The G7 summit last weekend ended with verbal fights and accusations amongst allies on the Sunday morning talk shows. In Singapore, on Tuesday the dictator of North Korea and the President of the United States met face to face and laid out a rough plan for working together. On Wednesday, the Fed raised interest rates and announced plans for more. On Thursday, the European Central Bank confirmed the end of their “quantitative easing” by the end of the year. And yet, through all of this, the markets have barely moved a whisker. This week’s trip into the Dividend Café will give you our take on why, on what markets do care about, and a refresher on “surprise.” With all that said, let’s get into it …
The Fed is Not Ahead
As was 100% priced into markets ahead of time, the Fed raised rates 1/4 point on Wednesday, and telegraphed another two rate hikes this year. The market had already [nearly] fully priced in one of those, and the futures market sits at ~50% odds of a second hike in December (same place it was before the Fed announcement on Wednesday). It is tough to forecast five months in advance. What we believe at The Bahnsen Group is not related to what they will or will not do, but rather, the fact that whatever they do will be well-telegraphed to markets plenty in advance. The Fed is forecasting GDP growth that we believe is much lower than it will end up being, and yet ultimately, what markets care about is the pace of tightening, not the direction of it. Put differently, the market is a discounting mechanism, and for markets to be truly disrupted by normalization of monetary policy, it will have to be because the policy gets ahead of the discounting. We watch this vigorously.
I spoke on CNBC yesterday about what to expect from the Federal Reserve and how it should impact investor thinking.
Yield Curve Redux
The ten-year bond yield has not moved much in months. And yet, short-term rates have continued their move higher the entire time (the two-year Treasury, this week, hitting 2.56%), creating an increasingly flatter yield curve. I was most intrigued by Chairman Powell’s comments this week about longer rates (as opposed to the expected actions around short-term rates). Essentially, the curve is flattening, not so much because short rates are higher (a by-product of strong policy), but because the longer rates are not cooperating and moving higher with them. This is the bond market saying, “we don’t believe the inflation is coming.” This is the bond market saying, “the Fed will not be able to sustain this policy normalization.”
History has not been kind to people betting against the bond market. Do we know the bond market to be wrong? Of course not! And if you get healthy, non-inflationary, productive growth, we not only would expect long-term rates to go higher, but we want it to happen! So all I can say while this fight plays out is that the Fed is focused on models, while the bond market is focused on economic actors with skin in the game. For our money, we continue to believe global conditions and disinflationary forces will not let rates move much higher, certainly not in a secular sense.
Why didn’t the market respond to North Korea summit?
Even in the height of the tension last summer, the bond spreads in South Korea were tight as can be. In other words, the REAL risk markets were NEVER anticipating actual day to day risk from the North Korea noise.
The North Korea risk (nuclear conflict, elevated military action) was what we call TAIL RISK – meaning, very low probability, very high effect. Tail risk doesn’t get priced in and out of the markets day to day because, well, it is tail risk. The highly unlikely bad things that could happen come and go, but they never all go away. So such tail risk persists. Even as this one improves, others remain.
The REAL day to day issues of the market remains the continued tug-of-war between a very strong economy/earnings environment, largely brought on by tax reform and deregulation, VERSUS the new monetary landscape of a normalizing Fed. We think the Bulls win, but volatility and directionless-ness will persist until it doesn’t.
A break from the news to talk about stuff that actually matters
The Energy Information Administration (EIA) updated their production forecasts this week to call for 10.8 million barrels per day from the U.S. in 2018, and 11.8 million barrels per day in 2019. The figure was 9.4 million barrels last year. So 15% growth year-over-year, and 9.3% into next year. Natural gas production is also expected to continue growing. And natural gas power plants will be responsible for 34% of electricity generation next year, more than coal, nuclear, and all the minor players.
The story for midstream pipeline assets has always been contingent upon these two things: (1) There will be increasing need for the liquids that flow through the pipelines; (2) There will be increasing production of the liquids that flow through the pipelines. We feel this is playing out on both fronts.
Tax reform monitoring
Year-to-date dividend increases in the S&P 500: 196
Last year at this time? 167
Estimates are for $1.36 trillion of dividends to be paid this year globally – an 8.5% increase year-over-year. Since 2009, global dividends have risen 75%.
