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Podcast Series
GREATER POSSIBILITIES
Join us for candid conversations with portfolio managers, market strategists,
economists, political experts and more, about the possibilities they see ahead.
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LISTEN TO THE LATEST
QUICK TAKE: THE DEBT CEILING DEBATE
As the X-date looms, we talk to Invesco’s Head of US Government Affairs Jen
Flitton about the debt ceiling debate: How did we get here, what comes next, and
why has this process become so difficult?
00:00
00:00
24:58
Listen25 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to Greater Possibilities Podcast from Invesco, where we put concerns
into context and opportunities into focus. I'm Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. We're talking about the debt ceiling today. Jen Flitton
is here. Yes, I know. Favorite topic, right? So Jen is Invesco's Head of US
Government Affairs, and she's going to shed some light on the negotiations
happening in DC and let us know where she thinks this is all heading. And since
she's here, we'll also ask for her thoughts on the national political mood and
how things might be shaping up for 2024. I know you always like to get a sneak
peek into that, Brian.
Brian Levitt:
Feels too soon.
Jodi Phillips:
It feels a little too soon. But in any case, are you ready for another debt
ceiling crisis?
Brian Levitt:
I'm ready for it. I feel like I may already be living it, although hopefully
we're getting some slightly positive news here. Jodi, life is strange when
you're constantly refreshing your screen to see how high the one-month US
Treasury yield is going. That's where I am in life right now.
Jodi Phillips:
No, I hear you. If you don't know if you'll be paid the income on it, makes
sense to keep an eye on it. So, look, with that question Brian, what are you
saying to investors who have that same question?
Brian Levitt:
I'm trying to be optimistic. Look, we've done this 86 times since John Kennedy
was president. We usually do it without incident, usually a mere formality. And
so I think we'll raise the debt ceiling. I keep coming back to that line about
what Churchill was said to have said about Americans.
Jodi Phillips:
We always do the right thing, but only after exhausting all other options. I
think I've heard you say that in a podcast or 10.
Brian Levitt:
Exactly. I probably need some new material here, but we keep-
Jodi Phillips:
No, stick with the classics.
Brian Levitt:
We keep repeating over and over, so I keep coming back to it. But another
favorite of mine is that market volatility doesn't emerge out of nowhere, it's
always the result of policy uncertainty. And so that's what we're looking at
here, perhaps.
Jodi Phillips:
Well, we are, but it's a little ironic. Just when we get maybe some clarity or
close to clarity on monetary policy, now we get uncertainty about fiscal policy.
Brian Levitt:
And hopefully short-lived. And the good news is we do have a historical parallel
to consider. If you remember 2011, you had a very short-lived risk-off trade.
And I still think it's ironic — Treasuries rallied. Something's going to
potentially default, let's buy the thing that's going to potentially default. So
Treasuries rallied and ultimately, it created a buying opportunity for investors
in the early stages of a new cycle.
Jodi Phillips:
Very good. Well, on that note, let's bring in Jen to help explain what's going
on in the here and now. Welcome, Jen.
Brian Levitt:
Hey, Jen.
Jennifer Flitton:
Hi guys.
Brian Levitt:
Hey Jen, why do we still do this when this is happening?
Jennifer Flitton:
Well, it depends if you're a Republican or a Democrat, what your answer would be
to that.
Brian Levitt:
Well, I'm not allowed to answer that question. I'm everything to everyone.
Jodi Phillips:
What about both sides? Let's get both sides.
Jennifer Flitton:
You're right. From the Democratic perspective, they would love to push this off.
In fact, some say if they had their way, if they were able to get rid of the
filibuster or had the reconciliation process back, they would extend debt
ceiling forever, get rid of this congressional authorization of debt ceiling
raising. From the Republican perspective, we have a $31.4 trillion debt. So
we're looking at austerity arguments from the right for a while now, and I think
that this will be used consistently as leverage going forward.
Brian Levitt:
Jodi, I had read that if you take 31.4 trillion dollar bills and stack them, you
would get to the planet Uranus.
Jodi Phillips:
Well, that's some trivia that you're not going to find on any other podcast. So
Jen, let's talk about the calendar a little bit. Personally, I was surprised
when Janet Yellen came out and said June 1st was looking like the X date. I
thought with incoming tax receipts, the Treasury had extraordinary measures, I
was under the impression that they could buy some time until the fall. So what's
behind June 1st, and can we still extend that a little bit?
Jennifer Flitton:
Well, yes, and she did give a caveat when she said June 1st is the X date. She
did hedge herself a bit stating that it could be a few weeks, a few days from
June 1st. So the real magic number would be June 15th, because if they could get
to June 15th, the quarterly tax receipts, then you could extend it probably till
the end of July. But it's just not clear. She's going to make another
announcement next week.
Brian Levitt:
But we were originally saying September, October, November, right?
Jennifer Flitton:
Well, we always said it could be as early as June. Treasury did warn us.
Brian Levitt:
Maybe I was saying September, October, November.
Jodi Phillips:
Maybe that's why I was so surprised, Brian. I know where I got that from.
Brian Levitt:
I just make it up and sound confident.
Jennifer Flitton:
And we saw on the horizon from some of the analysts, whether it was Goldman or
JP, I can't remember, but they were saying some of the tax receipts coming in
after April were looking like maybe cap gains were a little too low and that
that could affect this X date, and it may have.
Brian Levitt:
What is an extraordinary measure?
Jennifer Flitton:
Basically, once the Treasury Secretary gets to a certain point, she has to
extend into extraordinary measures. And because we spend a lot more than we
bring in, that usually is in the first quarter of the year where we start to
acknowledge the fact that tax receipts and payments aren't going to match up.
Brian Levitt:
And so what does that mean? We're not going to invest money in government
pension funds? Are there things that we do that let us push this out a little
bit?
Jennifer Flitton:
It's a little gimmickry in the way that Treasury accounts for things, without
getting too technical, that allows for them to extend their budget.
Brian Levitt:
And so what do the Republicans want? I obviously used the word austerity, and I
remember in 2011 when we went to the brink, correct me if I'm wrong, the Obama
administration ultimately conceded to $2- to $3 trillion in spending cuts over a
decade. Seemed like some pretty large numbers. Are we talking something similar
here?
Jennifer Flitton:
Well, where the Republican stand is on the bill that they were able to pass last
month, which was April. And now Democrats are coming to the table and coming up
with a different negotiating position. That's what we're seeing. But included in
that original House bill, I think it was a cap to 2022 spending and it extended
only a 1% increase in discretionary spending until 2033. So that's a 10-year
move. That's not going to be acceptable to the White House. So reports are
they're coming back with a 2023 cap, but only for two years. I think they'll
probably land somewhere in the middle, but closer to the White House's position.
But you're right, this is very similar to 2011, and that's what brought on the
sequester. And that really comes out through the appropriations process. Because
it's a promise into appropriations, how they're going to spend the framework.
Jodi Phillips:
Sequester. That word takes me back a little bit.
Brian Levitt:
Remind me of the sequester. What did that mean?
Jennifer Flitton:
It was a little bit of budget gimmickry, because what ended up happening was a
promise of decreased spending, and then the constituencies of federal government
spending came in around the appropriations process and they were able to kick
some of that sequestration down and basically out of actually happening through
the appropriations process. So this is the easy part. You're just setting a
framework with these budget caps. Actually doing that comes later, during the
appropriations process.
Brian Levitt:
I have a really dumb question, Jodi.
Jodi Phillips:
Go for it.
Brian Levitt:
So let a little bit more than 10 years ago, so this was Obama in 2011, they
agreed to the spending cuts over a decade, and yet we just saw $6 trillion of
spending in 2020 and 2022 for COVID. So most of that's within the 10-year
period. So did we accomplish anything the last time we did this?
Jennifer Flitton:
Well some of the sequestration happened, but a lot of it that was difficult to
do didn't happen because there were... Especially when it came to some physician
payments, and I was on the Hill at the time, I remember just the health care
community coming down and being really concerned with some of the cuts and how
that would affect patients and hospitals, et cetera. So some of it happened,
some of it didn't. I think what you're looking at with the COVID payments, that
was outside of the ordinary budget. It was emergency appropriation money. And so
a lot of that is still sitting at Treasury. It's sitting in the coffers of the
states. But a lot of it's still sitting at Treasury and that's why it's on the
table for this negotiation.
Jodi Phillips:
So looking at the math and the makeup of Congress right now, how many
Republicans would need to break party line to raise the debt ceiling? What does
that look like? How does that shake out for getting this done?
Jennifer Flitton:
So McCarthy needs a majority of the majority. So he needs at least 120 members,
somewhere around there, to vote for whatever he negotiates with the White House.
So keep in mind, this last meeting that was announced on Wednesday, or was it
Tuesday when they met. They decided that it would just be McCarthy and his team.
So Garrett Graves, who is McCarthy's right hand man. McCarthy's team and the
Biden team. So Steve Richetti, who has been a longtime advisor, and Shalanda
Young, who is the OMB Director, the Office of Management and Budget, and she
used to be the staff director of appropriations. She's well liked, she's well
respected on both sides of the aisle. So now with these brains in at the table
and only them... Because before it was too big, there were too many people at
the table. They've really narrowed it down. And so they're negotiating right now
and McCarthy is socializing it with a few folks and getting his top people, his
top members of Congress, together. They had a table session yesterday to get
ready to socialize to a larger segment of the conference.
Brian Levitt:
Jen, what I think in some ways Jodi was getting at there is the last time we did
this in 2011, the Democrats had just gotten shellacked in the midterms and I
purposely use the word shellac. That was Barack Obama's word, that was not my
personal word. Now this time, there was an expectation of a red wave that didn't
materialize to the extent that some expected it to. So can I have any confidence
in the fact that the Democrats had to figure out how to get 50 or 60 Republicans
on board for this in 2011, versus today they need to get five or six. Can that
make me more hopeful or is that just being too Pollyanna?
Jennifer Flitton:
Well, I think Democrats, you mean in the House?
Brian Levitt:
Yeah.
Jennifer Flitton:
Hakeem Jeffries, who is the minority leader, the leader of the Democratic Party,
he's going to have to bring a number of folks to the table, for the voting
actually.
Brian Levitt:
So it's going to be hard to get all of his because of the cuts that are being
made. So if Biden plays hardball and they can get all of the Dems, are there
five Republicans or no?
Jennifer Flitton:
Oh no, you mean in a discharge petition. Because they have a discharge petition
that they put out. But you don't have five or six Republicans who are going to
undercut…
Brian Levitt:
They're not going to do it.
Jennifer Flitton:
... right now. No, that's not going to happen.
Brian Levitt:
So even though you needed 50 in 2011 and today you need five or six, it still
doesn't matter.
Jennifer Flitton:
Yeah, no. It would be like voting for Hakeem Jeffries as speaker. You're just
never going to get this vibe.
Brian Levitt:
It's the end of your political career if you do that.
Jennifer Flitton:
What's going to happen is McCarthy and Biden are going to come to some sort of
agreement, and then McCarthy has to go back and sell it to his people. His very
right are not going to vote for it. But can you shave off a few of them? Can you
get a few of those Freedom Caucus members? And to give cover for others who are
going to get hit from their right, that it's not enough. And then you have
Jeffries who is going to have to make sure that his moderates and his
establishment Democrats are voting for it as well, even though the progressives
are going to rail against maybe some of the work requirements that might be
included in it. And so they have to be concerned about each of their right and
left for length.
Brian Levitt:
I'm singing Schoolhouse Rock in my head right now.
Jodi Phillips:
Just a bill.
Brian Levitt:
Just a bill.
Jodi Phillips:
So what about other methods of getting around this? There's a lot of talk about
the 14th amendment, the validity of the public debt shall not be questioned.
Does that give cover to just forget about the debt ceiling?
Jennifer Flitton:
Yeah, it would be a constitutional crisis. And so you've seen Secretary Treasury
Yellen, pretty much outright rejected. Now, I think there are others within the
White House who may be a little more open minded to that or to minting a
trillion dollar coin or something. But ultimately that would go into the court
system, it would be litigated, and it could really be devastating as far as the
process.
Jodi Phillips:
Brian, the trillion dollar coin, I know that was your preferred method of fixing
this, right?
Brian Levitt:
Yeah, I was very excited about that. We mint a coin and we make it available to
ourselves. Oh yeah. Well, it doesn't sound like we're going to be minting that
trillion dollar coin. So Jen, we don't mint the coin, unfortunately. What would
it look like if we breach it? I know Jodi and I had joked up front about the
one-month T-Bill. People don't want to invest there because they don't know if
they're going to be generating any income in that particular month. Is it just
the thing, if you own it, you're going to get paid back at some point, you just
may have lost income? What does it mean to default on this?
Jennifer Flitton:
And what is a technical default and how can Treasury prioritize payments in
order to pay the debt first? And I think that's really the larger question.
Brian Levitt:
Can we do that? Shut down a national park and keep paying the debt?
Jennifer Flitton:
I don't think we're going to save too much there, but we could potentially.
Brian Levitt:
Don't pay the prosecutors? What are we doing?
Jennifer Flitton:
Think of infrastructure or military infrastructure where 13% of our budget goes.
Defense projects, et cetera.
Brian Levitt:
So it's not rangers at the park.
Jennifer Flitton:
That's not really our money maker. That could happen in some sort of
prioritization. So you get the Social Security checks, you get the veterans
checks, and you get the debt paid for. And really think about it this way, say
June 1st is the true X date. You have two weeks you really need to account for
in the prioritization. Now, what would actually happen to the credit rating in
the United States if we get past the X date? That's a much larger question. What
do the markets do? But technically, we know the New York Fed's been running
tabletop exercises on this sort of thing happening for the last decade. So there
is a way to buy time, at least it's been suggested in reports, that there is a
way to write buy time through prioritization.
Brian Levitt:
And thus far, the markets have been pretty sanguine about this, at least it
seems
Jennifer Flitton:
It seems, right?
Brian Levitt:
It seems. We haven't had a big drawdown, little range bound on broader markets,
S&P 500 type of thing, but nothing extreme. So the most likely outcome, Jen, you
still believe that we get past this without significant incident?
Jennifer Flitton:
I think we either go right up to the X date with some deal, or maybe just go a
little bit past it. And I think the framework of the deal is going to be budget
caps of some sort. It's going to be COVID funding rescissions, it's going to be
energy permitting reform, and some degree of work requirements around TANF,
definitely not Medicaid, possibly around food stamps, the SNAP program.
Jodi Phillips:
So Jen, while we have you here, let's talk about legislation. Are there any big
topics that investors in particular need to be focused on?
Jennifer Flitton:
Well, again, going back to this legislation, this is probably one of the biggest
that we're going to see happen. And then the next big move will have to be
appropriations. Then we can get back on this podcast and talk about a potential
government shutdown.
