Presenters: Scott Minerd & Steve Brown
Hosts: Jack Chee, Rajat Jain, Jason Steurwalt & Scott Jones
Date: February 28, 2019
Starting at 00:03:35 minute marker per instructions
SJ: Good day, everyone. I’d like to thank all of you for joining us for today’s webinar. Our topics today are the recently-launched Litman Gregory Masters High Income Alternatives Fund, the Litman Gregory Masters Alternative Strategies Fund, as well as the Litman Gregory Masters International Fund.
I’m Scott Jones. I’ll be hosting the call today. I’m the institutional relationship manager for the Masters Funds here at Litman Gregory. Joining us on the call are members of the Litman Gregory research team and Guggenheim Partners, one of the subadvisors for the High Income Alternatives Fund.
Before we begin, I would like to provide a few key points about the High Income Alternatives Fund. The High Income Alternatives Fund seeks to generate a high level of current income from diverse sources — consistent with the goal of capital appreciation over time.
It features skilled, experienced managers running differentiated strategies focused on non-traditional and less-commonly-utilized sources of income. It draws on Litman Gregory’s 30 years of intensive manager-due-diligence, asset-class analysis and tactical-allocation expertise.
The Fund also features an expense-ratio of less than 1%. This collection of managers and their strategies creates a diversified mix of non-traditional income-producing investments, while still keeping an eye on volatility and downside risk.
Today we are joined in this webinar by Jeremy DeGroot, Chief Investment Officer and Partner at Litman Gregory, co-portfolio manager of the High Income Alternatives Fund, and portfolio manager for the Alternative Strategies Fund.
We also have members of the Litman Gregory research team. Rajat Jain, Senior Research Analyst and Partner at Litman Gregory; portfolio manager for the International Fund. Jack Chee, Senior Research Analyst and Partner at Litman Gregory, and co-manager of the High Income Alternatives Fund.
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Jason Steuerwalt — Senior Analyst and Partner at Litman Gregory — and also co-portfolio manager for the High Income Alternatives Fund.
We also have with us Scott Minerd and Steve Brown, portfolio managers from Guggenheim Partners.
Before we move our discussion of the two alternatives funds, I would like to bring on Rajat Jain, portfolio manager for the Litman Gregory Masters International Fund, for an update on the International Fund. Rajat? Would you please start us off?
Rajat: Certainly, Scott.
2018 was a disappointing year for the fund in both absolute and relative terms. It was a tale of two halves. The first half of the year, the fund was ahead of its benchmark and also peers — quite nicely.
Basically, all the underperformance stemmed from the second half of 2018, when as we know, trade-war tensions rose. Along with it, investors’ concerns across China’s growth and global growth in general also rose.
As a result, many cyclical and China-related holdings in the fund sold off materially. We wrote in our recent annual letter that this selloff may prove temporary if trade-war tensions abate.
While very short-term, year-to-date, so far this year it’s pleasing to see the fund recoup some of the lost ground. Some of the detractors in the second half of 2018 are up nicely this year.
For example, MGM China — a gaming company based out of Macao, China — is equated to Las Vegas. It’s up over 25% year-to-date.
We met Thornburg’s Vincent Walden, who owns this stock in the fund, earlier this week in our offices. He sees a long runway for MGM, given the secular China demand for gaming.
Further, China has made significant infrastructure investments in the Macao area, such as the Hong Kong -Zhuhai Macao bridge. Also, China has invested in several airports in the region to increase airport capacity, making it easier for more customers to visit Macao.
Another stock — Softbank — is up over 40%, year-to-date, driven in part by its announcement of a large buyback. We spoke to Pictet’s Ben Beneche about two weeks ago, and discussed in detail the company’s capital allocation and leverage.
To summarize our nearly hour’s conversation on this company, Softbank CEO Masayoshi has a strong track record of generating high returns from many investments. Not just Alibaba, for which he is famous.
Importantly, in a lot of his investments — including the Vision Fund — Softbank has limited its downside risk in the manner deals have been structured.
Regarding leverage, Beneche says it optically may look high. But in the holding company or parent level, it’s reasonable in absolute terms and also relative to similar holding companies, which invest in other companies.
Especially after a good chunk of proceeds from the fractional sale of its Japanese mobile business, where he used to pay down debt.
As such, Beneche says Softbank is trading at an attractive discount, relative to the underlying assets. Or his estimate of NAV. Net Asset Value. Even after the recent appreciation. And based on our conversations on this stock with Pictet, their NAV estimate is conservative, in our opinion.
In Softbank’s case, the Pictet team added to the stock on weakness in the second half of the year, lowering the overall cost basis. They recently trimmed it some, as we have seen nice price-appreciation.
This in general has served the fund well this year. This is what we expect from our managers, if they have done the necessary work and have a high level of conviction in their investment thesis. And if they believe that fundamentals have not been negatively impacted, as reflected in the stock prices, then this adding and trimming can add value.
It is our experience, taking advantage of short-term macro-related market disruptions such as we’ve been seeing lately in the markets — it’s helped our managers beat their respective benchmarks.
Among the five managers currently in the fund, three have been with the fund for at least three years. I’ll just say our evaluation period, though, is longer, given each manager is running a very high active-share portfolio comprised of no more than 15 stocks of their highest-conviction names.
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All three managers have outperformed their respective benchmarks with their excess returns since inception date of the fund — net of their subadvisory fees — ranging from 140 bps to 220 bps annualized.
Since the fund’s inception in December of 1997, there have been 10 managers — to include both past and current — who have been on the fund for at least three years. All 10 have beaten their benchmarks.
While this batting average is a key reason behind the strong long-term results, the fund is ahead of its benchmark and peers since inception by an annualized 140 and 240 bps respectively, shorter-term results have been quite disappointing. Some of the disappointments stem from macro factors. Brexit in 2016 and an escalation of a trade-war in 2018, as I just mentioned.
These factors, we’d place in the largely unknowable or uncontrollable bucket from a manager’s perspective. In most cases, these macro issues have not resulted in a permanent loss of capital. It’s more a matter of being patient for our managers’ theses to play out.
Lloyds — a UK bank — is a great example of that. A UK-oriented bank, Brexit uncertainty has resulted in poor sentiment toward this stock. Meanwhile, Lloyds’ competitive position remains excellent. It is well-capitalized, and operating results remain strong.
Lloyds is up over 20% year-to-date.
