Markets have responded to the latest spat in the "China trade/tariff war" by bidding stocks up a few hundred more points in the Dow. With about three weeks to go until the next known market catalyst - namely, the launch of Q3 earnings results season - markets are largely subject to headline events, conjecture about monetary policy, and more than anything else - the continued absorption of incredibly shareholder-friendly things taking place in corporate profits. This week we look at the wisdom of global diversification, Japan, Politics & Money, and even bring the active/passive debate to the world of municipal bonds. So jump on into the Dividend Café ...
I would be remiss to not share my heartfelt gratitude to all of our clients, partners, and team members, who all share in the credit for the honor of being named one of the top wealth advisors in the country last week by both Barron's Top 100 Independent Financial Advisors and the Forbes Top 250 Wealth Advisors. The information is here, and I mean it when I say, my team is the finest there is - we are a family of professionals who love each other and love our clients. And I mean it when I say, our clients and the trust they have placed in us are the lifeblood of this business. We are so very grateful.
Why not just stay home for vacation?
If the year were ending today, the #1 story in the world of equity investing would not be that shocking downside volatility in early February, it would not be the back-and-forth challenges of March through June, and it would not even be the positive catalysts (tax reform) or negative catalysts (trade war) that have impacted stocks in 2018. No, if the stock market were at December 31 now (and I should point out the obvious - that we have three months to go) - the major equity story of 2018 is that equity investing has only been a positive experience this year in the United States.
In 2017, the extremely rare theme we write about was the globally synchronized recovery - where not only was GDP growth positive all over the globe, but stock markets were healthy across almost all geographies. Move that to 2018, and you see a negative market on the year in the United Kingdom, a negative market in Europe, a very negative market in China, a negative market in Japan (though the last five days have seen much or all of this reversed), a negative return environment for emerging markets, and so forth, and so on. The MSCI World index is up 4-5%, yet the MSCI World ex-US index is down 4-5%. I have never seen such a stark contrast between U.S. markets and, well, everything else, in a single year.
But rather than merely continuing to comment on the facts of this divergence, let's actually unpack it a little bit. What does it really mean for us? Should we have avoided international markets? Should we avoid a global approach to investing going forward? In a six or nine-month period when one asset class outperforms another, does that mean that the winning asset class should become 100% of an investor's portfolio? Is global diversification dead? I am hoping the answers to all of these questions are obvious, but let me address these head-on in the next segment:
No, every prudent principle of investing has not become obsolete because of a couple bad quarters in International Markets
I believe that is the longest "headline" I have ever had in the Dividend Café, but it needs to be said. The idea that diversifying one's opportunity set becomes a bad idea because of one or two bad quarters, or the anomaly of a year like this, is insane. But to be more forceful, the results this year are not even that much of an anomaly. The dollar has rallied, the U.S. markets launched tax reform, and much of the world economy is slowing while ours is accelerating. Was this dollar rally foreseen? Quite the contrary. Are emerging markets likely to struggle in perpetuity? If their struggles continue, I might argue one of the great convergence opportunities in decades is coming. The fact of the matter is that asset allocation is built around the idea that an investor is generally not supposed to have all aspects of their portfolio going up at once. The entire point of asset allocation is zigs and zags working to offset downside risk at various points, all the while moving the entire aggregate portfolio up through time. We tend to approach international markets tactically - entering Japanese dividend equities just over a year ago, avoiding European equities throughout this debt and currency fiasco, adding to emerging markets recently, etc. But we don't regret international exposure when the U.S. outperforms International any more than we regret U.S. exposure when international markets outperform the U.S.
I know of no serious investor, including the best and brightest in the world, who choose to forego the wisdom of global diversification. We have no intention of abandoning prudent investing principles no matter what the gift of hindsight says in short-term intervals.
Land of the Rising Sun reprise
Japanese equities have modestly struggled much of the calendar year, largely as the dollar has rallied against most global currencies, including Japanese Yen. The last week or so, though, has seen a violent rally in Japanese equities, erasing much of the downside of the year. Their central bank unsurprisingly reiterated a "lower for longer" theme in their monetary rate policy. But what we would point out, which we believe will win in the end, is that corporate profitability is the brightest it has been in over 25 years. The $40 billion of net outflows from Japanese equity markets (at the hands of non-Japanese investors presumably many from the U.S.), is as lovely of a contrarian signal as I could have hoped for. Business investment is on the rise. And all the uncertainty around future central bank activity is to miss the forest for the trees.
Meat on the Bone
So if there is an opportunity in Japan, what is it? Where is it? How does one do it? Our view has been that we wanted to tactically add this exposure to our equity allocation one year ago (after 20 years of abstaining from Japanese equity participation), and we have done this through two "actively-constructed ETF's" - meaning, diversified single-securities that are constructed around actual factors, not the entire Nikkei index. The equity universe in Japan trades at just 11x earnings, yet is experiencing multi-decade highs in profitability. Corporate governance has substantially improved. Wages are improving, and their domestic health is much better than their export economy. We take on both a large cap and small cap approach, with a heavy focus on dividend payers in both. We hedge the currency in large-cap, but stay unhedged in small cap, meaning we want to be as currency agnostic as possible.
