Player:
Media Manager
Video ID:
16369
Video ID:
54b982c7150ba03a298b4596
Basic Info
Video Image:
Description:
What forces will shape fixed income in 2015?
What are the most attractive areas of fixed income? How is the sector impacted by rates and monetary policy outlook? Watch as three experts discuss what they expect from fixed income in 2015
Joseph Higgins, CFA - Portfolio Manager, Multi-Sector Fixed Income at TIAA-CREF Asset Management
Doug Folk, CFA - Partner at EARNEST Partners
Dominick DeAlto - Head of Global Multi-Sector Fixed Income and Head of Sector Rotation at Fischer Francis Trees & Watts
Listen to the Podcast version here
Take the CE Quiz here
Duration:
00:57:33
Transcript:
Courtney: Welcome to Asset TV’s Fixed Income Investing Master Class. Our experts will weigh in on rates, monetary policy, and the most attractive sectors in fixed income. Joining us today are: Joseph Higgins, CFA, Portfolio Manager, Multi Sector Fixed Income TIAA-CREF Asset Management; Doug Folk, CFA Partner, EARNEST Partners; Dominic DeAlto, Head of Global Multi Sector Fixed Income, FFTW. Gentlemen, welcome. In today’s low rate environment, how do you make the case for fixed income, Dominic?
Dominic: [00:00:45] Well, I think to answer the question, you have to understand what the purpose of fixed income is in a broad balanced portfolio. Typically, fixed income is owned as a diversifier to the income generating or growth generating portion of a portfolio. So it’s a diversifier to equities, it’s a diversifier to commodities and other alternative investments. The fact that interest rates are quite low is very relevant right now, but it doesn’t necessarily mean that over the course of an investment horizon interest rates are going to remain low. I think, what it means is that those investors that use fixed income in their balanced portfolio need to be much more dynamic in terms of how they express that fixed income exposure. So, many people view fixed income in very broad terms. And typically, what they think about is government bonds. But in reality, there are a great many different sectors or asset classes within the fixed income space that actually provide a nice buffer to a low interest rate environment or can poise a portfolio to take advantage of decreasing interest rates.
Courtney: [00:01:55] And, Doug, in this low rate environment can you make the case for fixed income?
Doug: [00:01:58] I think so, yes. First of all, fixed income sets the base for all other asset classes, to keep it simple. So, for a low turnaround fixed income, we’re in low turnaround for every asset class, whether they want to admit it or not, so. And then to Dominic’s point, fixed income has proven to be a very good diversifier over the 80 years of reliable history we have for how the asset classes perform. But to go one step further we’re in a low rate environment, how bad does it have to be for bonds for anyone to walk away from them? You know, a bad day in bonds is not like a bad day in stocks, to keep it simple. You know, a bad five years in bonds is not like a bad five years in stocks. And there’s plenty of data to show that. And, here we are at a point where the five-year Treasury is not so far away from what it was in the 1950s, early 1950s, that wasn’t the end of the world. I think people need to realize that with fixed income, reinvestment drops performance over time. And yes, bond prices fall when rates rise. But in a very liquid fashion, reinvestment can help drive total returns to a higher level than you would have gotten if rates had just stayed where they were. So it’s very conceivable that over the next 5, 7, 10 years, total returns for fixed income portfolios strategically allocated will be higher than the yield we’re looking at today. That’s not a negative or a down, that’s actually an upward trajectory for performance that will actually drive other asset classes as well. So I think, definitely, fixed income, and probably at this point, it’s even more important to protect capital and to focus on the asset classes that can deliver the upward performance.
Courtney: [00:03:42] Joe, do you concur?
Joseph: [00:03:44] I do. Fixed income, depending upon the nature of an investor, their time horizon, their risk tolerance, should always have … generally should always have some role in a portfolio. We like to think of fixed income returns on an inflationary-adjusted basis. And even though nominal yields are clearly very low in the US, much lower elsewhere in the developed world, on an actual inflationary-adjusted basis, they’re not so low. Inflation expectations have been declining significantly in Europe, in the US, and indeed around the world. And the real returns that you’re getting from fixed income are in fact relatively stable. So, the Fed is targeting 2% inflation, and we are running now in the US well below that. In Europe, they’re running dangerously low, approaching zero, which would be deflation. If you take Japan as an example, their fixed income markets have been, for the five-year and ten-year, nearly zero for decades essentially. And in fact, the real returns have been positive because Japan has suffered from deflation. And as Dominic and Doug mentioned, and I certainly agree, you know, equities can go down significantly. And there is a balance to a portfolio that fixed income can bring in. And you can have fixed income diversified by currency, which can offer certain benefits and as Dominic implied.
By asset class, where in many areas of fixed income right now, I think we’ll talk about it soon hopefully, the yields are quite significant and on a risk-adjusted basis very meaningful and those areas include certain EM countries, high yield, certain structured asset classes, and then a host of private investments. So, it has a role, certainly on… an ongoing role, and on a superficial basis, yields look rich, but they are in fact not.
Dominic: [00:05:42] I think there was an excellent point in there insofar as, you know, I had mentioned the differentiation between different asset classes. But in reality, there’s also a great differentiation between regions around the globe. And whereas I think, ironically, we were having … we were asking ourselves many of these same questions at the beginning of this year, having come to what we thought was the end of a 32-year bond rally. But in reality, if you look at where indices have closed the 2014 year, we have the Bar Cap Global Agg Index having a return of upwards of 15%. So, fixed income was indeed the equity-growth asset class this year. And part of the reason for that, and part of the reason why there was such an attractiveness in the US market, despite the fact that it looked quite rich, was because the alternatives were so poor. When, to your point, when JGBs, Japanese JGBs are yielding negative real rates of return, when the five-year Bund is a negative .02%, clearly, there is no beneficial reason to have an investment in those areas. But that said, other fixed income areas still looked quite attractive. So at what was at the beginning of 2014 a 3% 10-year yield, to many of us working in the industry seemed insanely, insanely rich, actually looked quite attractive to other global investors.
