Dividend Café

Bombshell Productivity - May 3, 2019


Dear Valued Clients and Friends,

The month of April ended in positive territory, extending the market’s monthly winning streak to four months, and prompting all sorts of additional media discussion of what will come next and how long it will last and so forth and so on.  I believe you will find this week’s Dividend Cafe to be quite focused on the really important things, from the bombshell productivity report that came out Thursday, to where we stand in earnings season, to an actually coherent understanding of what the Fed said this week, to what oil is telling us, and so much more.  As we do each week at this time, let’s jump into the Dividend Cafe.

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Did someone say Productivity?

Markets and news cycles got hung up this week on the Fed Chair’s use of the word “transitory” to describe the present low-inflation environment, as well as the AG Barr testimony in front of the Senate Judiciary Committee.  But in the real world, I kid you not that there actually was a release this week that mattered – matters to markets, to investors, and to regular people – and that was the data report that Q1 productivity rose at the fastest pace since 2014, and labor unit costs fell.  This is the BIGGEST story of the week, and it will barely get a whisper of mention.  While people harp around the sham of a Senate grilling of AG Barr, or Chairman Powell’s exact language in the Fed presser yesterday, the trees and forest are all being missed.  Productivity increased 3.6% in Q1, far above the 2.2% analysts expected.  This productivity surge absorbs growth in labor costs and enables corporate profits to expand.  It suppresses inflation.  We call it “unit labor costs,” and there is no healthier way to restrain “unit labor costs” than with growing productivity.  If this story holds, and it will need multiple quarters of validation for me to forecast that it will, we will indeed be talking about a multi-inning expansion of this economic recovery, and this bull market.

Earnings Watch

49.2% of companies have now revised earnings expectations to the upside in April.  10 of the 11 S&P sectors have experienced earnings revisions to the upside. 77% of those companies that have announced Q1 results thus far have beaten profit expectations.  With exceptions here and there, it has been an exceedingly positive earnings season thus far.

Capex update

The pick-up in Capex intentions in the data bodes well for our key thesis for economic growth …  Companies have not given up on their plans, and the trade war delay of late 2018 will hopefully soon give way to action on the parts of these companies.  Capex orders were up 1.3% month-over-month in March.  What is on the line is nothing less than an extension of the business cycle …

The GDP report makes my argument for me

By now you should have read that Q1 real GDP grew at a 3.2% clip, far higher than most were forecasting.  But a look under the hood shows that 2/3rd’s of the growth was accounted for by rising inventories and declining imports (the less “growthy” and less sustainable aspects of GDP growth).  And the contribution to GDP growth from non-residential fixed investment continued its decline from the prior quarter (the light blue line below).  Business investment grew 2.7% in Q1, but 5.4% in Q4. It had been around the double-digit mark in the quarters before that.  That continues to be the variable that matters.

One trimester down, two to go – in OIL markets

It seems silly to talk about how markets have done year-to-date without focusing right in on oil.  The 32.5% YTD change in oil is a perfect encapsulation of why equity markets are up, and yet not in any way because a higher oil price has caused markets to go higher.  Rather, the higher oil price is proof of the inaccuracy of so many of the concerns that were plaguing markets coming into 2019.

A recession is coming?  Oil demand says no, it isn’t.

Dollar strength is killing American competitiveness?  The dollar hasn’t dropped, but it is only up ~1% on the year vs. a basket of global currencies.  Oil, denominated in dollars, has thwarted the strong dollar narrative.

Capex is collapsing?  Oil supply says no, it isn’t, as high oil prices push more energy infrastructure projects on line

Emerging markets instability will collapse oil and create a severe headwind on U.S. markets?  EM markets have stabilized and with such enhanced the outlook for global consumption.

Oil is one of the weird components in financial markets that people use to make their case no matter what is happening.  If oil prices are high, bears say it is a threat to the consumer, and bulls say it demonstrates global economic momentum.  If oil prices are weak, bulls say it is a boon to the consumer, while bears say it crushes industrial projects.  The truth is that oil prices are perhaps the most non-forecast-able thing in all of capital markets, and it takes a real outlook on why oil prices are doing what they are doing to drive an economic conclusion from it all.

Reading between the Fed lines

The Fed held rates the same this week, as expected.  They alluded to the idea the recent low inflation data they believe to be “transitory” – and expect to see inflation get back towards their 2% target (neither they, nor anyone else, has any idea when inflation will go back to 2%; and we, of course, have no idea why anyone would want it to).  They did unpack more about their so-called quantitative tightening measures, whereby they said they have been reducing the Fed balance sheet by $50 billion per month ($30 billion from treasuries and $20 billion from mortgage-backed securities), and plan to reduce that Treasury reduction to just $15 billion per month for the next four months (so $35 billion total), and then eliminate any reductions at all.  However, in October, they will allow the $20 billion of Mortgage Backed to continue rolling off, BUT will replace with Treasuries (so no net change, yet an altered composition).  They slightly lowered the interest being paid on excess reserves.  They are highly unlikely to move rates in the June meeting either.

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Fears in corporate credit?

The question mark at the end of that headline is important.  There is a common practice in our business of people picking a conclusion (“corporate leverage means the world is about to end”), and then working backward to mine the data necessary to prove the pre-determined conclusion.  When one looks at borrowing in corporate America (let alone borrowing in the government sector), there is always some available data to create fear because there is always a whole lot of borrowing in the universe!  And because most things that go wrong have as a predicate excessive debt or credit issues, the mere discussion of debt and credit issues is a good way to talk about things going wrong.

That said, and being aware of the potential for false or inconclusive data, the health of credit markets is an obsession of ours, and the following charts warrant awareness.  The first is the growth of the “covenant-lite” levered loan market.  This is the level of corporate borrowings with very few restrictions or covenants around collateral, required ratios, and payment terms.  Now, before you panic, it is absolutely imperative that I point out that some started waving the flag on the increase of covenant-lite loan issuance in 2011.  The sector has not had a negative year since!  And we talk to significant portfolio managers in the space that say there are fewer covenants on loans now, but that is because these borrowers have better payback ratios and lenders do not need them.  They further point out that recovery rates were not less for covenant-lite borrowers in the aftermath of the financial crisis.  However, all things being equal, it appears to me to be a great example of something one does not need to worry about until they need to worry about it.

* JP Morgan Asset Management, Guide to Alternatives, Q1 2019, p. 30

Frankly, the other chart is probably more of interest to me.  It reflects the slow, steady deterioration of credit quality in the senior loan market since the financial crisis.  In the early years, debt-to-earnings ratios were barely 3x as de-leveraging was the name of the game, and lenders were still bitten and bruised.  Slowly but surely that appetite has increased, and the debt-to-earnings ratio is significantly higher than it was ten years ago.  This re-leveraging was the stated policy, but whether or not it ends badly remains the question all economic analysts must be asking.

* JP Morgan Asset Management, Guide to Alternatives, Q1 2019, p. 31

Who’s afraid of a Fed rate cut?

I am, for one.  Look, there is no doubt that the Fed’s signaling of more rate hikes late last year after the seven rate hikes that had been carried out in the two years prior created a revolt in credit markets, and one could argue that the flat yield curve told the Fed to cool it for the time being, at least until growth could sink in and the long bond could increase with elevated growth expectations.  And I get the argument that to cut right now when economic growth is so strong would represent a contradictory message and damage the credibility of the Fed, even though I also get the argument (of Larry Kudlow amongst others) that if the rationale for the last one or two hikes was inflation fears, the data has now changed in that regard.

But at the end of the day, there is pretty much one reason I do not want the Fed to cut rates at this moment: I am fairly confident it would lead to an asset bubble forming.  And I hate, hate, hate, when asset bubbles burst.  And they always do.  

Politics & Money: Beltway Bulls and Bears

  • The United States ended the waivers on sanctions for countries importing oil from Iran, essentially decreasing the output of oil Iran can put in world markets.
  • Herman Cain withdrew from consideration for the Federal Reserve Board of Governors, as did Stephen Moore.  We will see what the President’s next move is.
  • President Trump met with Speaker Pelosi and Senator Schumer to discuss where common ground may exist for an infrastructure bill.  I would put the odds that both parties will take the risk of giving the other side the appearance of a victory at somewhere below 0%.

Chart of the Week

I really can’t tell you why this fascinates me so much, but it does.  What it essentially says is that all of the 30%+ move in markets since the beginning of 2017 has come during off hours (i.e. the time between one market close and the next day market open).  And it shows that all sell-offs (net) were during market hours.  There are a lot of ways to interpret this data, but I think it at least adds prima facie support to the idea that (a) One ought to stay invested and not try to jump in and out during trading hours, and (b) Panic-prone investors are trading during market hours while smarter institutional forces are buying in the futures market.

Quote of the Week

“Preparation, not prediction.”

~ Dr. Pippa Malmgren

* * *
I will be attending the annual SALT Symposium in Las Vegas next week, the industry’s largest hedge fund and alternative investment assembly.  It is an extraordinary collection of thought leaders, asset managers, and economic actors, and I have benefited immensely over the years in my participation.  This year I actually am a panelist one of the days and I hope to have something to share after the presentation.  Regardless, I promise next week’s Dividend Cafe will be colored with ample inspiration from the symposium, and I further promise that the intellectual capital harnessed out of next week will be actionably discharged to the value of our clients.  To that end, we work.

With regards,


David L. Bahnsen
Chief Investment Officer, Managing Partner


The Bahnsen Group

This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet

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