Having said that, some mistakes have been made by our managers. No manager bats 1,000. Investing, as we all know, is about stacking the odds in your favor.
We discuss managers’ inevitable mistakes. It’s important we think hard about what we already know about a manager’s investment discipline and ask ourselves what we really want to understand. What’s reasonable to expect from a manager in terms of what they can know and not know?
This suggests being intellectually honest.
Within reason, what they could have done better. Is there a weakness, and to what extent is it an opposite reflection of their strength that we regard highly? What are the right lessons to learn? Are they learning them and becoming better?
There are many other questions that we evaluate and ask. We apply the same lens to our mistakes and try to become better.
I guess in a nutshell, in the absence of any material concerns, we are very willing holders. This discipline has helped us avoid whipsaw — that is, selling managers at the bottom of their performance-cycle. It’s helped the very long-term results of the Masters International Fund.
Scott, back to you.
SJ: Thank you, Rajat, for that insight on the International Fund.
We’ll now move our discussion to the Alternative Strategies Fund. We’ll bring on Jeremy DeGroot for an update.
Jeremy: Okay. Thanks, Scott. Thank you everyone on the call for your time, today.
So yes, the Alternative Strategies Fund certainly wasn’t immune to the challenging environment in the fourth quarter. The fund was down 2.8%, although relative to the losses in equity markets and many other alternatives funds, it performed reasonably well, in our opinion.
The fund’s performance during the sharp stock market decline in the fourth quarter was in line with our expectations and what we’ve consistently communicated to shareholders. In this case, the S&P 500 dropped nearly 20% from its high on September 20th to its low on December 24th. While the Alternative Strategies Fund fell less than 1/5 as much — down 3.6%.
We think this highlights our managers’ risk-management strengths, as well as the overall fund construction and the complementary nature of the underlying strategies.
For the full year 2018, the fund was down 2.1%, while the Morningstar multi-alternative category returned negative-4.7% — and the HFRX Global Hedge Fund Index was negative-6.7%.
2018 marked the second time the fund had a loss on the year. The other time was in 2015, when it fell less than 1%. It then rebounded with a strong return in 2016, and obviously there are no guarantees of that pattern repeating.
But our managers, to varying degrees, did take advantage of the market volatility and lower prices in the fourth quarter, to become somewhat more aggressively positioned within their strategies, while still maintaining appropriate caution and liquid reserves for further buying opportunities.
So far this year, the fund is up about 3.5%.
Longer-term, the fund’s risk-adjusted returns since-inception is satisfactory to us. We’re pleased that it has more than quadrupled the total return of both its Morningstar category and the HFRX Global Hedge Fund Index, with comparable or lower volatility and beta.
From a big-picture perspective, three of our managers — DoubleLine, FPA and Loomis Sayles — remain relatively defensively positioned within their strategies. Although they did do some buying in the fourth quarter, as I just mentioned.
As a reminder, our managers have considerable flexibility within their individual mandates on the fund, to shift capital to the best risk-adjusted return opportunities they see. As well as to increase or decrease the risk-exposure, based on how attractive the environment is for their strategy.
We’ve seen them act more aggressively and opportunistically at several points during the life of the fund, as well as in their history of running similar strategies prior to our fund.
Our managers’ skill in assessing and managing risk — while also being opportunistic and eager to seek higher returns when the opportunities are compelling — is a key strength of our fund. It differentiates it from our peers, in our opinion.
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Now I’ll briefly touch on the performance and positioning of the five strategies on the fund, as of year-end. I’ll start with the DCI long/short credit strategy.
It posted a 2.8% loss in the fourth quarter, which was a reversal from their positive third-quarter return. The strategy’s performance for the year was disappointing, but far from alarming — down about 4.2%.
During the year, we revisited and intensified our due-diligence on the DCI team and strategy, to understand the key drivers of the recent performance slump, and to put it in the context of the historical and expected strategy performance.
Based on our work, we continue to believe DCI’s fundamental security-selection, portfolio-construction and risk-management processes are sound. So we expect to see much better performance from the strategy, going forward and over a full market cycle.
Much of 2018 saw a combination of narrow credit spreads, low-volatility in credit markets, and outperformance of lower-quality credits relative to higher-quality. These were all headwinds to DCI’s strategy.
But we believe they’re not sustainable, and we’ve seen a nice rebound in DCI’s performance this year.
The DoubleLine Opportunistic Income Strategy continues to perform very well. It gained 1.2% in the fourth quarter, and was up 3.5% for the year.
Over the course of the year, Jeffrey Gundlach and his team reduced their cash position, established a new 5% allocation to bank loans and also added to their CLO, CMBS and ABS holdings.
As of year-end, these credit sectors comprised 24% of the DoubleLine portfolio. The strategy’s allocation to the non-agency RMBS sector remained the largest exposure at 53%. Agency MBS comprised 24% of their sleeve.
The DoubleLine portfolio’s duration stands at just over 5 years, with a yield-to-maturity in the mid- 5% range. DoubleLine has a cautious risk-outlook, as the economic cycle is getting long in the tooth. But they don’t see a recession as imminent, so they’re staying short in their maturity for their credit-risk allocations. That’s balanced against long-duration in their agency securities.
FPA’s Contrarian Opportunities strategy lost 10.7% in the fourth quarter, with performance dragged down by their exposure to financials, internet names and industrial stocks. For the year, FPA’s sleeve lost 8.1%.
But the volatility during the fourth quarter allowed for a meaningful repositioning of their portfolios. Their portfolio — their cash-position declined by over 5 percentage points. And their net-equity exposure increased by roughly 5%, to around 71% net exposure at year-end.
Largest sector-exposure remains in the financials at about 22% of their sleeve. About 14% is in the industrials and materials sectors, combined. And 14% in the communications/services sector, which now includes internet names such as Alphabet, Baidu, Facebook and the Naspers/Tencent pair-trade.
About 27% of the FPA portfolio is in foreign stocks, and they have about 5% in short positions.
FPA emphasizes that while they increased their net exposure to stocks late last year, they still have about 28% in cash reserves to take advantage of lower prices. To put more capital to work, they require a larger margin-of-safety than what the market currently offers, based on their analysis.
