Dear Valued Clients and Friends,
Greetings from the financial capital of the world that is New York City where I have officially begun my annual “due diligence” week, and where another week in the markets deserves comprehensive analysis. We focus our efforts this week on what was done and not done in the “pre-written, phase one” trade deal, but we also delve into Brexit, the yield curve, Elizabeth Warren proposals, and even the lottery this week. But one thing I ask this week – persevere through all the weekly commentary to get to the “economic lesson” of the week. It is the subject most near and dear to my heart this week, and hopefully will be well worth the read. So jump on into the Dividend Cafe!
Dividend Café – Podcast
Dividend Café – Vidcast
The Beginning of a Deal, or ????
We unpacked all of this “trade stuff” more elaborately here. This stage of the “partial trade accord” is not yet signed, but is expected to be as soon as next month. Tariff escalations have been suspended, and China has agreed to significant increases in agricultural purchases. The “currency manipulator” label appears to be being removed, and intellectual property measures are going to have to be addressed in future deal iterations.
Dividend Café – Investment Committee Vidcast
There are two risks I would mention. The first is simply that in the course of this phase one deal being written, something breaks down. It would seem unlikely that would happen given the level of attention and clarity both parties wanted around this pre-written deal, but it can’t be ruled out altogether. The second is where things stand or will stand around “phase two” or “phase three” deals. The market wants clarity and certainty, and this incrementalism in deal structure certainly extends the period of ambiguity and question.
That said, the cessation of new tariff escalations is the biggest part of this deal, and it can’t be said enough that for the sake of business investment, manufacturing, and capital expenditures it is a huge positive that, for now, this phase one deal has been reached. $12.5 billion of tariff increases have been avoided already, and if the December escalations get avoided that represents another $24 billion. So if $36 billion+ of planned disasters are avoided, that is substantial.
* Strategas Research, Policy Outlook, October 14, 2019, p. 3
I still believe what can be agreed to before the election is limited, but a cease-fire (especially one that might, just might, actually hold this time) is good news on the margin. The agriculture purchases were expected, the currency section is probably better than expected, but Huawei being left out is either good news or bad news depending on what it was going to say had it not been left out. Net net this was a positive deal, even if it wasn’t a game-changer … And …
As for markets …
Putting aside the big picture aspirations various parties may want or not want out of an eventual deal or in some phase of a multi-phase deal, the number one biggest issues markets care about is (a) Certainty (they won’t get that any time soon), and (b) Tariff relief (their deflationary impact erodes profits and confidence). As for B, this trade deal does not repeal legacy tariffs of the last 18 months, but does pause planned escalations in tariffs, so that is what markets have enjoyed, but why they haven’t enjoyed it all that much.
I will finish by saying that the uncertainty which has kept capital spending muted could very well get a cyclical reversal, providing the incentive some companies need for long-overdue capex projects. It is certainly true that we believe this needs to happen, but it is also true that we believe an improving capex picture surfaces with each improvement in the U.S./China trade relationship. And while I cannot measure it, I do believe it represents a marginally real justification for optimism.
“After this, but [maybe not] because of this?”
No sooner than this phase one trade deal hit the news wire did the ten-year treasury bond yield rise above the level of the 3-month treasury bill yield for the first time since late July. Did this happen entirely because of improved optimism around trade resolution? It is impossible to say it had nothing to do with it, but unlikely it was the sole factor either. Fed open market actions, market expectations on short term interest rates, and yes, change in global risk views, all contributed.
The primary issues I believe sober policymakers want addressed in the U.S. relationship with China deal with intellectual property theft and national security. Reasonable people can disagree over the extent that bringing trade into those issues has helped or hurt the overall objectives in the U.S. policy stance with China. The weapon used by the President to address the combined milieu of policy issues was tariffs, a tax on imports paid by the company importing products from China. The tariffs have had a decimating account on China’s economy, yet have not produced the leverage or the trajectory to get a deal done. Instead, a negative impact on American manufacturing, farming business, and overall business confidence all came together to create a liability for the President politically, even as the primary issues of national security and intellectual property theft remained (a) Vital for American policy interests, and (b) Politically desirable to address.
Politics are in charge now as much as economics, and we do expect this phase one deal to cross the finish line at the Chile meeting in mid-November. We further expect the December tariffs to come off the table.
