcoming book, The Case for Dividend Growth, Investing In A Post-Crisis World (PostHill Press), offers some solutions.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