Loomis Sayles’ absolute-return fixed-income strategy was down 1.8% in the fourth quarter, but posted a slight gain of 0.2% for the full year. Securitized assets such as ABS, non-agency RMBS and CMBS were the key contributors to the positive returns for the year. The Loomis team took advantage of the fourth-quarter volatility, as well; specifically in credit markets where they added significantly to their high-yield corporate exposure. Going from what was an historically low allocation of only 3% of their portfolio, to nearly 12% in high-yield at year-end.
They also added further to securitized assets, which remain their largest exposure, at 36% of the portfolio.
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Their non-dollar currency exposure remains pretty modest right now. At year-end, the Loomis portfolio had an attractive yield of 5.9%, with a duration of under 1 year. So, very low interest rate risk.
Finally, Water Island’s Arbitrage and Event-Driven Strategy was down a half-percent in the fourth quarter, and was flat for the year. The strategy’s merger-arbitrage equity and credit positions had a positive return for the year. But that was offset to a large extent by modest losses from their softer catalyst equity-special-situations positions.
In the fourth quarter, Water Island shifted the portfolio to focus on situations with a more definitive catalyst. Harder catalysts, shorter-duration situations such as announced mergers-and-acquisitions have lower correlation to the market swings — helping insulate the portfolio in times of stress.
As of year-end, three-quarters of the portfolio’s long exposure was in merger-arbitrage situations. That’s up from about half of their portfolio at the end of Q3. The remaining 25% of the Water Island portfolio at year-end was in equity and credit special-situations, with an emphasis on credit-based opportunities, which tend to have lower volatility than equity-based special-situations.
Just to wrap up, big-picture, we like how the fund is positioned, with our subadvisors holding plenty of lower-risk dry-powder that they can put to work at more-attractive asset-prices and higher expected-returns. In the meantime, we expect the fund to continue to serve a beneficial role in client portfolios, by mitigating the downside risk in other areas of the portfolios, while also generating strong positive returns over time.
Scott?
SJ: Thank you, Jeremy, for that update on the Alternative Strategies Fund. We will now move to Jason Steuerwalt for an update on the High Income Alternatives Fund.
Jason: Thanks, Scott.
It’s definitely an interesting time to launch a new fund. Nobody can accuse us of being market-timers; or at least good ones.
Given the bounceback that markets have experienced this year, it seems like a distant memory, but Q4 was really bad for most assets. S&P was down 13.5%. Russell 2000 was down about 20%. It was a brutal quarter.
The fund’s performance during the quarter and in this heightened volatility was also negative. But in line with our expectations.
The fund declined about 3.1% in Q4. Significantly less than high-yield bonds, which declined 4.7%. Not surprisingly, though, the fund trailed the Agg, which rose 1.6% during the flight-to-safety period. We typically expect to trail the Agg during periods like that.
As Scott mentioned, the fund’s objective is to generate a high level of income, consistent with capital-preservation over time. But in panic environments like Q4, it’s unlikely to match the performance of perceived safe-haven assets. Like investment-grade bonds.
For that reason, it’s designed to be a complement to traditional fixed-income allocations. It’s shooting for long-term returns that are significantly higher than core bonds, with low-correlation to the Agg, and less interest-rate sensitivity, but probably higher volatility.
Over the long-term, we think returns should be competitive with high-yield bonds, but with lower volatility and less downside risk due to the diversified sources of return, as well as the flexibility and risk-management mindset of our subadvisors.
During the fourth quarter, the performance of the two flexible credit managers — BBH and Guggenheim — which are each 32.5% of the fund, was essentially flat after fees. They both preserved capital well in a tough environment.
Neuberger-Berman’s Option and Income Strategy, which is 20% of the fund, suffered a 5.1% loss. In the Ares Alternative Equity Income sleeve, which invests in BDCs, MLPs, mortgage REITs and selectively in closed-end funds, was down 12.2%.
This volatility is why the Ares sleeve is a smaller allocation, at 15%. But the performance was still disappointing in light of the strong fundamental performance of the underlying holdings in their portfolio, and what were already pretty attractive valuations in both the BDCs and MLPs, when the strategy launched.
I’ll mention again, each of the strategies performed basically in line with our expectations, given the sharp risk-off environment. We were definitely happy that the fund had dry powder to invest into the market dislocation, which we thought should provide a good base, going forward, for attractive returns.
This was particularly true for Ares, where the PMs had reduced exposure in November and December, due to the weakness they were seeing in credit markets. They were able to opportunistically add some closed-end funds toward the end of the year at very steep discounts to NAV.
That optimism we had about prospective returns has been validated so far this year, as the fund’s up about 3.4% net.
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At the subadvisor level, BBH is up over 1.5%. Guggenheim up almost a percent. Neuberger Berman up over 3.5%. And Ares up in the mid-teens.
They’re all in the black since-inception on a gross basis, except for Neuberger-Berman, which by its nature is less able to recover in a really sharp V-shaped manner in a short time period. Since the vast majority of return is generated by income, and it doesn’t have the potential sharp price-rebound potential of other managers that own securities that can really bounce back really quickly, following sentiment-driven selloffs.
I don’t want to get too far down into the rabbit-hole on the Neuberger-Berman strategy. But I did want to note that if risk-assets had not rebounded so sharply, it’s very possible that Neuberger could have been the best performer so far this year since by December, the implied volatility in options — and thus, the premium that the fund earns by selling them — was dramatically higher than it was at the fund’s inception.
I’ll touch on that again shortly.
To briefly recap what the portfolio looked like as of year-end, the option-income strategy was 20%. That basically consists of a couple dozen or so written options, collateralized by short-duration treasuries. ABS was a bit over 16%. That includes a lot of non-mainstream sectors, like drug-royalty, railcar, cell-tower and venture-debt ABS. Really, not the mainstream stuff you’ll see most places.
Bank loans, almost 11%. RMBS, 6.5%. BDCs, 6%. It goes down from there — including other areas like corporate bonds, MLPs, closed-end funds, mortgage REITs, et cetera.
Cash was about 25%. Guggenheim and BBH both still held significant cash at year-end. They were investing patiently rather than rushing to be fully invested just for the sake of being fully invested.
Then lastly, we get asked about the portfolio’s yield a lot. We can’t publish an official number, yet. But if we kind of look at the separate sleeves, you can get a sense of it.
Again, as of year-end, the yields by-manager were BBH, 4.5%; Guggenheim a little under 4%. Both of those managers had very low duration and conservative positioning. Both, as I mentioned earlier, holding significant dry powder.
