Dear Valued Clients and Friends,
I am relieved that no client of mine emailed over the weekend or on Monday itself to say, “Oh no! What will the market do about this government shutdown?” While the press did all they could to make it a news event, let alone a market event, the people weren’t biting on it either. The market shrugged the silly little incident off, and as best I could tell most people did as well. Is there a political statement in this? Not at all! Rather, it is a clear markets statement – markets have so tuned out Washington D.C. dysfunction, and are so monolithically focused on earnings and fundamentals, that we ought not be surprised by this at all any longer.
Those things that do drive markets are what we write about in the Dividend Café, and you’ll see it all this week – inflation talk, equity risk premium, the Fed, stock buybacks, correlation to the dollar – and more. It is a hearty week in the café, so let’s get into it …
Dividend Café Video
Dividend Café Podcast
If a government shutdown doesn’t hurt markets, what will?
Take the non-event of last weekend’s embarrassing government shutdown and its non-impact on markets as a symbolic furtherance of the crucial principle at play right now (and all of last year): Markets respond to earnings; markets ignore Washington D.C. So the question becomes what will impact earnings or their value to markets that could change sentiment, valuation, and momentum? The economic cyclicality seems to have further room to go for expansion (perhaps a lot of room). Therefore, the likely catalyst at some point would not be global growth slowing (and thereby earnings slowing with it), as much as monetary tightening – eventually calling for a re-pricing in risk assets as the risk-free rate grows and compresses valuation of risk assets.
To inflate or not inflate, Part ___
A reasonable (though I think, inaccurate) view of tax reform and inflation is that the onset of fiscal stimulus coming in the form of new personal and business tax cuts, at a period of basic full employment, will drive consumer spending into an inflationary breakout, and deficit spending will exacerbate this. As we have argued before, most recessions are caused by the actions the central bankers have to take to cool down an inflating economy. But it is important to point out the possibility that the consequences of tax reform will be more productive capacity – and that the growth generated will be anything but inflationary.
Mnuchin says what?
Yes, that was the Treasury Secretary of the United States of America saying this week in Davos, Switzerland (World Economic Forum) that “a weak dollar is good for us.” Now, one could be pleased with the honesty of what he said, in that we all know they think it anyways (competitiveness with global trading partners trumps actual sound money for these people, and has for a long time). But it is bad long-term policy, and is even more confusing when they acknowledge that (“short-term we like a weak dollar, but long term we like a strong dollar”). What exactly is the timing of “short-term” vs. “long-term” here, you may wonder? When does it become convenient to switch what we like from weak to strong?
I want to be very clear. Secretary Mnuchin’s statement was unprecedented and sort of shocking. But it represents nothing new in actual policy and action. For 15 years+ policymakers have acted this way; he just said it out loud. For our purposes, we stand with Alexander Hamilton on this one.
And don’t expect other countries to just take our Treasury Secretary’s declarations lying down. Two can play at the game of currency weakening. Or three, or four, or …
Joining Fox Business’ Varney & Co. Live from New York City
The slippery mess of understanding oil
I want to join the cause of arguing for supply-demand factors as the primary driver in oil prices, and indeed, supply-demand factors are the primary driver of oil prices (ultimately) whether we adequately understand all the complexities there or not. But one thing that drove our opinion in 2014 and 2015 when an acceleration of Saudi production pushed prices even lower on the back of excess supply was that if Saudi objectives were trying to drive the market then (we would argue – unsuccessfully) a reversal of those same Saudi objectives would also play in on the other end of all this. Saudi Arabia had $750 billion of reserves in 2014; that number is down to $350 billion today (and they will burn through another $50 billion this year, even with oil prices firmly above $60). Their current fiscal necessities, combined with the preparation of this Amarco IPO (the state oil industry spin-off to private markets) caused us then and cause us now to forecast a continued bias in supply policy to boost oil prices.
Game-changer at the Fed?
One of my big themes in late Q3 and early Q4 of 2017 was the impact that a changing of the guard at the Fed could create. At the time, there was heavy discussion that the replacement to Janet Yellen could represent a pretty severe break from the neo-Keynesian interventionism of the Yellen/Bernanke school of thought (Kevin Warsh, John Taylor, etc. were being discussed). I was excited about the possibility, but well aware that it could certainly represent a real increase in volatility (perhaps severely so) if markets had to digest uncertainty or radical transformation at the Fed. That didn’t happen. The replacement ended up being Jerome Powell, a smart and seasoned banker/economist, but largely in the same school of thought as Janet Yellen. We stand by our call that a very slow pace of normalization and a status quo framework on phillips curve, model-driven, “wealth effect-sensitive,” highly accommodating approach to monetary policy is likely to rule the day.