But the final deal is the question mark. We join all Americans who favor national policy improvement in hoping it will strengthen protection on intellectual property rights of American technology companies, stabilizing currency fluctuations to be more market-oriented, and of course, avoiding breaches of national security. But that final deal is a ways off, and frankly, the market is more concerned with stability around trade and tariffs than it is the comprehensive “final deal.”
This week’s sign of the apocalypse
Does anyone remember Greece, that famed European country which spent most of the last decade in financial insolvency, pleading with European creditors to roll its debt and keep the country afloat? The country whose bond yields were through the roof a few years ago, reflecting the fact that they were in default, and that bondholders would be fighting for scraps to get paid back on their debt?
Guess what those bond yields are now?
For three month debt – an investor needed 4-5% in annual yield to buy Greek debt just five years ago. Now, you get to pay money for the right to lend Greece money, as they join the list of countries trading at negative yields.
* Over my Shoulder, Charts that Matter, October 16, 2019, Mauldin Economics, p. 1
Corporate Profits Q3
Here is what I think, and I hope I am wrong …
I think if earnings come in below expectations across the entire market, it will cause the overall market to decline. But I am not expecting that – I just wouldn’t give it a 0% chance.
And I think that if earnings come in way, way above expectations (with guidance forward far, far above expectations, that the market will go higher. But I am not expecting that – I just wouldn’t give it a 0% chance.
But if earnings outperform expectations, but not in dramatic fashion, I actually think it will not necessarily cause market prices to rise, as I think markets have already been rated for some outperformance. The valuation reflects some earnings growth that has not yet happened, and I think it could happen, and cause valuations to catch up to prices, but not necessarily see prices increase substantially.
All things being equal, of course.
Isn’t that deadline we’ve heard so much about coming?
The deadline for a Brexit deal that Prime Minister Boris Johnson has sworn he will uphold is, indeed, two weeks away, and the summit this weekend is sure to tell us a lot about how things look. The sudden surge upwards in the sterling pound is a response to the optimism that a deal will be struck which avoids a so-called “disorderly” Brexit. I found this decision tree of potential outcomes and probabilities from my friends at Gavekal Research absolutely fascinating, and worth perusal.
* Sizing up the Brexit Risks, Gavekal Research, Anatole Kaletsky, Oct. 14, 2019
The apparent change is the idea of Northern Ireland staying within the European Union from a regulatory standpoint, but staying part of the United Kingdom from a political standpoint. This has been called “one country, two systems” throughout the discussions, and has been a deal-breaker on various sides of this issue until very recently. As of press time, Thursday morning, the UK and the EU say they have a deal (though Northern Ireland is not yet onboard). Expect a weekend of drama, British-style …
Another sign of the apocalypse?
What is perhaps the largest transfer of wealth that no one ever talks about? Did you know that $80 billion (with a “b”) is spent each year on lottery tickets? Of course, this is money people are voluntarily transferring to someone else (nearly half to various government agencies, and the rest to prize winners) whereas most wealth transfers are involuntary. But to put that amount of money in perspective – even if you only count the amount that was transferred from people to government agencies, it represents about 40% of the fiscal stimulus from corporate tax reform. Just sayin’ …
This Week’s Economic Lesson
I have tried to tether in important economic discussions these last few months as I believe the constant short-termism around the trade war and other headline events, while highly justified in their short term relevance, causes us to ignore some of the multi-decade realities we face as investors. And none, I mean it – none – are as important as the low-interest rate paradigm we find ourselves in now. If all there was to it was “how to construct a portfolio when interest rates are low” it would not be so complicated, but there is much more to it than that. The reason for the low rates matter – excessive debt that has created a deflationary spiral and invited unprecedented interventions from central banks. And the thought process that so many investors have (“well, this must be good because it facilitates more borrowing and spending and activity”) scares me to no end … It scares me because it is wrong. And as a fiduciary investment advisor, I must repudiate what I know to be wrong.
Do low rates have cyclical stimulative impacts on economic activity? Of course, they do. And do they re-rate risk assets to the upside because of the relative valuation factor compared to the risk-free rate? Yes indeed. But do they create long-term economic growth, particularly when long-term economic growth is the absolute need of the hour? No, my dear clients and friends, they do not.