Ares was slightly over 10%. Neuberger-Berman is a little more complicated, since the option-income doesn’t technically count as yield. It resets very frequently as the options expire and new ones are written.
But the collateral portfolio itself had a yield of about 2.5%. Then in terms of the options-premium, as I mentioned earlier, at year-end, they were very high. The annualized premium on 3% out-of-the-money one-month S&P 500 options was 20%. That may not mean a lot without context of knowing the strategy well, but maybe it helps to know a little bit that as of a few days ago, that number is down below 10%. It was extremely elevated at year-end.
Overall, I guess I’d sum it up by saying we’ve got a healthy level of yield in the portfolio now, as well as a good amount of dry powder. We’re really excited about the prospects going forward. Especially with the quality of the subadvisors we have on the fund.
With that, I’ll pass it over to Jack.
Jack: Okay — thanks, Jason!
Today, we are joined by two members of the Guggenheim investment team. We have Scott Minerd and Steve Brown. Scott and Steve — are you there?
Steve: Yes, we are, Jack.
Jack: Hi, Steve. How are you?
Just by way of introduction, Scott Minerd is a founding managing partner at Guggenheim. He’s the chairman of investments, and Global Chief Investment Officer. Obviously, one of his main roles is guiding the firm’s investment strategy.
We also have Steve Brown, who is a member of the portfolio management team for Guggenheim’s active fixed-income and total-return mandates. So thank you both for joining us today. Appreciate your time.
Just to give everyone a roadmap for how the remainder of this call will go, we’re going to have Steve Brown kick off the conversation with a brief overview of the multi-credit strategy and approach, which they’re running for us in this fund.
Then we’ll hear from Scott Minerd, to get his market views and outlook. We’ll tie that all back together with how those market views are impacting portfolio construction.
Following that, we’ll try to leave some time for Q&A. I just want to remind everyone to please feel free to submit your questions through your desktop control panel.
Steve, would you want to kick things off with an overview of the multi-credit strategy and what you’re trying to accomplish, and how, in this sleeve of the fund?
Steve: Absolutely. Thanks, Jack. Thank you, everyone, for joining the webcast today.
On Slide 16, we have a brief overview here of the multi-credit strategy, which is what we’re running for the sleeve in the High Income Alternatives Fund.
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Really, it’s an unconstrained fixed-income allocation. Unconstrained in the sense that it doesn’t have any min or max sector weightings, and we really have the ability to invest flexibly across the fixed-income credit markets.
What we do is dial up and down the credit-exposure over time, based on our view of where we are in the business cycle. And how we think the risk/return is skewed for the various fixed-income sectors at our disposal.
We’re unconstrained from a performance standpoint. But we try to accomplish LIBOR-plus-300 to 400 bps over a cycle. We do that by tactically allocating across different fixed-income sectors, based on their relative value.
Over time, that means we’ll have in some cases, when we’re earlier in the business cycle and we think we have relative value in high-yield credit or bank loans. We’ll have a larger exposure there.
Or when we’re relatively more defensively positioned, we’ll have higher allocations to primarily investment-grade and loss-remote structured credit.
If you look, you’ll see in the bottom left-hand side of the page, the composite-return. The historical recurrence for this strategy against both the bank loan and high-yield credit-index. You can see we’ve been able to outperform over time, and have a lower volatility — which is important for us, particularly at this point in the cycle.
We’re not looking to have surprises from performance. We want stable performance that’s probably going to be most closely approximated by our current yield.
If you annualize our performance year-to-date so far, as Jason said, we’re up close to 1%. That would track for about a 6% year, which we’d be happy with. You’ll see on the top right-hand side of the page, our sector allocations are pretty widely diversified across the credit markets.
We as a firm do have particular expertise, we think, in structured credit and corporate credit. You’ll see that our structured credit allocation remains the largest weighting in the strategy, given the loss-remoteness of the categories that we’re investing in. We have a heightened sensitivity to idiosyncratic credit risk at this point in the cycle, and generally have a lower corporate credit exposure accordingly.
With that, I’d like to turn it over to Scott Minerd, our global CIO, for our macro views. Thanks, Scott.
Scott: I appreciate it, Steve. Thank you. And Jack, thank you for having us today.
Jack: Yes, sure.
Scott: I’m going to walk through this fairly quickly. I never like to be a slave to a deck. But since we have slides, it’s probably easier just to step through the slides. Then we can have questions.
The presentation, as you’ll see is called “The Pause that Refreshes.” That is the events that have occurred in the wake of Federal Reserve’s shift in policy. Fairly dramatically since the 19th of December.
I always ask myself the question, on Page 18, “Where are we now?”
If you move on to Slide 19, you can see that the US economy is growing in excess of potential during 2018, and is substantially above potential. Going into 2019, while we see the economy decelerating, we do believe that it’s still growing faster than the potential output.
I just got asked today, “Scott, what is the potential output?” Potential output is basically determined on the factor inputs into the economy, such as the growth in the labor pool and productivity growth.
Then of course this green area you see on the slide here is the effect of changes in deficit spending by the US government.
If anything, I’d say if there’s a risk to the 2019 number, the estimate that we have here — which is approximately 1.9% — is that output could actually grow faster than we’re expecting it to.
Moving on to Slide 20, you can see here that based upon the Congressional Budget Office estimate is where full employment is, the history of the unemployment rate relative to full employment, and then the length of time between reaching full employment and the start of the next recession.
So far, we’re now 27 months past the point where the CBO has estimated full employment is — which is approximately 4.6%. The average, you can see, is generally somewhere historically between 25 and 30 months before we arrive at a recession.
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Of course, there was the period I would point out in 1997, when it was 56 months to the next recession. Then you look at the period back in 1987, where it was another 35 months.
One of the reasons that I want to talk about those two periods in particular, both of those periods were associated with the Fed raising rates and then having their interest rate tightening path interrupted by an exogenous event.
In 1987, that exogenous event was the stock market crash. In 1997/’98, that exogenous event was the Asian crisis.
What’s interesting about both of these periods is that while the Federal Reserve had been raising rates and then ultimately paused and reversed course, the economy continued to build up excesses. What happened was, when the recession finally did arrive, it turned into something more severe than people had expected.
In the ’87 experience, in the wake of the stock market crash, it allowed the excesses in the real estate market to continue to compound. Ultimately, we ended up with the S&L crisis and the Resolution-Trust Corporation, which was created by the government to bail out the bad assets off the balance sheets of savings-and-loans.