Courtney: [00:07:12] And you mentioned 2014. Doug, did you have any surprises in 2014?
Doug: [00:07:18] I think the answer to that question, for us, is no. We are not a macro shop. We’re a bottom-up shop. And we certainly watched the world, and have opinions about the world and then consider our opinions about as valuable as a lot of others investors’ opinions. And I think 2014 was supposed to be the year of rising interest rates. Yes, since Henry Kaufman called the peak in rates in 1981, we’ve had the consensus opinion that rates are going down, this 32-year bull market. And the consensus has always been wrong. And to the point that even you might argue is the contrarian strategy, it might actually be better in that regard, as it is in equities and other places as well. So, you know, a surprise in yields, and I think a lot of investors probably didn’t see that happening, looking at where peers stacked up in terms of strategies. So in spite of a decent year for spreads, perhaps, we are duration neutral, and that’s why we’re duration neutral. So it doesn’t surprise us, nothing would have surprised us, if rates had gone up, it wouldn’t have surprised us. We’re in such a perilous business to believe you can do that consistently year in, year out over 10 years.
Courtney: [00:08:24] Joe, what’s your take, did you see any surprises in 2014?
Joseph: [00:08:28] Yeah, absolutely did, as we do every year. And we’ll continue to have surprises, I’m sure. Our economist was expecting rates to increase modestly during the year, certainly I thought that they would, particularly as I examined the improving job situation in the US, auto sales, very modest improvement in housing, but started to see an improvement, in business CAPEX, all of which could under other circumstances be inflationary. In fact, it was not primarily because of weakness elsewhere around the globe. And it’s important to remember that even though, for example, I expected rates to rise modestly, it’s a global market and a global capital market. So that surprise makes some sense if you will. I also expected EM to perform a little bit more weakly earlier in the year as US rates could rise, and of course they didn’t. Did not expect the significant fall in oil of this magnitude and, clearly, I don’t think anyone else did.
So I think, you know, that’s 2014, and I think for 2015 to extend your question we have to ask what could be the surprises in the coming year. And one of them, I think it’s an outlier case, but could be that oil recovers a little bit more quickly than folks believe, for example, it’s not impossible that oil could recover to, say, $60. It’s not a base case, but it’s not impossible, towards the end of 2015, depending upon demand growth and supply cuts in the States. And, of course, what OPEC members, primarily the Emirates and Saudi Arabia, choose to do in terms of supply. That could be a surprise. If we were to have wage growth pressures in the US, currently it doesn’t look like it’s going to manifest, we could see the Fed actually raise rates, even in spite of the weakness we see elsewhere around the world, including Europe. Right now, it doesn’t look likely, because wage growth actually came in negative. On the most recent release, we’re seeing some weak retail sales and the like. But really, we have to remember that surprises can come about from a shock in data. The Fed is data-dependent, so it doesn’t seem to be the case, but probably could have those surprises coming in 2015 along with perhaps some geopolitical or specific country shocks if oil indeed does stay very low, that can cause quite a bit of turbulence.
Courtney: [00:11:03] And, Dominic, what are your expectations for 2015?
Dominic: [00:11:06] Well, different than perhaps the beginning of 2014, where, like both Doug and Joe, our thought was … our expectation was for higher interest rates particularly in the US. Sort of answering your last question a little bit, what did we get wrong? We were also of the opinion, again, that interest rates would rise. We didn’t think that they would rise meaningfully, so given a couple of tempering items, the first of which was we saw a fairly significant demand for Treasury securities from pension plans who were … particularly those that are in liability-driven types of programs where wonderful equity performance allowed them to de-risk to some degree. We also thought that there was also a demand from pension plans that were just simply rebalancing. So we didn’t think that interest rates would perhaps rise as much as others of our peers. But that said, what we missed was the profound demand from global investors, from central banks around the globe, going back to that relative attractiveness of the US Treasury market, relative to their own domestic markets. That’s something that we didn’t necessarily pick up on. So we too had a fairly short duration type of position, meaning effectively a bet that interest rates would go up. And that was certainly one of the things that we missed.
The second thing that we missed was … and we have … we go through what we see as sort of our long-term mega themes, if you will, every year. And we did indeed expect, although we’re not a commodity shop, we did expect that there were enough things in place that would cause oil to begin to slowly, gradually fall. We didn’t see … we didn’t have an expectation of this profound drop that we’ve seen, because supply is a known known. And it’s something that we had a very good sense of going into 2014, that indeed the US was coming online. The cause, which to me is still somewhat unknown as to how we’ve gotten to where we are right now, is still out there. Now, there’s obviously a terminal end to which oil can drop. So I would agree with Joe to some degree that, you know, the resting rate is not quite here. But we don’t necessarily know where that resting rate, or when we’ll get to that resting rate of somewhere around 60/65, we agree with that number. So how we position for that is that, you know, typically when you don’t know what’s causing something, you try not to bet against it or with it. And so we have sort of pulled back a little bit on our duration call. We have… we’ve actually changed our duration call a little bit. I think we talked earlier about the divergence in policy. So rather than just taking an outright duration position, we’re finding it much more beneficial to look at countries or regions relative to each other, or to look at yield curves within a particular country, rather than making an absolute duration call.
Courtney: [00:14:15] Joe, we may be nearing the end of a 30-year cycle of declining rates. How does that impact how you’ll position yourself along the yield curve and in terms of duration?
