Dear Valued Clients and Friends,
The Federal Reserve did something they have not done in nearly eleven years this week – they cut interest rates. The last time they cut rates, we were in the middle of what was the worst recession since the Great Depression. Currently, unemployment is at the lowest level it has been in the post-WW2 era. So there is a lot to unpack on this rate cut and what it means (and doesn’t mean) for investors. And I know just the place to do this unpacking …
This week’s trip to the Dividend Cafe will look at the overall health of the U.S. economy, at the state of credit markets, at all the context around the Fed’s present thinking, and some very important reminders about dividend growth during this crucial time.
Dividend Café Video
Dividend Café Podcast
The headline number is that Q2 real GDP growth was up +2.1%. This is down from last quarter, but up from the 1.6%-2% number that some were forecasting. However, and this is important, consumer consumption was +2.9% of GDP growth, and government spending was +0.9%, meaning that there were 1.7% worth of negative detractors to get to the +2.1% number. Those negatives were capex (-0.1%), inventories (-0.9%), and trade (-0.7%). The non-residential fixed income decline of 0.6% was the key number from this report.
So this lays bare the issue … Economic growth cannot be sustained off of government spending. We know the consumer will spend if they have a paycheck (and often if they do not), so that is not the wildcard of the current economic climate. Business investment is as supply-side as anything in the GDP formula – it is its own contribution to economic growth, and it begets other contributions to economic growth. The 2017 and 1H 2018 numbers in that category were extraordinary. They have now dried up.
My view is that further statistical validation of this trend should be taken seriously. Expect consistent coverage on this subject from yours truly in Dividend Cafe each week for months and months to come.
Its all about the credit markets …
High Yield spreads came back to November lows last week (roughly 400 basis points, meaning an investor will receive 4% more income from owning “junk bonds” than they will in owning government Treasuries). This is significantly tighter than it had been during the credit crunch of late Q4, but still wider than we saw in the first nine months of 2018. Right now credit default swap prices are the lowest they have been in 18 months (the price of insuring against corporate bond defaults). New issuance of corporate debt is running at record levels.
So why should the Fed worry if all these metrics are pointing to highly functioning, liquid, lubricated credit markets? Alas, it is not unlike the reason people get vaccinated for polio even though no one gets polio any more … The reason credit markets are so loose and happy is because of the anticipation that the Fed would be “assisting.” In other words, (for the Fed) the happy state of credit markets is not a reason for the Fed to re-think their plans, but actually, the reason they are acting.
Investors should be prepared for two things when central bankers add stimulus to asset prices that are already operating as if they do not need any stimulus: (1) What is high is very possibly going to go higher; and (2) Bad investments will get made, and bad investments do not end well, ever. No central banker or politician can change that.
So the Fed cut interest rates as expected (by a quarter-point). Perhaps less expected, they ended their so-called “quantitative tightening” effective immediately. It was supposed to be phased out in a couple of months anyways, so this wasn’t huge news, but it does represent $70 billion of additional reserves that will sit in the reserves of the banking system (vs. $70 billion that would be extracted). The fact of the matter is the way the market reacted to Powell’s speech real-time on Wednesday (it first sold off nearly 500 points before settling down about 300 points) cannot be taken all that seriously. The market has had a long time to price in what happened Wednesday, and price it in ahead of time it did. Powell did not say that they were done cutting rates, but did say that they did not anticipate a “long cycle of accelerating cuts.” Thank God, right?
A long cycle of accelerating cuts would mean, ummmm, that we were in a recession! Why would anyone be rooting for that? The futures market is still pricing in a 75% chance that there will be one or two more cuts by the end of the year, and it is pricing in a 56% chance there will be one additional cut by September. Computers traded and stops got hit during Powell’s speech, but fundamentally, market investors can know three things right now:
(1) The Fed has made sure there is a lot more liquidity sloshing around the economy now than there was a year ago – a lot more.
(2) Any investors depending on what the Fed does or does not do for the success of their investing strategy is going to be sorely disappointed, at some point in time.
(3) A quarter-point here, a quarter-point there. He said this; he said that.
Look, at the end of the day, the details are less important to markets than this simple fact: The U.S. central bank we call the Federal Reserve has been a provider of liquidity to markets and a backstop when risk assets are threatened for over two decades. The concerns a year ago that this Fed may see themselves differently have been exposed as nearly comical.
The Fed Part 2
Why is the Fed stuck, meaning, forced into a more dovish framework for how they treat interest rates for the foreseeable future?
I think this chart tells the entire story. Global conditions force the hands of central bankers lest other countries export their deflation to us. The story can be discussed in U.S. isolation all we want, but that is not the way it works in this global economy. This week, the Fed did not capitulate to President Trump … they capitulated to Germany, Japan, and France.
* Strategas Research, Investment Strategy Report, July 29, 2019, p. 2
If past is prologue?
Seventeen times since 1980, the Fed had cut rates when the S&P 500 was within 2% of its all-time high. And seventeen times, one year later, the S&P 500 was up.