Brian Levitt:
Wait, will the national parks be open?
Jennifer Flitton:
Now that actually might close the national parks. But so that you give some
runway then to the appropriations process can really begin, because they've had
a hard time doing budget resolutions on either side of either chamber because
this looming debt ceiling is so large and it's just sucked all the oxygen out of
the room and taken a lot of the folks who are needing to draft on appropriations
into this negotiation.
Brian Levitt:
So Jen, given that this is the Greater Possibilities Podcast and we give the
public, we give the people what they want, we're going to ask about 2024. I'm
not even ready to start thinking or talking about 2024, but the people want to
know what you're thinking. Are we running it back again? The fans want to know,
are we running it back again? Is it Biden v. Trump? Who's going to win?
Jennifer Flitton:
Right now, Biden has said he is running and he's the president of the United
States, and Bobby Kennedy Jr. is what? Running at 20%. Although that is rather
high in some-
Brian Levitt:
Is he at 20%?
Jennifer Flitton:
He's 19%, 20% on some polls.
Brian Levitt:
Wow. Talk about name recognition, huh?
Jennifer Flitton:
Well look, President Biden obviously has some issues in his favorability, and
the fact that Kennedy is running against him, and I think Marianne Williamson
threw her hat back in the ring too, although I don't think she's polling. That's
going to cause a bit of a headache for the Democrats, because that's a little
too high in the polling. And we'll see if that's adjusted as we get closer to
the general. But in the primary for Republicans, you have a lot of folks
throwing in their ring.
There are going to be a number of people around the Memorial Day period that are
going to formalize their run, like Tim Scott's expected to announce, for
example, on the 22nd on Monday in Charleston. He just launched his exploratory
committee. Some of these guys have just launched exploratory committees and are
now going to officially get in the race. But of those currently in the race, you
have Nikki Haley and Asa Hutchinson, and DeSantis has not announced yet, but he
will. And it's going to be a very wide field. You're going to start to see the
debates then around the August, September period for Republicans, and that's
really going to feel like the kickoff for the American people who aren't paying
attention quite yet.
Brian Levitt:
The big stage with a lot of podiums again.
Jennifer Flitton:
Exactly.
Brian Levitt:
And that probably favors the former president?
Jennifer Flitton:
I think the more Republicans in the primary, the better for former President
Trump. How many stay in, I think is the larger question.
Brian Levitt:
And does it feel like a change election, 2024, or too soon to say?
Jennifer Flitton:
Too soon to say. I think we have to allow the process to play out a little bit
to see where these numbers start to fall.
Brian Levitt:
And you had made an interesting point about where Hillary Clinton was polling in
the 2008 primary before, just to put a finer point on how early it is.
Jennifer Flitton:
That young first-term-
Brian Levitt:
Junior senator.
Jennifer Flitton:
... Democratic junior senator from Illinois, Barack Obama, had the gall to go up
against Senator Hillary Clinton. And she was polling much higher than he was.
And I think that's why you have to take some of this and step back and realize
that we're going to have... Americans really just aren't paying attention yet.
Jodi Phillips:
All right. Well, what I'm getting, the theme of this podcast is let the process
run its course, whether it's the debt ceiling or elections. So Brian, are you
feeling any better than you were at the top of the show about that process?
Brian Levitt:
Yeah, I feel good. Yes, I'm one of those people who believes in the Churchill
line. Ultimately, we will do the right thing, we will get past this, and we'll
be back to focusing on what's most important for investors, which is where are
we with regards to monetary policy? Is a new cycle starting to play out? And I'm
looking forward to getting back to that focus, but I'm thrilled that we were
able to have Jen here as we're dealing with these current challenges.
Jodi Phillips:
Yes, thank you for joining us, and hopefully we won't have to have you back to
talk about a shutdown, but would love to talk about anything else that's going
on. So thank you.
Jennifer Flitton:
Thanks.
Brian Levitt:
Bye Jen. Thank you.
Important information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of May 18, 2023, and are subject to change without notice. These
opinions may differ from those of other Invesco investment professionals.
Invesco is not affiliated with any of the companies or individuals mentioned
herein.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
Number of debt ceiling increases from the US Treasury as of December 31, 2022.
Information about Treasuries rallying in 2011 is from Bloomberg. US Treasuries
rose 6.7% from July 2011 to September 2011.
All data provided by Invesco unless otherwise noted.
TANF stands for Temporary Assistance for Needy Families.
SNAP stands for Supplemental Nutrition Assistance Program.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
WHAT'S NEXT FOR THE COMMERCIAL REAL ESTATE MARKET?
After the recent issues at regional banks, concerns about commercial real estate
have grown. Is this market “the next shoe to drop”? The headwinds have been
well-publicized, but challenges create opportunities. Invesco Real Estate’s Bert
Crouch joined the podcast to discuss the shorter-term and longer-term
opportunities he sees in the market.
00:00
00:00
32:36
Listen33 min
Show transcript
TRANSCRIPT
Brian Levitt:
I’m Brian Levitt. Before we launch into our latest conversation about commercial
real estate, I wanted to note that this conversation took place shortly before
the failure of First Republic Bank as well as before some of the other
challenges that have emerged within the regional banking system. So as we talk
about the lending landscape, you’re not going to hear their name mentioned. But
that’s OK. What’s most important about this conversation are the long-term
opportunities that our real estate experts see ahead. And that’s just as true
today as it was when we first recorded this in mid-April. Enjoy the podcast.
INTRO MUSIC
Brian Levitt:
Welcome to the Greater Possibilities Podcast, where we put concerns into context
and opportunities into focus. I'm your host, Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. Bert Crouch is on the show today. Bert is head of North
America and a portfolio manager with Invesco Real Estate. We're getting a lot of
questions, Brian, about commercial real estate. So Bert will be addressing those
and discussing why he believes some of these concerns may create opportunities.
Brian Levitt:
Ooh, very on par with the branding of the podcast, right?
Jodi Phillips:
I listen. Yeah.
Brian Levitt:
Would you say that we're going to put concerns into context and opportunities
into focus?
Jodi Phillips:
I would. I would say that for sure. But hey, before we get to Bert, I do want to
add that I did enjoy your conversation last time about Silicon Valley Bank with
Justin Livengood. I got to experience that as a listener instead of a host this
time. Terrible timing for my kids' spring break to coincide with such big news.
Brian Levitt:
It's funny you said that. I was talking to Bert a few minutes before starting
this and he said the exact same thing. It's got to be Murphy's Law for both of
you. You finally get away a little bit and we get this little financial crisis
that we have to deal with.
Jodi Phillips:
A “little crisis.”
Brian Levitt:
A little crisis.
Jodi Phillips:
Yeah. That sounds like an oxymoron, Brian, like “organized chaos.”
Brian Levitt:
What's your favorite oxymoron? I'm going to go with, maybe I'm going to go with
“accurate estimate.”
Jodi Phillips:
I like that one. I mean, look, “jumbo shrimp” is a classic menu-oriented
oxymoron.
Brian Levitt:
“Awfully good.”
Jodi Phillips:
Awfully good. I like that one, too.
Brian Levitt:
Awfully good.
Jodi Phillips:
All right. But little crisis is where we're at.
Brian Levitt:
Little crisis. Yeah. I mean, it might sound like an oxymoron, but it's accurate
and it could have become a bigger crisis had we not seen policymakers respond
quickly. So we learned in fairly short order that depositors will be protected,
the Fed opened the discount window widely to any bank that needed emergency
liquidity. And I would say it also hasn't hurt that the bond market at least
primarily has rallied recently.
Jodi Phillips:
Yeah, not at all. No. It does feel like things have calmed down. And as you were
telling me before, the deposit flight from the small banks seems to have ended.
Brian Levitt:
Yeah, it looks like deposits have bottomed, they're climbing again. So that's a
good sign. Maybe it's a little bit of confirmation bias on my part, but that
feels like a good sign. And I don't know. I mean, probably a lot of that's just
from you, Jodi, right? You got your bonus in February and you put it in a small
bank, and that's why deposits are up so much?
Jodi Phillips:
“Podcast bonus.” Yeah. Is that one for the oxymoron list? Oh, nevermind.
Nevermind.
Brian Levitt:
We need a few million more listeners.
Jodi Phillips:
So look, now everyone is focused on what's next and how does commercial real
estate fit in. So we've all seen the headlines. Some say commercial real estate
may be the next shoe to drop from this little crisis.
Brian Levitt:
And I don't think we can disentangle the interest rate environment, the
challenges at regional banks, the challenges for the economy from the real
estate market. Obviously, it's all connected.
Jodi Phillips:
And that's why Bert's here. So let's bring him on to address the current
environment and how he's navigating it. Plus we'll ask about the structural
themes that he believes are intact and likely to offer opportunities to
investors.
Brian Levitt:
Bert, welcome to the show.
Bert Crouch:
Yeah, thanks for having me, guys. Appreciate it. And I've got to go with
“cautiously optimistic.”
Brian Levitt:
Ooh, I like that one.
Jodi Phillips:
Ooh, nice, nice.
Bert Crouch:
That's a real estate oxymoron, if you'll work with me there.
Brian Levitt:
And you hear it a lot, right?
Bert Crouch:
All the time.
Brian Levitt:
Cautiously optimistic. Just me, that's like Harry Truman's one-handed economist,
right?
Bert Crouch:
Well played. Yes, exactly.
Brian Levitt:
So, first condolences on Spring break. My apologies that you didn't get as much
time off as you probably deserved.
Bert Crouch:
It's all good. I think my kids were thrilled.
Brian Levitt:
Your kids were thrilled that you were working and they were-
Bert Crouch:
Correct.
Brian Levitt:
... were enjoying some leisure time?
Bert Crouch:
That's right. That's right.
Brian Levitt:
Good, good. It's hard to open a newspaper, I don't know, do people still open
newspapers? Or maybe swipe on the phone now without finding warnings about
commercial real estate, which is probably why you were working on spring break.
So I'm just going to tick off a couple of these things that I think investors
are hearing, and maybe we can take them one by one. So, just a couple of
problems I'm hearing: the challenges in the regional banks, this whole work from
home phenomenon, retail at a crossroads, higher rates, a wall of maturity on
commercial real estate loans.
So let's start with the regional banks. Why was Silicon Valley banks such an
issue and why did you have to work on Spring Break as a result of it?
Bert Crouch:
Yeah, it is a good question, and that was a tough intro. I think I need a
cocktail for this morning.
Brian Levitt:
There'll be cocktails. There'll be cocktails.
Bert Crouch:
For the morning podcast.
Brian Levitt:
It's coming.
Bert Crouch:
But joking aside, I do get a lot of questions on SVB, Silicon Valley Bank, and
why was it so relevant to commercial real estate? When you look at their balance
sheet, it was irrelevant. I mean, it was of their total loan books sub 4%, total
assets, sub 2%. So why did it matter? And it mattered for a couple of reasons. I
think most importantly, liquidity was already at a premium in commercial real
estate. When you think about just year over year, it's Tale of Two Cities, and
you touched on a lot of the aspects out of the gate. But I mean, a year ago, Fed
funds was essentially zero.
Brian Levitt:
Zero, yeah.
Bert Crouch:
SOFR, Secured Overnight Funding Rate was essentially zero. So you could borrow
in commercial real estate at 2%. You had capital markets were humming,
Commercial Mortgage Backed Securities, CMBS, CLOs, Collateralized Loan
Obligations wide open.
So you had capital flowing excess M2 coming off the stimulus out of COVID, and
the regional banks were playing a huge role in that. So when you think about
banks, generally, I like to break it up a little bit simpler because we debate
regional and super-regional, money center, bulge bracket. Think about it this
way, just on assets, zero to $10 billion, small. $10 billion to $250 billion,
the mid-size. And then $250 billion up, whatever you want to call it, bulge
bracket. And then you've got the G-SIBs, the Systemically Important Banks at the
top tier.
When you think about the regional, let's call it the mid-size, so $10 billion to
$250 billion. Why SVB mattered is because Signature failed right after. And
Signature failed on a Sunday and Signature was very much overweight commercial
real estate, especially here in the New York City metro area. And it created a
couple of things. It changed the mindset of bankers generally, which was one of
the last bastions of liquidity. If you look at CMBS already being down really to
a two-decade low in the first quarter.
Brian Levitt:
And that's because of the interest rate move?
Bert Crouch:
Interest rate move, but also just broader capital markets dislocation. I mean
it's down over 80%. Basically nothing got securitized. And we can hit on that
again later to the extent of interest. But going back to the regional banks,
last year, so 2022, they were over 40% of market share. They've grown — their
total loan book has grown over the last decade from just under 20% to just under
30%. They did, I think it was $1.3 trillion of origination last year. So they
have been loading up on commercial real estate because they've had excess
deposits and the excess deposits, excess liquidity coming out of the Fed
stimulus, M2's gone through the roof, where to house it? Back to SVB. Why is
that relevant? Social media and technology. We saw a bank run in 24 hours. $42
billion on Thursday, a hundred billion teed up for Friday, and then Signature is
failing on a Sunday?
Brian Levitt:
And nobody even had to line up.
Bert Crouch:
No one. I mean, it happened so quickly. It has forced "bankers", their credit
teams, to reassess how sticky really are deposits. And you mentioned, they've
stabilized a little bit, but some headlines this morning, whether it was M&T or
State Street, I mean just everyone is focused on deposits and are they sticky?
The better question is, will you now lend them out at the same velocity that you
would before if they can be pulled back so quickly?
Now go to your interest rate comment. What was SVB's issue? They had
hold-to-maturity assets in fixed income, and when they had to liquidate those to
stem the deposit withdrawal, you realize they weren't worth what they showed.
Why? Because of simple convexity, right? It's Finance 101.
Brian Levitt:
Convexity?
Bert Crouch:
Right? This is me-
Brian Levitt:
That's like Finance 401, isn't it?
Bert Crouch:
This is me trying to act intelligent. I'm just a dumb real estate guy at the end
of the day, you and I both know it. Let's just be honest. But when you look at
that, it exposed it. So it changed, it furthered... If you think about inflation
and what happened in the wildly unfortunate situation with Ukraine, it really
just exaggerated a trend that was already moving forward. And I'd argue somewhat
similarly here, an exogenous circumstance like SVB and then ultimately Signature
took a dislocation just to the next level.
Brian Levitt:
So Jodi, are we going to need a “It's a Wonderful Life” for the new digital
environment that we went through? I could already start casting it in my mind.
Jodi Phillips:
Well, while you do that, I'm going to ask Bert, as we mentioned in the intro, of
course, some say commercial real estate's the next shoe to drop from all of this
banking turmoil and banking crisis. So how would you respond to that statement?