Joseph: [00:14:23] Right, Courtney, certainly the consensus view is that we are nearing, or the consensus view was, that we are nearing the end of a 30-year cycle. And that has tremendous implications for positioning on the curve. You would obviously want to be short duration and then position at points on the curve that are most poised to benefit, or not, from potentially rising rates. Clearly, in 2014, we’ve seen the benefits of being long, the long bond. For going forward, however, we’ve really seen a significant shift in global growth prospects and in inflation expectations. And I can’t emphasize that enough, how closely we follow expectations. So they are dropping around the world. The likelihood that the Fed will have to raise rates in 2015 is dropping quite precipitously. Our call was for either June or September of 2015, and our view is rapidly shifting on that in reaction to new data. The weakness in Europe is surprising, oil at current prices is telling us, we think something else is going on globally, beyond, say, the supply-and-demand dynamics around oil. It could be an indication of significant weakness, as yet to be determined where that may lie. We know some of it is coming from Europe. China may be having a greater weakness than heretofore most people thought. But the weakness in oil is severe enough that we have to be conscious of the direction of the global economy.
So with that, the Fed has indicated in Q4 of 2014 that they are now cognizant and observing what’s going on in the global economy. So you know, while you would want to be short duration at the end of a 30-year cycle, what I am certainly relaying is that that end of the cycle appears to be ways off. And it would be prudent, and we think it’s prudent, to be rather tactical around duration, not to veer too far, in fact, similar to what Dominic said earlier, until we know the degree of the drop that’s underway in global strength, economic strength, it’s really prudent not to be short duration in the months and weeks ahead.
Courtney: [00:16:55] Doug, and since we’re nearing the end possibly of a 30 year cycle, how will you position yourself?
Doug: [00:17:02] We will pick up at the exact same place, I think that, again, we are duration neutral, we tend to be curve neutral as well. It’s hard to pick up on the curve and make accurate forecasts with that that are consistent in our view. You know, I just think back to just the last timing cycles and an excellent example of what happened, Chairman Greenspan’s conundrum, when he testified in front of Congress and said, “I’m raising the Fed funds rate” from 2004 to 2007, yet long rates are coming down. And we’ve actually looked at that to see… Opportunity costs are as much a loss in this business as anything else. If you make a bad forecast, you have to double down to get it back. If you can’t, if you leave money on the table, and, you know, investors who shortened from baseline Treasury portfolio to an intermediate Treasury portfolio, who were perfectly [unclear 00:17:47] in forecasting rates in 2004, 2007 in terms of the Fed funds rate, left money on the table. And in fact the contrarian trade was to buy long Treasuries. And of course rates came down again in 2007, there’s no way anybody can make that back from shortening up, it’s just a perilous business.
So, curve neutral and certainly, if you are duration neutral, to the viewers, the consultants who are watching this show, you do get a little bit more of the yield curve too. So it’s a little bit more of the benefit of what bonds can offer you today, and just in case we are in this, you know, 30/32-year bull market, doesn’t mean we’re going to a bear market. And it took 30 years to get here. So it takes 30 years to get back to the peak again, if that ever happened. You really have to believe that you might as well take all the yield you can get and just try to neutralize the impact of the curve, and then work really hard to find good bonds and sectors.
Courtney: [00:18:41] Dominic?
Dominic: [00:18:42] Well, specific to curve, curve dynamics are multi-varied. And the shape of the yield curve, if I think about, you know, most positioning in 2014 was indeed, again, short duration at most shops. And I think many of the smart shops were positioned for a flattening of the yield curve. But I think the reason for the flattening, as I said, it can be multi-varied. I think the reason was that there was an expectation of rising interest rates at the front end. The front end has remained quite anchored. The front end is effectively controlled by monetary policy and what the Fed is going … or the expectation of what the Fed is going to do next. So all along throughout the year, particularly with asset purchases coming to a close, there was a real expectation that US growth at least would be enough to begin to start the dialogue about the exit of monetary accommodation. Well, that never came. So while we still have a front end that’s quite anchored, what we saw was again, as I said earlier, a tremendous amount of demand for the back end of the curve. So we got the flattening anyway. But we got it for very different reasons. So we got what we would call a bull flattener as opposed to a bear flattener, where the front end actually becomes unhedged.
Going forward into 2015, again, as I mentioned, our expectation and I would echo what Joe said our thinking is that the Fed, that dialogue is likely pushed out a little bit further. So from a duration perspective, our expectation is that interest rates should probably remain where they are, they could even continue to drop somewhat over, at least, the near term. Again, longer-term, we do indeed have an expectation still that interest rates will rise. But that’s a much more tempered view. And in terms of the curve, we don’t necessarily see that demand in the back end changing. So we have to sort of rethink why the curve may or may not flatten. Now, again, we think that it will be a more traditional bear flattener when the Fed becomes more engaged in monetary policy again. But as Joe mentioned, that’s not likely to happen, at least in the near term. So to Doug’s point, you get your yield where you can from the standpoint, even in low yielding Treasury securities, it still makes sense to have that duration in the portfolio, because it’s a lot cheaper than being short. Short has a negative carry bleed inherent in it. So for the time being, our curve positioning is still for a modest flattening, at least in the US, for that reason, and a slightly long duration position.
Courtney: [00:21:34] We’re also seeing a significant divergence in global monetary policy with all the developed nations, ex US… they’re embracing QE, and the US is poised to raise rates potentially later this year. How do you see this divergence impacting fixed income?
Joseph: [00:21:50] Well, it’s a great question and it’s going to have a very significant impact to the extent that Europe starts its QE program, which is probably only days or weeks away, the actual purchase of European sovereign bonds. That will create … indeed, the intention is to create a lot of demand for other yieldier assets within the eurozone. The idea behind quantitative easing is that if the government is buying risk-free, or nearly risk-free, bonds, that investors will need to invest in higher-risk securities. And theoretically, that should stimulate the economy. It’s happened in the US, but the US was more proactive after the financial crisis; in engaging in QE, Europe is quite late to the game. So the benefits are likely to be less than what we witnessed in the US. But the implications therefore that risk assets in Europe should perform well, high yield and other risk assets in Europe are not as tight, or they haven’t benefitted from the QE, like US high yield securities have. That’s a positive in Europe. The implication for currencies are very significant. The US is done with its QE cycle, whether we raise rates or not in the near term, and Europe is really beginning official QE now.