Active vs Passive without Taxes
I spent a great portion of the Dividend Cafe's weekly real estate two weeks ago discussing the "active vs. passive management" debate that has become so hot when discussing the stock market. The same debate has profound implications within the fixed income world, and we have very strong opinions about it in both the taxable bond and tax-free bond world. It is that municipal bond world I want to focus on now.
There is, essentially, an infinite amount of stock available to a regular investor. Companies with multi-billion dollar market capitalizations that trade millions of shares per day provide big liquidity for investors in any form they choose to own them. Treasury bonds also have a sort of infinite accessibility. The total size of the market is well into the trillions, and treasuries trade heavily across pensions, endowments, sovereign wealth funds, and in the retail investor world. But tax-free bonds are different - very different. Pensions and endowments do not generally own municipal bonds because they are already tax-exempt organizations. Foreign investors generally do not own them because they don't receive U.S. tax benefit. And obviously, sovereign wealth funds do not buy them. In other words, the market for municipal bonds (the customer base) is a tiny fraction of the market of stocks and treasury bonds, etc.
So that leads to a liquidity reality. Some bonds get issued and then are just not sold. There are fewer people owning them, and the nature of the asset class is much less turnover-driven. It makes replicating an index of bonds with real-life bonds very, very challenging in the real world. Yes, one can try to fabricate an index with comparable maturities, or credit qualities, or coupons, but the fact of the matter is, unlike the S&P 500, the lack of infinite supply means the vast majority of index funds underperform their own index - because the index is a fantasy construction, but an index takes real parts.
So what does that have to do with active investing in the municipal bond space? We advocate active management where there can be transparency, flexibility, customization, and significant tax management. Yield curve management is an important aspect of improving total return in the bond world, above and beyond the mere coupon of the bond. Understand and managing around call features, supply technicals, new issuance, and other such matters dramatically impact results, and do so far more than mere things like insurance and credit agency ratings. Mutual funds and index funds are deeply affected by what the masses do, whereas active, separate account management of municipal bonds transcends these retail characteristics. Executions can be far better this way as well (economies of scale).
So while stocks are a more exciting asset class than bonds, and the entire active vs. passive debate is misunderstood and misapplied, there is a real utility to getting this right with all asset classes. Municipal bonds are not one to follow the herd on.
OK in the UK?
We remain firmly in the camp that a deal with the EU is coming regarding the particulars of Brexit, and that underlying volatility along the way has been just that - volatility. I do not believe hardline Brexiteers will like the final deal, and I do not think Europhiles and Bremainers will like the final deal either. But I do think U.S. investors with U.K. exposure, will.
Making sense of Tariffs that make no sense
The optimal interpretation of how markets have rallied in the face of growing tariffs with China is that the markets are increasingly convinced a post-election trade deal with China is likely.
Politics & Money: Beltway Bulls and Bears
- I think the markets would be very afraid of the President of the United States saying this: "China is now paying us billions of dollars of tariffs" - if it were not for the economic team around the President (Mnuchin, Kudlow, etc.) who obviously know that, ummmm, no, China does not pay the tariffs. Importers of the products pay the tariffs, and they either eat that cost or for those who have taken Econ 101, pass them along to the consumers they sell the product to.
- The President this week nominated Nellie Liang to the Federal Reserve Board. She is a Ph.D. economist, registered Democrat, and highly regarded central banking expert. It is surprising to me that the President has not gotten flack from his base for his highly conventional choices with the Federal Reserve vacancies. It is not surprising to me that his opponents have not given positive recognition. =)
- White House chair of the Council of Economic Affairs, Kevin Hassett, who I adore, commented this week that the targeting of tariffs was done where there existed "maximum consumer choice" so as to minimize the impact to U.S. consumers out of the new taxes on the products they use. I have not done any study to evaluate how effective they have been in such an endeavor, but I thought the admission itself carried a profound implication: The administration recognizes the risk in this path they have chosen. In other words, if "tariffs are good" and "trade wars are easy to win," why be so strategic in implication?
Chart of the Week
One of the great signals of the insane technology bubble of 1999 and the year 2000 was the disconnect between the weighting of technology in the S&P 500 based on actual stock prices, relative to actual earnings. In theory, those two numbers should highly correlate together (for as profits go, so goes the market). You will note in the Chart of the Week, the technology sector has become 26% of the S&P 500 due to its big price appreciation, while earnings represent 23% of the index. This isn't exactly partying like its 1999, but it's worth watching.
Quote of the Week
"What lies behind us and what lies before us are tiny matters compared to what lies within us."
-- Ralph Waldo Emerson
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I will be spending the weekend in isolation trying to finish the book I am writing on dividend growth investing. My publisher deadline awaits, and I am anxious to get through the remainder. I can't work on the book in the work week, and frankly, this book has been much easier to write than my last one, for dividend growth thinking oozes out of my fingers on to my keyboard (I have been writing about this very subject in other mediums for many years). So I am hoping for a productive weekend of completion … (the book comes out in April, by the way).
As is always the case, we encourage all readers to reach out with questions or comments on anything market or economy related. Stay asset-allocated, and may your weekend enjoy the peace that asset allocation is supposed to bring to your portfolio affairs.