With that said, there is conversation about an abandonment of the current 2%-inflation-targeting, and even the possibility of “price-level targeting.” I imagine whoever the selection of vice-chairman ends up being could represent an influence on this thinking. Is it possible that the Fed gets some of the rules-based thinking of Warsh and Taylor, even with Yellen-like personnel in Powell and others? I wouldn’t bet on it, but I sure wouldn’t mind it. If nothing else, it is encouraging to think that the present Fed chair may be open to such intellectual inquiry.
A primer on equity market risk
Should bond yields move from 2.6% to 3%, or higher, it is hard to believe that equity markets would not suffer. But the major category of risk in equity markets for over a decade now has been deflationary pressures, pressures that are effectively hedged with long duration bonds. But rising bond yields in response to economic growth are anything but deflationary, and in that case, the proper diversifiers are inflationary hedges (commodities, TIPS, etc.). These are bizarre paragraphs to type, because it is the polar opposite of what has been the risk and conversation for so many years. But these conversations are going to become more common in 2018.
A bull market for me but not for thee
One of the possibilities I am trying to wrap my arms around is the possibility we will enter the end of the “risk-on, risk-off” paradigm we have more or less been in since the financial crisis ended. With some minor exceptions, we have pretty much seen periods of all risk assets rallying together, or all risk assets retreating – but not so much various risk assets moving in different directions against one another. This has been understandable – globalized monetary accommodation begged for a synchronized behavior of risk assets, and most periods of downward pressure were contagion-driven fears of systemic slowdown (European crisis of 2011, Chinese crisis of 2015, etc.). Differentiation amongst macro environments and drivers has been hard to come by, and so what we call risk-on, risk-off has become very familiar to asset allocators like us.
But what if, maybe, just maybe, that paradigm is about to change? Is it remotely possible that the U.S. bull market will peter out, but emerging markets are just getting started? Could Europe resume headwinds even as Japan advances out of a corporate profits reversal? We think these possibilities are real, and if nothing else, warrant asset allocators thinking differently than they have since 2009.
Not so fast on small-cap?
The counter-argument to our tactical call in favor of small-cap stocks starting off 2018 is that many small-cap stocks are heavily correlated to interest rates due to their newfound indebtedness, many are trading at multiples not seen before, and as I pointed out in this year’s white paper, many are not profitable at all. All of these things are true, and all of them are why we favor active management and a more selective/concentrated approach to small-cap investing than any passive index can provide.
Revising the revisionism of the revisers
A popular refrain to rebut the idea that repatriation of foreign profits is going to be stimulative to the U.S. economy is that in 2005, fully 90% of repatriated money were used for stock buybacks and dividends. It is an absurd statement, but one used to belittle the notion that these tax cuts will help the real economy. Why do I say it is absurd? Well, TOTAL stock buybacks in 2005 were $150 billion – total – and over $300 billion of U.S. corporate profits were repatriated. Are we really to believe that ONE HUNDRED PERCENT of stock buybacks flowed out of repatriation? First of all, $30 billion of that $150 billion was a special Microsoft purchase announced the year before! The reality is that this unique potpourri of supply-side tax cuts (slashed corporate rate, immediate expensing, territorial system, and repatriation) is going to create a potpourri of allocations (stock buybacks, dividends, bonuses, wage growth, new hiring, M&A, and business investment). No revisionism of history is going to change that.
Nothing to see here
In keeping up my scorecard that we are entering a new era of social and political pressure for the “big, cool” tech companies that have been such a huge part of market growth in recent years, this little nugget jumped off the screen at me this week: Apple, Amazon, Facebook, and Google spent a combined $50 million in lobbying last year, record numbers for each company (1). In some cases, it was 3x what they had ever spent before.
Chart of the Week
Now this is an incredible chart … It basically turns the U.S. dollar upside down, and shows how highly correlated a weak dollar has been with energy and materials stocks for decades! So a reasonable investor might conclude two things: (1) The weak dollar environment we are currently in should bode well for energy stocks; and (2) There is a disconnect between this relationship at present that ought to mean-revert (i.e. dollar weakened; energy stocks did not appreciate, yet)
Quote of the Week
“The average long-term experience in investing is never surprising, but the short-term experience is always surprising.”
~ Charley Ellis
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Fox Business had me talk about a handful of our 2018 themes this week (energy infrastructure, political pressure in big tech). Market talk on a market network can be so refreshing vs. the 24-hour political circus! The Davos World Economic Forum has been on all week and managed to make a headline or two worth noting (from our perspective). Earnings season has been noteworthy thus far for how non-noteworthy the simply amazing revenue and profit growth has been. All things considered, with a partial week to go, January has pushed 2018 off in a way that most risk investors will like.
And The Bahnsen Group likes how it has kicked off as well. We love talking with our clients, meeting them, pouring into the services we can provide them (above and beyond our portfolio management work). And we love seeing the fruits of our labors play out in real life consequential financial goal achievement. That is what it will always be about. Enjoy a weekend with no football on (sad), and reach out for any way we can be of service to you. It is to that end, that we work.
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner
(1) CNBC.com, Tony Romm, Jan. 23, 2018