Q2 Picks Up Where Q1 Left Off

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Posted: Apr 05, 2019 11:27 AM
Q2 Picks Up Where Q1 Left Off

Source: AP Photo/Richard Drew

Q1 in the can

So the Dow ended up Q1 11.8%, and the S&P ended up 13.6%.  Small-cap outperformed all with a 14.5% gain.  Emerging markets advanced by nearly 10%, and even the bond market moved up over 3% (with municipals outperforming taxables, and high yield scoring a +7% return on the quarter).

On a sector basis, technology, real estate, and industrials led the way (energy was not far behind).  Health care and financials were the laggards, but still nicely positive.

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It was not an easy quarter to find things that went down.  The pricing in of a Fed that will be constricting access to credit and tightening monetary conditions compresses valuations and expectations; the re-pricing in of the opposite of that, well, that expands valuations and expectations, a lot.

Capex Update provides encouragement but not answers

We know that capex sentiment dropped substantially in the second half of 2018 versus where it had been in late 2017 and the first half of 2018 (due to fears around the trade war).  We also know that this reversal has not yet "reversed back" - both new manufacturing orders and capital goods orders show capex still slumping vs. where it had been a year ago.

Click here to view the chart.

And yet Durable Goods orders have remained strong, and the capital stock in the economy is as old as it has ever been (meaning, we need a replacement of unfathomable amounts of goods and inventories).  I don't think we are going to know the answer until late in this year and early next year, but ample evidence exists that the long-run upside for capex is substantial, though not guaranteed.  What we do know, is that it is needed!

Click here to view the chart.

The oil price conundrum

One of the factors behind the stock market's big rally in 2019 thus far that has not gotten adequate attention (perhaps inadequate even here at the Dividend Cafe) has been the big move higher in oil prices, and what that has meant for the energy sector.  One of the reasons the topic is hard to cover is the debate over the chicken vs. the egg.  Do higher oil prices reflect healthier economic conditions and growing demand, or is the economy actually growing because oil prices are going higher?  The latter view is preposterous on its face.  Oil prices signify demand growth, or supply weakness, or both - and then higher oil prices create demand weakness (at some point) - rinse and repeat.  This supply/demand fulcrum is the very most fundamental component of basic economics.

As supply/demand forces work their way through oil price markets, we have a conundrum taking hold: The Fed went dovish on us a few months back as inflation expectations collapsed amidst fears of a global economic slowdown (and as was evidenced in oil prices that utterly collapsed in the fourth quarter).  Should oil prices find a stable home closer to $70, the weak inflation thesis may find itself challenged yet again.

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Our view continues to be that Saudi has every motivation to keep prices higher, and that the skyrocketing Permian production levels remain in a bottleneck, keeping a lid on supply levels even as demand has remained stubbornly high.

China trade deal benefits

The notion we have largely held to the last few months has been that the vast majority of the eventual China trade deal is already priced into markets, and therefore could lead to a fade in the market if any part of it remotely disappoints.  That view has become so consensus that the contrarians in us increasingly believe there is a chance the China deal will outperform expectations.  For one thing, the very idea of a deal produces a self-fulfilling dividend, if you will - uncertainty of ongoing tension gets removed.  But in the details, if the deal transcends "no new tariffs" and reaches "repeal of some old tariffs" there is room for market advance.  The idea that China's use of currency manipulation will be addressed (and apparently is already agreed to) produces more embedded stability in the global economy.  In more specific sectors, where agricultural and energy purchases are to be increased out of the deal represents an additional opportunity.

China and Everything Else

Let's ignore the benefits to the stock market and the U.S. economy in getting this trade war behind us, though, and just look at China's economic health in isolation.  Nominal GDP growth there has slowed to ~8%, and deflationary pressures in their overheated economy are real.  No significant reflationary policy tool is available as they have had to deal with the need to cool their industrial and financial economy, not double down.  Now, a more stable currency will mute the impact of their challenges on the rest of the world (limit their chance to export their deflation, as Japan has done for decades), but the fact of the matter is, regardless of trade deal resolution, China's macroeconomic health still represents a lingering factor in global economic health, and the outcome is always uncertain.

