Dear Valued Clients and Friends,
It was a short week in the markets with the MLK Day holiday on Monday, yet the news cycle and pick-up of earnings season helped make it feel like a full week. The substantial move higher in markets so far this month has not yet been interrupted, as a 300-point drop on Tuesday was offset by a 170-point increase on Wednesday, and markets mostly seem to be an in a “wait and see” mode now. This week in the Dividend Café we jump into China, a U.S. recession watch, housing, some unforgettable diversification principles, the earnings growth narrative, and oil. You have the weekend off from NFL playoff action, so jump on into the Dividend Café …
Dividend Café Video
Dividend Café Podcast
Understanding China is necessary to understanding everything else
It is not untrue to say that the President’s trade war with China exacerbated their economic distress in 2018, but it is true to say that it does not tell the entire story. China’s fear for some time has been an explosion of credit growth that has created significant vulnerability in their shadow banking system. Their shadow financial system has been largely shut off from funding infrastructure projects and participating in the banking system, so credit needs have been met elsewhere (in less risky domains, I might add), but the net effect has certainly been a decline in overall credit growth. This weak credit growth, while necessary, has been at the heart of China’s woes this last year, and when combined with the trade pressures instigated by the administration has created a perfect storm of concern for Chinese economic policymakers.
And then understanding the United States …
Through all of my boring talk on capex and business investment, a very simple summary can be presented as to what the operative question for 2019 is: Will businesses continue to enjoy a higher return on invested capital than a cost on borrowed capital? That is the issue that not only defines our current phase, but it is really at the heart of all economic analysis. Growth in business investment can remain positive if this spread persists. What jeopardizes the spread is a confidence collapse generated by a trade war, or credit conditions tightening to the degree that the cost of borrowed capital exceeds expected returns on capital investment. Should interest rates hold steady in 2019, we may very well face an expansion of this spread in 2019. But recession watchers know that this is the economic metric that matters, and lots of variables play into it.
An update on housing
Sales on existing homes fell 10% in December (to a three-year low), and housing sentiment (University of Michigan) hit its lowest level since 2008. Median home prices nationwide had grown 5-7% since 2014 but slowed to 2.9% in late 2018. Housing supply, though, is not overdone by any stretch, and I wouldn’t be surprised to see construction levels pick up in 2019.
Our base case remains that a garden-variety correction takes place in housing prices around the country this year (it clearly already has begun), the results of which will be positive for the U.S. economy (as rational levels of affordability become somewhat more attainable).
Looking at diversification in graphic form
I have loved the periodic table of asset class returns chart ever since I entered this business, as few things more effectively demonstrate the need for diversification than this graphic representation. And as I sought to demonstrate in my annual “white paper,” the story of 2018 was not about the stock market; it was about everything under the sun.
A fair question
Embedded in the bullish narrative for stocks in 2019 is that, beyond overcoming the headwinds of tightening liquidity/credit and the global trade way, is the assumption of continued stellar earnings growth. And indeed, from consensus views all the way down to stress-tested “worst case” scenarios, the outlook for U.S. corporate earnings growth is very strong for 2019, even if at a much lower growth rate than last year. That said, the significant downward revision in global earnings estimates are a cause for concern. From Asia to Europe to other markets ex-U.S., we have seen significant revisions to the downside on expectations for earnings, and the question for markets will be whether or not the valuations already reflect these revisions (which I suspect), or whether or not there is a less benign earnings environment than many have assumed.
Say it ain’t so! A “no deal” Brexit?
Expect enhanced fear-mongering in the days and weeks ahead around the possibility of a so-called “hard Brexit.” There is a chance such a hard Brexit will happen (a departure from the European Union as scheduled without new deals on trade already teed up), though I am skeptical. It is also true that a new referendum on Brexit will be called for, though I think that would be a political mess (and travesty). If I were a betting man, and that is all this is, I would speculate that an extension will be approved to move things past the March deadline and that ultimately it will be a soft Brexit approved too. But it does remain fluid …
Slipping on the oil story
The “capex” thesis I write about almost every week is the very high conviction belief that increased capital expenditures (business investment) are needed to boost GDP growth and extend this economic recovery. In addition to credit markets tightening and trade war suffocating demand, oil prices that render energy capex a bad investment is one of the great threats to the overall business investment thesis. But oil has recently moved comfortably above the price level that might necessitate a cut to Capex, and is up a stunning 19% already year-to-date.
Source: Factset
Value isn’t just for stocks
We are always looking for value in any asset class in which we invest client capital, and right now we are heavily discussing whether or not the price deterioration of the floating rate loan market in December and the spread tightening in High Yield bonds here in January has created a relative value opportunity in bank loans vs. high yield. There are technical factors, supply/demand considerations, and other issues to evaluate, so we are doing this right, but yield differentials right now suggest a value opportunity in loans vs. the high yield bond market. However, besides the yield differential factor here, we need more evidence that floating rate is not dependent on flows to drive performance, as flows have (for now) slowed down substantially.
Refresher in diversification, time, and the ABC’s of investing
I used to reiterate this reality all the time, but I was reminded this week that I hadn’t done it for a while when I saw the following appear on another financial site I read frequently:
Source: S&P 500
It can’t get a lot simpler than this – the shorter the time frame, the greater the possibility of a negative return (though even in as little as a daily glance, it is still less than 50% of the time); and the longer the time frame, the greater the odds of a positive return. It is hard for evidence-based, data-dependent, mathematically-minded people to not find this chart obvious in its takeaway: Stock market investing is for multi-year goal planning, not intra-day speculating.
The statistics around diversified portfolios which allocate between stocks, bonds, and other asset classes become even more compelling. So TIME and DIVERSIFICATION. It’s not easy, but it is simple.
* Diversification is (Almost) Undefeated, Ben Carlson, A Wealth of Common Sense, January 15, 2019
Politics & Money: Beltway Bulls and Bears
- The shutdown noise has accelerated and political pressure intensified for some resolution to be found. The President has upped the ante with tangible immigration policy proposals being offered that force the House Democrats to respond. Chatter has picked up that forces in the Senate are working to create a re-opening as well. At press time, the easy path to face-saving for both sides that enables the government to re-open is not abundantly clear, but that both sides seem to be indicating an appetite for such is.
- Congresswoman Alexandria Ocasio-Cortez was named to the House Financial Services Committee. Yep.
- Commerce Secretary, Wilbur Ross, said yesterday that on one hand “he is confident both the U.S. and China want to find a deal,” and on the other hand, “we are miles and miles apart from having one.” Traders and computer algorithms can debate if this is a net good or a net bad.
Chart of the Week
This is not merely a profoundly important chart for investors, it is profoundly important (and thrilling) for citizens of the United States. And this is before several new export terminals go online in 2019 and 2020. The export story of oil (and natural gas) is finally about to hit its actualization.
Quote of the Week
“From the sublime to the ridiculous is a single step.”
~ Napoleon Bonaparte
* * *
I will leave it there for the week, and start doing what I generally do when one Dividend Café is closed up … thinking about the next one. I believe it will be time to focus more on earnings season next week as we will substantially increase the number of companies that report results. Thus far it has been quite positive, but it is early and I want to have more data to analyze before drawing any conclusions.
I am off to a big weekend conference in the desert tomorrow, and deep into the heart of client review season. This review process is so important for investors – not just for the relational and communicative purposes, but for re-visiting so much of one’s portfolio, and more importantly, the plan behind the portfolio. It is to that end that we work!
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
