Dear Valued Clients and Friends,
We have a fun Dividend Cafe for you this week, with by far the most important things on my mind in the summer of 2022 getting all of the attention. This is a short, easy read, and easily digestible for anyone looking to make heads or tails of the current market conditions. I will spare you further introduction and jump right into the Dividend Cafe …
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(1) What to expect from inflation next?
We know that in the month of July, the rate of inflation came “down” to +8.5% vs. the +9.1% of the month prior. The “0%” claim that President Biden has been understandably criticized for is a reference to prices not going higher from June to July. The -4.6% monthly drop in Energy prices helped offset the +1.1% monthly increase in Food and +0.4% increase in Services. Of course, +8.5% higher prices than the year before is still more than 0%, but it was the first print in some time that the increase was lower than the prior month’s increase.
My arguments for a continually decreasing rate of inflation in the short term are:
(1) Supply chain issues that were at the heart of the inflation we experienced last year have improved materially, though are not fully resolved, leaving more improvement still to come
(2) Energy inflation has, for now, subsided, and it was a substantial contribution to inflation as inadequate production existed to meet status quo demand
(3) Though subject to a big lag in the reporting data, housing prices and rents have either stopped going up, started going down, or at the very least, gone up at a drastically lower pace than before
(4) Massive debt levels leave loan demand muted, which puts downward pressure on the velocity of the money in circulation, which is anti-inflationary (because PV=MT)
and then (5) is the …
Chart of the Week
The huge inconvenient truth about inflation in more recent times is where I circled #1 below in the chart – post-GFC, the money supply absolutely exploded, but a decade of extremely low inflation followed (I have written about the reasons for this many times). Of course, Japan is already a 30-year inconvenient truth here, but I have long accepted now the willingness of many to be totally comfortable with pretending Japan’s counter-factuals don’t exist.
A resurgence of inflation came in concert with the money supply explosion out of the COVID moment (see #2 below). President Biden’s spending bill #3 is often discussed as an explanation, but of course, there were two massive spending bills (Cares Act and the $900 billion lame duck session bill) before that one. Regardless, there was $5 trillion of new government spending that coincided with this. Prima facie, a pretty reasonable post hoc …
But then, if #2 was the cause and effect for inflation below, then where I circled #3 becomes a very big argument for pending disinflation, right?
*Real Investment Advice, Isabelnet, Aug. 18, 2022
(2) So, what will the Fed do about rates?
So they raised rates 0.75% on two occasions this summer (one in June and one in July) and previously had raised rates 0.25% in April and 0.50% in May. So, you get 2.25% of interest rate hikes from the Fed over the last four months. And in fairness, so far, they haven’t broken anything. Yes, Nasdaq and “shiny object” valuations got right-sized, but I promise you that was going to happen with or without a Fed intervention at some point (because of trees and the sky and all that jazz). So as we sit here at what is effectively a 2.5% fed funds rate, where are we going next?
I am in the 50 basis point camp for the September meetings (getting them to a range of 2.75% to 3%). There is no meeting in October. And then in early November, I think they do another 25 or 50. Regardless of whether they do 25 and 25 in Nov and then Dec or get it all done sooner, I think there is 100 basis points more to go between now and the end of the year. This is not a foregone conclusion; futures markets price in a reasonable chance (16%) of ending the year higher than 3.5% – but I will take the under. The exact pace of rate hikes in the next three meetings is not totally important much as the ending rate somewhere in the mid-3’s.
And then a pause. Or not.
What makes the “or not” lead to more rate hikes in 2023, a scenario I promise you the market is not pricing in whatsoever? Well, a higher rate in CPI than 8.5% in the months ahead, for one, and an unemployment rate staying in the 3,5%, for another. The Fed has had to pretend that it is the arbiter of CPI (they are pretending), and they act on the belief (they really believe) that employment and price levels are at odds with one another (it is called the Phillips Curve, and it is the most fallacious source of bad monetary policy ever concocted). At least if they had higher unemployment, they would have ample cover for not raising rates even if CPI rates were staying elevated. But if that scenario played out, and I firmly believe it will not on BOTH counts, but IF you had a CPI > 8.5% and unemployment lower < 3.8%, I imagine 2023 means more forced rate hikes. I would give this a 10% probability, which is more than zero.
