The Weeks After: Morning in America
The first week after the election hardly represented a “reprieve” from politics, as all eyes are intensely on the formation of the Trump transition team, and we are particularly focused on the formation of his economic team and what that will mean to investors. This week’s Dividend Café covers the important parts of where this leadership transition has brought us (in terms of markets, the economy, etc.), but it also delves into a few other areas we think you will be find particularly compelling. With all that said, let’s get into it …
The weatherman called a hurricane, a tornado came, and then he bragged
Anyone paying attention knows the punditry class was expecting a stock market dip in the event of a Trump election. Our own forecast was that there would be typical and historically consistent volatility coming into the election (indeed, at one point the S&P was down nine days in a row), and that after the election we would see standard normalization as various fears of uncertainty and unknowns came off. The violence of this stock market rally is a bit of a surprise to us, but the general fact pattern is not. However, the key occurrence for diversified investors since Trump was elected is not what is taking place in the stock market, but rather the bond market. Bond yields have jumped higher (we discuss why more below), pushing bond prices down about 2.5% across a core portfolio and more than that for long-dated bonds.
While you will see below that we very much agree part of this is the market expectation that Trump will get passed some of his pro-growth economic agenda, and that there may be some accompanying deficits that matter to the bond market, there is ample reason to not put this entire bond back-up at the feet of this electoral feat. For one thing, bond yields were just insanely overdone, and from a valuation perspective reached levels this summer that no one could really rationalize. Secondly, just the doubling of oil prices since the beginning of the year represents a more realistic assessment of inflation pressures. Bond yields were assuming levels of inflation lower than any analysis could justify. So do the infrastructure spending plans and proposed tax cuts of Team Trump explain some pressure on bond prices? Of course. But we have been in a secular bond bubble for quite some time regardless. Now we’re just recalibrating. Net-net, global value of stocks has increased $1.3 trillion since the election, while the global value of bonds has decreased $1 trillion (which is only the second time in history bonds have seen that level of global drop).
The Polls Getting it Wrong Was Just the Beginning
We actually cannot blame the various pundits who predicted a Hillary Clinton victory, because pretty much everyone predicted it, and all of the statistical modeling analyses certainly forecasted it. The polls were not all in on it together – they just were all sharing the same flawed assumptions about turnout and enthusiasm. We have more information about the nuances of this year’s electoral realities we could share if you were interested, but the fact of the matter is that it was nearly a universal assumption that Hillary Clinton would win. Where we would point to an even bigger breakdown in forecasting accuracy, though, came from a smaller group of financial writers who were not content to assume market volatility from a Trump win, but actually forecasted a full-blown market collapse. RBC modeled a 12% decline if Trump were to win. Barclays foresaw as much as a 14% drop. The Brookings Institute spoke of a 15% drop. Ray Dalio and Bridgewater Associates, regarded as some of the most astute investors alive, forecasted a 10.4% drop (pretty specific, eh?). Doomsday ran amok, and the response was not just less bite than bark; the response was the biggest UP week in the stock market in over five years. We say all the time that the markets biggest task is to make the biggest fools possible out of as many people as possible as often as it possibly can. Well, mission accomplished Mr. Market.
A Growth Agenda Just in Time for a Bond Bubble Bust
At the risk of pouring any water on the bullish sentiment that is understandably circulating (we say understandably, because we agree that corporate tax reform, deregulation, foreign profits repatriation, full cash expensing for business investment and capex, and many of these other political initiatives are likely to be wildly bullish for stocks should they come to fruition), it should be pointed out that the bond market is responding in the exact opposite way. The interest rate on the 10-year treasury bond was 1.5% a few months ago, and had creeped up to 1.8% before the election. It has now blown out to 2.25%, leaving heavy duration-sensitive bond investors sweating as their portfolio values have declined. Bond positioning that was more credit-sensitive and less rate-sensitive (duration) has benefitted a great deal! Now, beyond the noise of a one-week or two-week market response, should bond investors be concerned? We talk more about interest rates below.
Emerging Markets and the Dollar
There has been a sell-off in emerging markets the last two weeks and there is little to explain it other than the stock answer of “the dollar has rallied.” The chart below shows the inverse correlation between the dollar and emerging equities in this recent move. Our belief is well-documented: Good emerging markets investing does not rely on a weak dollar, but rather fantastic operating companies with pricing power. Currency moves come and go, and have little or no impact on what fantastic operators are doing to serve domestic markets. This is noise. Always has been.
Growth – and love – conquers all. But the timing matters!
Our general viewpoint is that investors are caught in a tension right now between two forces, both real, both we believe somewhat predictable, and yet both on different timelines so therefore hard to predict in terms of how these things will play out. On one hand, interest rates are rising even as the global economy has been weak. And on the other hand, we really do buy the argument that much of what we expect from the new political administration here in the states will be very bullish for growth. The tension comes because the impact of higher rates will be felt immediately, while the pro-growth policies we are talking about out of Washington D.C. are months, if not a year or more away. We are watching how high rates go and may be compelled to take a larger position in bonds if we feel they become valuable on a price basis, and on a recessionary hedge basis. We still believe growth is the likely outcome here in the states, but this timing tension is real and somewhat unpredictable. Bond yields are the number one macro thing we are watching now, and will stay such for the foreseeable future!
The nearly final tally of Q3 earnings results show 73% of companies having beaten their earnings expectation, and done so by an average of 16%, with 53% having beaten in top-line revenue expectations (by an average of 3%). This represents a solid Q3 and is a factor in the market’s post-election rally. In other words, the market was being held down pre-election by various hesitations, hedges, and fears about unknown and uncertain results – it was not being held down by earnings fundamentals.