In 1998, after the Asian crisis, the excesses continued to mount. Of course, we got the internet bubble, which was followed by a large increase in corporate defaults. And such accounting scandals as Enron and WorldCom that caused a lot of damage to the corporate bond market.
Those are important to keep in mind. Because when we look at where we are today, we’re going to find that the excesses that are starting to exist in the economy are where we’re going to find the problems in the future. But let me set that topic aside for a minute and move to Slide 21.
Now here, you can see that the unemployment rate or the employment cost index — sorry — is continuing to rise. At the same time, we’re starting to see a deterioration in the quality of labor that’s available in the workforce.
If the quality of labor — that is the marginal worker that could be brought into the workforce — deteriorates, it causes problems with productivity. While at the same time, it causes employers to begin or to continue to bid up wage rates.
We are on-path here to see wage-rates continue to rise during the rest of this expansion. Probably get close to the kinds of increases that we saw back prior to the stock market crash — certainly at least to the levels that we saw in the period leading up to the financial crisis.
What’s interesting here is, this data is not inflation-adjusted. In both of those periods, the inflation rate was significantly higher. So actually, in terms of real wages, wage-growth at this point in the expansion is significantly higher than it was in the prior expansions.
When we go on to Slide 22, we can see how this translates into CPI. As we see GDP continue to rise, there’s a strong correlation with the increase in consumer price index, based on a six-month lag. Over the coming months, while we might at this moment see some softness in the data in the next few months, over the course of the year, we continue to see inflationary pressures mounting. If we go on to the slide on Page 23, we see how this passes through to the PCE, which is the inflation rate or core PCE, which is the inflation statistic that the Federal Reserve monitors for its inflation targeting.
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Going on to Slide 24, one of the things that is also a wildcard in terms of inflationary pressures is tariffs. For those who don’t recall, back in January of 2018, the US placed trade tariffs on aluminum and washing machines.
Now, believe it or not, the consumer price index has a component for washing machines. What you see here is that in the wake of a 25% tariff or a 20% tariff on washing machines, three months after the tariff was announced and was implemented in April, we see this sharp spike in the cost of washing machines.
Now, the spike in washing machine prices has mostly to do with the fact that once you eliminated or caused the foreign competition to have to sell their washing machines at a higher price, domestic producers just followed suit. They take advantage of it to raise their profit margins.
So the washing-machine tariff is an example of what happens when these tariffs are applied to other merchandise such as automobiles. Interestingly enough, this spike in washing-machine prices is the single-largest spike in prices of any component ever in the CPI.
The effects of a tariff are pretty profound, and while I’m very hopeful that things in China are getting better, and that we’re going to avoid a full-blown tariff-war with China, things in Europe are not looking so good.
The president’s attention is likely to turn back to Europe, where we’ve already told them we’re going to impose 25% tariffs on automobiles. The European Union has shown no willingness to discuss any of the issues around the reasons for the tariff. They’ve already come up with a retaliation list in the event that we impose 25% tariffs on automobiles.
Obviously, a 25% tariff on automobiles will have a much larger impact on the US economy than a tariff on washing machines. But again, we are not out of the woods in terms of trade tensions around the world.
Moving on to 25. We can see that even if the president does negotiate a successful deal with the Chinese, the China trade tension is likely to remain a thorny political issue for years to come. While it could very well improve, it could also quickly be replaced by the EU as the number-one target of concern politically.
If we look on Page 26, while weak global growth has been weighing on the US, and this is one of the Fed chair pointed to in his press conference after the first meeting this year. We can also see that looking overseas, things in China on Slide 27 are actually beginning to improve. The Chinese are ready to take further action.
They’ve already cut reserves. The required reserve ratio at banks. They’ve signaled a willingness to cut at least another 2 or 3 times.
As you can also see on Slide 28, their money supply has begun to stabilize, and we see historically that as money supply stabilizes and begins to rise, that economic activity begins to respond in China.
00:45:00
In Europe, the ECB has already begun discussing the possibility of doing more targeted long-term refinancing operations. Now for those who aren’t familiar with what the TLTROs are, they’re essentially the same thing as quantitative easing. Except the funds are put into the economy on a pre-specified term. Like 3 or 5 years.
It’s very likely in the March meeting that the ECB will announce more TLTROs. In addition to that, it’s also likely that the guidance they’ve given that rate increases are likely to come before the end of the year, they’ll be revised to indicate that there will be no rate increases. And that rate increases will be pushed into 2019 or 2020 or later.
In Japan, Governor Kuroda of the Bank of Japan has already stated that he’s prepared to act. How they will do that exactly is not certain. However, it could be that they could cut short-term rates even further into negative territory. In my mind, more likely, they would expand asset purchases just to push up money supply.
When we get to Slide 30, we see the headwinds we had going into the fourth quarter. We became very conservative with our portfolios back in August, in anticipation that we were going to have a market correction.
Those headwinds have since reversed. Interest rates have come down fairly dramatically. That’s giving a lift to the housing market, which was showing signs of peak back in the fourth quarter. We’d expect that the rate-decrease we’ve had in the United States is going to be a lift to the economy.
When I was at the Federal Reserve a few weeks ago, Paul Tudor Jones made a comment that he felt the current change in policy guidance — that the Fed would go on hold and that they were prepared to stop or taper the roll-off of the Fed’s balance sheet. In and of itself, that constituted a 50-bps rate-reduction.
I can’t disagree with Paul. I think he’s absolutely right.
To go back to that slide for a moment, where I was talking about the exogenous event that occurred with the stock market crash and the Asian crisis — and how it caused the Federal Reserve to reverse policy and ultimately cut rates —
The reality is that in substance, we already have had a 50-bps rate cut. That is going to give a lift to risk-assets, which you can see in the bottom left-hand slide has already happened. It probably will continue to happen throughout the first half of the year.
On the upper right-hand corner, we can see that credit spreads have tightened dramatically, which I just saw before coming into the meeting. We now have had $200 billion worth of new-issue corporate debt so far this year. Which is a record pace.
It’s giving corporations an opportunity to once again re-lever their balance sheet for either stock repurchases or M&A activity.
Trade tensions, as you can see, is a giant question mark. We’re not sure of how this story plays out. However, they certainly for the moment seem to be reduced. And we’re getting some good signals out of China. The only question in my mind is, will we see another round of trade tensions with Asia.