So what creates a “not pause” leading to rate cuts? Let’s just say you have a CPI rate that is dropping (and by the way, they actually use the PCE measure of inflation, which I happen to agree is a superior one, but for our purposes, we’ll just keep it simple and use the media fave of CPI). And then let’s say you have unemployment inching or even more-than-inching higher, and you get real pressure in financial conditions (dried up liquidity, widening credit spreads, etc.) – see: Q4, 2018 – then, I think you are talking rate cuts in 2023. I would give this a 30% probability.
And what leads to my default 60% probability view of stasis? Some in-between-ing of those two scenarios above, of course.
(3) Are the midterm election results going to play with markets?
I would have guessed for the first 5-6 months of this year that the Republicans would end up with some lead in the Senate after the midterms and a large majority in the House. I now believe it is almost a foregone conclusion that the Republicans will end up with a lead in the House, but a smaller one than previously anticipated. And that the Republicans will not take a majority in the Senate. There is still a path to keeping a 50-50 tie in the Senate, but I think the bigger debate is whether the Democrats end up with 50, 51, or 52 Senate seats (and 53 is possible) – not whether the Republicans take 51 or more. Now, anything can change, and some of the polling here has been wrong in the past (a Wisconsin Senate seat in 2016 comes to mind).
But the question was about markets. And since we know there will be a Democrat in the White House after the midterms, and we are assuming a Republican majority in the House after the midterms, the Senate composition is likely less significant as the presumption will be for gridlock. And markets do not mind gridlock (some would say they like it).
The issue about the Senate majority with markets is committees. It is more political machinations than low-hanging market fruit, but it is not insignificant. For Republicans, it is a mind-boggling reversal of fortunes and opportunities versus months ago. For Democrats, it is a good offset to what they believe will be a loss of control in the House.
But for this political junkie looking to apply it all to markets????? It has very little to do with 2022/23 and everything to do with what to expect out of the next Presidential election in 2024. The markets would have loved to discount a high probability of an economic and cultural landscape more favorable to market conditions post-2024, but the muddled picture the 2022 midterms are likely to create will prevent that from happening and leave us with a roller coaster of possibilities in the next two years about the political landscape.
(4) Is de-globalization real and is it a game-changer?
I need to do an entire Dividend Cafe about this subject so forgive me in advance for the abridged answer here. Yes, there is a decline in the levels of expanded globalization playing out right now on many fronts. Yes, there is a seeming disengagement from the international order from the United States. I have strong beliefs about the nuances in all of this and various levels of appreciation for it (I support less reliance on China where matters of national security and vital intellectual property are concerned), as well as various levels of strong concern (a disengagement from world affairs for the United States will allow someone else to fill that void, and I don’t think it is going to be Canada, if you catch my drift).
My view is that various elements of de-globalization will play out, and some will be positive (regionalization of manufacturing, in some cases). BUT, when pain comes (and it will) around certain economic or geopolitical dimensions of this, I believe American sentiment will shift. We live with a constantly shifting pendulum in American life, a hallmark of the Madisonian order.
(5) What is the criteria for “quality” from public companies right now?
A rising P/E ratio is not an indicator of quality. It can be a measure of optimism. And it can reflect warranted optimism at times, no doubt. But it also can speak to mere hope and even unwarranted speculation. It is not a measure of reality.
Free Cash Flow is hard to denigrate. Strong balance sheets could just mean a company is strong now but will set its assets on fire in the years ahead. Only Free Cash Flow keeps a balance sheet strong. Only Free Cash Flow pierces through the bull*&^% of various accounting metrics. Only Free Cash Flow transcends the challenges of abnormally high capex.
And Free Cash Flow Margin means that you don’t have to use a lot of your revenue for working capital and capex.
So, high free cash flow is a must in this day and age – an absolute must. And yes, we know many companies must invest in capex for their future productivity and growth. The question is how much free cash flow has to be used to fund such needs, cutting into margins and basically limiting the ability of the company to turn revenue into distributable profits over time.
FCF and Margins in tandem are indisputable metrics of quality, divorced from the circus of monetary policy most market observers are obsessed with.
Quote of the Week
“If you don’t feel comfortable owning a stock for ten years, you shouldn’t own it for ten minutes.”
~ Warren Buffett
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Maybe you had five different questions more on your mind than these, and if so, by all means, fire away. But these five take the cake for me as we get ready for summer to come to an end over the next two weeks.
And then we enter the fall, where by far the most important question on everyone’s mind will be … How are the Trojans looking on the field?
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
