An Economic Battle For The Ages

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Posted: Jun 21, 2019 9:49 AM
An Economic Battle For The Ages

Source: AP Photo/Richard Drew

I think there is a chance this is the most "economic" I have ever gotten in the Dividend Cafe, and that is probably not a great hook to get you to keep reading.  But actually, the unpacking of truly pivotal economic understandings in this week's Dividend Cafe just happened - I started typing and I couldn't stop - and I am positive that you will benefit from reading through it.  As a fiduciary advisor to clients, I have a moral responsibility to counter-act some of the nonsense people hear in the financial media, a breeding ground for simplicity and often outright fallacy that can lead to really negative outcomes and behaviors for investors.  So yes, there is some "jargon" this week (really it isn't that bad!), but I believe you will find this week's Dividend Cafe to offer clarity on the great economic questions of our day!

It was rally mode on Wall Street this week and if we are not at all-time highs by the time you are reading this, we are awfully close (the S&P did hit an intra-day all-time high Thursday).  But the reasons that everything happening are happening are important to understand, and an investor's perspective can only be enhanced by looking into the big picture around these things - so join us in the Dividend Cafe, and let's get our economic knowledge on!

Stocks vs. Bonds - A Battle for the Ages

The message of the stock market is right now (and has been for some time) that the economy is growing, that earnings are great, and that the economic expansion is not likely to falter any time soon, despite occasional trade hiccups, etc.  The message of the bond market is right now (and has been for some time) that long-term economic growth is not on the horizon, that global economic headwinds are dramatic, and that secular forces persist which represent a long-term drag for investors.  The ten-year U.S. bond yield is presently 2%.  It was 3.3% just nine months ago.  It was 2.6% when President Trump was elected. 

So who is right - Mr. Stock Market, or Mr. Bond Market?  And is it possible that stocks are right in one time frame, but bonds are right for another?

The answer is, as you may guess, complicated.  Of course, the easy answer is, "no one knows yet," and that is certainly true.  But it is also true that the two indicators are more intersected than one may believe.  Let's unpack further ...

Do stocks like low interest rates or high interest rates?

The answer to this question is, "yes," and the answer can be "no" - all depending on circumstances.  A low growth environment that pushes government borrowing rates down but pushes corporate borrowing rates up is as negative for equities as one could imagine.  The market rate of interest (the level at which companies borrow) must be lower than the natural rate at which they are growing.  In that sense, the market rate can be high or low, but it all depends on what that rate is relative to the return on capital.  So if the spread between the return on capital and the cost of capital is positive, that environment (with rates high or low) is positive for stocks; and if that spread is negative, it can be very bad for stocks.

Cost of capital vs. return on capital - it gets even more fun!

So what happens when the cost of capital exceeds the return on capital (borrowing costs for companies exceed their expected return on new projects, etc.), is that naturally, companies use their cash to pay down debt, not invest into new projects.  Economic activity dries up.  And you get a negative feedback loop (that we generally call "recessions").  In this sense, the money it cost a large government like the United States or Germany to borrow money is not the key variable.  American companies have done very well when Treasury rates were 2%, and they have done very well when Treasury rates were over 5%.  The key is that spread between government yields and corporate yields.

The last time these two numbers really went in the wrong direction (corporate borrowing rate spread widening vs. government yields) was the great recession of 2008.  Now, in late 2018 it began to happen.  And in early 2016 it began to happen.  And it mid-2015 it began to happen.  And in mid-2011 it began to happen.  But none of those head fakes played out - in each case either a central bank intervention or some other market force reversed the concern, and the healthy environment of companies return on capital exceeding their cost of capital resumed.

So where are we now?

The question I must obsess over is whether or not the Fed will be successful in their desire to extend the cycle of companies generating a higher return on capital than their cost of capital.  The Fed cannot help the Return on Capital.  Only innovation, technology, competition, organic growth, and healthy market forces can do that.  So the Fed has tried to help by keeping the cost of capital down.  That can be very beneficial for a season, but it also can lead to bad investment decisions, unhealthy debt build-up, and excessive risk in the economy.  Right now, the bond market is saying that the economy is going to weaken in the future.  And right now, stocks are saying that companies have a healthy spread over their borrowing cost - that their ability to generate earnings supersedes various economic questions marks ...

Our take at The Bahnsen Group: The debate will not be settled by machinations around the cost of capital, but rather around the return on capital generated by America's best and brightest.  Monetary intervention (cost of capital) buys time, impacts valuation, and generally puts a backstop in risk assets.  But the long-term answer that neither the stock market nor the bond market know at this time will come down to whether or not organic growth can be found that keeps the cycle going. 

But why?

What are bond markets reacting to?  Why are German bund yields negative, and why are U.S. Treasury yields making new lows?  Global growth is the most obvious answer - bond markets have prepped for a sustained period of low growth in Europe and Asia.  Fears abound that credit can continue to grow.  There is at bare minimum some question as to what impact the trade war may have on global economic activity.  The European Union's banking system is in disarray, and its very solvency is in question.  All sorts of culprits can be found.