Bert Crouch:
Yeah, again, Brian kind of hit on it out of the gate. A lot of sensationalist
headlines right now we've got to be careful about. So the next shoe to drop,
euphemisms aside, I mean there's clearly some headwinds there. You read about
the wall of maturities, $900 billion maturing over the next two years. Good news
is relative to the global financial crisis, leverage is lower. It was more
prudently done. So if you look at the fixed rate universe and CMBS, Commercial
Mortgage Backed Securities, loan-to-values — global financial crisis started in
the mid to high sixties. Now they're sub 60, at least going in. Debt service
coverage ratios were higher. Now, base rates were lower, and that's changing
now, but your starting point is better. Leverage was less utilized, it was more
prudent, and CMBS is a smaller part of it. So I think that's the positive news.
The negative news is all the things, again, Brian, you just touched on, and Jodi
you as well, you got SOFR at almost 5%. You got spreads up. So if you financed
an apartment asset a year ago that was going to be done at low two percents,
that's now somewhere high sixes to maybe as high as 8%. So you've seen that fly
up. And what does that mean? Even for good assets, there could be challenges on
the refinance front. Does that mean widespread distress post Lehman? I'd argue
no. But does it mean that we're facing some real headwinds from a, if you go
back to the comments we were just making, regional banks are going to want to
decrease exposure to commercial real estate.
The regulators are all over them. You read about it over the last week and a
half, Dodd-Frank rollbacks, they want to refocus on the sub $250 billion asset
banks. Uncertainty around is there a recession coming or not? I don't know. But
a chief credit officer is worried about that. They're pulling back, CMBS
nonexistent, rates up. It just creates a tricky picture that candidly, Jodi, we
feel like is going to create some real opportunity.
Brian Levitt:
Bert, let's take a giant step back for a second and talk about the mechanics of
this. So the regional banks are lending money over a set period of time at a
certain interest rate to who? And what's coming due for them and at what rate
versus where they were not so long ago?
Bert Crouch:
Yeah, good question. So when you think about regional banks, usually they're
floating rate. So your life insurance and commercial mortgage-backed securities
are going to be your five- to 10-year fixed rate. Your regional, and really all
banks mid-size, large to small are going to be usually three-year initial term,
two-year, one-year extension options, all floating rate. Why that matters is
most of them required you to buy some sort of interest rate hedge. Layperson's
terms, what does that mean? It means the interest rate could only go up so high
before your hedge kicked into place. In large part, that's the case now. Think
about what the Fed's done. They've taken rates up almost 500 basis points in
around 12 months. That is twice the average on a monthly basis. So the last nine
rate hike cycles, it's been sub 20 basis points a month. This is 40. People have
to put that in context. It's not just the absolute amount, it's the time in
which they've done it.
Punchline for real estate and your question, when those hedges expire, suddenly
they're exposed to significantly higher debt service costs. And that creates
that decision point. Do I continue to feed this asset? What does it look like on
a refinance? How much capital do I have to inject to right size that loan? And
that's going to create that stress in the system. And again, as I just alluded
to Jodi, we think some real opportunity here.
Jodi Phillips:
All right, Brian, so do we pivot to the putting opportunities into focus section
of the podcast?
Brian Levitt:
Yeah, I mean, why do we want to focus on the negative for so long? I mean we've
laid it out. Bert understands it. He's got his hand on the tiller of this
portfolio, and let's think about how we take advantage-
Jodi Phillips:
All right. Yes.
Brian Levitt:
... of all this negative sentiment in the asset class.
Jodi Phillips:
All right, let's go then. So, Bert, are there any dislocations emerging that
you're viewing as opportunities at the moment?
Bert Crouch:
Yeah, of course. So, in the old Winston Churchill, “you never want to waste a
good crisis.” And that's kind of how we're viewing this. You don't want to
exploit the market. You want to take advantage of it. And so our job as a global
real estate investment manager, people ask us all about what differentiates
Invesco Real Estate and how does that translate to opportunity today? 21
offices, 16 countries, truly global. We play across a risk-return spectrum: core
equity to high-returning equity, and then across the capital structure, equity
to credit, and then also listed real assets to private. And so today you've got
to play all aspects of that, and that's the key.
So you asked me about the banks earlier? I referenced the wall of maturities
that you read a lot about, banks, specifically $550 billion over the next two
years-ish. There's going to need to be gap financing that's going to need to be
injected there.
So we've been pivoting a lot of our strategies where historically we'd say, why
wouldn't we buy that asset? Today, the question is why wouldn't we lend on it?
It's just a better inherent opportunity. So if you're a seller and you don't
like today's pricing, so the cap rate on an industrial asset, well leased, you
like, has gone up a hundred plus basis points. So values down 15% to 20%. You
say, "I'm not a seller, but I've got to pay down my loan to extend or
refinance." We're a great preferred equity investor there.
And you answer the question that everybody wants to ask, where are values today?
You say, "I don't care because I've got a significant cushion to the last dollar
value here and my return is more current than upside." The other way to play
that is just be a lender. That's what we've done. We've originated over $4
billion annually the last two years, just filling the void, whether it's CMBS or
now going to be the regional banks.
So what we're really leaning into today in the private side is some aspect of
credit. We expect there to be consolidation in the banking industry. You're
already starting to see that on the regional banks. We expect to see more of it,
and/or they're going to start to move some of these scratch-and-dent legacy
portfolios to take — if the regional bank has, whatever, 20% to 30% of their
asset base, and they probably want to take that down, whether it's five points
or cut it in half, they're going to want to move some of the best product. We
can be a great buyer of that on a moderately levered basis. So you can kind of
play the credit dislocation three or four different ways.
Brian Levitt:
Now, are there parts of the market that you're looking to avoid versus parts of
the market that you're diving into when you hear about things like work from
home, or retail at a crossroads, or demographics, people are going to need
different types of living facilities. Are you leaning into and out of some of
those different structural stories that are taking place?
Bert Crouch:
Yeah, absolutely. So when you think about commercial real estate at UC, it was
kind of the big four. Think about the old accounting. It was office, industrial,
multi and retail, and now it's not. We've redefined our index to really have
nine different sectors.
Brian Levitt:
Nine? Nine times.
Bert Crouch:
So, if you think about it-
Nine times, I'd say it's a great... Oh, we named our dog. We got a dog in the
middle of Covid, named him Ferris.
Brian Levitt:
Love it.
Bert Crouch:
But back on point. So when we think about the different sectors, instead of
looking at it as apartments, we call it residential. Single family rental is an
area that we're leaning into hard. If you think about today, affordability
prices are still high, but mortgage rates are an all-time high. We've seen new
supply pull back and the regional mom and pop investor that needed that
accretive leverage to invest is gone. So competition, down; market opportunity,
better; and pricing more attractive. So we're seeing some entry points like that
where we're leaning in more.
I'd say there's also an inelastic story, so take medical office, some of your
questions. Life science, the 75 and over demographic is expected to increase
almost 50% in the next 10 years. That's huge. We want to take advantage of that.
That demand driver, again, whether it's life science on the R&D (research and
development) side, or whether it's MOB (medical office buildings) around a
hospital, that has been shockingly resilient, very attractive, and very
financeable. Flip it on the other side, to answer your question. Retail is
misunderstood. Neighborhood and community retail today, vacancy is sub 7%.
Brian Levitt:
It is?
Bert Crouch:
Yeah. It's better than it was pre-COVID.
Brian Levitt:
Is that right?
Bert Crouch:
Yeah. Why? Because new supply didn't hit. It's been pulled back. Footprints have
been right-sized. Now there's still some struggles in power centers at times,
but on the whole, it's better than it was. Regional malls, a little bit of a
different story. But if you look at, just take apartments and regional malls in
the public universe, multi-family's down, call it 30% just because it got so
highly valued where regional malls had already gotten hammered. So it's only
down 9% year over year. So there's been some anomalies there. Office is the
tough one.
Brian Levitt:
Before we get to office, I want to talk a little bit about the retail. You've
seen sort of a changing face of it, where it's more experiences rather than
necessarily going to buy a shirt that you could just get on the internet. I
mean, I'm seeing it's a Starbucks, it's a Pliable, it's a Dave and Busters, it's
these types of places, right?
Bert Crouch:
Yeah. Look, it's the omnichannel experience. You know, want to have enough in
the store to attract. I mean, in the experiential mindset, you got to get people
open air, foot traffic where they can do more than just shop. And that's what
people want to do. Whether it's safety, whether it's fun, whether it's actually
shopping, usually it's a combination of those things. It's gotten much more
creative. But at the end of the day, those that are most successful have the
online presence, but have the brick and mortar presence.
Brian Levitt:
Jodi, you got one of those strip malls by your house that you dropped the kids
off and you don't see them for hours?
Jodi Phillips:
Yeah, no, I was about to say I have two teenage boys. And somehow they manage to
spend so much money at the mall and never come home with a shopping bag. What
did you do with that money, right? They're eating, they're playing. It's a
virtual reality center and shooting zombies. They don't bring home anything.
Brian Levitt:
And those pretzels are usually pretty good.
Jodi Phillips:
They're not bad.
Brian Levitt:
Yeah, those pretzels with the cheese sauce? That's really good.
Jodi Phillips:
Good stuff. Well worth the money.
Brian Levitt:
I want to hear about the work from home. I mean, I'm enjoying the flexibility,
but I want to know, two of us are sitting here in the office. Actually our whole
multimedia team is here as well. And Jodi, you're home today. So how's that
working? Are you productive? Are you making it work through the phone?
Jodi Phillips:
You can hear me. I can hear you.
Brian Levitt:
Oh yeah.
Jodi Phillips:
We're making a podcast, it's seamless.
Brian Levitt:
Yeah. So where are we going with this, Bert?
Bert Crouch:
Everyone starts with the Kastle data. So Kastle with a K, does card swipes. We
come in and out of the office and they have a very statistically significant
sample set of who's returning to the office and when. Two or three trends I'd
highlight, one, we've all been kind of waiting for some sort of normalization.
We're starting to see it. Nationwide, we're around 50% that are actually coming
into the office and it's stabilizing like that, which is well below
pre-pandemic. And we're seeing that, Brian, very coastally focused, meaning it's
very different. San Jose, California, generally in the mid-thirties, Texas up to
mid-sixties, New York, somewhere in between. But very challenged.
Now, it always takes a good recession, a good scare, market dislocation
volatility, and people want to come back to the office. Not to mention a lot of
our younger cohort on the investment professional fund have not seen a downturn
in their careers. So we're feeling that's driving people back. We saw Jamie
Dimon put out MDs (managing directors) have to be in five days a week to show
certainty, to tutor, to mentor their younger people. So we are seeing a positive
trend there. But where they're going - very bifurcated. If you look at office
space built between 2017 and 2020, that's 200,000 square feet or more, so large
institutional space, that's new. New means it's well-amenitized, it's got great
light, it's got everything -
Brian Levitt:
Ping pong tables?
Bert Crouch:
Ping pong tables, got your beer tap. Nothing that any Invesco offices have
anyway.
Brian Levitt:
Maybe a coffee, a coffee cold brew. Not the cold brew you may want.
Bert Crouch:
Yeah, we got one of those new flavored water dispensers.
Brian Levitt:
I like that.
Bert Crouch:
That's the new, right, folks?
Brian Levitt:
Right. You save the bottles.
Bert Crouch:
But the punchline there is occupancy is way up or said the inverse, may be
vacancy is sub 10%. If you go to that 2016 older cohort, it's over 20%. So that
obsolescence is a huge debate. And right now capital flows, whether it's equity
or credit, it's just not there. So it's really pushed values down. If you look
at the public REIT (real estate investment trust) space down over 50%, trading
at an almost 60% discount to the net asset value, historically high cap rates
approaching 10%. So you look at the fundamentals, very “Tale of Two Cities.” And
from a valuation standpoint, at least what the public market's telling you,
pretty tough.
Brian Levitt:
Are you trying to avoid that part of the market?
Bert Crouch:
You know, you are. With the outlook there, you just want to be careful. Now
again, we have office holdings that we fundamentally believe in. You just have
to position yourself to get through this. And I go back to your question on
retail. Retail went through a similar period. You had winners and losers. We
very much believe the same to be true here. But in this broader capital markets
environment, what you truly believe in, you need to hold and live to fight
another day.
Brian Levitt:
Okay, so we talked about experiential retail, we talked about life science, we
talked about being very specific with regards to office space. We talked about
tech centers, apartment rentals. What else? Anything else that we missed that
gets you excited?
Bert Crouch:
Well, industrial.
Brian Levitt:
Industrial?
Bert Crouch:
Yeah, industrial. Yeah, a hundred percent. The e-commerce trend continues. The
biggest change over the last 6, 9, 12 months is Amazon. Amazon drove the market
and they've really pulled back. Pulled back on capital investment, pulled back
on new leasing, net absorption. So that's something that needless to say,
everyone in the market is very aware of. That said, demand continues to be
strong. Now the second derivative, it's tailing off the rental demand, the net
absorption is starting to slow, which you would expect to see. But overall, the
sector's one that we believe in long term.
Brian Levitt:
Second derivative and convexity in the same podcast.
Jodi Phillips:
Yes. Yeah.
Bert Crouch:
Hey, I named my dog Ferris man, come on. I'm just trying to provide some balance
here.
Jodi Phillips:
Balance. You balance it out.
Brian Levitt:
You remember that book?
Bert Crouch:
Yeah, “You Can't Fix Stupid.”
Brian Levitt:
You remember that book? Clearly not fixing stupid here. You remember that book,
“All I Needed To Know in Life, I Learned In Kindergarten?” I think we're going
to change it to All I Needed To Know in Life, I Learned in Calculus Class. Now
the second derivative, the change in the rate of change.
Bert Crouch:
I have no idea what that means.
Brian Levitt:
Amazon, why is Amazon pulling back? Is that just, they overbuilt?
Bert Crouch:
Yeah, I mean they were the largest and when they say built, majority of that was
done third-party. So someone built it for them and then they leased it. But yes,
extremely aggressive over the last three years as they should have been coming
out of COVID. And a lot of COVID stories, they pulled demand forward five years.
So what they would've done in a five, maybe even a 10-year period, they did in a
three-year period. So I look at it, they're just being smart, hitting the pause
button a little bit, reassessing the efficiencies where they want to focus their
capital allocation. And I would expect them to expand again at some point in the
near future.
Brian Levitt:
I wish they would stop sending one box at a time. Can we just group these things
together and be a little bit more efficient, A little bit greener?
Bert Crouch:
My 15-year-old daughter would beg to differ with that statement.
Brian Levitt:
Yeah, I'm sure she would. I'm sure she would. So Jodi, now do you want to ask
your famous question?
Jodi Phillips:
Yeah. Well I don't know how famous it is, but I think it's important. What did
we miss, Bert? What should we have asked you that we didn't?