My feeling is that the president is extremely sensitive to the stock market, as he uses it as his own barometer of the success of his policies. For the near-term, I think he’s going to try to avoid any new turbulence until the market reaches new highs.
Now, the markets are rebounding and as the policymakers are responding to the recession threat, “Where are we going?”
If we go over to Slide 33, this is a bit dated. This is the dot-plot from the Federal Reserve, at the December meeting — which has become sort of infamous for having created a lot of turmoil.
You can see that based on the median estimate of the dot-plot, what the path of short-term rates is.
The green line below is basically what the market is pricing for, today.
00:50:00
I went on CNBC on the day the market bottomed. Brian Sullivan put me on the spot and said, “Scott, what do you think the chances are of a rate cut in the next year?” I said, “50/50.”
The reality is that I think we do still have a risk that the Federal Reserve will reduce rates. Maybe I don’t think the chances today are 50/50. Maybe I think the chance is more like 25% chance they’ll cut rates and 75% that they’ll ultimately raise rates on their next move.
The reality is, whether they actually did cut rates that you could observe, in substance, the market cut rates for them. This is going to continue to lift the economy.
As you note in the next slide, if we do get one more rate hike, that would historically, based upon what long-term rates have done relative to short-term rates — it would put the 10-year note somewhere around 2.9%. If we get 2 more rate hikes out of the Federal Reserve, that would put the 10-year note somewhere between 3% and 3.25%, which means that ultimately —
If the Fed — in my mind — when the Fed begins to raise rates again, we’re going to see long-term rates begin to rise. So, my view is that the rate hikes will probably re-emerge in the fall. We ultimately will probably see long-term rates back at those kinds of levels.
Slide 35, I think, is a very interesting slide.
Five years ago, I asked my economics team to do some work to try to figure out where the terminal rate would be when we got to the point we induced a recession. They did work based on leverage in the economy. They determined that if you just looked at US non-financial-sector debt-to-GDP, using a slide regression, that the terminal rate would be somewhere around 3.5%.
If you look at the right, using the same regression, but just using public-sector debt, that rate would be somewhere around 2.6%.
I think that the moral here is that —
The reality is, we know the terminal rate is probably somewhere between 3% to 3.5%. Depending on which metric we want to look at.
The question I asked at that time was, “This regression is interesting, but you can prove a lot of things by just pulling data and running regressions. Why is this going to happen? What fundamentally is happening that would cause this?”
They went back and did work. What they discovered was, given how levered Corporate America had become, the amount of interest-rate increase relative to rate-increases from the past would not have to be as severe. Because the level of free cashflow that would be sucked up by interest with a rate of somewhere around 3.5% would result in a free cashflow number after-interest, very similar to where those sorts of numbers were in past recessions.
This regression is interesting. Mostly from the standpoint that it’s basically telling us the economy has become hypersensitive to Fed rate increases.
When you look at Page 36 and you consider the change in QE flows relative to the year-over-year change in the US financial positions, the likelihood based on where QE is currently or QT is currently targeted, it’s going to lead us to essentially be in a mode of financial tightening throughout the world.
However, as I just mentioned, this has not been revised. We haven’t seen what the ECB is going to do. But in all likelihood, this in my mind will probably turn back into something that’s expansionary and not contractionary. Also, not nearly as expansionary as it was over the last 10 years.
00:55:00
I spoke to you about leverage in the system. If we go to Slide 37, you can see that there’s a plot here of both the total debt-to-EBITDA — which is the blue line higher up, and the net-debt-to-EBITDA, which is the purple line — which is lower.
I want to focus on the blue line first, because I think that’s the more important line. I’ll come back to that in a minute.
You can see that our total debt-to-EBITDA number in the economy is at levels that have historically been associated with recession. As a matter of fact, we’re as high as we’ve been.
The interesting thing, however, is that this level of total debt-to-EBITDA is at the level that historically has been reached at the end of a recession; not at the beginning. As you can see on the slide, there’s a significant increase in the total debt-to-EBITDA during recessions. That’s because the denominator is becoming smaller as cashflows in corporations are getting weaker.
We’ve never entered a recession since we’ve been keeping data on this kind of stuff at this kind of a leverage ratio.
The reason I put aside the net-debt number to the total number is, a lot of people make the argument that — yes — net-debt isn’t nearly as high as it’s been in prior cycles. The response that I’ve come up with to that is very simple. The difference of the cash on the balance sheet for net debt is largely contained by five companies.
Unless Elizabeth Warren is going to introduce a program of corporate socialism, which causes companies with cash to give companies without cash cash, the reality is, I don’t think that the cash hoarders in the market — like Apple as an example — will become philanthropists and start giving money to the cash-starved companies.
I think the total-debt-to-EBITDA number is more instructive. It’s telling us that we have lots of warning signs that the next recession is going to hit the corporate sector pretty hard.
I’ve been throwing around the “R” word a lot. So on Slide 38, when we originally came up with our projection, based upon where the Fed’s path was to this 3% to 3.5% range on the overnight rate —
We estimated that would occur probably somewhere around the end of the first quarter of 2020.
I asked my team to go back and look at paths of indicators which typically indicate that we’re going to have a recession. What did they look like?
About two years ago, we developed this dashboard for a recession. You can see things like the blue line, which is the average of the unemployment gap. That’s the rate of unemployment versus the full employment rate or the natural rate.
To the right of that is the Fed Funds rate versus the neutral rate. The next to the right is the shape of the yield curve. Then down lower on the left, leading economic indicators. Average weekly hours and retail sales.
This has been a very telling chart. You can see that we are pretty much following a standard path of where we’d expect all of these indicators to be if we were going to be in a recession. It says here in February of 2020. But let’s just say by the first or second quarter of 2020.
We have revived this work over the last few weeks, to see if the indicators are starting to tell us anything different. Also, to look at other indicators.
Everything that we’ve looked at so far continues to confirm to us that the recession is likely to hit in the middle part of next year.
Part of that reason is on Slide 39.
01:00:00
As you can see here, the tax-reform. I hate to call it tax-reform. I typically just call it “tax cut.” Then the increase in government spending.
In 2018, it gave a significant lift to the economy. The residual effects of that are probably going to give us a pretty good lift in 2019.