Ultimately, my contention is that bond yields are low because excessive debt is deflationary, and pushes bond rates lower.  Central bank interventions complicate things but ultimately reinforce the narrative.  Central banks want inflation if for no other reason than that they live in utter horror at the prospects of deflation.  But central banks cannot wave a wand and create inflation, try as they may.  In a lot of ways, the long term interest rate environment is the market's way of saying they don't believe the central banks of the world have any power here.

I am confused, and I need you to help me

What does this mean for investors?  Are we to believe that the Fed can't move markets in the here and now?  Absolutely not!  They can, they have, and they will.  This is where the challenge lies - there are long-term forces fighting the big fight about debt, deflation, and economic growth - and they co-exist with shorter-term forces dealing with cost of capital vs. return on capital.  The Fed is engaged in that second fight.  The bond market is pointing to that first fight.  And somewhere in all of these two things, an investor has to formulate an investment policy for themselves.

One option is to develop a conviction about how it will all play out.  Predict what will happen, and when, and attempt to time one's way through those evolutions.  This is likely the surest fire way to blow up.  Markets are dynamic, unpredictable, and inherently unknowable.  The volume of inputs one would have to understand to get this right is beyond any mortal's comprehensible skill set.  The other approach is to make long-term strategic decisionsaround one's goals and expectations for major asset classes.  This involves a worldview of macroeconomics, but not the ability to navigate the specific nuances and details each step of the way.  Then, making some mid-term tactical decisions within that plan around more transitory matters like the Fed, earnings, and such to align one's portfolio with their risk tolerance and return needs as one's own financial goals dictate ...

This construction - strategic planning in the context of investor goals - this is the need of all investors.

Speaking of the Fed ...

So they did not raise rates this week, but stocks rallied around the message that, said or unsaid, they all but promised they would be doing so next month.  There is debate as to whether or not they cut a quarter point or a half point at the next meeting, and will the cut more beyond that, but there is little debate in the Fed Futures market that rate cut(s) are coming.

The Fed's message right now is a sort of bizarre mix of perfection for risk assets: "Everything is awesome, but risks are growing and we are there to help, and in fact will help sooner than later."  In other words, growth is good but inflation is low, so we can act pre-emptively.

There is a contradiction in the message that is unavoidable no matter what anyone wants the Fed to do.  My assessment is that the Fed regrets their last hike (or two), and yet can never say "we went too far last year."  The economic climate is allowing them to unwind and save face all at once.

I do question that they actually believe a deflationary disaster is around the corner (why wait, of so?).  But I am confident they fear deflationary issues and the challenge of the debt-overhang above all else, and the late 2018 impact to credit markets of a tightening policy revealed the dangers of unwinding the Fed accommodations of the last ten years.

Click here to view the chart.

Trade War Update - is the pain getting real?

Markets loved hearing that President Trump and President Xi have, in fact, solidified plans for their "meeting" at the G20 next week.  We do not know what will come of the meeting, and market risk exists around it being a disappointment ...  But all things considered, it does increase chances that the new "tier 4" tariffs will be suspended (for now).  Both sides are feeling the economic pain of this trade war, with construction spending, industrial production, and several key indicators reflecting the pain.

Politics & Money: Beltway Bulls and Bears

  • I am planning a special Advice & Insights podcast after next week's initial Democratic Party candidate debates to provide an investor overview of how investors can be thinking about the various economic platforms and policies of various Democrat contenders.  The media has made it very clear that former Vice President Joe Biden is leading in the polls, though that head over his fellow party rivals has softened a bit in recent weeks.  As for the general election itself, I am going to do everything I can to resist pontificating on what may happen in November 2020 until at least the summer of 2020.  History has been too humbling to people who think they can predict political outcomes 18 months in advance.  It is at least a safe prediction to say that President Trump's chances go higher if the economy continues to be performing well, and they shrink (perhaps entirely) if the economy reverses course.  But beyond that "the sky is blue" revelation, there is not much to say about the general election, yet (though I did offer CNBC viewers my take near the end of this clip on Bernie Sanders chances of winning) ...
  • Reports circulated this week that the White House explored the possibility of "demoting" Fed Chairman Jerome Powell several months back (not firing him from the Fed Board of Governors, but demoting him from the Fed Chair position).  There is ambiguity as to whether or not this is legal, and nothing came of it.  But it does speak to the transparency that now exists around the myth of central bank independence.  Now, I would argue it has never existed ...  But this may be the first administration willing to say so.

Chart of the Week

I have promised to keep you apprised of the various things that we look to that indicate when the bull market may be coming to an end.  This oft-updated chart from our friends at Strategas Research is a helpful way to consider present circumstances and leading indicators relative to the past two bull market endings.

Click here to view the chart.

Quote of the Week

 “To live is to maneuver.”

-- Whitaker Chambers

I am writing this from Grand Rapids, Michigan where I spoke at the annual Acton Institute symposium on Thursday morning -- one of my very favorite events of the year.  Economics conferences, especially ones rooted in transcendent truth, tend to really rile me up, so if this week's Dividend Cafe was more economically philosophical than normal, now you know why!

I welcome any questions, any time, and wish to remind everyone in the light of new market highs: We are not out of the woods yet; the Fed remains a mystery; a trade deal is not yet history; and tomorrow is a new day.

David L. Bahnsen writes at the Dividend Cafe.