Bert Crouch:
I think we covered the bases fairly well. The environment right now is
challenging in a good way. The dislocation, it breeds opportunity here. We're
really leaning in, as I said to start, and I'll say again to finish. From a
private credit standpoint, just seeing a lot of opportunity in the three areas
that I touched on, whether that's non-bank origination, gap financing or what
we're expecting to see in some secondary scratch and dent, maybe even some
distress in the second half of the year. But if you can be convicted today and
reallocate dollars, it's something that we think from a current income and
portfolio fit, too.
Jodi, correlations have really gotten uncorrelated, meaning, and I'm kind of
saying that in a double negative, stocks, bonds, gold, crypto, it's moving very
similarly in a correlation that has defied historical norms. And one of the
things that we've really liked as we talked to clients about portfolio fit,
efficient frontier, how does private credit, how does real estate credit fit
into that? Whether it's Sharpe ratio, looking at risk relative to return,
whether it's correlation, how does it play into my real estate equity? How does
it play into my stock positions? Historically, it's fared incredibly well as a
complement to a broader portfolio. So maybe that's a good tag along. It's not
just the opportunity set, it's not just the total return. It's not just the
relative return, but it's also portfolio fit.
Brian Levitt:
So Jodi, we've got jumbo shrimp, we got challenging in a good way. We got
correlated in an uncorrelated way.
Bert Crouch:
I'm just trying to stay on theme, on point.
Jodi Phillips:
We've got jumbo shrimp to convexity. I don't know how we covered so much ground
in this short amount of time.
Brian Levitt:
My new favorite one is correlated in an uncorrelated way.
Bert Crouch:
We are fishtailing beautifully. I love it.
Brian Levitt:
I love it. Bert, thank you so much, very informative. Great having you on the
show, we'd love to have you back again soon.
Bert Crouch:
Appreciate the invite guys.
Brian Levitt:
Absolutely.
Bert Crouch:
Thanks so much.
Important information
You've been listening to Invesco's Greater Possibilities Podcast.
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According to Green Street’s Commercial Property Price Index, apartment prices
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by 15% for the same period.
Office card swipe data from Kastle Systems as of February 28, 2023
According to Green Street on April 14, 2023, public office REITs on average were
trading at 50.2% of net asset value, with some individual office REITs
discounted in even deeper negative territory. Cap rates implied from office REIT
valuations averaged 9.8% on that date.
M2 is a measure of the money supply that includes cash and checking deposits as
well as savings deposits, money market securities, mutual funds and other time
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A systemically important bank is a financial institution that US federal
regulators say would pose a serious risk to the economy if it collapsed.
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Correlation is the degree to which two investments have historically moved in
relation to each other.
A basis point is one hundredth of a percentage point.
Cap rate is the rate of return on a property based on the income that it is
expected to generate.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
QUICK TAKE: THE SILICON VALLEY BANK COLLAPSE
Senior Portfolio Manager Justin Livengood discusses the state of the bank
industry, the reaction from regulators, the economic implications, and the
potential response from the Federal Reserve.
00:00
00:00
27:38
Listen28 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Greater Possibilities Podcast, where we put concerns into context
and opportunities into focus. I'm your host, Brian Levitt. Jodi Phillips is off
this week. I think today we will be leaning into that line about putting
concerns into context.
Justin Livengood is coming up. He will be helping us put recent concerns into
context. Justin is the Senior Portfolio Manager of the Invesco Midcap Growth
Strategy and a Senior Research Analyst in Healthcare, Financials, and Real
Estate sector on the Invesco Discovery Growth Strategies.
So real quick, anyone who has not been paying attention over the last couple of
days, we did have the second-largest bank failure in US history — that would be
Silicon Valley Bank. And I know that sounds particularly disconcerting to a
number of people. Now this was a bank that was heavily focused on banking for
tech startups. And those tech startups had their deposits at the bank, but they
were largely funded by venture capitalists. And when that money dries up and the
tech startups need access to their deposits, money starts to leave the bank.
Over 90% of those deposits for some reason or another — which Justin may help us
understand — were not insured. And the banks were sitting on what seemed to be
high quality assets, but many of those high quality assets were US treasuries or
mortgage-backed securities, which had become worth less as interest rates had
gone up.
Selling those assets to meet deposits would've resulted in sizable losses for
the banks and ended up in a bank failure and concerns that would then lead to
crisis throughout the regional or smaller bank parts industries as concerns that
deposits would then move and more banks would fall under similar pressure. So,
of course, we got a policy response by the Fed, the FDIC, and the treasury.
The bank did fail. It's not a bailout. Don't listen to what you hear on Twitter.
The bank did fail. The depositors were protected, and regional banks get access
to a line of credit from the Fed.
So that's the backstory. Let's bring in Justin. Justin, thank you for joining.
Justin Livengood:
Thanks for having me.
Brian Levitt:
You and I have known each other for a long time. Have we done this enough? I
mean, are we through cycling through crises or is this just the rest of our
career?
Justin Livengood:
I can't believe if I think back a week ago that I'd be sitting here today
talking about the failure of actually two banks, not just Silicon Valley, but
Signature was a $100 billion bank that went under on Sunday night.
Brian Levitt:
And Silvergate…the crypto one.
Justin Livengood:
And before that Silvergate…exactly! So this is definitely more of a shock than
perhaps even some of the crises we've dealt with in the past.
Brian Levitt:
And Justin is such a good resource for me and somebody I always talk to when
things like this happen. And we have just been through way too many of these. I
mean from having conversations about a Global Financial Crisis and a pandemic
and on and on, it gets a little tiresome. But here we are again.
Let's start from where we were before all of this happened. You always hear that
when the Federal Reserve tightens interest rates significantly, something ends
up breaking. Had you been concerned that something could break? And were you
particularly concerned about anything in the banking sector?
Justin Livengood:
I wasn't concerned about a break, at least in this degree. And the reason is the
credit picture in the banking industry was, and still is, quite clean. The bank
CEOs were actually pretty surprised, and I'm talking about large and small
banks, that they haven't been seeing more non-performing assets and loans
starting to slip past due, which you might expect at this point of an economic
cycle. That's typically where a bank crisis starts — on the credit side. And
that's what happened in 2007-2008 etc. That wasn't happening here. In fact,
Silicon Valley Bank was not on, nor Signature, any watch lists of any
regulators.
Brian Levitt:
Yeah, some of the analysts had them as outperform.
Justin Livengood:
Oh, absolutely. Now what I was concerned about, particularly as a growth
investor, the banking industry was struggling with the yield curve and the
downward slope of the yield curve, which was pressuring net interest margins and
their ability to grow profitably their loan book and their earnings. And so,
through the back half of last year, and certainly here at the start of 2023,
earnings estimates for the group have been coming down. The stocks had not been
performing well and valuations had been compressing, but it was again entirely
related to yield curve dynamics and just the bank's inability to grow more. It
had nothing to do with credit, had nothing to do with people expecting some sort
of an exogenous shock like this to suddenly put a run on the banks in front of
everyone. So while the group was struggling, this was not on people's radars.
Brian Levitt:
Can I hear you say again that it's not 2008?
Justin Livengood:
Yeah, it's not 2008. This is not a systemic credit issue where there are going
to be other problems on the left side of banks’ balance sheets, this is all on
the right side. This is all funding, liquidity, deposits, and confidence. This
is not, oh boy, everybody's sitting on a bunch of bad bonds. As you said a
moment ago, the Silicon Valley balance sheet, the securities portfolio, was a
bunch of treasuries and AA-rated mortgage-backed securities…Fannie, Freddie
stuff.
Brian Levitt:
These are not subprime loans that are packaged up and put on the balance sheet.
Justin Livengood:
And what happened, and we don't need to dwell on this too long because I think
it's increasingly well known, but Silicon Valley grew…they doubled their
deposits in 2020-2021 over that two-year period by a magnitude of almost a $100
billion dollars. And they just couldn't lend that deposit inflow out quick
enough, which is understandable. And so, when banks find themselves in that
situation, they put that deposit overflow into securities.
The mistake, in hindsight, that Silicon Valley made was they went out the curve
as they were investing those excess deposits in 2020 and 2021 by buying things
with 4, 5, 6-year duration — but again, they were high quality instruments. And
when the Fed started to tighten, they were slow to either adjust the duration of
that portfolio by hedges or however you want to risk manage it. And so they
ended up with a pretty big unrealized loss in that portfolio.
They opted last week to try to sell some of those securities in a transaction
that, in isolation, kind of made sense in terms of taking a loss, backfilling it
with some capital, they had already kind of booked the loss on their balance
sheet. So from again, blinders on sort of perspective, what they were trying to
do here in the last couple weeks wasn't nuts. The problem was it was
misinterpreted by their deposit base. And this gets to where now you really had
the crux of this crisis.
That deposit base of Silicon Valley was way too concentrated. Because it wasn't
just that they had all these small tech and healthcare companies that were their
depositors, it was really that they had a hundred key relationships with the
venture capital and private equity firms that owned all these companies. And
when a couple of those VC and PE firms last week sensed, or got wind, that there
might be something wrong at Silicon Valley, they sent an email to their entire
portfolio of 50 companies, I'm making that up, and said, ‘Hey everybody, get
out, get out.’
And that is a very small clubby world. And as soon as a couple of them did it,
everybody did it. And the stat that now is becoming, I think, well known but is
worth repeating, on Thursday in a six hour span, $42 billion of deposits were
withdrawn or attempted to be withdrawn from Silicon Valley Bank because of this
stampede created by a very small number of depositors of VCs. Compare that to
2008 when Washington Mutual went under and had to be taken over the Fed and JP
Morgan in the two weeks leading up to their collapse, they had $17 billion of
cumulative outflow. So two weeks to take out $17 billion at WAMU versus six
hours.
Brian Levitt:
Everything's so much faster these days.
Justin Livengood:
So much faster.
Brian Levitt:
You put something out on Twitter, get out and…
Justin Livengood:
Exactly. So, Silicon Valley was essentially done on Thursday night, which is why
Friday morning California time, the regulators had to take the bank over. They
couldn't even wait until the weekend.
Brian Levitt:
Help me understand this number…something like 93% or 97% — depending on where
you read it — of the deposits were not insured. Was that a mistake of the CFOs
at these tech startup companies? Do these tech startup companies have CFOs?
Justin Livengood:
They should, most do. It's a fair question. I think part of the problem is
Silicon Valley Bank was around for 35 years. They have long-standing
relationships and well-earned good relationships with all these constituents in
this ecosystem — the venture capital firms, the management teams of these
companies, they'd earned their trust.
90% of the innovation economy out there was in some way banking with Silicon
Valley. It's just what you did. And so that mentality exacerbated this and
created, I think, a higher amount of uninsured deposits than you might see in
sort of a normally diversified set of clients. And for over three decades that
wasn't a problem. So again, it's amazing that when all of a sudden there was
someone yelling ‘Smoke’… the proverbial smoke in a dark movie theater…it caused,
otherwise you would think sophisticated financial people, VCs, private equity
folks to panic, and no one hesitated to just pull everything.
Brian Levitt:
And Silicon Valley on HBO was one of my favorite shows, and I remember…
Justin Livengood:
Great show.
Brian Levitt:
Right? Richard had a deal with so many different issues. I don't think he ever
actually had a deal with his deposits being uninsured.
Justin Livengood:
That's true.
Brian Levitt:
Is this typical of other banks, the deposit issue?
Justin Livengood:
Being uninsured?
Brian Levitt:
Yeah.
Justin Livengood:
I mean it's typical in that certainly for commercial banks, yes, the majority of
their clients are keeping more than $250,000 with them in various deposit
accounts. Again, I think what might have been atypical here is these clients
weren't diverse. They didn't have six operating accounts. Because if I'm a CFO
of a startup tech company, I've got a lot more to do than worry about properly
diversifying my cash when I'm just burning it anyways trying to come up with the
next product we're working on.
So they weren't spending their time, as other companies might or sophisticated
or larger companies, building out a whole portfolio of relationships and
properly moving accounts. Silicon Valley can do most of the things that these
startups needed, and so they were all comfortable working with them as their
primary if not exclusive bank.
Brian Levitt:
So speaking of being comfortable, was the policy response enough? Are you
comfortable with what the Fed, the FDIC, and the Treasury have done?
Justin Livengood:
I think so, and it's still evolving as we talk on Tuesday morning here, but I'm
glad that yesterday, Monday, went relatively well in terms of no additional
failures. I do think that the regulators over the weekend had to insure all the
deposits or provide a discount window and a backstop for the uninsured deposits,
as much as that created a now well-discussed moral hazard that we can in a
moment chat about.
But I do think it was necessary and I think it will get us through the shock
part of this crisis. I think people will, over the next few weeks. finish moving
deposits around to get comfortable that they aren't going to be vulnerable to a
situation like this with everyone's legacy banking relationships. And so I think
we've weathered the worst of that storm.
Now there are definitely some additional issues that need to be dealt with in
the industry, and I'm sure going to talk about those. But I do think upfront
this was a relatively effective coordinated response and I'm glad the regulators
sort of pushed back on the political rhetoric over the weekend that suggested
maybe we let Silicon Valley fail. I think that would've been, especially with
Signature right behind it, if you would let both these banks fail, that's $300
billion of failed assets…commercial assets…with a lot of important corporate and
commercial relationships, that would've been a tough blow.
Brian Levitt:
Now you and I are both sitting here in downtown New York City. I did walk by
Zuccotti Park this morning. I did not see people occupying Wall Street…at least
not just yet. This idea of a bailout or this idea of taxpayer money being spent
on this, is that largely a misnomer? Is the FDIC overfunded so that they can
provide support on the deposits?
Justin Livengood:
Well, they're properly funded…I don't know if they're overfunded after this, but
what they have said is they are going to assess all the other FDIC banks a fee —
an assessment fee to essentially pay for this retroactively. So, at some point
in the next few months, every bank CEO in America I guess, is going to get a
bill in the mail that says, ‘Hey, you owe X to pay for Silicon Valley and
Signature’s mistakes.’
And they're not going to have to pay the full amount because again the FDIC does
have a decent amount in the trust fund right now and they're selling down
assets. I mean they're actually going back to what we talked about a minute
ago…there's a lot of good collateral at both banks, but particularly at Silicon
Valley Bank, that the regulators can now sell and use.
Brian Levitt:
Sell the assets, right?
Justin Livengood:
…to help manage this so this isn't going to end up being a $100 billion hit to
the industry. But to the extent there is a little additional needed to kind of
true up the trust fund after that, they're going to charge the member banks. And
that's just going to be one of many incremental new things the banks that
survive this are going to have to be grappling with.