So we’ve seen the euro weaken considerably, break down through initial parity… initial euro levels of 1.17 at the start of the euro currency. And the implications of that are that the US dollar will get stronger, US exports become less competitive, the US economy weakens. European goods, and indeed goods from around the globe that we import, become cheaper, effectively as a result of weaker currencies. And that also pressures US manufacturers and brings US inflation pressures down further. Essentially, it’s the export of disinflation. So we have to watch that dollar strength. I think it’s a good time to be in US-dollar-denominated assets. The majority of the dollar strength, we believe, has already manifested, but there’s probably more to come in the coming year. And US risk assets at the edges, say CCC corporates or some riskier assets and structured products and elsewhere, may begin to see more volatility. They were priced to perfection, now there’s another game in town, so to speak, European high risk assets that may offer more return. So, the core effect that we’re watching is really the export of deflationary pressure to the US and what those implications are over time.
Doug: [00:24:43] The only problem with the QE situation in the US that still stands out in my mind is that the Fed bought all these Treasuries, but banks left the money on deposit at the Fed. Bank cash is at record levels as far back as you can get the Fed data which doesn’t go back too far yet, the 70s. Record levels for cash, record levels for excess reserves. Yes, asset prices have gone up, but it’s not because the banks were buying the assets, they weren’t making the loans to anybody else to buy the assets. The cash is there. I still have to wonder, you know, quantitative easing is coming to an end, they’re going to raise the Fed funds rate, but have we really done anything that really makes this economy much better? Things are getting better slowly, and maybe that’s just what it is, is that organically, that wealth is getting better in this country. The dollar’s strong, I totally understand the point about, you know, we are going to slow down our economy somewhat to help other economies out in terms of fighting for global exports. And thankfully, oil’s down, and oil’s still priced in dollars, so... [laughs] One good thing about the reserve currency of the world, everybody benefits from that, except for the producers. So that’s a Hail Mary for you, for Europe and Japan, and so... But I still have a problem with the QE disconnect. Excess reserves are enormous, and to think about the implications for bank solvency in this country, you know, banks may or may not pass this solvency test, we get those news reports every now and then.
If that money was actually invested in loans, risk-based capital would be higher. You wonder how … We still are in a credit crisis, there’s still lingering effects of it. And to pretend, even those who go back like Bernanke did to the 30s, I mean, we’re approaching that 36/37 … 1936/37 point where the economy stumbled again. I think we really do have to wonder. I don’t see rates as an imminent rise. And I think all these wonderful things in the global economy, which are… rather than the US being in a great depression, we have… the whole world is weak to some extent. So we’re strong, things are getting better. I’m an optimist. But things are not necessarily robust by any stretch of the imagination.
Courtney: [00:27:01] And, Dominic, how do you see the divergence between the US and ECB, BoJ, PBOC monetary policy.
Dominic: [00:27:09] I think there’s an interesting … there is a paradox embedded in this. I think if you look at … if you go back to 2008, there was, you know, there was certainly a well-orchestrated narrative by all central banks that accommodation was necessary, that very real and meaningful accommodation was necessary. Where the first divergence came was in how they employed it, or if they employed it. So the US bought into that narrative with both feet. And so, as such, we had TARP and a number of different programs. We had QE I, II and then III, Operation Twist. And as a result, what we see, and I completely agree with Doug, that we haven’t seen the normal transmission function of accommodation that we would see which would be for, you know, the so-called multiplier effect, whereby all of this cash in bank coffers would lead to lending, which would then lead to capital growth, which would then lead to more robust growth in the economy. But in a sense, when you think about that original plan, it was really to stabilize the markets and not so much to change economic, you know, the economic direction or the economic trajectory. In fact, if you look at 2008, we actually had a very strong economy. So it wasn’t until much after the crisis itself that the economy began to roll over. In Europe and in Japan, we saw the narrative, we heard the narrative, we heard the rhetoric, but we didn’t see the actual employment of those tactics.
Now, the BoJ did in fact employ QE I, II and III effectively overnight in mid-2012. And the ECB is now beginning to, you know, sort of three years later, think about what the US did. Now, the ECB is facing a much different challenge than the US did, because, again, as I said earlier, the US was effectively trying to stabilize the marketplace. It was trying to make sure that the banks didn’t go out of business. Well, the ECB isn’t necessarily in that jam right now. What the ECB is trying to contend with is a massive disinflationary environment and a significant rollover in growth. Now, monetary policy alone is very good at doing that. Quantitative easing certainly makes sense to the earlier points, when you’re crowded out of risk-free rates and you’re forced to own, because the end client doesn’t change their return requirement, at the end of the day, pensioners have to be paid, mutual funds still need to deliver a return. So there is in fact still a great appetite for yield, and that’s what QE does. What makes it quite different right now, though, is that what we’re talking about… what the ECB is talking about, 500 billion, one trillion euros, it’s really not enough.[00:30:10] And whereas acting first, as the US did, was quite beneficial, at this point, the ECB is going to require far more. So on one hand, we completely agree that risky assets are by far the way to go right now, because QE, at least in a knee jerk reaction, is very, very positive for risk assets. But we also call into question how effective QE is going to be in Europe. And that, certainly from a longer-term perspective, leads us quite … leads us to a position that’s still quite uneasy.
