The Fed Is Up, And Rates Are Headed Down

This week has been all Fed, all the time, with investors preparing for what’s next.

It seems like the entire week has been inundated with Fed talk, and that’s probably fine as by this time next week we will be kicking off earnings season, and I fully expect the fun stuff (bottom-up company results) to drive markets and media air time for the three or four weeks that follow.  But until then, it has been all Fed, all the time, and Chairman Powell’s two days of testimony this week helped to drive a very Fed-heavy week in the news cycle.

In this week’s Dividend Cafe we really do give you the bottom line on the Fed, the future of interest rates, a sober assessment of recession, the reality of the tax cuts, and a nice play-by-play of the battle between stocks and bonds.  It is chart-filled for those of you who like pictures, and ready for your digestion.  Jump on into this week’s Dividend Cafe …

As of press time, the fed funds futures market is now pricing a 100% chance of a quarter-point rate cut in July, with a 33% chance that there will be a half-point cut.  The inverted yield curve is not going to be resolved by the long end going higher any time soon, so the short end must come lower.  The stunning 224,000 new jobs created in June added fuel to the fire of those saying the economy does not need a rate cut (hard to argue).  But ultimately, in the face of impressive job growth and wage growth, one has to remember that the Fed really believes in their inflation target, and they really believe they are failing to achieve it (which calls for easier policy, not tighter).

That the 3-month to 10-year Treasury has been inverted this long now, but the 2-year to 10-year has not, is a pretty compelling call for the Fed to cut (and to many analysts, reason to believe a recession will still be averted).  I am more interested in what they will do than what they ought to do, and I believe a quarter-point cut is going to happen, and a half point is not.  But I am merely following what the futures market is telling me…

What is fascinating about all of this is that the Fed is saying they need to cut rates because they are worried about economic weakness surfacing, and we know that many times historically (not all) Fed rate cuts have preceded the onset of a recession, and yet investors are just loving the news.  I believe the answer to that paradox was squarely addressed here in Dividend Cafe a couple weeks ago: Companies still enjoy a Cost of Capital that is lower than their Return on Invested Capital …  And until that changes, investors like what is happening, and I will not see a recession on the horizon.

I am in the “one and done” camp – that the Fed will do this July cut (a quarter point, not half), and then sit.  I am sure a second cut in September is possible (but not assured) – the market is assessing a 59% probability to such right now, but I would be shocked if they dare to go beyond a total of 50 basis points worth of cuts.  I don’t much like the concept of an “insurance cut,” but for those pricing a 38% chance we will see three cuts by the end of the year, or a 17% chance we will see four, I would gently point out that in no way could that be called an “insurance cut.”

I would be surprised if resolution (or even progress) comes from quite some time.  The talks have resumed, and that is really all we know at this time.  In the meantime, supply chains are moving out of China, and that is likely to continue happening until there is resolution here.

The collapse of longer-term bond yields in recent months, even as risk assets have made new highs, points to a tension in global markets that will continue to play out in the second half of 2019.  Equities are responding to healthy corporate earnings, a Fed signaling a backstop for risk assets, and a healthy economy validated with full employment and robust wage growth.  Bonds, though, we are told, are pointing to low growth and recessionary fears.

The fact of the matter is that low bond yields reflect the expectation of low interest rates.  If that sounds redundant it is because it is – this is the ultimate self-reinforcing mechanism in finance.  The Fed is not signaling easy monetary policy because the bond market is saying so; the bond market is saying so because it expects the Fed to effect easy monetary policy.  The central banks of the world are doing politician’s jobs for them (managing the burden of excessive debt), and the bond market does not believe these central banks have any gumption to buck the trend.  This leads to growing valuations for risk assets and bond yields that reflect that reality.

There is a general, unspoken sensation out there that a debt bomb lingers over our economy, and that one day it will explode and ruin the world.  Those of us who do not believe the ending to the debt saga is going to be a certain explosive moment filled with cats and dogs raining from heaven are often accused of being complacent about the debt issues that hang over the economy, when in fact, I feel that the more rational, thoughtful school of thought here is actually more pessimistic than the doom-and-gloomers here.  Allow me to explain …

The sensationalist response to the debt crisis lacks a real rooted view of how these things tend to play out.  Believing that the debt-to-GDP ratio of our country will lead to a long term contraction in economic growth is not an apathetic view; it is a horrific one.  Economies have always contended with cyclical woes; but this is a structural one that policymakers have thus far shown no aptitude for dealing with. 

In fact, Keynesian orthodoxy being what it is, policymakers tend to try to treat the low-growth ailment (caused by excessive debt) with, well, more debt.  They have us in a negative feedback loop, and seem utterly oblivious to the issue at hand.