Since when do real estate developers like higher interest rates?
Since one became President, I suppose? Actually, the story of bond yields blowing out since the election is quite simple. They were way, way too low prior to the election (and for the last, I don’t know, six years???). And of course, the market is reasonably expecting the Fed to begin some degree of rate hikes next month. But the bigger issue that does delve into the political is that the market believes Trump has the political ammunition to get a large infrastructure spending bill into law (since it is his own party that would have to block it), and such spending commitments would add to deficits, and push rates higher. The initial knee-jerk response of bond markets may not be fully thought through, but there is some wisdom to it: Secretary Clinton may have wanted a big deficit spending package, but she would have faced Congressional resistance; President-elect Trump will not. So what do we expect out of interest rates? We have no opinion on the next 30-60 days. Generally speaking, we believe interest rates have been way, way too low, for way, way too long. But with that said, we think longer term rates stay generally lower than historical averages for a long time, as global growth and global yields and global deflationary pressures anchors them lower. Trump may be able to generate some boost to growth with tax reform and such but fundamentally the rates have two issues for borrowers and investors to understand: (1) The rate levels we have been in have been preposterously, irrationally low; (2) Even as they inevitably go higher, they can’t go THAT much higher knowing that global growth isn’t producing enough demand for money.
What’s a contrarian supposed to do?
Long-time readers know that besides our deep commitment to investments that are continually growing their cash flow generation to investors, few principles are held more near and dear to the heart of The Bahnsen Group than basic contrarianism. It is a fundamental tenet that, timing fears notwithstanding, the crowds can generally be relied upon to do the wrong thing at the wrong time. This makes it tricky in those periods when the behaviors of the crowd are mostly logical and rational. Ultimately, contrarianism does not say that the crowd is wrong that Trump will increase defense spending (as a random example); contrarianism just says that the crowd will over-shoot. In other words, what makes a contrarian thesis true is that often the crowd is doing the right thing, at first, and then just plain over-does it (because of human nature, the greed goes too high, or the fear goes too high). Right now, we understand the “crowd” selling off what we call bond-proxies – investments like Utility stocks and REIT’s generally bought for bond-like yields – as interest rates in the bond market have risen, making the risk-adjusted returns of these investments somewhat less attractive. Our contrarian impulse? To take on some REIT exposure soon – as we think the crowd has, or soon will, once again overdone this response.
The Inflation Scarenation Hyperlation
Expectations of rising inflation push bond yields higher as bond investors expect greater compensation to offset the damage being done to their purchasing power by the impact of inflation. Rising debt levels theoretically add to this fray, though the greatest explosion of debt in world history in recent years has been directly correlated to incredible deflationary pressures around the globe. One can argue (as we would) that the current policy environment is likely to push inflation expectations somewhat higher (though as we wrote above, our hope is for productive growth, not inflationary growth) without arguing that “hyper-inflation” is on the horizon. Hyper-inflation fear is a permanent bogeyman for a certain segment of society, and all we can say is that inflation scares are self-correcting, and that the slack in the global economy is large enough that we see little chance of this genie getting out of the bottle any time soon. Inflation scares? Sure. Inflation epidemic? No.
Consensus Good, Bad, Ugly – and Unknown
The generally accepted view is that at least what we know of Trump’s economic agenda would be good for market participants around tax reform, growth production, and deregulation. The consensus is that what we know around world trade, monetary policy, and the dollar is a negative. These broad and somewhat unspecific viewpoints have prima facie support, but frankly are being too widely accepted on too little information to act with much more specificity than in the areas we have already discussed. The notion that a lasting Trumpian dollar rally is a sure thing is a particular viewpoint we would be quite skeptical of. We view the unknowns in all of this as quite relevant before developing increased conviction on how to act (in emerging markets, currency, commodities, and other such asset classes). We would not be trying to trade around those things right now.
One Eye on Washington D.C.; The other eye on Beijing
As we have said, the present market optimism stems from a hope that pro-growth fiscal policies are coming back to Washington D.C. under a new united government Congress and Presidential administration. We share that optimism and outlook, with caveats. But let’s not take our eye off the ball of the largest catalyst to global downside risk: China. The consensus view is sanguine right now – that the Chinese economy is mostly stable even as it proceeds through a soft slowdown. Fair enough. And I don’t even want to think about how much money certain actors have lost betting against this thesis, so far. But let us not forget – their monetary policy is the loosest it’s ever been (for them), domestic debt levels are growing exponentially, and it’s hard to argue they are not in a huge big city property bubble (any of those things sound familiar?). We don’t fear a trade war with China (yet) as much as we fear a policy war within China. And when China sneezes, we expect the world to catch a cold.
Chart of the Week
What a fascinating chart this week. The VIX is what we refer to as the “fear index,” and it refers to what traders are willing to pay for protection on the S&P 500. When investors get panicky, the VIX usually shoots up in price. We would like to point out that the three largest drops in history in the VIX all came about when (a) The thing investors were worried about DID happen, and (b) That thing was political. In other words, investors panicked about Brexit (it happened), Bush tax cuts expiring (they did), and Trump winning the election (he did). And in all three cases, the result was THE LARGEST WEEKLY DROP IN THAT FEAR TRADE PRICE IN HISTORY. We can’t say enough how powerful this lesson is: When everyone else is buying insurance against Armageddon, don’t.
Quote of the Week
” An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.“
~ Evan Esar
Originally published on The Dividend Café