* S&P Dow Jones Indices, Week of June 11th
As an aside, $296 billion of cash was repatriated to the United States in the first quarter.
Financial risk and our self-awareness
One of the reasons we show clients the “standard deviation” results of their portfolio (the volatility around the portfolio return), not to mention the basic asset allocation (percentages of different asset classes), and “draw-down” (amount of downward movement from a peak to a trough), is because we want our clients to be aware of “risk” – meaning, the emotional realities of what they have theoretically been exposed to. The fact of the matter is that often returns are generated, certain risks (i.e. potential for downside volatility) do not come to fruition, and it numbs or spoils investors about the reality of said risk. It is difficult to be concerned about risks that don’t bite. So the numbness or complacency then builds further, and voila, when least expected or prepared, real risks hit – and the pain is worse.
How do we defend against this? Constant communication. Constant truth-telling. And consistent financial education. What is the greatest lesson in financial understanding? There is no free lunch. Return premiums have a cost. To pretend otherwise is not something we will ever do.
When dividend growth can solve the controversies of the day
There is a discussion playing out in the financial press right now about the role of “short-term guidance” from public companies in corporate America. I managed to find a way to connect this story to dividend growth in this week’s Market Epicurean piece.[Linked Here]
Politics & Money: Beltway Bulls & Bears
- The President made some of the most extraordinary headlines of his Presidency last weekend, as the G7 talks ended in a significant twitter fight with Canada over tariffs. The market did not respond to the significant American re-heeling over tariffs and trade, and I would be lying if I said this did not surprise me. The reality is that the U.S. exported $341 billion to Canada last year, and imported $333 billion from Canada. The U.S. has a trade surplus with Canada, which strikes me as at odds with the belief promoted heavily when discussing our trade relationship with China, that trade deficits are the great problem. We are told our trade relationship with Canada is so bad, it qualifies as a national security threat. And yet, we have a trade surplus with them, the opposite of what we are told is also a threat in the trade deficit with China.
- North Korea dominated the news most of the week, with some pundits wondering why the market was not more thrilled that the threat of nuclear war was seemingly reduced. Of course, there is the fact that many details and ultimate direction of this remain unknown. But more importantly, for investors, this idea that we may have been headed to a nuclear war with North Korea is called “tail risk” – a highly unlikely event that has a high impact result (in this case, the annihilation of the world). Markets can’t very easily price in the downside of tail risk when the risk itself is so binary. Therefore, markets can’t exactly rally when a tail risk subsides … The fact of the matter is that “tail risks” always exist. One goes away; another one still lingers. Markets do not move day to day based on those high standard deviation events; they move day to day on capital flows, sentiment, and surprise announcements. Oh yeah, and ultimately, they move on earnings … Always and forever, earnings.
- The court’s approval of the AT&T / Time Warner merger this week obviously has implications for owners of those two stocks, but it also has profound implications for the overall M&A environment in corporate America, especially in the healthcare industry. The fears were that the blockage of this merger by the Trump administration indicated a challenging environment for company mergers and acquisitions. The court trumping the Trump administration here likely fuels optimism that the approval process will not end up being politicized.
Chart of the Week
Why do we believe active management will prove more attractive in the years to come (presuming good active management, of course)? Because we believe the embedded benefit of passive management was greatly enhanced by the balance sheet expansion of the Fed since the financial crisis. This made differentiation and selection more challenging. So if the Fed is indeed reducing its balance sheet (it is), we suspect that takes away some of the “leveling” effects that benefited passive over active.
Quote of the Week
“Emotion, which is suffering, ceases to be suffering as soon as we form a clear and precise picture of it.”
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What a crazy week in the news cycle! I saw some things and I never thought I would see, and that doesn’t even include what could become another round of merger mania! The market has been resilient in recent weeks, and the Q2 earnings results are a month away. As readers of this week’s Market Epicurean know, our long-term projections are not moved by one quarter’s activity. We commend you who are focused on the long-term dividend growth of companies looking to sustain long-term success. And we remain at your beckon call with questions or comments related to your financial guidance! To that end, we work.