Brian Levitt:
It feels like a small price to pay to avoid a run on the banks. So let's talk
about the issues that the banks are now facing as an investor and somebody who
works in the financial sector. Are you optimistic about the banks or you still
have concerns?
Justin Livengood:
So, I still have concerns and I can discuss a few different issues here. The
first is you still have an inverted yield curve, albeit less inverted than a
week ago, but still an inverted yield curve and a lot of pressure on just their
core fundamentals — putting aside all the liquidity stuff that just happened.
Now the next issue is every bank CEO in America right now has no idea what his
or her deposit base is going to look like tonight or tomorrow night…things are
still moving around. It will be incredible to listen to these Q1 earnings calls
next month and see where the quarter balance sheets ended up and what that's
going to mean just in terms of near-term earnings and growth outlooks. I mean
banks are going to have to potentially shrink and reset expectations to the
extent they've seen outflows…maybe they've seen inflows of deposits. This could
go both directions.
Brian Levitt:
Some of the larger money centered banks.
Justin Livengood:
But ironically, the larger banks that are probably taking deposit inflows are
going to have to put up more capital. They almost don't want it. Yeah, if you
noticed, Chase and B of A aren't paying you a lot for your checking account.
Brian Levitt:
Right, right. I notice it every month. I'll notice it on my tax returns also. I
put down my 12 cents.
Justin Livengood:
And that's not changing because they don't really want our deposits given how,
again, the way the regulators treat excess deposits like that. So my point is
there's still a lot of stuff moving around that is going to require these banks
to step back, be cautious, be conservative, just in terms of near-term operating
funnels. Intermediate term, the issue here I think particularly for the
regionals and that group of banks just below the top 10 SIFI banks, is that
there is going to be a whole swath of new regulations and capital requirements.
I'm already hearing things. After the Global Financial Crisis, the Fed, and the
regulators put in a whole set of rules for those top 10 banks, but they cut it
off at banks with $250 billion of assets.
Brian Levitt:
How did that go?
Justin Livengood:
It sort of worked. But these banks, which ironically got just up close to that…
Brian Levitt:
They were very close.
Justin Livengood:
…$100 billion and $200 billion respectively in assets. So they're going to lower
that threshold, and so are they going to lower it to 50? or who knows? But I
guarantee that the next 75 to 200 banks on that list of assets are preparing for
a whole bunch of incremental disclosures, new audits that are going to have to
go through with the regulators, increased capital charges, carrying more capital
for all the different activities they're doing. This is going to be incremental
operating — I remember vividly going back after the French crisis meeting with
lots of banks, including banks First Republic and Silicon Valley, who I knew
well back in 2010, '11, and '12, and how much they were complaining about all
the hiring they were having to do right after the financial to manage all these
new rules and regulations that they were being asked to comply with.
In fact, the joke for a while was the best job you could try to get coming out
of school was to be someone that had any interest in or expertise in bank
regulation because there was a feeding frenzy for these people.
Brian Levitt:
Absolutely. I think Eisenhower probably should have warned us about the
regulatory industrial complex.
Justin Livengood:
That's right. So, I don't think it will be quite that severe, but there's going
to be an element of that for these regional banks now as we move into the back
half of this year and next year.
Brian Levitt:
Which I have to assume means slower nominal growth for the economy as well. This
whole idea that we're moving to a new level of nominal growth in this
inflationary world, does this take away some of that?
Justin Livengood:
It might in two ways. First, just in general, as banks overall are pausing a
little bit to make sure they understand ‘what's my deposit base look like?’ And
then ‘what are the rules of the game going forward, regulatory-wise?’ They're
going to be less inclined to make a new loan, maybe less inclined to onboard
certain types of clients.
But then very specifically, the second thing I'd mentioned is in the technology,
healthcare verticals that are directly affected by the Silicon Valley failure,
there's going to be a period of friction here where you've got to go find a new
bank. You've got to move, and it's not just, ‘oh, I've got to move my deposits
over.’ It’s ‘I've got to move my payroll system. I had a line of credit that I
was using with vendors, and I had 16 vendors hooked in and now I got to move
that.’
Well, guess what? The banks that you want to move to either aren't going to be
able to do everything because they're now afraid to bring on all those
relationships as quickly as they otherwise might, or they're only going to do
two things. Okay, Brian, you can bring me your deposits, but I'm not going to do
all the other stuff that Silicon Valley was doing. I can't or I don't want to.
So now I'm going to have to go find three new relationships and that may take me
four months. And in the meantime, I can't do all the growth investing that I
wanted to do as a …
Brian Levitt:
That's a shame. I mean, that just means a less innovative economy in the near
term.
Justin Livengood:
Exactly. And it'll sort itself out, so I don't want to suggest this is a
long-term issue. But it's definitely a short-term disruptive issue, particularly
on the smaller end of the innovation economy. And I think the broader growth
outlook could be a little bit impaired by this.
Brian Levitt:
And if the broader growth outlook is impaired, then that should potentially
support the type of strategies that you invest in or the type of strategies that
you manage. Because if you're back to a slow growth world, we probably need to
pay up for growth wherever we can find it again.
Justin Livengood:
That's right. I think companies that are secular growers, that have products and
ideas that are not as sensitive to the economy, and are well managed and well
capitalized, are going to have increased advantages and get better valuations.
And that is exactly the universe that we try to focus on in our different
portfolios. The economy wasn't ripping, and all of a sudden this is going to tip
it down. The economy was already, I'd argue, moving into a slow growth
environment, and this is perhaps just going to nudge it a little bit more down
that trajectory.
Brian Levitt:
Recession.
Justin Livengood:
I don't know.
Brian Levitt:
Semantics, probably.
Justin Livengood:
I agree. Exactly. I think it's less important whether we actually go negative
for a couple quarters on nominal GDP or not. I do think the inflation topic is
important because I think the Fed and monetary policy matters more than
anything.
Brian Levitt:
As always.
Justin Livengood:
Ironically, the events with the banks here probably caused the Fed to be a
little more dovish than they might have wanted to.
Brian Levitt:
Silver linings…perhaps.
Justin Livengood:
Perhaps, but we just saw a few minutes ago a CPI number that was for the month
of February in line with expectations at least, but still 6% overall, 5.5%
ex-food. That is not the 3%-ish number that I think the Fed ideally would like
to get to. Forget two. I think three is what they're really... I don't think
you're seeing 3% this year.
I mean, the pace of improvement in inflation is slowing. It's going to keep
declining, but it is not going to collapse, I think, just based on the latest
trends. So that's perhaps the biggest impediment is that the Fed is going to
have to keep rates elevated at whatever the ultimate terminal rate is — probably
well into next year — and that's going to continue to be a drag on the economy.
Now you layer on top of that what's just happened to the bank system where the
banks are going to be a little more reluctant to lend and be as aggressive as
they might have otherwise been. Particularly in certain parts of the economy
that were serviced by banks like Silicon Valley. And yeah, it's a recipe for a
slow growth environment.
Brian Levitt:
I can't let us end on a negative though. I've got a growth manager here, his
last name is Livengood. Give me some optimism.
Justin Livengood:
Well, first of all, I do think, again, we're through the shock part of this
banking crisis, so on the topic of this podcast at least, I do think we've seen
the light at the end of the tunnel. Again, there's going to be a lot of
subsequent stuff to deal with for the banks, but I think it's all manageable and
I think our regulators and our banking system came through this relatively well.
And again, this is not a credit related issue, which suggests this isn't going
to be as pervasive as the financial crisis of '08-'09, so hopefully that's some
good news.
Brian Levitt:
I'll take it, we'll take it.
Justin Livengood:
Even though I just said the Fed is the most important thing for the economy,
they are essentially done or near done raising rates. And so there is some
optimism in my mind that we've reestablished a proper equilibrium in monetary
policy and that's going to let people adjust to a more normal yield curve
—whether that's in the housing industry or industrial parts of the economy.
And as that reset happens, I think that's healthy and that's good, and that's
going to be a stronger base for the economy and for the stock market to operate
from in the next two to three years. I'm not saying that's going to cause
anything perhaps in 2023 that's particularly exciting, but we needed to get away
from some of the things that had happened the prior three years between COVID,
the war — this has been an incredible stretch of volatility and just really
unusual circumstances. We needed to get back to a more normal operating
environment, and we're getting there.
Brian Levitt:
Well, let's look forward to that more normal operating environment. Justin
Livengood, Portfolio Manager of the Invesco Midcap Growth Strategy, as well as a
Manager on the Discovery Growth Strategies. Thank you so much for being here.
This has been incredibly informative, and we look forward to having you again
soon.
Justin Livengood:
Thanks, Brian.
Important information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of March 14, 2023, and are subject to change without notice. These
opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
Data on the size of bank failures sourced from the Federal Deposit Insurance
Corporation, or FDIC, as of March 13, 2023.
Data on the amount of uninsured deposits at banks sourced from the FDIC as of
March 10, 2023.
Information on the growth of deposits and makeup of assets on Silicon Valley
Bank’s balance sheet sourced from the FDIC, as of March 13, 2023.
Information on the speed and amount of withdrawals at Silicon Valley Bank
compared to 2008 events sourced from the FDIC, as of March 13, 2023.
Data on the Consumer Price index, or CPI, sourced from the US Bureau of Labor
Statistics as of February 28, 2023. The CPI measures changes in consumer prices.
The profitability of businesses in the financial services sector depends on the
availability and cost of money and may fluctuate significantly in response to
changes in government regulation, interest rates and general economic
conditions. These businesses often operate with substantial financial leverage.
Growth stocks tend to be more sensitive to changes in their earnings and can be
more volatile.
Mortgage- and asset-backed securities are subject to prepayment or call risk,
which is the risk that the borrower’s payments may be received earlier or later
than expected due to changes in prepayment rates on underlying loans. Securities
may be prepaid at a price less than the original purchase value.
A systemically important financial institution, or SIFI, is a financial
institution that US federal regulators say would pose a serious risk to the
economy if it collapsed.
The yield curve plots interest rates, at a set point in time, of bonds having
equal credit quality but differing maturity dates to project future interest
rate changes and economic activity. An inverted yield curve is one in which
shorter-term bonds have a higher yield than longer-term bonds of the same credit
quality. In a normal yield curve, longer-term bonds have a higher yield.
A credit rating is an assessment provided by a nationally recognized statistical
rating organization (NRSRO) of the creditworthiness of an issuer with respect to
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The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
A GOLDEN AGE FOR BONDS?
Matt Brill joins the podcast to discuss why he believes the Federal Reserve can
engineer a soft landing for the economy, where he sees opportunities in
corporate bonds, and what investors should consider when positioning their fixed
income portfolios in 2023.
00:00
00:00
35:41
Listen36 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Greater Possibilities Podcast, where we put concerns into context
and opportunities into focus. I'm Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. Today we have Matt Brill, Head of North American
Investment Grade Credit. So, we're talking bonds today, Brian.
Brian Levitt:
Are you already hearing it, Jodi? After last year, we're already hearing people
call this a golden age for bonds?
Jodi Phillips:
I have. I have heard that. It's quite a welcome perspective after last year and
the rough go that both stocks and bonds experienced together.
Brian Levitt:
Yeah, I'm sure investors could have done without that selloff last year, and
then they're even calling that now the “death of the 60/40,” right? Such
hyperbole in our industry.
Jodi Phillips:
Oh yeah, that was the refrain: “Diversification isn't working.” But that's
quieted down so far this year though, right?
Brian Levitt:
Yeah, I would say the reports of the death are greatly exaggerated of the 60/40
portfolio.
Jodi Phillips:
A Mark Twain reference, Brian, that's definitely-
Brian Levitt:
Yeah, we're going literary.
Jodi Phillips:
-not your usual '80s lyrics. Putting that aside for a minute, all right. I will
say though, fun fact, that quote was reportedly a little exaggerated itself.
Brian Levitt:
No.
Jodi Phillips:
Yeah. No, no, he actually said “the report of my death was an exaggeration.”
Brian Levitt:
Oh, so they embellished it?
Jodi Phillips:
Little bit, little bit.
Brian Levitt:
Oh, and I fell for it.
Jodi Phillips:
You did, but that's all right. That's what I'm here for.
Brian Levitt:
I guess a sucker is born every minute, huh?
Jodi Phillips:
Okay, so P. T. Barnum, another fun fact, there's no evidence he said that
either, Brian.
Brian Levitt:
Oh God. Jodi, I give up and this is what I get for having an editor as a co-host
on the Greater Possibilities podcast.
Jodi Phillips:
That's right, that's right. You're in charge of the numbers, I'm in charge of
the words. That's how we split up the two things around here.
Brian Levitt:
Every quote I say was never said.
Jodi Phillips:
Nope. Nope, not at all. But all right, all right, back to our topic though. I
could do this all day, but tell me why could this be a golden age for bonds,
Brian?
Brian Levitt:
We'll have Matt talk to us about it, but yield for the first time in a long time
certainly feels nice. I know my father appreciates it. Maybe even return
opportunities, right? Total return opportunities if and when. I'm going to say
when interest rates go down, not if and when, but again, we'll ask Matt his
opinion on that.
Jodi Phillips:
Yeah, I mean, it feels like that's already started to happen, right?
Brian Levitt:
Yeah, well, certainly a bit. I mean, just think of 10-year Treasuries, I know
people use that as the benchmark, certainly off their highs, but borrowing costs
for corporations are significantly higher than where they were a year ago. I
guess that's what happens when you get a lot of policy tightening in a very
short period of time, it creates concerns that the economy could roll over.
Jodi Phillips:
That's right. But as you always like to remind us, Brian, the market leads the
economy. So, has the corporate bond market already priced the worst of it?
Brian Levitt:
Yeah, perhaps. Although, again, well, I keep saying it, this is why Matt's here.
I love having him on, because we'll talk to him about so many things. We're
going to talk about the Fed, we're going to talk about the path of rates,
recession concerns, opportunities in corporate bonds or other parts of the bond
market and how to structure a fixed income portfolio. If 60/40's not dead, well,
then what does the 40 look like?
Jodi Phillips:
Excellent question. Yes, that's a ton to go over, so let's not delay anymore.
Welcome, Matt. Appreciate you joining us today.
Matt Brill:
Thanks Jodi, thanks Brian. Good to be here.
Brian Levitt:
It's good to have you here. What's the bond market telling you? I mean, we've
now heard from the Fed we're probably past peak hawkishness. What's the bond
market telling you?
Matt Brill:
Yeah, so I think the first thing the bond market's telling you is that the Fed
is going to win this battle versus inflation.
Brian Levitt:
Yeah, can we stop and celebrate?
Jodi Phillips:
Shortest podcast ever.
