Dear Valued Clients and Friends,
The first quarter of 2018 will come to an end next week, and great effort will be exerted (by us, and others) to properly analyze what all took place in Q1, what it means, and how we should feel about the state of markets in the present, and future. Undoubtedly, investors will feel there were high points and low points in the quarter, and certainly, some will promote the idea that there were “surprises.” Indeed, we talk about the “surprises” of 2018 ourselves in this week’s Dividend Café! But should the word “surprise” ever be used when discussing the world of investing? Is anything less of a surprise than the reality of surprises? Perhaps that should be the lesson of Q1 – that when there is no volatility, or high volatility, or something that zigs when you think it will zag, or a relationship between two assets that behaves even more “abnormally,” none of it is actually a surprise. That is certainly the major lesson I have learned in a career of managing investor assets – the lesson of not being surprised! Let’s unpack all of this, and more, in this week’s trip into the Dividend Café!
Dividend Café Video
Dividend Café Podcast
The Ides of March
Since the initial market panic attack of early February, we saw markets stabilize, then rally up, only to see another rally down in late February (upon the announcement of White House tariff intentions). Coming into March, we rallied in the early part of the month after the market digested that the tariffs were more bark than bite, and as greater economic news was announced. But now in the last week or two, we have given up those March gains and are sitting back near where we started the month. What explains the downtick of this week? Oil prices, after all, are advancing. Economic news has been expectedly solid. And we are not in an earning season so therefore there have been no earnings disappointments to speak of. Essentially, we have fragile markets right now in terms of day to day volatility. There is not enough clarity that new Trumpian trade policy will be the protectionist disaster he has threatened, but nor is there clarity that it will not be. Markets recognize there is a lot of negotiating and posturing going on, but also recognize that some of what is being jockeyed about is truly concerning. Add to that level of fragility tremendous vulnerability this week in some big tech names that have been leading the market, and ongoing drama around the White House/Mueller/special counsel investigation, and there is just enough “noise” to create volatility. And of course, all of this must be understood in the context of a market losing some of its “put” from the Federal Reserve (not all of it, but just an incremental slow-drip of healthy normalization in monetary policy). But the fundamental backdrop is this: There is an inflation vs. deflation debate playing out that does matter, and there is a strong earnings environment in a strong economy that does matter. Does this leave us bullish or bearish? It leaves us cautious. But for totally different reasons than what is driving market volatility!
Surprises worth noting in 2018
As our key forecasts for 2018 centered around a melt-up in the market (January – check), increased volatility over 2017 (February/March – check), conversation increase around inflation (check), and a heightened scrutiny socio-politically in the new tech sector (check, check, check), it is tempting to think that we have all this pegged right now. However, there are some key surprises taking place in the capital markets right now and they represent the major challenges we are debating and discerning as we speak …
(1) Growth has actually outperformed Value year-to-date despite higher market volatility, a weaker U.S. dollar, and higher interest rates (all things that should bode well for Value over Growth on a relative basis).
(2) Oil prices are up quite a bit, and the Trump administration has proven every bit as friendly to the energy sector as we had hoped/expected, and yet energy stocks are once again lagging.
(3) Bonds are not at all serving as a buffer against equity volatility, but in fact seem to be trading with stocks right now.
(4) Europe and Japan are hardly catching a bid either even as U.S. stocks are caught in further uncertainties …
(We should at least note that the relative performance of emerging markets over U.S. and European markets is the one thing we think does make sense in the behavior of investing markets thus far in 2018).
Okay, well what does that all mean?
So energy stocks are a surprise, the value vs. growth activity is a surprise, and equity markets behavior given currency conditions are a surprise. But beyond being “surprised,” what is one to do? Does the energy index performance YTD mean greater value is being offered, or that the market knows something we do not? Are high-priced growth companies perhaps just set to permanently outperform their value cousins, or is there more to this story that we need to act upon?
You will forgive us if we confess that any investment decision that begins with “this time, it’s different” is one we permanently and unconditionally reject, sight unseen.
We would not dare to speculate as to what catalyst is required to see a re-pricing come through in value vs. growth, or the energy complex, or energy companies overall. What we would say about these macro themes is that a disconnect between fundamentals and sentiment is not remotely uncommon, and that structural realities are at play here (for example, the heavy ETF ownership of FANG stocks which creates a certain bid under their prices, until it doesn’t). The conclusions we draw are that markets will forever and ever revert to fundamentals and value, and we see the macro environment reinforcing the outlook we have, not contradicting it, despite present pricing. So by way of a recap:
- We see value stocks offering a better opportunity than growth as markets recalibrate to normalcy in 2018
- If there is a sector whose prices do not reflect their fundamentals, we think it is the energy sector
- As investors look around the globe for a non-U.S. opportunity, we think emerging markets will offer it more than Europe
Sources of VOLATILITY vs. Sources of VALUE
What is creating market volatility right now?
- Fear of higher interest rates and inflationary pressures
- The Mueller investigation uncertainty
- Concerns around Trumpian trade/tariff policy
But why be optimistic?
- Business optimism is growing, and we think this means more capital expenditures
- Small business optimism higher than it has been since Reagan
- Consumer confidence is at extreme highs
- Industrial production is surging
The Fed is not Dead
As expected, the Federal Reserve hiked rates again this week by a quarter point, bringing the fed funds rate to a 1.5-1.75% level. We suspect that we are over half-way there (in terms of where they will end up considering things “normal”). There were absolutely no surprises in what the Fed announced, or in Chairman Powell’s first press conference as Fed chair. They have a generally more hawkish tone now and are saying all the right things about attempting to normalize and stay data-dependent.