Joseph: [00:30:45] Yeah. I would add to what Dominic said. To have the central banks of the world doing all of the hard work through QE, well, Europe has engaged in many years of extreme austerity, and indeed the US in some respects has also engaged in austerity, but to a lesser extent, puts enormous pressure on the central banks, creates distorted markets. Risk is not priced properly, necessarily. And then ultimately, as an end game, increases tail risk, the potential of something going very wrong. So, we’re not policymakers or politicians here, but certainly I would be of the view that, and many are, that what’s been lacking in Europe and the US both is fiscal stimulus during this post-crisis period. And Carmen Reinhart and others will often speak about the fact that following a severe financial crisis, it takes a minimum of 10 years for an individual country, or by way of implication in this case the globe, to really recover. So where we’re at, at this point in time is, as Doug alluded to, is not necessarily that surprising. There are limits to what QE can do. And you know, some of the issues really are just weighting, and then applying other formulas for growth, which would be fiscal.
Courtney: [00:32:07] And everyone touched on oil, it’s 57% off its high from last year, between that, low wage growth, and the commodities tanking, how do you see the Fed reacting to these deflationary pressures? Dominic?
Dominic: [00:32:21] Sure. Well, to be sure, lower oil … I mean there’s definitely a have and have-not aspect to the price of oil. Not everyone is an oil producer, not every company is in the oil patch. So it clearly … a massive reduction in the cost of fuel has a very positive impact on a number of countries, regions, sectors, companies, it certainly has an impact on the household as well. The thing is, is that it doesn’t happen overnight. What we know historically from the last three experiences of sharply reduced oil is it takes upwards of a quarter to perhaps even a year before we see all of that transitory benefit come into play. So if we look at what caused some asset classes, some riskier asset classes, to roll over in the mid-October period, we hearken back to the IMF’s release of a new forecast where they had reduced global growth… their global growth forecast down to 3.5% from 4.2. That took the markets for a tumble. When you think about what the impact of oil is on that very number, it actually brings it back up to 4.4. So in a sense, in the long run, lower oil is quite good for global growth. And the impact is actually more profound domestically in the US.
So, from a growth perspective, it could actually make the Fed a little bit more aggressive from a move away from accommodation. But conversely, it also has an impact on inflation. And so, while it’s not necessarily a part of the “core” inflation, it’s hard to ignore the fact that oil has a very meaningful impact on the cost of prices paid for most everything that we do. And that is a counterbalance to Fed policy. So in fact, lower inflation actually keeps the Fed a little bit more easy insofar as they don’t feel as if they have to worry about the implications of that multiplier effect that I spoke to earlier. So in many ways, oil is tempering, you know, there’s sort of a two-sided, double-edged sword to what oil is doing, at least in the US. The implications elsewhere can be quite real. So depending, you know, if we look into the emerging markets, there too, we have an asset class with those countries that are beneficiaries of lower oil and those countries that are suffering very significantly from lower oil. With volatility as it currently is, with an environment where I don’t think anybody’s really forgotten how bad 2008 felt, we tend to throw everything out with the bathwater. So right now, what we’re seeing, at least in emerging markets for example, is everything getting soaked. That’s not necessarily going to be the case for the rest of 2015.
Joseph: [00:35:40] We’re seeing the Fed state publicly, and indeed we believe privately, they are concerned about the drop in oil, as I alluded to earlier, possibly indicating a greater weakness in the global economy, which will have implications for the US through exchange rate mechanisms and the like. But as Dominic pointed out, the Fed does look towards oil price changes as a cyclical and a non-secular trend. They try to look through it. The reality is that everything is iterative and there could be, you know, there could be other implications. So I think the Fed is looking for signs that the drop in oil is related partially … whether or not it’s related partially to just declining global growth prospects as well as supply-and-demand trends. In fact, the opportunity set right now in financial markets and in securities specifically is fantastic in the sense that, as Dominic alluded to, in high yield you have basically 50% defaults priced in for oil-related bonds. And I think oil is around 22% of the high yield bond index. In fact we believe that’s a worst-case scenario. It ignores many companies’ ability to cut CAPEX, to merge and the like, and then ultimately defaults will be lower. So for a fundamental shop, that presents a lot of opportunities, similar to what Dominic said, countries like India, very inefficient with their oil and net oil importer, they stand to benefit enormously from the drop in oil to the extent it’s sustained, while Brazil and Russia, obviously, as net producers will not.
And the US, we often forget, is an oil-producing nation. So we will have mixed benefits in our view. We’ll see the likes of quick-service restaurants and entertainment venues and the like do well with the additional money in consumers’ pockets, and maybe other non-discretionary items. But we will see significant regional weakness in oil-producing regions. The net effect, we would certainly agree with what Dominic stated, is likely to be positive for the US, but delayed. In the meantime, we have to, the Fed and all the rest of us investors have to continue to assess the global growth trajectory discrete from oil and understand if we’re dealing with something, Doug, like you alluded to, you know, a weaker patch like 36/37 during the great depression, not too strong an allegory, but something to be aware of.
Courtney: [00:38:31] Doug, how do you view the lower oil prices impacting the fixed income markets?
Doug: [00:38:37] I think the question that Joe raises is, the first thing we look at is, is there a bigger issue here, because this caught everybody by surprise. This is not something that … I mean bond deals were under oil levels, people, no one … if I go back and pull up the press 12 months ago, this was not on the table. So there is this huge question that the market’s telling you something, perhaps, that we don’t know about or, as they have both pointed out, do we just go back to a steady $60/65 a barrel and resist an overreaction. I do believe that there is probably tremendous opportunity in the oil space. There is always the ability, if corporations have leverage to pull, to survive problems like this in terms of, as you said, with the credit metrics. And generally, for the economy, it should be a benefit for most people. And so I think to that … but the question that we still have is, what’s driving this? You know, what really is, this is a surprise, and it’s one of those big ones. And is the market predicting something that’s going to happen, or is it an overreaction to something? We will see.
Courtney: [00:39:55] So given the current environment, what sectors in fixed income do you think are the best for 2015?