In 2020, those metrics turn negative. What have been tailwinds and continue to be tailwinds for the economy — by the time we get into 2020, are going to turn into drag on the US economy. If I’m right and the Fed begins to raise rates again this fall, then we’re going to have a monetary policy restriction increasing just as fiscal policy becomes restrictive at the same time. That of course would be very bad for corporate cashflow, which would probably cause Corporate America to lay off workers. That could lead to a recession.
Let me just give you a little —
I usually do this as a pop quiz when I’m with people. The typical increase in unemployment from its low, until you get into a recession, is around 4/10 of one percent. What that would translate into is that if we had — let’s say — four months of no unemployment growth in the United States, that would result in a recession.
It doesn’t take a huge increase in unemployment. It wouldn’t take a large increase in layoffs by Corporate America if they started to see cashflows impinged that would lead to a recession.
Of course, once recession hits and people are laid off, confidence declines. The impact on the economy begins to spiral.
Jack: Scott — do you have any insight into the severity of the recession that you could see?
Scott: Yes. We’re going to actually come to that in a minute.
Is that good?
Jack: That’s perfect.
Scott: Okay.
If you look at Slide 40, this is just telling you that the political battles in Washington are increasingly undermining confidence. If we did start to have layoffs, we could see the impact rise pretty significantly or be magnified dramatically in a certain way.
On 42, all we show you here is where we think the yield curve will ultimately reshape to. For the sake of time, I’ll just keep moving.
43 shows you in the lead-up to a recession, whether you think that recession is in 12 months or you think it’s in 2 years. This just gives you a pretty good sense of if stocks continue to perform pretty well, up maybe another 10% — mortgage-backed securities do well. I’m not sure that holds this time.
TIPS, treasuries — the Barclays Agg — investment-grade. We can see high-yield leveraged loans and asset-backed floating rate securities typically don’t do that.
Looking at 44, again, you can see how spreads widen in a recession. I find interesting two things that I’ll point to. One is that spike in 2016. That was the energy crunch. That was not a full-blown recession.
You can get a sense from where we are today to an event that is just a credit scare, compared to getting into recessionary territory — how much room we have for credit spreads to widen.
The reason I like this 2019 spike is, I’ve got to tell you something. The last three weeks of December were like a wholesale panic. Liquidity completely evaporated. It was really kind of scary.
I thought to myself, “If it’s this bad just on a scare, you can imagine how bad it’s going to be when we actually get to a full-blown recession.”
Page 45, you can see what happens to credit spreads in the lead up to a recession. They begin to widen. Of course in the period after the beginning of the recession, they really move up further.
01:05:00
Page 46 shows you the ratio of triple-B-rated bonds to double-B-rated bonds are higher than they were back in 2002 and 1999. I think that’s important to note.
Again, for the sake of time, I’ll just state some high-level statistics.
For the first time since people have been keeping track of this kind of stuff, the total triple-B bond market as a portion of investment-grade is more than 50%. A number of these credits — ATT, Comcast and others appear to be overrated, based upon the same metrics established by the rating agencies for those.
The leverage ratio for Comcast, which is a single-A-rated credit, is comparable to what Moody’s says is a double-B-leveraged ratio.
You can see that if a recession hits, and cashflows become squeezed, there are a lot of companies that are going to be downgraded. If we look at where we were in that 2001 experience, which I think is the closest to where we are today — the internet bubble — and where all the problems seem to be concentrated into the corporate sector, not in the household sector where they were concentrated in the last cycle —
Then if we have the same amount of downgrades from investment-grade to non-investment-grade, about 15% of the investment-grade universe will become non-investment-grade. That would be comparable to approximately $1 trillion.
The entire size of the high-yield market today is $1 trillion. The overnight explosion in high-yield, we think, is going to have a dramatic impact on high-yield and corporate bond credit-spread. Our view is that is Ground Zero for the next downturn.
Page 47 — basically shows you that based on the Fed’s model, that’s where interest rates are, and where forward P/Es are. Stocks look still relatively cheap.
However, on Page 48, our proprietary stock model actually gave us a sell signal in August of 2018. You can see on 48 that we continue to make new lows. That’s telling you that at some point, stocks are going to run out of breath, and we’re going to see a turnaround.
Jack, to your question, “How bad does a mild recession look?” That’s what we expect it to be. We think the policymakers will react quickly.
Based upon history, we would see the stock market decline somewhere between 40% and 50% from its peak. Then to move on to, “What will the next recession look like?” If you go to Slide 51, you can see on average, it’s been since the 1950s until today —
In the average recession, the Federal Reserve has had to cut rates 5.5% from the peak. Relative to the neutral rate, they’ve had to cut rates to 3.5% below the neutral rate.
As we know, we are sitting very close to the zero bound. If we go on to Slide 52, you can see that using the Taylor Rule, that would be caused based upon that sort of a decline in interest rates. It would be necessary once we were through the zero bound.
The Fed models would tell us that we would need to do $4.5 trillion worth of QE. If you go on to Slide 53, that would tell you what we would expect in the next recession, the Fed balance sheet to look like.
The one thing I’ll add is that since this presentation was prepared for me last week, there’ve been several speeches since Friday by Williams, Clarida, and others. They’ve been introducing the concept of yield curve control.
Yield curve control is what the Japanese are doing. They say that the 10-year note isn’t going to trade above 10 bps. So anytime the 10-year JGB gets up there, the central bank steps in and starts buying.
01:10:00
We did the exact same thing back in the ’40s and ’50s. During the Second World War, the Federal Reserve stated that they would not let the 10-year note trade above 2.25%. They successfully kept the rate below 2.25% for a decade.
Once that policy ended, we began a 30-year full-bear market in bonds.
I guess the moral of the story is, if you’re worried about long-term rates rising, if we are correct and we’re going to get another round of QE, and if the Fed is going to introduce yield curve control as a new policy tool — any backup in long-term interest rates is likely to be muted. Because the market will be expecting it. It will be an opportunity to add duration to the portfolios.
Jack — I talked as fast as I could. Hopefully people think they understood me. That means they probably missed what I was saying.
But Jack, do we have any time for questions?
Jack: Yes, I was actually going to see if it’s possible. Obviously there are lots of concerns heading out into 2020.
I think to your point, you’ve called it. I think you said there’s somewhat of an Indian Summer that can happen, given that the Fed has gone on pause. We’ve seen some of that happen as you pointed out in your slides, already.
I feel that yes, one of your papers — you called it, “Jog to the Exits.” So, reflecting your up-in-quality type of thing.
