We have been talking for a couple of weeks now about the underlying vulnerability in the markets, and why good news has not been responded to with bullish rallies, and even why bad news (or "less good news") is sometimes greeted with relief or joy. The basic summary to these counter-intuitive market actions is that monetary intervention has distorted certain rational expectations, ever so slightly, and economic actors are left guessing what things may mean to the central banks of the world, and to the bond market at large. This sounds like boring stuff, but it isn't, and we take some hardline stances while we caffeinate you in this week's Dividend Café ...
What happened yesterday, I mean today, I mean tomorrow
One of the dangers in using Dividend Café to talk about what the market has done a given day or a given week is, first of all, I have no chance of controlling the aging of that news within the 24-48 hours that transpire after I write it and before you read it. The news changes, quickly. Such is the reality of markets. But here is the bigger problem, and this one is much more important - it is very difficult to write about what the market did today, or the day before, or whatever - and simultaneously preach the truthful message as to why such stuff is completely irrelevant to our clients. I can understand the need to offer market commentary around extraordinary events - like the week of thousand point drops in the Dow back in early February, etc. But I can't maintain a coherent or consistent framework by preaching how irrelevant day to day noise is, and then devoting much space to coverage of that day to day noise. If we ever have an investment plan, for clients, that is sensitive to such day to day movements; we will have failed. I want our messaging in the Dividend Café to be consistent with that reality.
Taking a stand on rates
I recently had someone ask me to take a stand as to what I believe interest rates are going to do. I asked for clarification as to whether or not they meant this month, or this decade. I further asked for clarification as to whether or not they meant absolute yields, or spreads. I wasn't being sarcastic. We do have a stand on rates - and that is significant to the portfolio positioning of our clients, but our stand, and the significance for clients, is not remotely related to what the Fed will do next month, or where the ten-year Treasury yield will be in three months. I am sure those unknowable and volatile metrics will have something to do with where the Dow will be in three months, but even that is something we have no interest in forecasting.
Rather, we have to look at secular cycles, that have significant effect on the big picture of inflation, cash flows, market multiples, and therefore asset allocation decisions. One pundit may go on TV and say "interest rates are going higher!" - and he or she may mean, "over the next 90 days." That is uninvestible, uninteresting, and would be irresponsible for us to actually trade around. But another may say the exact same thing, and refer to an actual secular cycle of a ten-year bond yield moving over the next five or ten years. We don't believe it.
Our arguments are as follows:
- There is no precedent we have studied of a developed economy getting addicted to low interest rates and weaning off that addiction
- Technology has been a complete game-changer in the price efficiency of market behavior
- Government debt forces easy monetary policy to fund the deficits governments have created
- Demographics point to longer life expectancies for more people - so a sort of much less dramatic Japan factor, worldwide
Is growth strong enough to warrant higher bond yields than the silly basement levels of 2014-2017? You better hope so! "Too much growth" should be desired over "not enough growth" any day of the week, or more accurately, "in any 10-year cycle you can imagine." That we have gone from the post-crisis paradigm I have been living through to an era of people wondering if growth is "too good" is a sign of how quickly memories leave financial actors.
So "our stand"? Bond yields should stay higher than prior lows, but no secular period of continually growing long-term rates is forthcoming, for all of the reasons highlighted herein.
Back to Goldilocks
Whether it is media drivel or somewhat accurate, the theme we hear to be ideal is this idea of "goldilocks" - the "not too hot, not too cold" scenario - this is what we are told is ideal. The "not too cold" part is easy - that is supposed to mean things are going well in the economy, and that markets would like that for all the obvious reasons. The "not too hot" part is supposed to mean that things are not so crazy good that the Fed feels the need to tighten monetary policy more than expected or more than is already priced into the market. Personally, I find the whole framework simplistic, silly, and unsustainable, but as far as media narratives go, I get it.
The jobs report for April that came out last week was said to be in this "goldilocks" framework. The 3.9% unemployment rate is the lowest in 18 years, but is largely because of 236,000 people leaving the labor force. The 2.6% wage growth is good, but not as high as the 2.9% we saw in early February and give markets conniptions. The 164,000 new jobs number was good, especially with the 34,000 revisions to last month's report, but it was below the forecasted number. All in, the market took it to be a good report, but not too good.
Oh what a tangled web we weave when first we practice to use monetary policy to monkey around with the economy.
Who agrees with me on wage inflation?