Doug: [00:39:57] We have habitual underweight to treasuries. We tend to prefer credit and spread, and we throw spread out there because a lot of people tend to think that the only spread are credit issues, but we tend to like, you know, mortgages, and we tend to like areas of the mortgage market that are less represented in the indexes domestically, like multifamily housing, agency multifamily housing. We have always had a focus on structure. So we don’t always just buy, you know, negative convexity, we tend to like spread with structure. And so we look for places in the domestic markets where we can find, you know, we can pan for undervalued sectors, and then things that are in the index, or not in the index. And when it comes to credit, we really don’t care about credit on a sector basis. We tend to look for stories, and we tend to look for stories that we’re comfortable owning for three to five years. I think it’s … the symmetry in fixed income investing is completely reverse from other asset classes, and our firm runs equities, so we, you know, equity managers have a little bit of downside and all the upside in the world just to… fixed income, it’s not that way. We don’t really have any upside, I mean, maybe we pretend we do, sometimes we lock something in. But you know, we have all the downside and our firm comes to this business with wanting to err on this side of capital preservation for those things that we can understand, and that’s what we focus on.
So underweight in Treasuries, I think, you know, is an easy call, a lot of people will say that. I mean Treasuries have, you know, in one sense, they’re risk free, and then in another sense, they’re the riskiest assets in the world, and they have a tremendous amount of volatility, so focusing on the spread sectors in a broader sense.
Courtney: [00:41:39] Dominic, what sectors do you think are most interesting right now?
Dominic: [00:41:42] Well, I’ll start with structured securities; I mean, we tend to be … we tend to do quite a bit in the structured space. We view it as a very under-researched and also, as a result, undervalued part of the market. But more fundamentally speaking, within the structured space, we happen to like CMBS quite a bit. If we think about the fundamentals behind, there’s really a number of reasons why we like Commercial Mortgage Backed Securities. But if we think about the fundamentals first, part of, or a good part of what the US economic recovery has been founded on was an improvement in real estate. And that improvement was not necessarily just residential, in fact, it was also commercial. So that speaks well for the properties that live inside of these structured pools. But then, secondly, when we look at fundamentals, we do see a US economy that is muddling along, that continues to grow ever so slowly. And that’s obviously good for the tenants of those pieces of real estate. So it’s certainly good for the retailers, the hospital companies, the office buildings. And what we’re seeing then is that the fundamentals, the lease rates are quite positive.
From a technical perspective, again, it’s somewhat under-researched. And because of 2008, a lot of the original actors in this space have not returned, which is obviously a good thing from a technical perspective. And it’s also quite insulated from what’s going on geopolitically. And it’s also insulated from what’s going on in Europe in particular. And it’s also less, in fact probably more of a beneficiary of oil. So we see that space as quite attractive. We continue to like corporate credit, in particular we like our corporate credit to have more … we’re a global shop. So we like currently our corporate credit to have much more of a European/Japanese flavor to it as opposed to the US, the reason for that, I think Joe mentioned, valuations certainly, but also, again, we are not going to fight the central bank, which is the ECB. If they’re going to accommodate, we know that that’s certainly good for credit, for corporate credit. So that means corporate bonds, both investment-grade as well as high-yield. There’s still a very good chance that part of the asset purchase program by the ECB will include buying of corporate bonds themselves directly. So we like that space as well. In Japan, it’s the same thing. We like, you know, if we could buy Japanese equities we could, we’re a fixed income shop. So the next best thing is to buy Japanese credit. So we also see that crowding-out effect in Japan and other places in Asia where there continues, or there will continue to be a great demand for higher-yielding assets.
Courtney: [00:44:37] Joe, what sectors do you think are most interesting in this environment right now?
Joseph: [00:44:40] We definitely believe structured securities have a lot of value, like both of these gentlemen have said. The idea being US centric securities and cash flows, and that would include, in our view, legacy CMBS, which we like, which is shorter in duration, generally requires a lot of idiosyncratic research on individual loans, which we do, and you know, it’s relatively uncorrelated with equity movements and indeed Treasury movements. So that’s a significant area of focus. Auto securitizations, auto lease securitizations, credit card receivables, these things as well. And they’re US-centric, you can make a call, that certainly is, we’ve already discussed, that the US is performing much better and will continue to do so relative to the rest of the world. We like a lot of these areas too because you get significant yield at the short end of the curve. So if we were to see, which is no longer our base case, a spike in rates or a significant spike in rates, these would be modestly protected from the fact that they have a significant yield.
In the high yield space, we believe that the BB part of that space is more attractive, less volatile. Again, we think there’s opportunities both in select oil-related names and then in non-oil related names that will benefit from lower gas, consumer discretionary and the like. Treasuries, we are of the view that it should be largely neutral at this point until we have more data information about what’s going on in the globe, which will be forthcoming shortly. And then investment grade corporates, we also think are a fantastic place to be, the fund flows are continually positive, it’s less volatile compared to high yield. High yield has a retail investor base, and investment grade has the kind of investment base that, Dominic said it earlier, pension funds, central banks and the like, that bring a lot of stability there. And EM, you know, we think there are equal opportunities to be found as potential problems, and it’s a credit picker’s place. So for active managers, it’s really … it’s been a good year so far, inspite of the volatility, and will continue to be for active managers and fundamental or analytical shops.
Doug: [00:47:05] Domestic credit actually, the gentlemen have already touched on this in general, is actually a shrinking asset class in this country. CBS, you mentioned, I mean the likes of CBS are going away, by definition, they aren’t making any more of them. But the credit market, what’s going on here? You’ve mentioned about the long duration and the whole… uhm… If you take the Fed data on corporate bond data outstanding and commercial paper outstanding, put them together and divide them by nominal GDP, corporate debt is shrinking as a percentage of GDP, corporations are… or you could go into their… look at the other direction, see how their credit metrics look. But in general, the supply versus a $15-trillion economy, or whatever it is, is a shrinking universe, which … to the extent that they do offer investors a better return than Treasuries, which we can … Most years, you can avoid Treasuries and never miss a beat. You know, but the credit markets are … and I think in other markets as well, if you delve into municipals, a lot of things in this country are actually shrinking supply in terms of, an absolute sense, ABS markets are shrinking or are shrinking in terms of their importance to the size of the economy. And I think that actually is a good sign domestically for all spread products, because we’re in the money management business, but so many investors in this business run captive money, their own money, and banks and insurance companies, public pension plans are running, whatever they need, they have the money to work. And if the supply’s shrinking, they just have to have a good bid for it.