The contrarian nature of dividend growth investing
We normally use the term “contrarian” to describe a view that runs opposite of conventional wisdom. A “contrarian” investor is one who wants to buy what most people are selling, or sell what most people are buying. There is a lot of wisdom in contrarianism, to the extent that it seeks to run contrary to the mania of the crowds. Of course, sometimes the crowds are right. For example, it would not be good contrarian investing to go long VCR’s right now as a technology investment. But often times, and this has been prevalent in human nature for centuries, crowds go bananas. Trades get crowded. And what the masses love actually becomes a bubble, and what the masses hate actually become a screaming value. There are countless examples of this phenomena.
But I am not referring to this kind of contrarianism in the heading of this section … Perhaps a better term would be “counter-cultural.” Our culture has decided to measure the long-term success of business and stock investing with minute-by-minute reviews of the price of a stock. I get it. I find it silly, but I get it. But just because I get why the present system does something (instant gratification, intellectual laziness, and media manipulation all come to mind) doesn’t mean I have to agree with it or participate in it.
The Reality TV way for measuring investor success
I read a piece from a senior portfolio manager this week that makes the case we have been making for many, many years that the annual cash distributions from the company and of course the growth of that income stream are better measurements of investor success (1). While most securities and public financial websites measure the “yield” of an asset or a portfolio at any given time, the growth of that income is hardly ever measured. Why is that? Because the culture finds it cumbersome, methodical, and analytical – in short, “to0 many characters required.” Over time, I doubt you will find a better pure measure of a company’s success than its cash distributions to shareholders and the growth of those very distributions.
Stock prices change every single second. They are the ultimate reality TV. Dividends only change quarterly, and more commonly on just an annual basis. The “wisdom” of this age is anything, but when it comes to measuring financial progress. Call it contrarian. Call it counter-cultural. We call it prudent.
The MLP/oil & gas pipeline sector has two primary things in front of it to drive market price acceleration: (1) A peak in capital expenditure growth projects so that a period of pure free cash flow generation can be enjoyed and observed; and (2) Healthy global demand for natural gas … The producers (upstream) of natural gas have gotten hit because the cost is so low. But the demand for natural gas liquids is as high as ever, meaning takeaway through pipes is in as much demand as ever. The sustainability of this and appreciation for this is the need of the hour in the midstream world.
Prep ex it
(That is my clever blend of “Prep” for “Brexit” – Prep ex it. Okay, maybe not so clever). The new administration in the UK led by new Prime Minister, Boris Johnson, and Johnson’s appointed Brexit rep, Michael Gove, are pulling out all the stops to tell the European Union, “okay, if it has to be a no-deal Brexit, so be it.” Serious staffers, advocates, analysts, and policymakers have been assembled to lead the preparation for such a Brexit. The sterling pound has dropped in anticipation of this form of exit (though not to levels that can be considered surprising or problematic).
Ultimately the politics here are rather clear – Boris Johnson is trying to establish the leverage to make sure the European Union knows they will leave if a more reasonable deal cannot be reached. The parts of the world who have not become exhausted by the fear-mongering in this issue are watching.
Politics & Money: Beltway Bulls and Bears
- The Democratic debates this week were actually quite different from one night to the next, but did a lot to shore up where this primary appears to be going. There has been almost no discussion of foreign policy – none – in any of the now four nights of debate. Health care plans, border policy, and various domestic populist issues have dominated their discussions. What I think stuck out most this week is that the entire field (with the qualified exception of former Vice President Biden) actually appear to be planning as anti-trade candidates, much like President Trump. They were contrasting themselves this week more to President Obama than they were to President Trump, hammering NAFTA, TPP, and other foreign trade deals. I plan to record a thorough podcast in the week or so ahead capturing the economic and investment implications around this field and this race.
Chart of the Week
Why do most believe the Fed will be cutting rates another quarter or half point in the months ahead? Because the yield curve remains inverted until they do (the fed funds rate remains higher than a ten-year treasury yield).
* Strategas Research, Economics Report, July 31, 2019, p. 4
Quote of the Week
“Give me control of a nation’s money, and I care not who makes its laws.”
~ Mayer Amschel Bauer Rothschild
* * *
I hit “send” this week from my new New York apartment bright and early on Thursday morning, as I am flying back to California with my family after spending the month of July in our New York office. My kids being out of school got to spend July in the city and made the most of it with a variety of camps, outings, activities, and things that one can only do in New York City. It was an extremely productive work month for me, and there will soon be some very exciting announcements to come from it … When I am in NYC the media requests pick-up, so there are more TV appearances than normal as well. Summer is not the best time to be in the city, but for someone who, after twenty years, later still feels the same energy about the financial capital of the world as I did when I first took the ferry across the Hudson River from Weehawken, NJ to Manhattan as a brand new advisor at Paine Webber, there is never a bad time to be here.
But we return to California having accomplished what I wanted with the business in July, and having made some wonderful memories as a family. We will spend August with less humidity in Newport Beach, where our oldest son is daring to start high school in just a few weeks. High school. Come to think of it, those old memories as a newbie at Paine Webber really do feel like a lifetime ago!
Reach out any time, for any reason. We remain steadfastly committed to delivering a highly valued and respected client experience. To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet