Dividend Café

O Canada, and Other Such Stuff - Oct. 5, 2018


Dear Valued Clients and Friends,

Markets kicked off October loving the new trade deal with Canada, and we are going to cover that substantially this week.  We also cover our normal array of topics, with inflation, the Q3 market results, small-cap stocks, emerging markets, and so much more, so dive into this week’s Dividend Café.

Before we go there, though, I did a special Advice & Insights podcast this week to “wrap up” my series on the financial crisis – and recap for you the real lessons for investors out of this historical event.  The conclusion to the series (written articles) is available here.  Soon we will have a single link of the entire series, and a written booklet of it, available as well.

Into Canada, NAFTA, emerging markets, and a review of Q3 market action we go …

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Phew! Bitter Fight with our Canadian Enemies Friends Barely Avoided

The driver of markets big move higher to start the week was unquestionably the announcement of a trade deal between the U.S. and Canada, allowing for a revised NAFTA arrangement (though with a different name planned – USMCA).  It mostly followed the playbook we have seen so far with Mexico and with Europe and further reinforces the narrative that has come out of Larry Kudlow and other free traders in the office – that the White House is threatening a trade war, in order to avoid a trade war.  Of course, the big question is and will be how it plays out with China.  There are political benefits for President Trump in the deal (more auto parts production in Michigan and better dairy deal for Wisconsin), but the overall terms of the deal are not substantially different than expectations.

Will China play out like Canada?

It is fair to say that the reforms the administration is pursuing in China will not be as easy as a dairy arrangement with Canada.  There is much more risk in terms of global economics around China, and the cultural and hegemonic ramifications are categorically different.  One of the key differences is that the trade deals with Canada were never that problematic, to begin with, whereas there are optical issues in many of the China deals that are going to be harder to budge on for the counter-party.  Add to that the issue of intellectual property theft, and it just has to be viewed as more complex.  I expect a longer process with China, played out over 2019, and an outcome that no one can predict at this point in time.  If the Kudlow/Mnuchin wing wins out, and the objective is merely improving the parity in some of the trade and IP matters, I believe it will have a happy ending. If the Bannon/Navarro wing wins out, and what we are really fighting for is to flat out take away U.S. business investments in China, this thing gets much worse before it gets better.

Inflation Rate Scare, or a Non-Corroborated Story?

It is fair to say that the check back in markets Thursday was related to comments Fed Chairman, Powell, made Wednesday night about inflation concerns, and interest rates hitting their highs on the year (across the term structure).  It is very difficult to find cogent analysis on what to expect with this because the vast majority of it is written from the vantage point that strong economic data somehow inherently implies higher inflation (it does not).  The ability to separate productive economic growth from inflationary growth is the need of the hour, and I have little confidence in most purveyors of data to offer that differentiation.  Payroll growth, improving manufacturing, etc. are all positive developments, and not necessarily inflationary.  More corroboration is needed – otherwise, we have nothing to go on whatsoever.

Q3 Redux

U.S. stocks led the way on the quarter, primarily in large-cap, as small-cap slowed its growth (though still meaningfully leads on the year). Gold and commodities (besides oil) were hit hard on the quarter.  Bonds were dead flat, and down on a price-basis, for the quarter.  Emerging markets dropped but not nearly as much as they did in Q2.

* JP Morgan Asset Management, October 1, 2018

On a sector basis, and these numbers are YTD, not just Q3, Consumer and Tech sectors continue to stand out, with Staples and Materials the only negatives.  The yield curve flatness has continued to hold the banks down, whereas Telecom, Real Estate, and Utilities are all +1-3% …  Energy is up but nowhere near its historical valuation.  It’s a very mixed bag, and even within different sectors, there are really different results company by company.

* JP Morgan Asset Management, October 1, 2018

A small concern?

It is worth noting, that not only has the talk of “good year in the markets” been really, really limited to U.S. markets, and stock markets at that (vs. other asset classes), but lately, it has been quite specific to large cap as well.

* Bloomberg Finance, October 3, 2018

Emerging markets love

Q2 created a big sell-off in emerging markets equity, and the asset class dropped a tad more in Q3.  The narrative that there is a paradigm shift working against the space is fallacious, as far as we are concerned.  The fact of the matter is the emerging markets bond sector is indicating no crisis driven by currency or tariffs or anything else (the chart here shows the EM bond sector dividend by U.S. Treasuries).

* Bloomberg Finance, October 1, 2018

Really, the equity thesis is not one that keeps me up at night, at all.  The fundamentals in the earnings growth argument are well intact, and the primary argument against emerging markets doing well in the future is that they just got done not doing well in the extremely recent past (an inane argument).  Crowd behavior is a contrarian argument, and we confidently believe it will prove to be such in this case, too.

Did someone say capex?

S&P 500 companies spent $341 billion in the first half of the year alone, up 19.2% from the $286 billion spent last year in the first half of the year.  That is the largest increase year-over-year in over 25 years.  R&D (research and development) was up $147 billion (+14% YOY) – the biggest increase since before the financial crisis.  Capex is needed to drive business investment, to drive productivity growth, to absorb inflationary pressures, and create economic growth.

Bonds, Short Duration Bonds

At some point, it will stop being the short end of the curve going higher, and all those who have fallaciously believed shorter duration bonds were more interest rate-protected will end up being correct.  They have been wrong this year because they mistakenly believed that if rates go higher, they all go higher in concert.  In fact, we spent most of this year with the 10-year and 30-year anchored, with the ultra-short and short-term bonds moving much higher.  But the issue really is not just what bonds to own right now, but also why do we own bonds.  If you accept that bonds are either: (a) Part of a fixed income strategy to generate coupon income for withdrawal needs, or (b) Part of an asset allocation to temper the volatility that the equity side of the portfolio represents.  Put differently, or more accurately, bonds hedge deflationary risk.

So one can decide they don’t want to hedge such a thing – and I would suggest that is insane.  Or they can accept that they will have a very small return with a very small part of their portfolio for a bit.  Most attempts to generate offense from fixed income do not end well.  They are for income, or they are to facilitate an asset allocation.  Period.

I will not capitulate

As long as I have been writing weekly market commentary, I have repudiated “almanac analysis” – meaning, the idea that certain trends or historical recurrences in the calendar provide predictive benefit for investors.  It can range from merely “too open to exceptions to be investible,” all the way to “downright superstitious.”  In this case, I would argue that it is also not remotely predictive but may be historically interesting to some readers.

Politics & Money: Beltway Bulls and Bears

  • The Senate will vote Monday on Judge Kavanaugh’s confirmation to the Supreme Court.  There is virtually no market impact, but I will stretch for this potential consideration.  Many have been concerned that if there was a strong leftward move in the results of the mid-term election, it may end up impeding some aspects of either the legislative or executive branch economic policy agenda.  Markets may very well feel that this episode and a recent barrage of polls indicate a sudden reversal of that leftward electoral momentum.

Chart of the Week

And in “economic stories that have changed the world but no one is talking about,” the United States is officially a NET EXPORTER of natural gas.  It is really a phenomenal feat of human achievement.  And the investment implications for energy infrastructure, for import/export, and for geopolitics, are in early innings.

Quote of the Week

“It is almost impossible to do well in equities over time if you go to bed every night thinking about the price of them.”

~ Warren Buffett

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I know there were a lot of charts this week and I hope that makes it easier to read and follow.  I’m doing my best with these weekly commentaries to cover all bases and make it as engaging and interesting as possible.

I am off to the desert with my wife and kids this weekend, and hoping for some good family time and even a little rest.  I am not good enough at doing either.  I wish all of you a restful and family-filled weekend as well.  Reach out to us any time, for any reason.

With regards,


David L. Bahnsen
Chief Investment Officer, Managing Partner


The Bahnsen Group

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