Courtney: [00:48:41] Dominic, you have something to say?
Dominic: [00:48:42] Yeah, I was going to say, Doug made an interesting point, but I would mention that we view that point in a somewhat different way and position ourselves a little bit differently as a result. So you spoke to the fact that corporate debt is shrinking, that certainly cash on balance sheet is improving. What we’re finding, though, is that there’s a certain cyclicality to this. And the risk in this part of that cycle is that, what we tend to find more and more of after we hit that trough, is more LBOs. And so, you know, with the tremendous demands that you speak of…
Doug: [00:49:19] This was one of those times I get into a macro something, and you guys, I refer to you as the macros most of the time, but you’re right.
Dominic: [00:49:24] So generally, what we find is that, you know, CFOs, corporate America will then say, “Well, okay, corporate bonds are quite cheap, there’s great demand. I can fund some of the equity-friendly things that I need to do for my shareholders.” - which is really who they work for. They don’t work for the bond holders, they work for the equity holders. And as a result, what we find is that pendulum begins to swing back the other way, because they start to do things in a far less debt-friendly, acquisitions, LBOs, things like that. So while I totally agree with you, I think that the longer-reaching implication, it’s actually a bit of a red flag for us. So we’re actually staying more away from the investment grade side, because we see that there’s more risk. We also talk a lot about break-evens, meaning, you know, how much can a spread widen before you begin to lose real money? And in investment grade, the margin is quite low, because the risk premium is quite low. So we’re actually staying away from that area because we think that there’s a little bit less margin for comfort, whereas on the high yield side, we’re getting paid a lot more. We’re not getting dramatically more, but about five times more. And so, with that, we’re able to sort of discern among asset classes a little bit better.
Last point on corporate credit, as Joe mentioned, energy has a very strong showing in the high yield bond index. Having said that, there are a number of industries that also have a very high weighting in that index, retail for example, airlines, all very much beneficiaries of low oil in particular, and also very significant beneficiaries of this low interest rate environment. So it’s really become, as I think you’ve both mentioned, much more of a stock picker’s type of bond market, which I think plays well to an active manager.
Courtney: [00:51:10] And, Doug, how do you view the current state of liquidity in the fixed income markets?
Doug: [00:51:14] I think a lot is written about the state of markets in terms of liquidity. Only looking back at the last 10 or 15, 20 years, which perhaps were a period of hyper liquidity, you know, debt-fuelled financial booms, financial services boom. Our take on liquidity is that, compared to where we were in the 80s, 70s, liquidity is great. And I think one thing that’s changed, especially to be beneficial for liquidity, is tools that allow managers to find each other and to find trades, people are always … out of the thousands of investors globally, people are always coming and going for one reason or another. And to the extent that maybe Wall Street’s not taking down trades like they used to in terms of blocks, but can buyers and sellers find each other, I think liquidity’s actually better than most people realize.
Courtney: [00:52:05] Joe, what’s your view on liquidity in the fixed income markets?
Joseph: [00:52:08] Our view is that it has changed on a very secular basis as a result of implications of regulatory laws, Dodd Frank and others. And the Street used to be a borrower of last resort during periods of high volatility, at least in the last 10 or 15 years. And that’s kind of gone away. So we’re going to see wider swings, and from our perspective, generally, when we’re positioning securities and accounts, our view is we may have to hold it for a very long time. Or plan on the value being appropriate enough that you would, you know, be able to give a significant bid-ask differential when you choose to sell it. But it feels like a very secular change unless these laws are reversed, which doesn’t seem likely currently. And it should be incorporated into pricing and intention to hold over time.
Courtney: [00:53:04] Dominic, what’s your view on liquidity in the fixed income markets?
Dominic: [00:53:06] You know, certainly, as both these gentlemen alluded to, the Street is no longer the buyer of last resort, and therefore the Street is not providing the utility that it once did. It’s really basically up to us. What that means, from our perspective, and we use sort of a tongue-in-cheek analogy that every day’s trading sort of feels like a Christmas Eve or a New Year’s Eve type of day, where really nobody’s on the desk because there’s not a lot of flow. So the ways around that is to be much more conscious of the types of securities that we own. What we find is typically in the case of knee-jerk reactions, one sells what they can, not necessarily what they want to. So we treat our most liquid securities in a very different way. They’re actually our higher-risk securities, if you will. By the same token, we’re also trying to look at different types of securities. We’re looking at more derivative types of securities that do have the liquidity. And that might sound like a bit of a, you know, a counterintuitive idea. But the reality, if you look at the day after Lehmann blew up, there were certain things that did indeed trade very, very well, most of those were credit default swaps. They weren’t the actual bonds themselves. So all the bad press that swaps get, the reality is, it’s actually, you know, no longer the tail of the dog, but it’s in fact the dog itself.
Courtney: [00:54:24] Joe, what are your final takeaways?
Joseph: [00:54:26] Well, we’re in, you know, a very critical period in the global markets. And we are seeing the likelihood that things could get worse or things could get better. And it sounds like a very basic statement. But we really are at a type of inflection point. I believe the IMF has just reduced the global growth forecast or the US growth forecast as well as the global growth forecast again. So we have a lot of discrepancies in security pricing. So, with kind of this volatility, with this uncertainty always comes opportunities, and it feels like a good time to potentially get, you know, significant returns in the bond market through security selection, fundamental analysis, and, you know, kind of a long-term strategy, if you will.
Courtney: [00:55:20] Doug, what’s your final takeaways?