We know the housing crisis is a decade old at this point. And I am sure some lessons were learned (though sometimes I wonder which ones, and to what magnitude). But reading that 207,000 homes were “flipped” in 2017 – the most since 2006 – I cannot help but feel uneasy. On one hand, 65% used cash to buy their flips last year (vs. just 37% in 2004-2006 as the bubble insanity peaked), but on the other hand, the flip number being on the rise points to something systemically (and culturally) we have seen before.
Stocks and Bonds and their relationship
There is no better time for bonds to offset the volatility in stocks than when the pressures in stocks are deflationary. Bonds love deflation, forever and ever. Now, inflationary fears can mess around with stocks too. And bonds become a less effective hedge for stocks in an inflationary period than a deflationary one. So essentially, the key is not to expect stocks and bonds to behave a certain way all the time, but to evaluate the macro environment that may be creating different circumstances and therefore different responses.
It’s not as easy as you thought, is it?
The consensus view shared across nearly all pedestrian understanding of bond investing, and in too many professional camps as well, is that when interest rates are going higher, the right thing to do is have lower duration bonds (shorter maturities), so as to be less exposed to rate movements. Fair enough. But not quite so simple. Can SHORT term rates go higher, even as LONG term rates drop a bit? Absolutely. In fact, that dynamic of a “flatter yield curve” is exactly what has taken place recently – the result being lower bond prices for short maturities, and higher prices for long-dated maturities. “Interest rates being higher” (or lower) does not give enough information to drive an investment thesis. Simplicity often trumps complexity in the investing world, but sometimes over-simplification is just flat out wrong. The reality is that from credit risk to duration risk to bond selection to specific sector allocation, and certainly to yield curve management, in both tax-free and taxable bond categories, we wouldn’t dream of approaching this defensive necessity in our portfolio management duties without best-of-breed professional managers. Now, more than ever.
Did you know?
The ten-year treasury yield moved from roughly 2.5% to 2.9% (+40 basis points) in the first two months of the year. But did you know the ten-year bond yield has moved 40 basis points or more in a two month period 15% of the time over the last thirty years?
And the average 12-month return for municipal bonds after such periods? +3.8%
Speaking of municipal bonds …
The aforementioned “flattening” of the yield curve has left long-maturity bonds less attractive, and created an environment where the bulk of one’s bonds ought to be at or near their targeted (desired) maturity, as opposed to owning a plethora of maturities all over the map that simply blend to that average … Some credit risk looks attractive in the municipal space right now (as opposed to taxable where it is richer).
We have the prudent and selective MLP exposure we want in client portfolios. The entire space was dealt news last week when the FERC (Federal Energy Regulatory Commission) announced they were changing their minds on the tax allowance cost recovery in MLP pipeline rates (meaning, they are now disallowing it). This is essentially in response to a court ruling and left the regulators little choice. The space sold off across the board last week on the news. But many MLP assets were excluded from this policy reversal. The impact is not abundantly clear because not only is each and every MLP company different, but each contract that each MLP company owns is different as well. Many major players in the midstream space (including the ones that make up significant weightings in our holdings) are not expected to be impacted by this ruling at all. I spent a lot of time the last three days studying how different holdings would be impacted, and am quite confident that the market has once again overreacted to this news systemically, and that good operators have sold off in tandem with bad operators, creating attractive value for the good operators. But it creates yet another headwind for a space that has had extraordinary negative sentiment for much of the last three years.
Breaking down the state of the tariff stuff
Where we last left off in our discussion of the administration’s intentions towards trade and tariffs was basically as follows: The bad news is that a truly unhelpful and counter-productive posture was being taken towards how to deal with global trading partners; the good news was that actual policy movements towards that posture were limited, nuanced, and in many cases, toothless. Other good news was the choice of free trader, Larry Kudlow, to chair the National Economic Council, vs. the other more protectionist names that could have been hired.
Right now, the best way to describe the state of affairs is “uncertain.” They announced tariffs on China this week to punish them for intellectual property theft, but the punishments did not restrict Chinese investment in the U.S. as had been feared. There has been a rather comprehensive backlash against the idea of implementing tariffs to punish China that harm U.S. consumers more, so the thought is that this will be more muted and selective than originally feared.
Either way, as long as the ideological bend in the White House is one that sees limiting global trade as a potential policy tool, no matter the limitation in actually implementing such a tool, there will be some degree of uncertainty and even multiple compression (market valuation) that sits above markets. We are watching the rhetoric and the actions, daily. But the actions will prove more important than the rhetoric …
Chart of the Week
Why do we believe the trade relationship with China is important? We have almost 500 billion reasons …
Quote of the Week
“Show me the incentives, and I’ll tell you the outcome.”
~ Charles Munger
* * *
There was a lot to cover in this week’s Dividend Café but hopefully, it was comprehensible and applicable to you. I feel a particular burden that our writing right now maintains an angle on all the silliness that investors are exposed to, as I think we are in the early innings of the silliness era. The silliness I refer to is the idea that various external generators of volatility (trade policy uncertainty, geopolitics, internal politics, Fed decision, etc.) can be gamed, timed, predicted, exploited, etc. Or that they represent something to react to with certainty. Or that they represent something to react to dramatically. Etc. We have to monitor through the phase that lies head with sober judgment, cautious activity, and under the guidance of timeless principles that drive us. The silliness movement has no true north, and functions in the exact opposite of “sober judgment.” So our task is to counter-act the silliness, and move towards the achievement of actual client goals. To that end, we work.
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Managing Partner
The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.
All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.
This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.
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