The debt levels of today have not yet done great damage to the core U.S. economy because corporate America has been rising in productivity and earnings, and because defaults have been minimal.  But we must remember – post-crisis, the household sector in the U.S. has actually de-levered substantially. And in reality, the government sector’s leverage (debt-to-GDP) has flat-lined for about six years now.  It is the corporate sector that continues to lever up, simultaneously doing two things:

(1) Keeping the party going

(2) Raising the risks for when the party ends

I have spent some time in New York the last couple of weeks with several policymakers, analysts, and trade officials trying to decipher their feel for where we go post-G20 in the China/trade talks.  That a “truce” was called a couple weeks ago and the next round of tariffs not implemented is and has been a very good thing for markets, but it still seems that a further breakdown in talks is “highly possible” – and I might even say likely.  And I do believe the next breakdown will lead to the implementation of those tariffs (again, as a means of getting to a deal).  At that point, I think the results ends up being either (a) A comprehensive deal reached in the months that follow; or (b) The Trump administration choosing to run [purposely] on a “standing up to China” platform next year rather than cut a deal pre-election.

Much of this depends on how far off the two sides really are now.  But my skepticism that the very next step will be a final deal comes from the fact that I am just not convinced either side has created the leverage to get the other side where they want, yet.

As we have written about extensively in these very pages, our philosophy of engagement with the emerging markets is “bottom-up” in focus – driven by earnings growth and demographics.  That said, three things need to be said in the present tactical environment: (1) Oil prices have stabilized and even dropped a bit, and virtually every emerging markets nation is an importer of oil (meaning, this is good); (2) Lower interest rates in the U.S. and easier monetary policy reverses the concerns about tightening dollar liquidity, a major relief to the risk environment for emerging markets; and (3) The dollar is stuck between a rock and a hard place.  This is quite correlated to #2 above.  The dollar did finally soften a bit, which helped Emerging Markets last month, but has since seen the dollar retrace some of that move.  It is anyone’s guess right now, but few believe a systematic clear move higher in the U.S. dollar is fundamentally likely at this level.

So all that to say, there may be a macro backdrop that suits the bottom-up story of EM investors well in the months and quarters ahead.

I am absolutely amazed by the lessons of market history, like the predominance of energy production companies as market leaders in 1980 (they did not last as such until 1990, to put it mildly).  And in 1990, the majority of global leadership stocks were Japanese, a trend that didn’t last for two years, let alone ten years. In 2000 it was a fool’s errand to bet against telecom, media, and technology.  Many of those leadership names did not survive the decade ahead at all, and staying atop the world was laughable.  In 2010 China was back atop the world and commodity names were believed to be the story for the next decade.  That didn’t go well.  So as we sit here now with mega-cap tech names atop the world, do I believe that they will be the story of the next decade?

I’d have to despise history to believe such.

All politics notwithstanding, there is an increasing school of thought, particularly in this year’s Democratic primary, that one resolution for our fiscal challenges as a country may be in simply raising taxes on high earners.  Besides the fact that the new spending programs being proposed are many multiples of the present national debt, itself projected to reach $24 trillion in just a couple years, the top 1% of earners presently pay over 37% of all income taxes.

In 2017, the year before tax reform was passed, a grand total of $155 billion was repatriated by U.S. companies from offshore locations to the United States.  In 2018, ~$800 billion was repatriated.  For Q1 of 2019 alone, the figure was just over $100 billion (and is expected to reach $400-500 billion on the year).  With a trillion dollars having come back to the United States, and another trillion still out there, repatriation has to be considered one of the more stimulative elements of the tax reform bill.

83% of the companies in the S&P 500 pay some dividend (though it is paltry for a large percentage), and only 68% of mid-cap companies and 52% of small-cap companies do (and those often get even more paltry).  62 dividends across the broad market were cut or suspended in Q2.  Last year’s Q2 saw $13 billion paid out from public companies in dividends, where this year the figure was all the way down to $8.4 billion.  What do all these factoids point to?  The futility of “passive” management of a dividend growth strategy …

Call it “talking my own book” if you will – dividend growth can not be “indexed,” and requires an active approach to constantly assess dividend sustainability and outlook for growth.  The testimony of history is clear here, this most recent quarter, and throughout the decades before it.

  • The President nominated Judy Shelton and Christopher Waller to the Fed Board of Governors last week.  Shelton in particular is known as an advocate for rules-based monetary policy.  I will be monitoring this closely as I believe the ideological composition of the Federal Reserve board is very important to investors.
  • The CBO (Congressional Budget Office), frequently cited on the left when they project negative impact from tax cuts, estimated this week that a $15 minimum wage would eliminate 1.3 million jobs.  I’ll keep you posted when this report gets mass circulation from the media.

I do look forward to this next quarter’s earnings season we are about to embark upon, and that is not because I necessarily expect a surprisingly good season (I am reasonably agnostic about how it will fare).  I am just a little tired of “macro” (trade, and the Fed, to be more precise), and always crave a return to talking about “companies” when market talk gets too macro-heavy for too long.  Look, I am a macro-economist with a deep curiosity about the monetary machinations and global trade particulars that help drive economic reality.  But as an investor, I am investing in the enterprise of individual companies – I am buying a claim on the future earnings of a particular operation, a mission, a distinct business.  And sometimes the macro “stuff” crowds that out.  So I am looking forward to perhaps a little less Fed, a little less China, a little less beltway, and a little more company profits in the weeks to come.

Hopefully, a lot more company profits.

Written by David L. Bahnsen

David L. Bahnsen is a contributor to The Schpiel.


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