Doug: [00:55:22] I think that, for the financial consultants and advisors that are listening to this show, I think I would encourage them not to forsake bonds, as we started out with the very first question, that… to understand that fixed income is an important part of a diversified portfolio. They have the hardest job putting all the patchwork together, but, include bonds, strategically, bonds will do well over the next 10 years. But they’ll also provide that wonderful dampener to volatility. And then focus on bond managers that reduce risk in terms of correlation to the other asset classes instead of doubling up risk, but stay the course.
Courtney: [00:55:55] Dominic, what are your final takeaways?
Dominic: [00:55:58] I would echo what Doug said and go back to the first question about why fixed income. I think we are in a critical crossroads from an asset allocation perspective and so far as fixed income did in fact satisfy the goal of the diversifier for upwards of 35 years now. And we’re right now at an inflection point where, moving forward, fixed income may prove not only not to be the capital preservation store that it once was, but can potentially also cost an investor money. So the key takeaway that I’d want to share is that the approach to counter that is to be much more dynamic in your asset allocation. What it means is, that I think you need a dynamic fixed income manager that spends a lot of time doing that sector rotation, if you will, because it’s hard to tell what sector within that space is going to perform at any one given time, and the moves can be quite radical.
Courtney: [00:57:00] Gentlemen, thank you.
FFTW Disclaimer
This material is issued and has been prepared by Fischer Francis Trees & Watts* a member of BNP Paribas Investment Partners (BNPP IP)**. This document is confidential and may not be reproduced or redistributed, in any form and by any means, without Fischer Francis Trees & Watts’ prior written consent.
This material is produced for information purposes only and does not constitute:
1. an offer to buy nor a solicitation to sell, nor shall it form the basis of or be relied upon in connection with any contract or commitment whatsoever; or
2. any investment advice.
Opinions included in this material constitute the judgment of Dominick DeAlto and not necessarily those of Fischer Francis Trees & Watts at the time specified and may be subject to change without notice. Neither Mr. DeAlto nor Fischer Francis Trees & Watts is obliged to update or alter the information or opinions contained within this material. Fischer Francis Trees & Watts provides no assurance as to the completeness or accuracy of the information contained in this document. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Investment strategies which utilize foreign exchange may entail increased risk due to political and economic uncertainties. Investors should consult their own legal and tax advisors in respect of legal, accounting, domicile and tax advice prior to investing in the financial instrument(s) in order to make an independent determination of the suitability and consequences of an investment therein, if permitted. Please note that different types of investments, if contained within this material, involve varying degrees of risk and there can be no assurance that any specific investment may either be suitable, appropriate or profitable for a client or prospective client’s investment portfolio.
Given the economic and market risks, there can be no assurance that any investment strategy or strategies mentioned herein will achieve its/their investment objectives. Returns may be affected by, amongst other things, investment strategies or objectives of the financial instrument(s) and material market and economic conditions, including interest rates, market terms and general market conditions. The different strategies applied to the financial instruments may have a significant effect on the results portrayed in this material. The value of an investment account may decline as well as rise. Investors may not get back the amount they originally invested. Past performance is not a guarantee of future results.
The information contained herein includes estimates and assumptions and involves significant elements of subjective judgment and analysis. No representations are made as to the accuracy of such estimates and assumptions, and there can be no assurance that actual events will not differ materially from those estimated or assumed. In the event that any of the estimates or assumptions used in this presentation prove to be untrue, results are likely to vary from those discussed herein.
This document is directed only at person(s) who have professional experience in matters relating to investments (“relevant persons”). Any person who is not a relevant person should not act or rely on this document or any of its contents. The performance data, as applicable, reflected in this material, do not take into account the commissions, costs incurred on the issue and redemption and taxes.
* Fischer Francis Trees & Watts, Inc. is registered with the US Securities and Exchange Commission as an investment adviser under the Investment Advisers Act of 1940.
** “BNP Paribas Investment Partners” is the global brand name of the BNP Paribas group’s asset management services. The individual asset management entities within BNP Paribas Investment Partners if specified herein, are specified for information only and do not necessarily carry on business in your jurisdiction. For further information, please contact your locally licensed Investment Partner.
Important Disclosures
The content represents the views of Doug Folk and do not necessarily reflect the views of EARNEST Partners. EARNEST Partners is not responsible for the comments made by Mr. Folk or of any other speaker. Nothing presented is intended to constitute investment advice and no investment decision should be made based on any information provided. Investments cited may not represent current or future holdings of investment products and nothing presented should be construed as a recommendation to purchase or sell a particular type of security or follow any investment technique or strategy. Information provided reflects Mr. Folk's views as of a particular time. Such views are subject to change at any point and Mr. Folk shall not be obligated to provide any notice of such change. While Mr. Folk has used reasonable efforts to obtain information from reliable sources, he makes no representations or warranties as to the accuracy, reliability or completeness of third party information presented. Performance assumes the reinvestment of dividends and capital gains. No guarantee of investment performance is being provided and no inference to the contrary should be made.
Important Disclosures
The content above represents the views of Joseph Higgins as of January 14, 2014. These views may change in response to changing economic and market conditions. Investment, insurance and annuity products are not FDIC insured, are not bank guaranteed, are not bank deposits, are not insured by any federal government agency, are not a condition to any banking service or activity, and may lose value.
Past performance is not indicative of future results. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
TIAA-CREF products may be subject to market and other risk factors. See the applicable product literature, or visit tiaa-cref.org for details. Please note: Investments in foreign securities are subject to special risks, including currency fluctuation and political and economic instability.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc., is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).
© 2015 Teachers Insurance and Annuity Association of America - College Retirement
Equities Fund
C21705
Disqus:
Disable
Company info:
MASTERCLASS: Fixed Income Outlook 2015
Advanced
Allow Preroll:
0
Disable contact-me:
Show Contact me
Archive www.player:
0