Recession realities

All the talk about yield curve inversion has enabled more talk about the realities of recession, though I should say that a recession coming again at some point in the future (whether it be 2020 or 2021 or 2022 or ...) was hardly a mystery before the yield curve inverted.  We know recessions happen; we just don't know when.  But I think one of the reasons America takes its recessions in stride is that the magnitude of expansion periods is so much more powerful than the damage of contraction periods.  Consider:

Average expansion period lasts 6x as long as average recession

GDP has grown 24.3% (on average) during expansion periods since 1950; it is has contracted -1.8% during average recession

The S&P 500 is up 117% (on average) per expansion period; it is up 3%

12 million jobs have been added in each average expansion; 1.9 million jobs have been lost in each average recession

One of those factoids, by the way, should've particularly grabbed your attention: Even though it is just 3%, how is the market up during the average recession?  For the simple reason that markets are a discounting mechanism, pricing in today what they believe about the future.  Markets begin their upward climb before recessions officially end, always and forever. It makes waiting for the end of a recession to be properly invested a very expensive decision.

* Capital Group, Guide to Recessions, Q1 2019

Hedging against inflation

The impact inflation has on purchasing power is not something we take lightly, and something we talk about with clients all the time.  My earnest desire to avoid the hysteria of hyper-inflation forecasts has not numbed me to the awful effect of "regular inflation."  A 1-3% annual increase in prices effectively causes the cost of things to double every 25-30 years (or put more accurately, it causes to value of your money to be cut in half every 25-30 years).

So we agree inflation wrecks havoc on investors, but simply need to determine the best way to fight it.  TV commercials are filled with the claim that gold represents the best hedge against inflation.  And indeed, since 1980 gold is up 153% (from $800 to $1,300 per ounce).  And yet, inflation is up 230% in that same time period (which has actually represented a huge moderation of inflation).  Put differently; we are now well over an entire generation of gold substantially under-performing inflation itself!

Dividend growth stocks, on the other hand, have tripled the rate of inflation in income alone, not to mention the underlying increase in price.  They have created income, maintained liquidity, been tax efficient, are easy to "store" (i.e., own), and have offset the malignant effects of inflation time and time again.  One may argue that owning dividend growth stocks carries with it the unpleasant reality of market volatility (it does), but an owner of gold is not in a very good position to claim differently (the charts don't lie).

So what else has to go well?

My belief has been that no issue is more significant to the ongoing extension of the U.S. economic expansion than a capex boom.  But with that having been exhaustively covered already, I do agree that a plethora of other issues exist in the potpourri of that which will dictate economic fortunes this year and next.  I certainly believe an unforced error like shutting our border with Mexico would be a disaster.  Some turn for the worse with Europe on auto tariffs will not go over well.  Brexit's particulars could represent temporary disruption.  Oil price stability could reverse.

Most of these things are all going well or acting how they need to right now.  But a global economy provides perpetual opportunity for things to get complicated.

Absolute vs. relative performance junkies, pay attention

This certainly goes down as the craziest stat I have seen in a long, long time, and yes, those obsessing with how they do relative to the market ought to pay attention.  Absolute returns trump all in the real world, and always have.

If you had invested from 1960-1980 and beaten the market by 5% each year, you would have made less money than if you had invested from 1980-2000 and under-performed the market by 5% a year 

* Factoid courtesy of Michael Batnick at The Irrelevant Investor, Ritholtz, March 13, 2019

Politics & Money: Beltway Bulls and Bears

  • The House Ways & Means Committee this week unanimously passed the Secure Act, which raises the required distribution age for IRA's to age 72 (currently 70.5), allows 529 plans to be used for home school and to pay down student loans, and provides tax credits for small businesses that set up 401k plans with automatic enrollment.  It is a bipartisan bill that looks extremely likely to become law.
  • Democrat Senator Ron Wyden (the ranking member on the Senate Finance Committee) also proposed this week taxing capital gains "year by year" (even before an asset is sold).  It strikes me as one of the dumbest things I have ever heard, and assume this is going nowhere.
  • This talk of the President "closing down the border" with Mexico this week (to try and force action on immigration) is maybe one of the weirdest things we have seen in a while.  A self-inflicted wound like that would possibly be more damaging to GDP growth than the launch of the trade war was last year.  Just as a China deal is getting closer and closer, the impact to consumer prices and short term job activity in such a sudden and poorly thought-through Mexico action would create a significant disruption to economic activity.

Chart of the Week

Sometimes I think it is a good exercise to review the state of the market, in the context of all that has happened in various news cycles.  From the bad news of global growth scares and trade wars to the good news of tax reform and deregulation, markets have had some gyrations the last few years, but really the market trend has been steadily and nicely up, with a shock down in Q4, and a shock up in Q1.

Click here to view the chart.

Quote of the Week

“All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.”

-- Arthur Schopenhauer

David L. Bahnsen writes at the Dividend Cafe.