David Bahnsen | On August 20, 2018

Dear Valued Clients and Friends,

Some intriguing (two-way) volatility returned to the markets this week, as the dollar made new highs on the year, emerging markets roiled around currency concerns, and attention to trade talks zigged the markets some days and zagged it some others.  At press time, the market was actually up on the week despite a couple triple-digit drop days.  We’ll unpack what was causing the zigging and zagging this week as we dive into the Dividend Café.  And this week’s excursion will have a very global appetite to it, so let’s dive in …

Global tensions ripple through

The big story underneath the markets this week is what the shake-out will look like as global growth appears to be slowing, and that synchronized story of last year has all but collapsed.  U.S. growth continues to be very strong, and perhaps other domiciles are experiencing various pockets of growth as well (such as the corporate earnings rebound playing out in Japan).  But fundamentally, some emerging markets face real pressure where their countries have borrowed in U.S. dollars and have meaty leverage.  China is getting pummeled.  And Europe is tinkering right around the 0% flat line of economic growth.

Copper prices reached their lowest level in a year (which is heavily correlated to the Chinese Yuan, not surprisingly).  The gold and metals/mining stocks are down sharply.   Oil even dropped this week amidst a broad commodity sell-off.

Emerging contrarianism

Does this cause us to re-think our investment in emerging markets?  No, but it does cause us to want to allocate more money into emerging markets!  I cannot and will not “call a bottom.”   But the outflows have been extreme, and the excessively bearish sentiment is not aligned with the fundamentals.   The sell-off is NOT broadly distributed – India is UP 4.5% since the January high, while China is DOWN 24%.   This suggests there is a healthier environment for active managers engaged in fundamental growth analysis.

With that said, in the short term, if the dollar continues to rally, it heightens the squeeze on dollar liquidity, and could very well exacerbate this period of tension.  There must be a healthy respect both for the macro pressures creating this, but also the pricing realities taking place and what they mean for future value realization.  We like the opportunity here to buy emerging markets at these valuations.

Colds and Flus

The adage remains – when the U.S. sneezes, the rest of the world catches a cold (or worse).  The forgotten concept of “decoupling” is dead.  As the U.S. goes, so goes the world.  But it must be said, the opposite is not necessarily true.  Emerging markets cannot do well (yet) if the U.S. is not doing well, but the U.S. can do well even when international markets are struggling.  There is ample historical precedent for this.  So the two-way assumption in analyzing correlations between U.S. and international markets is only half-way right.

Thursday reversal

At the time of this writing, a rather stunning quarterly result (to the upside) for Wal-mart and Cisco, combined with reports that China and the U.S. are looking to resume trade talks, has caused a sizable upside rally for the Dow.  Prior to that, the aforementioned global question marks had weighed on markets this week.  We, of course, have no idea what will come of this particular China conversation, but it is worth noting how vulnerable the market is to a MELT-UP on the idea of this China/trade chatter getting a positive headline.  The same proved true in the European Union talks a couple of weeks ago.   My point is not to make a directional call here, as much as point out that directional vulnerability clearly exists in both directions, and given the nature of these trade talks and posturing, for understandable reasons.

Proof in pudding

Long-time clients know we have avoided European equity markets since the financial crisis.  The U.S. over Europe emphasis has proven very helpful for global allocators:

Click here to view the chart.

Some gravy with your Turkey

I wouldn’t dare to suggest that the issues in Turkey right now are not legitimately catastrophic for the Turkish people, I would just argue that they are virtually inconsequential for the American economy and markets.  Headline events boost volatility until they don’t, and that’s what we are seeing here.   The fact of the matter is that U.S. banks have about the same exposure to Finland that they do Turkey, with the number representing an aggregate figure so small it doesn’t even register in reports.  I talked about this (and more on Varney’s Fox Business show last Friday).  So yes, it creates disruption in the currency landscape of emerging markets, but no, it does not represent a perpetual threat to market stability outside of Turkey itself.

I thought everyone knew this, but just in case …

It does surprise me that this needs to be said, but I can think of no more useful truism about investing to share in the Dividend Café than this: If something sounds too good to be true, it isn’t true.

As I wrote a couple of weeks ago, more capital has been eroded by well-meaning people seeking “novelty” than anything I have seen.  The same can be said for those buying things that have no basis in reality.  Those who just swear they are receiving unbelievable returns with no risk; those who have a “can’t miss” real estate opportunity at some incredible yield with no downside – blah blah blah.

I also know this.  For so many people, there is no point in me sharing this permanent truism of life.  They can only learn one way, and as Edmund Burke said, “example is the school of mankind, and they will learn at no other.”

This week’s contrarian nugget

I have had a very fundamental concern around European equity investing for quite some time, and in the context of top-down, macro considerations, I still do.  That said, $56 billion of outflows from European equity funds the last five months is a stunning sign of capitulation, and forcing a contrarian like me to consider if and when an investible value level is coming.

Click here to view the chart.

A country worth watching

Few dynamics are more interesting right now than Italy’s relationship with the European Central Bank.  Our fundamental thesis is that the shared currency of the Euro has not worked (this is a profoundly true and empirically indisputable statement), and that the resolve of those determined to make it work is pretty high.  As the Draghi-led ECB prepares its long march to some form of monetary normalization, it will be very important to watch Italian bond spreads, and the impact that will have in their real economy, and more importantly, political leverage.   Italy making more demands of the ECB will lead to some breaking point, and the question will be when and how that tension between Brussels and Italy plays out.  Political pressure in Italy to abandon the Euro is sky high.  It was never going to be Greece that broke the Euro, but Italy is a large and substantial country.  No one has made money underestimating the ability of can-kickers to kick this can further down the road.  But the next exhibit in the futility of the Euro experiment is likely to get a new flare-up …

We still leave our house for some things

The unavoidable story and conversation about the death of shopping and going to the mall (a story I have critiqued numerous times, not as fully wrong, but as somewhat incomplete) seems to have another wrinkle to deal with this week: Regardless of what shopping people believe is happening “out at stores,” their appetite for dining out appears to be higher than ever.

Click here to view the chart.

Politics & Money: Beltway Bulls and Bears

• The story of resumed trade talks with China became the market story of the week and took Omarosa out of the news for a bit
• I do not know if it will make the ballot, and I do not know if it would pass if it does, but I learned from the good folks at www.mlpguy.com this week (CBRE Clarion Securities) that there is a group in Colorado seeking a minimum setback in oil and gas development to 2,500 feet (from current 500 feet).  This could be highly disruptive to the energy sector in Colorado, which represents 200,000 jobs there and over 9% of state GDP.   For now, there is not a specific story to monitor, but should there become one, this could be a major possibility for a voter-forced debacle in their own economy

Chart of the Week

The “heightened volatility” story of 2018 is a story for one reason, and one reason only: The extremely low volatility of 2017 which re-conditioned investor expectations unhelpfully.  In fact, 2018’s volatility is hyper-normal.

Click here to view the chart.

Quote of the Week

“By three methods may we learn wisdom: First, by reflection, which is noblest; second, by imitation, which is easiest; and third by experience, which is the bitterest.”

— Confucius

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David L. Bahnsen writes at the Dividend Cafe.