I have written extensively on my vehement opposition to the silly notion that increasing wages is evidence of or the cause of monetary inflation. I caught this quote out of a Kevin Warsh speech last week and felt I should share:
"A catch-up in wages would not tell me that 'oh my goodness, inflation is coming.' I do not have a 1978 view that unions have bargaining power and that will send us on a wage-plus-price spiral that's going to lead to inflation." - Kevin Warsh, former Federal Reserve Governor
Goldilocks never talked about capex
Our bullish thesis into a future leg of this bull market is dependent on the forecast that an increase in business investment in the United States is on its way, manifested in renewed capital expenditures. That story takes time to play out, but is vital for the economic growth, innovation, and productivity necessary to see accelerated (and needed) real economic growth. We would point out that the Institute of Supply Management (ISM) forecasts for manufacturing were increased from +2.7% to +10.1% for 2018 and for non-manufacturing the forecasts went from +3.8% to +6.8%. This is a big deal.
Slipping into a sticky mess
Some of the worst media commentary I have ever heard has taken place this week surrounding the level of oil prices, and particularly the policy decisions expected to be made and then made around the Iran deal. In fairness, sometimes the media does not "get it wrong" as much as they just plain embark into an arena that no one can get right. Predicting what drives oil prices and why is not something prone to error; it is something that cannot be done - period. It is complex, it is mysterious, and it is subject to significant impact from invisible and fast-moving stimuli. Is a potential change in what Iran can and cannot produce in oil for world markets a factor in oil prices? Surely it must be. But does anyone have a way to quantify that impact in current pricing? Of course not. Oil prices move in the short term in ways no one can comprehend, and longer term they move as a by-product of supply and demand. Oil is making new highs (since 2014 anyways) because global demand is huge.
Bond market brouhaha
It is one thing to talk about one's outlook on interest rates, but another thing to apply that to our outlook for the bond market. But keep in mind, we are sharing a long-term, secular perspective on interest rates in this week's Dividend Café; our tactical positioning in our client bond portfolios is less secular and more opportunistic in shorter windows of time. It is affected by much more than interest rates, but also overall risk appetite, credit spreads, fundamentals, supply, and currency. For what it is worth, here is a sort of checklist of viewpoints on various fixed income asset classes.
Municipal - as spreads relative to treasuries have risen this year, the tax-free space has become most compelling to us (for investors in the top two marginal tax brackets, especially in high tax states)
High Yield - spreads are too tight and equity volatility too high to find this space attractive at any more than a tiny allocation
Treasury - more attractive now than at beginning of year, or any point in many years
Emerging - currency risk must be managed, and trade threats enhance volatility, but growth trajectories suggest value
Floating Rate - strong cash flows and low recession risk suggest value, but supply seems overdone
I read a report this week from an analyst I generally like, from a firm I utterly adore, that I found to be perplexing in how badly it missed a certain point. The thesis was that business confidence is so high, and institutional risk tolerance so numb to the macro risks of a trade war, Fed tightening, rising bond yields, etc., that we may need to be cautious about this build-up of euphoria and numbness in the market. But the problem with that assessment is, well, the data. As I say over and over again, if there has been "too much faith" in this market, people sure haven't invested that way! Cash levels remain very, very high. Flows into bond funds continue to trump flows into stock funds. We have generally seen a retail investor class miss, or be underinvested into, this great bull market. I am hyper fearful of complacency, and agree that signs of unchecked euphoria and equity optimism should be viewed fearfully. But I simply don't see it. I see too many people worried about the next week and not enough worried about the next three years.
It is incumbent upon us to respect the risks that do exist, and we write about those every week here in Dividend Café. But the claim that equity investors are acting like it is 1999 is surely not accompanied by empirical support.
If this holds ... (and it won't, but still)
71.6% of companies that have reported results so far from Q1 have beaten profits expectations - a big number. But 72.1% have beaten actual revenue expectations! If this were to hold, it would be the first time in my career that more companies outperformed in the top line than the bottom line - a stunning feat and one likely indicative of how earnings expectations were adjusted up for the impact of tax reform, but the broad economic impact was not. Even if that percentage of companies beating in revenue forecasts drops below the percentage who are beating profit forecasts, it has still been a really unprecedented quarter for top line growth.
Chart of the Week
I have made the argument throughout earnings season: Earnings can grow from a lower tax rate (for obvious reasons), but revenues cannot. And company top line revenues have an amazing correlation with overall economic GDP (as the Chart of the Week makes clear). So what should we conclude from this? Economic growth is on the rise if Q1's revenue growth is any indication...
"In investing, what is comfortable is rarely profitable."
-- Rob Arnott
Markets remain in a sort of flat trajectory, with no clear direction as to whether or not more downside selling is on the table or some breakout towards the highs of January is in store. And as I lead off this week's Dividend Café saying, we don't much care. We remain captivated by the dividend growth we are experiencing from our individual holdings, and the Fed's fascinating telegraphing of what they have in mind for short term rate markets. Caution and defensiveness remain prudent, and yet the ability to maintain a discipline around one's risk asset positions is paramount. These two things are extremely compatible, and the reason I know that is we are doing it, client by client, portfolio by portfolio. To that end, we work.