As we enter the middle part of the summer, we also enter the beginning of Q2 earnings season, and this all adds up to fun times. The equity markets puttered around a bit this week and between the "wait and see" on a China trade deal and the "wait and see" on Fed accommodation, earnings ought to be the major story for the next couple of weeks.
In the meantime, I really tried to use this week's Dividend Cafe to unpack some foundational things about the U.S. economy. What does the yield curve tell us about a recession? Why has the Fed become so accommodative to capital markets (there is an answer!)? What would make someone want our Fed to not be independent? What do pension funds tell us about the future of asset allocation? What can government spending tell us about the state of economic growth?
If all of these questions are addressed this week, and they are, plus a few MLP and Brexit comments to boot, can you see why I am so excited to have you join me in the Dividend Cafe?
Yield curve watch
Don't look now, but that 3-month/10-year yield curve inversion has nearly disappeared (just 7 basis points inverted at press time vs. 25 basis points two weeks ago). And while the 2y/10y got as flat as can be, it stubbornly refused to invert throughout. This is a case of Fed guidance/indications being a policy tool in and of itself, and not just pointing to actual policy tools.
Our view is that the Fed's dovish switch will anchor the short part of the yield curve down, and that just basic modest improvement in growth outlook will push the longer part of the curve up a tad, meaning we will experience a steepening yield curve for the remainder of 2019. There are precedents where this chain of events ended up working out very well (1998 is the most historically interesting example), and there are precedents where this led to recession. History offers no lesson on how this particular situation will play out.
Click here to view the chart.
The math of it all
Did you know that the median assumed return for state pension funds is 7.5%, across all fifty states? (Yes, that means plenty use an assumed return rate higher than 7.5%). And I am sure you know that the ten-year Treasury bond yield is presently 2%. So any money in bonds in the multi-trillion-dollar pension system in our country is forcing them to need a higher return from their stock and alternatives portfolio to average 7.5%. Since you can't will your way to a certain return in risk assets, what options exist for pension managers who need a 7.5% return to meet expectations? Simply put - it forces them to move money out of bonds into stocks (and alternatives) as the present asset allocation will not facilitate the returns they have to get.
Now, stocks may not achieve it either, but at least they have a chance. They know the yield on bonds. The math requires more money into stocks. And this is the United States pension system where we do have some positive yield in our bond market! There is $13 trillion in global bonds around the world with a negative yield. How do they get to their discount rate with a negative carry in bonds?
This may prove to be the biggest driver of equity valuations for years to come - the pension realities here in the United States and around the globe, attached to the math of low (or negative) bond yields.
Should the Fed be independent?
This is actually one of the easiest things for me to answer without having to tip-toe around the politics of it (I am not sure if I ever feel the need to tip-toe around the politics of much). I happen to be pretty turned off by President Trump's jawboning of the Fed on Twitter and elsewhere, and I have never had any problem publicly saying so when I believe the President is wrong about something (or when I feel he is right about something). So, in this case, I do disagree with the methodology, and at the same time, don't believe it is particularly controversial to say that:
(a) The Fed has never been all that independent of political pressure here in the states (other politicos were just more subtle about it),; and much more importantly ...
(b Pretty much no other nation even pretends their central bank is independent of their political system
Our Fed is not fully "independent," but certainly no one else's is, and that matters right now. The ECB is about to re-ramp Quantitative Easing. I mentioned previously that $13 trillion of assets around the globe presently trade at a negative yield. Global central banks, tied to the hip of their political leaders, have found new monetary policy tools previously thought incomprehensible. But it is not our central bankers we look to make sure we are globally competitive; it is our politicians (Dear Lord). So "independence" is a pipe dream, even if we do agree that the twitter trolling is unbecoming.
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David L. Bahnsen is the founder, Managing Partner, and Chief Investment Officer of The Bahnsen Group, a bi-coastal private wealth management group with offices in Newport Beach, CA and New York City, managing over $1.5 billion in client assets.
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