Matt Brill:
It's not done yet, that's the thing, but they're going to win, the Fed is going
to win. With that, eventually rates are going to go lower. Whether we go back to
the really low rate era that we had for so long is debatable, but this
persistent inflation will get stomped out of the economy and the Fed's going to
win, and that's what the bond market's telling you.
Brian Levitt:
Can we call it transitory? Is that back now? Was it always transitory or the Fed
having to stomp it out means it wasn't transitory?
Matt Brill:
I think we don't want to use that word-
Brian Levitt:
Okay, we're done.
Matt Brill:
It has a really bad connotation to it. It could be a three-year transitory
thing, I don't know, but at the end of the day, the Fed had to act. So, this
would not have occurred without the Fed's actions. So if that's the definition
of transitory, then it certainly was not transitory, because the Fed had to do
something, the fire wasn't going to put itself out, essentially.
They've raised about 450 basis points at this point, and they did that in
basically pretty much a year, so one of the fastest hiking cycles that we've
seen in recent times. That was needed. I think the Fed got on board a little
late, but once they started to really through last summer continue to tell you
that they were going higher and higher, we all of a sudden realized, hey,
they're not going to stop till they win this.
Even in the comments that you're going to hear from all the Fed members, they're
going to tell you they still have more work to do, but that's only because they
don't want to declare victory too soon. So we're not saying it's over, but we
are going to say that they're going to win.
Brian Levitt:
So Jodi, Jay Powell's now singing “All I do is win, win, win no matter what.”
Jodi Phillips:
I would love to see the video feed of that, if that's indeed what's going on.
But Matt, are there concerns then that the Fed's going to over-tighten and take
it a little bit too far?
Matt Brill:
Well, that's the new shift or the new focus, in our opinion, is stop looking
backwards at the inflation, because that will be solved, now you need to start
focusing on whether or not the Fed is going to take it too far and drive us
straight into a recession.
But our general view is that the Fed can engineer this soft landing. The runway
for the soft landing keeps getting wider and wider, because the labor market is
still good. Maybe not as good as it once was before, because you're seeing some
layoffs in the financial sector, you're seeing layoffs in the technology world,
but the general what I would call the mainstream America economy is still yet to
see those layoffs.
So just in general, it feels like the labor market is loosening up a little bit
at the same time that inflation is coming down, which gives us the chance that
they're not going to put us straight into recession. But if the Fed stays at a
high level for too long, then that's the bigger concern. I think if you're just
looking at inflation, you're missing the story here, you need to start focusing
on the slowing of the overall economy.
Brian Levitt:
I'll mix the metaphor here and say that the porridge is tasting just about right
about now. Maybe I'll go on and say I guess we make hay when the sun shines,
right? So, I'm mixing a whole bunch of metaphors here.
So Matt, I'll tell you the biggest question I'm getting from people is, or among
the biggest questions is when I look at the yield curve, does it make any sense
to move out beyond short rates, or just take the bird in the hand? You're
getting four, four and a quarter at the short end of the curve. Why even think
about going longer?
Matt Brill:
Yeah, so we get that question a lot and a lot of people are just in T-Bills
rolling them along, and they're saying, "Look, I'm not going to get fired by my
client for getting them 4.5%." But I'd argue that you're not really looking
forward to their future either, you're not protecting for what we describe as
reinvestment risk. That's the term we keep throwing out in 2023 over and over
and over is reinvestment risk.
That tells you that yes, you might have a three-month T-Bill or possibly a
year-long Treasury, but what is that going to be yielding by the time that comes
due? What are you going to be rolling that into at that time? A lot of people
say, "Well, I'll take my chances when I get there," but that's not really the
way that you're supposed to be thinking about your finances, right? You're
supposed to be locking in these yields at these elevated levels for longer and
planning ahead.
You mentioned your dad earlier, that your dad's excited to get fixed income. I
go back to the '80s and I look at the charts. I was born in the '70s for the
record, but I look at the charts-
Brian Levitt:
Me too.
Matt Brill:
I look at the charts and you can see that in 1980, Fed Funds, I think it was
around 18% and the 30-year Treasury was around 12%. So at that time, you could
have bought a front-end T-Bill for 18%, or you could have bought a 30-year
Treasury at a very inverted curve. I hear stories all the time of the
grandparents back at that time that bought 30-year Treasuries for their kids, or
the grandkids, and they locked it in for a long time and they were the geniuses.
I have never heard ever of a grandmother buying a three-month T-Bill at 18% and
how smart that grandmother was, 'cause guess what happened? In three months or
six months, whenever that T-Bill came due, they had to roll it into something
else that yielded a lot less by that time, because Volcker had gotten inflation
under control.
So while we're not at those extremes, I certainly point out to people that when
you think rates are attractive, if you think 4.5% is attractive, why are you not
willing to take it for five years? Why do you only want to get it for three
months? As we're seeing already as rates are coming down lower, in a year or six
months, we do think yields will be lower than they are today.
Brian Levitt:
I'm just trying to picture you at three years old trading bonds, but you tell us
you're looking at the charts now, you weren't doing it back then?
Matt Brill:
I had a solid about 40 days actually, that's it, Brian, but it was a very short
period of time in the '70s.
Jodi Phillips:
So Matt, you heard at the top of the show that we don't always have the best of
luck accurately remembering famous quotes or being able to quote people word for
word, but one thing Brian always likes to reference, and we'll see if I get it
right, “get the credit cycle right and all else will take care of itself.” Is
that right, Brian? Did I get that-
Brian Levitt:
Yeah, that sounds right. See, I'm not going to pick nits the way you do and tell
you that you got the quote wrong.
Jodi Phillips:
Well, I appreciate that. So then Matt, given that, where are we in the credit
cycle?
Matt Brill:
So, we're sort of in the early stages of the credit cycle, actually. So, when we
think about what happens at the late stages of the credit cycle are that
companies do silly things, like they over-lever their balance sheet, they buy
back a lot of stock, they might even make a large acquisition that's
debt-funded.
Then when you get the fixing or the reset of the economy and you get through the
really good times, then you start to have the negative times, they start to say,
"Oh, I probably shouldn't have spent my money on that, probably shouldn't have
done that," and they really tighten their belts, and that sometimes creates an
additional feedback loop of the economy going into recession.
What we're seeing now is that you're at this point where corporations have said,
"We just went through this really strange pandemic, we survived it. We do think
that the Fed is going to make this economy worse." So, they're simply saying,
"We're just going to preserve our balance sheet. We're going to actually do
everything possible to prepare for this really bad period of time coming," and
they're ready for it.
So, I kind of feel like they can survive this fairly well. If and when we get
through this shallow-ish recession or soft landing, then we're going to really
start the new era of the credit cycle. So, I sort of feel like we're kind of at
the end of the belt tightening, the end of the really bad period of time for
earnings. You're going to see earnings fall off here for sure, but I would just
say that I don't see corporations doing silly things that they're notorious for
doing at the end of the credit cycle.
So it's a weird time for us right now, but the biggest point I'd like to make is
that companies are not going to be surprised by a slowing economy, so they're
prepared for it. This isn't like the pandemic that came out of nowhere that
really could not have been forecasted. Corporations are all hearing that there's
going to be a recession coming, and I would say this is the most forecasted
recession that we've ever had, so if you're not ready for it as a corporation,
you're not doing your job.
Brian Levitt:
So let's say we go into the shallow, as Lady Gaga might say, right? You said a
shallow-ish recession. Has the credit market priced for that? If you're looking
at a 5%, 6% in investment grade corporate, 8%, 9% in riskier credit, is that
priced for a recession already?
Matt Brill:
So, we just look at yields it is. So if you look at yields, you're saying that
these are elevated yields that are punitive to corporations and you're getting
paid to take on risk. Now that being said, Treasuries are also elevated, and so
the credit spreads or the premium you have to get paid to buy something other
than Treasury are actually not really pricing in a recession, so they're really
just kind of in the middle of the pack.
So, you can possibly buy just Treasuries or you can buy corporate bonds that get
that additional spread. So we look at credit spreads and they're kind of around
110 to 125 (basis points) depending on which metric you look at, and a
recession's more like 150 to 200. So, we're not-
Brian Levitt:
And that's investment grade?
Matt Brill:
That's investment grade. If you look at high yield, they're around low 400s, a
recession might be 600 or 700. They don't tend to stay there very long, 'cause
if you're yielding 700 basis points over Treasuries, you're probably not going
to either be in business very long or you're going to need to have the economy
rebound quite quickly, and people realize that there's value and they're not
going to stay at those levels.
So at the 400 and the 125-ish range that you're at on credit spreads, you're in
the middle of the pack, but what it's telling you is that corporations can
weather this. I think that's kind of the key point here is that the yields are
attractive, technicals are going to continue to be very good, because we feel
like there's going to be a lot of money flowing into the asset class.
And fundamentals should not be that poor, because even though they're borrowing
at higher rates, most companies aren't borrowing really at all. If they have to
borrow, then they're borrowing at higher rates, but they have fixed debt that
they have, they borrowed a fixed term. A lot of them borrowed back in 2020 and
2021 at kind of 2%, 3%, and now that rates are 4%, 5%, 6%, they're just saying,
pass, no reason to borrow. We'll use our excess cash. We'll maybe slow our
dividend payments, things like that in order to not have to borrow at a higher
debt level.
Jodi Phillips:
All right, so Matt, you had mentioned high yield spreads for a little bit, and
obviously you're the head of investment grade. Are you willing or able to reach
into the high yield bond market?
Matt Brill:
Yeah, so we do like pockets of the high yield market. I think if you're buying
the lower portion of the triple-Cs of the world, you really have to believe that
you are going to get a soft landing. If you think anything other than a soft
landing, triple-Cs will get hurt. But the double-B portion or the higher portion
of the high-yield market still looks pretty attractive, and all the yields there
are somewhere between 7% and 8%, which historically looks really good.
I would also point out that despite the slowing economy, we're forecasting that
you're going to see at least $50 billion of upgrades out of high-yield into
investment grade in the first half of the year, and you might even see a $100
billion total for the full year. So despite the fact that the economy is
slowing, there's still going to be more upgrades than downgrades in 2023.
Brian Levitt:
How does that happen?
Matt Brill:
Well, the ratings are just sort of behind the curve. So if you look back in
COVID, there's a lot of downgrades that hit then, a lot of these companies then
really repaired themselves quite quickly, and the rating agencies have said,
"Well, we'll wait till COVID's over." All right, well, COVID's pretty much over.
They said, "Well, we'll wait till we see what the recession is, really how bad
it's going to be." They keep kind of delaying that. At some point they're
saying, "Well, the metrics are really, really strong on these companies. We've
been waiting for the other shoe to drop and it just hasn't happened, so I guess
we're going to have to go ahead and upgrade now."
So, they've been very hesitant and the pendulum swung really far to the
downgrade side in 2020, we think it'll come back to the upgrade side this year.
So I mentioned $100 billion of upgrades potentially for the year, there's only
probably going to be about $15 billion of downgrades out of investment grade to
high-yield.
Brian Levitt:
Wow.
Matt Brill:
So the ratio is still almost 10 to one despite a slowing economy, and that's
because balance sheets are in such good shape. Again, it's all about these
companies having predicted the worst. The worst hasn't happened yet, and they're
in really good shape in just preparing for this proverbial winter is coming that
just isn't really happening.
Brian Levitt:
Yeah, Game of Thrones, winter is coming, right? It's the most forecasted
(recession), as you said. I got to imagine a lot of those chief financial
officers were banging their heads against the wall waiting for these upgrades,
huh?
Matt Brill:
Yeah, it's costing them money to not have been upgraded yet anytime they still
have to continue to borrow. The area that we found has really been the least
recognized by the rate agencies has been the energy space. There's a lot of
energy companies that have really completely repaired their balance sheets.
Back in 2020, we had WTI go negative for futures for things like that, but even
in a more normalized curve, it was still $40 a barrel versus now 70, 80 bucks.
Even the service industry, you've got drilling coming back. There's a lot of
areas within the energy space that are making a fair amount of money, and
they've just continued to pay down debt this whole time too.
So the focus on shareholders has not been there, and I think that's one of the
key things is debt holders that we like. We don't like to just make money and
pay it all out to the equity market. The equity market has said, "Let's get our
balance sheets fixed, particularly in the energy space. Let's get our balance
sheets fixed first, and then you can start paying us back after that, because we
just don't want to take any chances that you're going to be on the verge of
bankruptcy like you were in 2020." So, the focus on cash flow has been to pay
down debt and the rating agencies are soon to follow with their upgrades, we
believe.
Jodi Phillips:
Well, let's talk about upgrades. I was planning to ask you about potential
default cycle and what that might look like, but I mean, is there anything
you're keeping your eye on in regards to that?
Matt Brill:
Yeah, so the consumer cyclicals are still a challenge. Yeah, you've seen that
there's certain portions of the retail spectrum that we would be concerned
around. One of the things is that the high-yield market had a issuance down
about 80% in 2022 over 2021. The issuance of high-yield market is picking back
up this year, meaning that companies are able to borrow. Although it's
expensive, they are able to borrow.
With that, we've seen kind of the lower quality names really starting to rally,
because investors are saying, "It looks like these companies can actually get
access to capital." Versus in 2022, they would've never been able to borrow at
all at any price, and now they're able to borrow, and that'll enable them to
kick the can down the road a little bit.
So you can borrow to extend out your lifeline, if you will, for another year or
two, and the economy turns out to either not have a hard recession, or if it
just starts to have a recovery in back half of 2024, you've made it that far.
So, we're predicting around 3% in defaults for high-yield this year.
Certainly I would say just in general, there's always a greater risk that it's
higher than that, I think that's kind of the way the bond market is. But 3%'s
kind of our target for the year, but it could actually be even less if this
high-yield market stays open the way that it is now, because it's enabling these
companies to kick the can down the road and fight another day.
Brian Levitt:
When you say consumer cyclicals, is that a lot of the names that we expected to
have problems even prior to ever hearing the word COVID? Are these the names
that were being disrupted by eCommerce anyway?
Matt Brill:
Yeah. Yeah, and I think COVID sometimes gave them a lifeline in some instances,
whether it was through the government funding or just behavioral patterns that
have changed for a brief period of time. But the longer long-term trends for a
lot of the retailers, you saw Party City recently, they defaulted, but there's
areas like that that just weren't going to make it probably no matter what. They
tried to fight it as long as they could and eventually they had to throw in the
towel.
Jodi Phillips:
So, let's look globally for a minute, Matt, if you don't mind. What about the
emerging world, how do yields look there? Are they more attractive in those
markets?
Matt Brill:
Yeah, so EM in 2022 got hammered just as hard as the rest of us, if not more,
anything China-focused. So, China was specifically the problem child. You saw
Evergrande, the real estate company there in China, that was really the first
domino to fall, that there was some problems within the property development
space within China specifically. Then you also had anything industrial-wise that
was impacted by supply chain out of China and through a lot of the emerging
markets. Some of them benefited, but a lot of them just were very correlated to
China from a risk standpoint.