They depress saving (who wants to save when you are getting no interest, and it is so much more fun to consume?). Savings over the long-term must equal investments, and this deterioration of long-term investment destroys long-term productivity. A society that does not save is ultimately a society that does not produce. Never, ever forget this.
There is so much more I could say on this – the political ramifications, the moral ramifications, the way in which this boosts up the value of existing risk assets but sacrifices the creation of new risk assets – but I don’t want to bite off more than I can chew in this Dividend Café. I just want you to think about the trade war, Q3 earnings season, and the Brexit meetings as the transitory, short-term things they are (which is not the same as saying they are irrelevant), and understand that we have an obligation to constantly be considering the longer-term implications of the macroeconomic realities governing the world in which we live. They are complicated, but they do not exist outside a set of principles and foundational truths. And we will never, ever stop working to apply these realities to our investment allocation decisions prudently, wisely, opportunistically, thoughtfully, and cautiously.
To that end, we work.
Politics & Money: Beltway Bulls and Bears
- The entire assessment of how an Elizabeth Warren Presidency could impact investors has to be conducted on two tracks: If the Democrats win the Senate, and the somewhat more likely scenario (at this point) that they do not. For purposes of assessing maximum risk and specific considerations, let me assume for a moment the latter – that there is an Elizabeth Warren Presidency and that the net-net pick-ups for the Democrats in the Senate are enough to give the Democrats a majority. What then are likely to be the most vulnerable areas for investors?
- First of all, the taxpayers at large … The spending proposals are so far into the trillions it is hard to maintain count, and the need to pretend that the spending will be done without sweeping tax increases (especially on higher-income people and on investors) will be politically gone.
- Financials are likely to be the biggest target, with significant threats to “breaking up” big banks, penalizing private equity, intensifying capital requirements punitively, and repeated rhetorical attacks. I should add, some but not all of the intensity directed at this group can be achieved without the Democrats winning the Senate – purely on an executive branch regulatory level
- Pharma is probably close on that list if there is a Dem takeover of the Senate, as price-fixing machinations would be almost a foregone conclusion
- Energy would be very vulnerable, as even if her fool-hardy threats to eliminate all domestic fracking prove to be political bluster, the leverage she would have on total U.S. production and midstream infrastructure would be significant
- Technology – especially “big tech” – would likely face a plethora of antitrust issues and Washingtonian interference
- All of it has to be understood from the vantage point of political variables – right now the markets do not even know that Warren will win the nomination. And then they do not know that she will win the Presidency. And they certainly don’t know that the Senate will flip control. So there is a lot in front of us, and a lot that will change, move up, move down, and defy expectations in the weeks, months, and full-year ahead!
Chart of the Week
No further commentary needed
* Strategas Research, Policy Outlook, Oct. 15, 2019, p. 1
Quote of the Week
“How many times does the end of the world as we know it need to arrive before we realize that it’s not the end of the world as we know it.”
~ Michael Lewis
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I am sending this week’s Dividend Cafe from the very beginning of my annual due diligence trip in New York City. I and Deiya Pernas and Brian Szytel from my investment committee will spend the next week in well over a dozen meetings without major portfolio management partners, and in fact yesterday (Thursday) the trip began with a really significant Alternative Investment symposium with our partners at Blackstone. I spend today (Friday) in an annual conference event with my mentor in the business, an event I have never once missed in my career. The avalanche of one-on-one meetings begins bright and early Monday and will last all week. We enter the week with ambitious goals for our discussions and analysis, with a particular focus on each manager’s views on the current economic cycle, the impact of the trade war, and the risks (more than opportunities) of heavily “accommodative” monetary policy. I plan to prod harder than I ever have before on their 3-year, 10-year, 30-year thoughts around the debt cycle and monetary responses to such.
Out of this week’s work, we begin to frame our macro asset allocation targets as 2019 comes to an end and we prepare for life in 2020. This has been one of the intellectually stimulative and portfolio enhancing weeks of the year since 2006 when the trip first began. I look forward to a profitable download on all we take away from the week upon our return.
In the meantime, reach out with any questions, and enjoy your weekends. There is no time of year like autumn – especially in the greatest city in the world.
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
The Bahnsen Group is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, SIPC & HighTower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through HighTower Securities, LLC and advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee.
This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of HighTower Advisors, LLC or any of its affiliates.