There’s Never Been A Recession When Profits Were Growing
By the time you are reading this we are 2/3rd’s of the way through 2018, with the final trimester representing the greatest time of year (that is, of course, a reference to football season and the holidays, and not necessarily the market).
We will “celebrate” (okay, we will “memorialize”) the ten-year anniversary of the financial crisis next month, and I plan to write a series of short articles “reminiscing” the milestone days. There were no shortage of them! At the end of the series I will tie it into one happy “catch all” of what we learned, what should never be forgotten, and what it all means to the investors of today.
Let’s jump into this week’s Dividend Café and take a look at a market that is starting to increasingly feel that the tax reform benefits are trumping the trade and tariff risks.
I’ll take your never and match with my never
“We’ve never had an inverted yield curve that did not foreshadow a recession within 12-24 months.” I believe this is basically true, and you would have to have financial media on mute to not hear it 2-3 times per day right now. But let me add a factoid to the milieu …
We’ve never had a recession when corporate profits were growing. Ever. Q2 profits were up 7.7% vs. Q2 of last year. That is a surreal amount of profit growth, though perhaps expected when nominal GDP was up 7.6% and real GDP +4.2%. S&P earnings are up more than 20% year-over-year, and corporate tax receipts are 34% lower than they were a year ago.
Live from Jackson Hole
Federal Reserve Chairman Powell gave an uneventful speech in Jackson Hole, reiterating more or less all the talking points the Fed has had for the last several months. I want to break down what the fundamental tension is within the Fed and its critics right now. Driving much of the hand-wringing is the belief that low unemployment is fundamentally inflationary, a preposterous thesis disproven in various historical periods with much force (it is called the Phillips Curve). The very low unemployment we have has the Phillips Curvers on the Fed Board wanting to tighten monetary policy to curtail what they see as inevitable inflation. But on the other hand, because inflation is so low, many others see excessive tightening as playing with fire, likely to tip the economy into recession and mess up the low unemployment we have achieved in the economy.
The fact of the matter is that the premises are wrong, making the conclusions we are likely to get either wrong, or only accidentally right (therefore, not sustainable). The reason for the Fed to normalize monetary policy is not because low unemployment is a ghastly creator of inflation, but rather because pricing money below its natural rate creates distortions and malinvestment in the economy. The reason Chairman Powell wants to tighten in the face of low inflation is more related to finding a spot of equilibrium so as to not be caught without bullets in their gun when a recession does come. I am uncomfortable with a central bank setting any inflation target above 0%, but even if they believe creating 2% inflation is a good thing, those who see the absurdity of the Phillips Curve are right to be concerned – but for the wrong reason.
We believe the Fed is going to raise rates next month, and most likely, but not assured, again in December. And we think whether they do so or don’t do so, whatever decision they make, right or wrong, will likely not be for the right reason.
Bonds, Taxable bonds.
(If no one gets my attempt at a “Bond, James Bond” reference, please just ignore it and keep on reading).
The impact interest rates have had on bond pricing this year are well known. The irony that most investors flocked to short maturity bonds to avoid the price pressure of rising rates is that, well, the longer dated bonds have not been impacted since February as their yields have stayed in place, while the short and “safe” maturities in the low duration spectrum have seen continued elevation of yield (and therefore, negative price movement). Our approach right now is to let bonds be bonds, to view the asset class as a mere volatility hedge against equities, and to use the emerging debt asset class as the space for possible offense (in limited measure). U.S. credit has continued to perform well – floating rate, high yield, CLO’s – and we particularly like high quality CMBS (commercial mortgage backed). In no sub-class of the bond world do we wish to take on imprudent risk. Boring is better.
For those hoping the Fed hits the pause button …
I have good news, and I have bad news, for those hoping the Fed does not proceed with a rate hike in December. The good news is that it is entirely possible they will, indeed, pause. And that could very well be a boost to risk assets around the globe. The bad news is that I don’t believe they will pause unless something were to “break” – that is, something on a macro level were to really wear down. So in other words, the likely cause for the Fed holding back from a second rate hike between now and the end of the year, feared by many because of how it may impact risk assets, is something happening bad for risk assets. You get the idea.