So, we saw massive outflows of EM in 2022, we saw property developers in China
go from par to 15 that were investment grade rated names. Not household names,
but very large corporations within China. Some of those have come back and come
back 60, 70 points within the last eight weeks, which is just pretty phenomenal.
I would say those are not really things we generally would be investing in, but
it's just pretty interesting to watch. But the typical EM bond that often at
times is going to benefit from oil prices being higher has still gone materially
lower versus where it was a year ago, so we think there's some opportunities
there. We prefer to stay with companies in countries that are commodity-rich. I
think if you're on the flip side of that, or if you're a commodity buyer rather
than a commodity seller, you may have more issues. Then just overall, the rising
tide of China does lift all EM boats.
So we buy hard currency, not local currency. EM, generally we're not taking the
currency risk, but we just look at the champions in these emerging market
countries, and a lot of them were just severely punished last year, and now
we're seeing some pretty good opportunities. Again, I'd rather have the
commodity aspect of things. Middle East is a great opportunity for us, and then
we'd kind of be more some Latin America, that'll benefit from that as well.
Brian Levitt:
Where else do you look for yield beyond what we've asked you?
Matt Brill:
So, the housing market in general with non-agency mortgages is a really
interesting opportunity. You saw the fear that higher rates were going to ca use
just a massive housing market correction, it really hit the non-agency mortgage
market. So, the agency mortgage market is guaranteed by Fannie Mae, the US
government essentially at the end of the day, but the non-agency mortgage
market, even if you're buying the top of the stack or the highest rated, it's
going to be fine from a principal standpoint, but people start questioning how
bad is it going to get for the economy? How bad is it going to get for the
housing market?
You see the home builders really started getting sold off within the equity
market, as well as the debt market. We look at the non-agency mortgage market
and we say, well, there's still a housing shortage. It's probably going to have
to have some sort of correction just given where mortgage rates are. But all of
a sudden you look up and mortgage rates are probably 100 to 150 basis points
lower than their peak, and maybe the cost of the housing market isn't as
punitive as people might've originally thought.
So, that's one area that we're looking at. It's not as clean, it's not as
obvious that it'll be able to rebound here, but I'd say overall, that's one area
that tends to lag and still have significant amount of yield. If you believe
that rates keep going lower from here, it's going to be nothing but the wind at
the back of the housing market.
Jodi Phillips:
So Matt, kind of at the top of this episode too, we talked about the talk of the
60/40 portfolio, 60/40's dead, that that refrain has clearly eased off a little
bit compared to last year. But in your mind, looking at that 40% and looking at
how investors might want to think about it, the role of bonds in their
portfolio, what's your view of that bond allocation, and what do you think
investors ought to be thinking about at this moment?
Matt Brill:
Well, I think you need to think about, one main thing is why do you want to own
fixed income in the first place? I think a lot of people wanted reasonable
steady yield and they weren't getting it for the last decade, and so they came
up with new ways to buy their ultra conservative funds, or they bought
preferreds, or they bought a lot of dividend-producing stocks in order to
replicate that.
But more than anything, if you bought fixed income, you probably bought it
because you had to, not because you wanted to. Maybe your company forced it upon
you and said, "You have to own 40%, figure out the way how," and you got to try
to make that puzzle work. Now, what we're finding is that investors are saying,
"I don't have to own it, or if I do, I still want to own it anyway, and how do I
own more of it?"
The pain last year was really tough, and so why did you buy it? You bought it
for yield. Well, yield's got more and then everybody sold. So, then now that
things have stabilized and people just have a little bit more time to think with
a cooler head, they're looking at yields and they're saying, "I haven't been
able to buy bonds with these yields since, call it 2007, maybe for the peak of
2008 when everything really, really kind of fell apart."
So you have to have some credit spreads, but for the most part, you haven't been
able to buy it in a normal market since around 2007. This looks pretty
attractive, and so they're buying more. The technicals look really good, and we
feel like at the end of the day, you should like bonds of this 4% to 5%.
Now, are you going to be able to get back to that 6% that we saw in investment
grade bonds very briefly in October? Probably not, but everybody says they want
to buy more if they get there, which means you probably don't get a chance. But
at the end of the day, we feel like you're getting in stable cash flow, you're
going to not have to go through what you went through in 2022, which was really,
in our opinion, once in a lifetime correction, which is really, really painful,
but the adjustment that happened from it provided a lot of attractive yields.
Brian Levitt:
It's just a unique pandemic cycle and we're finding our way out of it back to
maybe some normal equilibrium. Is that how you're thinking about it?
Matt Brill:
That's right. You're still arguably being distorted by the Federal Reserve, but
in the opposite way. Meaning that the Fed is doing quantitative tightening,
they're selling bonds. A normal market where the Fed is not intervening in any
capacity, yeah, I think looking at yields at 4.5%, 5% would look attractive. So
when we get to that point, we think that people have been really kind of fed up
with the Fed-
Brian Levitt:
Distorting their bond portfolio.
Matt Brill:
They like that the Fed makes stocks go higher, they don't like it makes their
bond yields go lower. But the reason why stocks go higher is because there was
no yield in bonds. The whole TINA Market, right?
Brian Levitt:
Right.
Matt Brill:
So you had TINA for a number of years: “There Is No Alternative.” But now we're
talking about TINA's sister, TARA, which “There Are Reasonable Alternatives.”
Brian Levitt:
Ooh.
Matt Brill:
So TINA is no longer around, her sister TARA, her alternate personality, I
guess, is back.
Brian Levitt:
Did you just coin that or you're borrowing that from someone?
Matt Brill:
I've heard TARA out there.
Brian Levitt:
Oh.
Matt Brill:
I've also heard BAAA, three A’s: “Bonds Are An Alternative.” So BAAA or TARA,
but I kind of like TARA.
Brian Levitt:
I like TARA, because-
Jodi Phillips:
TARA works better.
Matt Brill:
Yeah.
Brian Levitt:
I might have to start using that and say it's mine. We all steal from each other
anyway, right?
Matt Brill:
I don't have a patent on it or any kind trademark.
Brian Levitt:
So Jodi, doesn't having Matt on make you feel so much better?
Jodi Phillips:
It does.
Brian Levitt:
Such clarity?
Jodi Phillips:
It does. I mean, we've run through such a long list pretty quickly, right?
Investment grade and high-yield and emerging markets and mortgages. Is there
anything that we didn't ask Matt that we should?
Brian Levitt:
Oh, I've got one.
Jodi Phillips:
Oh, okay, good.
Brian Levitt:
I've got, Matt.
Matt Brill:
Okay.
Brian Levitt:
Okay, so this debt ceiling thing we're going to have to grapple with at some
point-
Matt Brill:
Yep.
Brian Levitt:
A little bit different than 2011, because in 2011 the Democrats needed a lot of
Republicans to come on board, this time they only need a handful, so maybe we
don't go to the 11th hour like we did in 2011. But in 2011, Treasuries rallied
as it was happening. It was still viewed as the safe haven asset. Is there
anything that could happen or do you have any concern where that would look
different? Or would you still envision Treasuries to be the safe haven asset
should we have to go to the brink on this?
Matt Brill:
Yeah, we certainly hope we don't get that far, but if we do, our view is that it
would be a positive for Treasuries. Not for credit risk, but for Treasuries. The
government can't issue debt during that period of time if there's a supply
shortage, there's a flight to quality.
I think a lot of people often say, why are you selling all your Treasuries if
the government's going to have a shutdown? You're like, "No, actually, we think
you want to do the opposite."
Brian Levitt:
Right.
Matt Brill:
So it's completely counterintuitive, but at the end of the day, I think 2011 is
kind of the playbook for it, and that's the way we would see it playing out
again this time.
Brian Levitt:
Can we say what if, God forbid, or however you want to put it, they don't do
what they need to, do we even let our minds go there? I mean-
Jodi Phillips:
You don't want to say it out loud, do you, Brian?
Matt Brill:
Yeah.
Brian Levitt:
Well, yeah, I mean-
Matt Brill:
We just hope both sides will have enough sense to not allow that to occur.
Brian Levitt:
Yeah, yeah, yeah. Yeah, agree.
Matt Brill:
Too many good things are happening in the economy that we're kind of fighting
our way through this inflation problem that we had post-pandemic, and then just
to have it disrupted by that would be really unfortunate. So, it's-
Brian Levitt:
Yeah, let's not shoot ourselves in the foot again. Yeah.
Matt Brill:
Exactly.
Brian Levitt:
Agree. Well, Matt, thank you so much for joining us.
Matt Brill:
Great to be back.
Brian Levitt:
Incredibly informative, great clarity. Feeling better about the world, Jodi
seems to be too.
Jodi Phillips:
Absolutely, I do. Thank you so much for joining us.
Matt Brill:
I'm glad we weren't banned after the 2022 performance of bonds, so it's good to
be back.
Jodi Phillips:
No one's ever banned, it always comes back.
Matt Brill:
We look forward not backwards over here, so thank you all so much.
Brian Levitt:
Thanks, Matt. Thanks, Matt.
Jodi Phillips:
Thank you.
Important information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of February 1, 2023, and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
Diversification does not guarantee a profit nor eliminate the risk of loss.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates. Interest rate risk refers to the risk that
bond prices generally fall as interest rates rise and vice versa. An issuer may
be unable to meet interest and/or principal payments, thereby causing its
instruments to decrease in value and lowering the issuer’s credit rating. The
values of junk bonds fluctuate more than those of high quality bonds and can
decline significantly over short time periods.
The risks of investing in securities of foreign issuers, including emerging
market issuers, can include fluctuations in foreign currencies, political and
economic instability, and foreign taxation issues.
Investments in companies located or operating in Greater China are subject to
the following risks: nationalization, expropriation, or confiscation of
property, difficulty in obtaining and/or enforcing judgments, alteration or
discontinuation of economic reforms, military conflicts, and China’s dependency
on the economies of other Asian countries, many of which are developing
countries.
Businesses in the energy sector may be adversely affected by foreign, federal or
state regulations governing energy production, distribution and sale as well as
supply-and-demand for energy resources. Short-term volatility in energy prices
may cause share price fluctuations.
The 60/40 portfolio referenced throughout the episode refers to the traditional
asset allocation of 60% stocks and 40% bonds.
Data on the level of Federal Reserve interest rate increases is from the Federal
Reserve as of Dec. 31, 2022.
The references to yields between 4% and 4.25% are based on the 2-year US
Treasury rate as of Jan. 31, 2023, sourced from Bloomberg.
Data on the level of the federal funds rate and 30-year Treasury yield in the
1980s sourced from Bloomberg.
The federal funds rate is the rate at which banks lend balances to each other
overnight.
References to investment grade corporate yields between 5% and 6% and riskier
credit yields between 8% and 9% refer to the yield to worst of the Bloomberg US
Corporate Bond Index and Bloomberg US High Yield Corporate Bond Index,
respectively. Sourced from Bloomberg as of Jan. 31, 2023.
The Bloomberg US Corporate Bond Index measures the US dollar-denominated,
investment grade, fixed-rate, taxable corporate bond market.
The Bloomberg US High Yield Corporate Bond Index measures the US
dollar-denominated, high yield, fixed-rate corporate bond market.
Yield to worst is the lowest potential yield an investor can receive on a bond
without the issuer actually defaulting.
References to credit spreads for corporate bonds and high yield bonds sourced
from Bloomberg as of Jan. 31, 2023. Based on the option-adjusted spread of the
Bloomberg US Corporate Bond Index and the Bloomberg US High Yield Corporate Bond
Index, respectively.
Option-adjusted spread is the yield spread which must be added to a benchmark
yield curve to discount a security’s payments to match its market price, using a
dynamic pricing model that accounts for embedded options.
References to the borrowing costs of corporations are based on interest rates
set by the Federal Reserve.
References to forecasts of upgrades and downgrades based on Invesco estimates.
References to the decline in high yield issuance in 2022 from 2021 sourced from
Bloomberg.
References to price movements of Chinese bonds sources from Bloomberg as of Feb.
2, 2023.
References to the level of mortgage rates sourced from Bankrate.com as of Jan.
31, 2023.
A basis point is one hundredth of a percentage point.
WTI stands for West Texas Intermediate. WTI oil prices sourced from Bloomberg as
of Jan. 31, 2023.
The yield curve plots interest rates, at a set point in time, of bonds having
equal credit quality but differing maturity dates to project future interest
rate changes and economic activity. The short end of the yield curve refers to
bonds with shorter maturity dates. An inverted yield curve is one in which
shorter-term bonds have a higher yield than longer-term bonds of the same credit
quality.
Credit spread is the difference in yield between bonds of similar maturity but
with different credit quality.
Quantitative tightening is a monetary policy used by central banks to normalize
balance sheets.
Safe havens are investments that are expected to hold or increase their value in
volatile markets.
A credit rating is an assessment provided by a nationally recognized statistical
rating organization (NRSRO) of the creditworthiness of an issuer with respect to
debt obligations, including specific securities, money market instruments or
other debts. Ratings are measured on a scale that generally ranges from AAA
(highest) to D (lowest); ratings are subject to change without notice. NR
indicates the debtor was not rated, and should not be interpreted as indicating
low quality. For more information on rating methodologies, please visit the
NRSRO website for Standard and Poor's, Moody's or Fitch Ratings.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
NA 2738526
WHAT’S IN STORE FOR MARKETS IN 2023?
Kristina Hooper and Alessio de Longis join the podcast to discuss what they
anticipate for the year ahead, including moderating inflation, “convincing
signs” of a potential economic rebound, and a “golden opportunity” to rebuild
income.
00:00
00:00
32:54
Listen33 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Greater Possibilities Podcast, where we put concerns into
perspective and opportunities into focus. Hi, I'm Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. It's our first podcast of the new year, which means it's
time to talk about our 2023 outlook. Joining us are Kristina Hooper, Chief
Global Market Strategist, and Alessio de Longis, Global Head of Tactical Asset
Allocation.
Brian Levitt:
Jodi, welcome to 2023.
Jodi Phillips:
Happy New Year.
Brian Levitt:
Happy New Year.
Jodi Phillips:
And good riddance to 2022. I wasn't really that upset to turn the calendar page
this time around.
Brian Levitt:
Yeah, I think most investors probably felt that way. It's amazing how there's
just something therapeutic about turning a calendar after a difficult year in
the market.
Jodi Phillips:
No, you're right. There really is. But does it really mean anything? I mean, it
may be a new year, but is anything really different, or has nothing changed?
Brian Levitt:
That actually sounds like a U2 lyric.
Jodi Phillips:
Does it?