I think what might be helpful, just for people to understand — given all these risks and concerns — how you’re positioning your sleeve right now, to protect against that while still seeking some opportunities.
Scott: Sure.
I’ve got to tell you something. This is where I have to fight with myself. I’ve kind of like got a dual personality.
I ran trading for Morgan Stanley and Credit Suisse. I was a bond trader for 15 years.
I always have to remind myself, “Am I a trader or am I an investor?” The difference is this —
If I’m a trader, all of these short-term moves I’ve just talked about — and I appreciate you reading our commentaries, Jack. It’s nice to know at least, now, that I have three people reading them.
The risk-off trade that we anticipated in the fourth quarter and that we set ourselves up for, performed really well. And the first quarter is going along okay.
But, a lot of people could be critical of me and say, “Hey, Scott — why didn’t you reload on risk in late December, when you were talking about the stock market bottoming and Indian Summer coming?”
The reality, I discovered in December, was the liquidity was so bad that reloading on risk could put us in a position that if we had another exogenous event or things didn’t go exactly according to the script that I think there is out there —
You could find yourself getting caught offside in a lot of bad positions.
Steve elaborated going into this, our fund is really designed to give — on average, over time — a LIBOR-plus-300 or 400 return with the lowest possible volatility.
What we’ve been doing is the same thing we’ve been doing since last year. We’ve been slowly selling our credit exposure when the market is strong.
We’ve been reducing our spread-duration to credit as time goes on. I think you can see in the chart that Steve was talking from —
I think our spread-duration is about half a year right now.
We are obviously up in credit. We’ve also — interestingly-enough —
When December came, in the middle part of December, things really —
Here. Let me just explain our strategy as one more thing.
Just like the Fed is tapering its balance sheet, we’ve been tapering our credit positions. Rather than trying to pick the day that we were at the top and fell out, we’ve been basically budgeting. We’re going to sell x-percent of our credit positions in every month.
01:15:00
That is something we’ve been something we’ve been disciplined about and been doing. When we got to December, that got so hard to do. Given my view of the world, even though we didn’t reload on credit, we suspended our tapering program.
We believe that ultimately, a lot of these spreads will continue to tighten. With a spread-duration of half a year, we’re not going to make a fortune. But it is on balance probably going to be a positive experience for us.
Once markets get back into levels that are starting to look like the November timeframe, October timeframe — we will once again start tapering.
Our goal would be that before the end of the year, we will be out of our floating-rate or most of our floating-rate ABS positions. We will be out of our non-agency mortgage positions.
We are adding to some short corporates. One-year and one-and-a-half year sort of stuff. So we can get some yield. But we’ll be fairly well-protected in the backup that we’re anticipating. You saw that in that one slide about credit spreads pre-recession.
We’ll look for the opportunity to reload.
But I always like to tell people, I’m a pretty boring guy. That’s a part of my job. I don’t want our portfolios to be terribly exciting. I want them to be boring. Things that are terribly exciting can be exciting in both directions.
We’re not here looking to trade the portfolio at every tick and change. We’re here with the concept that we advertise all the time. We’re acolytes of Danny Kahneman. Danny Kahneman would ask me, “Scott, what’s your five-year outlook?”
I’d tell him, and he’d say, “So why are you worried about trying to catch a trade for the next three or six months, when your long-term outlook is what it is. Why don’t you invest based on your long-term outlook? Be disciplined and stop worrying about the fact that you could have made an extra 50 bps for the quarter if you’d positioned yourself another way. Just be slow and boring. The tortoise will win the race.”
That’s kind of our philosophy, Jack. I hope that answers your question.
Jack: Yes. Just one more question. Just to wrap up, because we’re over our time.
Steve in the beginning mentioned that this is a flexible strategy. One of the dials that you’ll turn up and down is your exposure to credit. Obviously that dial is turned way down right now.
I think it might be helpful just to give listeners some perspective and context on how aggressive that dial can be turned up. Maybe early as 2016 is a good example of that.
Scott: Right.
The 2015/’16 experience — we bought a lot of mezzanine CLO paper.
Steve: We bought mezzanine CLO and investment-grade energy.
Scott: Energy.
Steve: Our high-yield and loan exposure got up —
If you look at the history of this strategy, our high-yield and loan exposure combined could be upwards of 2/3 of the strategy. Away from having short-corporates, build asset-swaps — we have just an overall low beta to begin with, now.
Even when we had 60% or 70% of our portfolio in below-investment-grade credit, we still had allocation to senior structured credit and other credit sectors.
We’d say on a scale of —
If zero to 10, we’re 3 right now on credit exposure —
Scott: Yes. I’m not even sure — 2?
Steve: And Jack, to your point, in 2016, the rep [representative] account or even our mutual fund GIO was up over 10%. We had that increased exposure in late ’15 when spreads were widening. Importantly, we thought we were much earlier in the business cycle. The risk/return skew was much more favorable to increase that credit exposure than it is now.
To Scott’s point, we really want to minimize any potential drawdown, or avoid it. Then be able to add back all the credit exposure to the same degree that we have in the past.
01:20:00
Scott: And you know, Jack, we’re going to wade into it. Nobody picks the tops and the bottoms. I would say if we had to go back and look at that ’15/’16 experience, we were probably a 7 on our scale. Will we go to 10? Yes.
In the financial crisis, we were a 10. But we’re not Spinal Tap. We don’t go to 11.
Jack: Okay. Guys, thank you so much. I just want to be conscious of the listeners’ time. We’ll wrap up here.
Thank you so much again. Appreciate all the comments, Steve and Scott. I’m going to turn it back to our Scott to close things out.
SJ: Thank you, Jack. Thanks to everyone for taking time out of your day to join us on this webinar. I would like to thank the team from Guggenheim Partners, Scott Minerd and Steve Brown, for their time.
I also want to thank the research team at Litman Gregory — Jeremy DeGroot, Rajat Jain, Jack Chee and Jason Steuerwalt, as well. We appreciate your interest in our funds, both the newly-launched High Income Alternatives Fund, the Alternative Strategies Fund, as well as the International Fund.
I would mention that if you had interest in the High Income Alternatives Fund, our research team has put together a great piece. A research background report on the fund and its strategies.
If you’d like to learn more about any of our funds, please reach out to us at Litman Gregory. And visit our website, www.MastersFunds.com.
Thanks, everyone. Have a great day.
01:21:34
[session ends]