Which way will the rotation turn?
The theme of how disproportionately non-U.S. assets have suffered from the 2018 trade and tariff disruptions is a pretty obviously cogent theme … Threats of declining global trade have contained or contracted all equities, but that containment/contraction has clearly been most severe in China, the emerging markets, Europe, and Japan. The very logical assumption is that when investors see trade fear alleviation, some rotation out of favored-child U.S. assets is highly likely. At that time, I believe the emerging markets are more likely to benefit than Europe is. Better growth fundamentals, and as shocking as it is to say, arguably better political stability!
The U.S. dollar and stock market favored-child status for global investors could last a long time; I’m simply arguing that at whatever point that overweight will be marginally reduced, emerging markets are a more likely beneficiary than other parts of the globe.
Capex is a good thing, you say?
A fascinating back-test by our friends at Strategas Research of how company stock prices are performing based on various primary uses of cash post-tax reform reveals the reality of capex and productivity. Companies whose primary cash outlet have outperformed the market by nearly 2%, and the market itself has outperformed companies whose primary use was share buybacks. Companies whose primary use was M&A have performed the worst. Why would capex use be so favorably reflected in stock prices? We believe it indicates an investment into enhanced productivity, and the fruit of productivity is – well, profits!
Does capex matter to the yield curve?
One of these things is not like the other, right? Peanut butter and chocolate are not part of the same conversation, correct? Well, maybe not. For rising capex sparking increased robust productivity could indeed keep a flattened yield curve from inverting – if it leads to sustained profits growth. How do we know the yield curve can flatten, and stay historically flat for a sustained period, without inverting? Because it did so: For a five year period!! 1994-1998 is a great example … Now we would not dare say this will play out the same way, but if capex is the key to profit growth sustainability, and profit growth is the key to managing the yield curve, we do see connectedness here and will be monitoring diligently.
Politics & Money: Beltway Bulls and Bears
- The big news of the week in markets, no doubt, was the announcement of the progress with Mexico on a revised NAFTA agreement. No doubt, the strategy to deal with the EU and Mexico (and we presume, soon Canada) all before China is beginning to look like a very effective strategy. Should Canada enter the fray, and the EU talks settle as expected, it provides the Trump administration a lot of leverage in the final party to transact with – China. That will be the trillion dollar question – will there be a way out that is beneficial to both China and the U.S.?
- In the meantime, the expectation is that the next round of tariffs (on $200 billion of goods) will go into effect next month.
Chart of the Week
To further reiterate the point made earlier, we have never had a recession when corporate profits were growing.
Quote of the Week
“I can calculate the motions of the heavenly bodies, but not the madness of the people.”
— Sir Isaac Newton
* * *
And with that we will bid August adieu … This makes for two months in a row of strong risk asset performance after five straight months of market choppiness. The final four months of the year will bring us two Federal Reserve decisions, historic midterm elections, and incredible scrutiny around the state of earnings growth, and GDP growth. Hold on to your seats – volatility is your friend.
David L. Bahnsen, CFP®, CIMA® is the founder, Managing Director, and Chief Investment Officer of The Bahnsen Group, a private wealth management boutique based in Newport Beach, managing over $1 billion in client assets. David has been named as one of Barron’s America’s Top 1,200 Advisors as well as On Wall Street’s Top 40 Advisors Under 40 and Financial Times Top 300 Advisors in America. He brought The Bahnsen Group independent through the elite boutique fiduciary, HighTower Advisors, in April 2015 after eight years as a Chairman’s Club Managing Director at Morgan Stanley and seven years as a First Vice President at UBS Financial Services. He is a frequent guest on CNBC and Fox Business and is a regular contributor to Forbes.
David serves on the Board of Directors for the National Review Institute and the Lincoln Club of Orange County, and is a founding Trustee for Pacifica Christian High School of Orange County.
David’s true passions include anything related to USC football, the financial markets, politics, and his house in the desert. His ultimate passions are his lovely wife of 15+ years, Joleen, their gorgeous and brilliant children, sons Mitchell and Graham, and daughter Sadie, and the life they’ve created together in Newport Beach, California.