Brian Levitt:
Do you remember that song about whether anything changes on New Year's Day?
Jodi Phillips:
Oh yeah, it sounds a little familiar.
Brian Levitt:
I mean, I think you could find strategists, pundits, the so-called experts on
both sides of this debate. It's very bifurcated whether anything has changed as
we move into this year, or if we're still grappling with all of the same
challenges that we were dealing with last year.
Jodi Phillips:
Okay, so then what's your take?
Brian Levitt:
I actually think things have changed. The good news is, and we'll talk to
Kristina and Alessio about this, the markets had already priced in a fairly bad
outcome. We're seeing, from the Bureau of Labor Statistics, inflation coming
down, perhaps the Fed's getting closer to the yen, seems like it's becoming a
better backdrop for risk assets. So it's hard to say that nothing has changed. I
think quite a bit has changed.
Jodi Phillips:
Well, that's good. There's still some negativity out there though. But I've
heard you say before that market cycles seem to be born in pessimism. So I don't
know, is that true here?
Brian Levitt:
Yeah, I think that's exactly right. Now, I'm not saying it's going to be easy.
We obviously have some issues to deal with, but history suggests by the time
inflation has peaked, or by the time whatever challenge you're facing is
starting to get better, you tend to see a better environment for markets, albeit
if it's not a straight line. But we're certainly getting to a better backdrop.
Jodi Phillips:
Well, good. I'm feeling hopeful. So let's continue this conversation with our
guests. We're going to set the stage with Kristina, and then follow up with
Alessio to talk about the asset allocation implication. That's hard to say,
Brian. Asset allocation implication.
Brian Levitt:
That is hard to say.
Jodi Phillips:
Hopefully, Alessio will do a better job with it than I did.
Brian Levitt:
How now brown cow.
Jodi Phillips:
All right, got little rusty for the new year. In any case, welcome, Kristina.
Kristina Hooper:
Oh, thank you so much for having me. It's great to be here.
Jodi Phillips:
So let's start with a quick postmortem on 2022, if we could. I mean, it's hard
to remember, but at that time, no one really expected that the Fed would tighten
as much as they did over the course of last year. I mean, I don't think the FOMC
really expected it themselves. So how would you characterize what we've been
through?
Kristina Hooper:
Well, I know Brian referenced U2, but I'm thinking Talking Heads, how did we get
here, right?
Brian Levitt:
Same as it ever was?
Jodi Phillips:
Great question, great question.
Kristina Hooper:
So you're absolutely right, Jodi. No one expected 2022 to play out the way it
did, and that includes the Fed, right? If we think about December of 2021, when
they released the “dot plot,” they anticipated that by the end of 2022, we'd be
at 90 basis points for the fed funds rate. And then fast forward to the end of
2022, and we ended up in a far different, a far tighter place. So I like to
think of 2022 as the year of monetary policy whiplash, which then turned into,
in my opinion, when we looked at asset class returns, annus horribilus. But it
doesn't sound as good as when Queen Elizabeth said it with that great British
accent.
Brian Levitt:
Hey, 90 basis points to 450 basis points. What's the difference for markets?
Kristina Hooper:
Exactly.
Brian Levitt:
It's like a rounding error. So when you think about all of that tightening, and
the economy's still generally resilient, how concerned are you about the lagged
effects of that policy tightening?
Kristina Hooper:
Well, what we lived through in 2022 was a great experiment. We don't know
exactly how much of an impact that fast and furious tightening has had. I mean,
let's face it, the Fed did not allow for enough time to see the impact, and they
certainly tightened in much larger chunks than normal. So you always, I think,
in this kind of situation, would worry about the potential impact on the
economy, how much damage was done. But from everything that I can see thus far,
it looks like the US economy has been very resilient. In fact, many economies
around the world have been quite resilient, despite what has been really, really
intense tightening.
Brian Levitt:
The Hooper family is still going out to restaurants, still traveling
occasionally? We're still spending some money like the rest of the Americans?
Kristina Hooper:
A little bit, but I have imposed new budget constraints.
Brian Levitt:
Yeah. Well, and that's part of it, right? I mean the idea was to make us all
feel a little bit less wealthy. I think the Fed did a pretty good job of that.
As we feel less wealthy and as we put some of those constraints on, do you start
to think that that inflation story becomes a bit passé, or it's starting to move
a little bit behind us?
Kristina Hooper:
I think so, and that's what we're seeing from the inflation data we're looking
at, right? I mean, the most recent CPI print suggested that inflation is
moderating nicely. Now, we're nowhere near the Fed's target. We're moving in the
right direction. And I think we have to anticipate, as we look out on 2023, that
this is going to be a period in which inflation is likely to continue to
moderate. But we have to think of it in terms of the three buckets that Jay
Powell laid out recently when he talked about inflation.
There is the goods bucket, there is the housing bucket, and then there is the
services ex-housing bucket. And so clearly, goods inflation has come down very
significantly, and housing, despite the most recent CPI print, appears poised to
roll over. I mean, clearly, there's been a lot of pressure on the housing sector
with mortgage rates going up so much, and I think that that will have an impact
on housing inflation and help moderate it. But the real stubborn area is going
to be services inflation, especially because so much of that is driven by wage
growth. So we are going to see inflation moderate, in my opinion, this year.
It's just unlikely that we get to the Fed's inflation target by the end of this
year. I think that's going to take more time.
Brian Levitt:
Jodi, you heard Kristina say it, my wage growth is going to be just fine this
year.
Jodi Phillips:
Oh yeah, we have that recorded. Absolutely. We all have witnesses. Obviously,
looking past the US, we've seen the eurozone has also had to deal with pretty
aggressive tightening. How is the eurozone economy holding up?
Kristina Hooper:
Well, it's actually held up relatively well, given all the headwinds that it has
faced in the last year. Not only has there been significant tightening, but of
course they have been subject to very high inflation, especially coming from
energy. I mean, there's just been a lot of hits to the Eurozone economy, and yet
what we saw in the most recent PMIs is that while they remain in contraction
territory, they've actually improved. And so that suggests to me a Eurozone
economy that is quite resilient.
Jodi Phillips:
What about China? I know the big headline there has been rolling back so many of
those COVID measures that were in place for so long. How is that adding up in
terms of your growth outlook for China?
Kristina Hooper:
Well, when we first sat down to talk about the outlook back in October, when we
took a look at China and thought about what could be possible for 2023, we felt
the economic outlook hinged on two factors: property and COVID. And what we saw
was that Chinese policymakers have addressed the issues in the property sector.
They released this 16-point plan this fall. That seems likely to have a material
positive impact on the property sector.
So then the other issue is COVID. I mean, we've seen pretty significant COVID
stringency in China, and rolling that back is going to create some headwinds
initially, because of course there is a significant increase in COVID
infections. But I think that opens the door for significant economic growth as
the year progresses. I think we just have to anticipate some headwinds in the
near term, but this could be a very positive year for China growth.
Brian Levitt:
Alessio, let's bring you into the conversation. Thank you so much for joining
us.
Alessio de Longis:
Thank you, Jodi. Thank you, Brian. Always a pleasure being with you.
Brian Levitt:
So I know that you always like to think about it from the perspective of what
phase we're in, or what regime we're in within the cycle. How would you
categorize this current environment, where it seems like risk appetite may be
picking up a bit from where we were, call it September, or maybe even a little
bit in December?
Alessio de Longis:
Yeah, the market has certainly, since late November, early December, has
certainly started picking up a much, much stronger tone. The way I would like to
characterize it is that we have basically been waiting for that recession for
six to nine months now, the most well-telegraphed recession that, of course,
didn't happen. So since early December, what is happening is that inflation, and
therefore speculation on the end of the tightening cycle, inflation is rolling
over more quickly than growth is rolling over. So the market is feeling
optimistic, because it's finding that sweet spot now where inflation may be
coming down, monetary policy tightening is coming to an end, while growth, as of
today, is still holding up.
Brian Levitt:
So that sounds like a soft landing. Is it a soft landing? And for investors,
does it have to be a soft landing, or have we already priced in a mild
recession?
Alessio de Longis:
I think right now a soft landing is really the best way to characterize it.
Basically, we have knowledge that growth has been close to zero, but now we can
see light at the end of the tunnel and expect it to actually rebound, rather
than going into negative. So we will characterize that market reaction more
consistent with the market pricing and recovery regime, right? Growth still
being low, but actually improving.
How long will that last? Well, this goes back to the eternal debate about the
long and variable lags of monetary policy. I agree with Kristina. At some point,
it will be more obvious what the damage has been or will be from past monetary
policy tightening, but it's not here, and it doesn't have to be that severe. The
unemployment rate is still globally near all-time lows. So without a doubt, this
is not the beginning of a new economic cycle, precisely because the unemployment
rate is at all-time lows, but we are dealing with a soft lending, similar to...
Brian, I like to draw analogies. Obviously, the circumstances were very
different, but remember how many fake recessions we had, such as in 2011, in
2015? To me, the relationship between the economic situation and the market
reaction is analogous to those. Those were very difficult years from a trading
perspective, and there were large negative returns, but the economy ended up
holding up and eventually the market recovered. So that's how I think the market
is pricing in, basically, reduced risks of a recession in timing, in duration of
that recession, and potentially the magnitude of that recession.
Brian Levitt:
That's interesting you bring up '15 and '18, I mean, '15 was, what, one rate
hike, a Chinese currency devaluation? '18 was a US-China trade war. In
hindsight, do those pale in comparison to what we've just seen, a 450 basis
point rate hike in nine months? So I'm trying to get what you're saying. You're
saying that it feels like a soft landing. We may still need to bump on the
bottom a little bit. Is that what you're suggesting? But we're not there yet?
Alessio de Longis:
What I'm suggesting is that the market is... It's ill-advised to position with
bearish traits, to position for a recession for too long. As we all know,
positioning for a recession, be it in credit, in fixed income, in equities, it's
an expensive proposition, right? Waiting for that recession to happen is
difficult. So unless you have the evidence staring at you that that recession is
rising in probability, no news is good news. And in front of no news, or
improving news such as falling inflation and a toning down of hawkish rhetoric
by central banks, those are catalysts for a better market environment that
should not be ignored.
I guess my point is to say, yeah, the market is recovering, but wait because a
recession will eventually come? No. Actually, thank you for asking that
question. What I want to be clear on is that you need to acknowledge what the
market is doing, and when the economy begins to deteriorate, when you begin to
see those cracks, be it the unemployment rate, be it credit spreads, we have
another chance at being more cautious and defensive. But right now, we are
seeing some pretty convincing signs across all capital markets that we should
take seriously a potential rebound in economic activity, especially, as Kristina
mentioned, in the weakest zip code, which is Europe.
Jodi Phillips:
So Alessio, help me figure out what this means for portfolios and investors and
asset allocation. You talked about seeing some convincing signs. For those who
are tactically minded, they're trying to figure out what they should be doing at
this moment as we're looking for signs and looking for evidence, what types of
assets are you favoring?
Alessio de Longis:
So for the last couple of months, where we've begun to see this improving risk
sentiment and falling inflation statistics, we have gone back to overweight
equities. In other words, we believe that it's appropriate to run above-average
risk again after being very defensive in the second half of 2022, above-average
risk being expressed through both equities, but primarily, risky credit. Credit
spreads are still wide above their long-term average, have started to come in,
but they're still wide. You are still getting compensated.
As investors, we're now having the opportunity for 5% to 9% yields that we
haven't seen in the last 15 years, so it's a golden opportunity to rebuild
income in the portfolio to harvest some credit risk. In this particular market
context, risky credit such as high-yield emerging market debt or bank loans
offer equity-like returns, but with lower volatility. So that's important. In
the equity space, I think it's appropriate to run some slight equity overweight,
but primarily within that equity composition, favor value over quality, favor
small and mid caps over large caps. In other words, favor the more cyclical
sectors and more cyclical styles of the market.
Brian Levitt:
Let's go back to fixed income. You talk about, when you say 5 to 9%, 9% is
pushing out in credit risk, so call it, what, a high-yield bond index around 9%.
Is that enough in your mind to compensate for any type of default cycle that we
may have?
Alessio de Longis:
That's a good question. So harvesting that yield in a very diversified way, it's
always the best strategy. I think defaults, if they occur, are... Given how
de-levered these sectors have been, how... We have gone already through a large
cleansing of the debt situation, both on the consumer side and on the corporate
side. Default rates, which will inevitably rise in the worst-case scenario,
should not be large, systemic to lead to underperformance on a two, three year
rolling basis on risky credit, in my opinion, and also, especially for the risky
credit cores that also have duration. So in that sense, emerging markets debt
and high yield offer more duration than bank loans, and that duration always
offers a little bit more of a ballast than the purest credit exposure. So yes, I
think on a two, three-year rolling basis, these level of yields are quite
attractive, in my mind.
Brian Levitt:
Now, Kristina's always asking me what's the top question I'm getting from
clients, so I will pose the top question I'm getting from clients to you,
Alessio. When you're thinking about-
Alessio de Longis:
Bring it on.
Brian Levitt:
When you're thinking about generating income and you want to do so, perhaps call
it in the Treasury market, are you taking advantage of two-year yields at four
and a quarter (percent), or are you moving out in the yield curve where you're
only getting on a 10-year, say 350 (basis points), but does longer duration make
more sense if the economy slows in here?
Alessio de Longis:
That's a great question, and one that is really, really topical at the moment.
For the first time in three years, we are moving away from flattening yield
curve exposures. In other words, the yield curve is now inverted by a full
hundred basis points, when you look from T-bills to 10-year Treasuries. That,
for our generation, is as flat as it has ever been. The only times the yield
curve has been more inverted than that was in the 1970s, in the 1980s where it
got to negative 150. Obviously, the inflation situation today is comparable to
that one, but it gives you an idea of the risk-reward.
So to answer your question, we are now starting to move out of the long end in
terms of where do we choose to have our duration exposure. We're starting to
come back up towards the two-years and five-years, where you now can harvest 4%,
4.5% yields. It takes basically a doubling of those yields for you to lose money
on those bonds, right? So especially on the two-year, this is now becoming
really, really attractive.
The two-year, obviously, because we're going, we believe that the Fed will
eventually pause, and the market will begin to price in some easing. Whether the
Fed delivers that soon or not, that's a different question, but the market
always starts pricing in the beginning of the next cycle. Being in two-year
bonds, in three-year bonds might give us also an extra juice in terms of
declining yields, rather than being in cash at three months. So yes, I think the
front end of the curve is now starting to look quite attractive.
Jodi Phillips:
All right. Well, Brian covered what the top question is from clients that we're
hearing, so I'll ask my personal favorite question, and I want to ask you and
Kristina as well. What are people not asking you? What are you not hearing about
that you think people should maybe be paying more attention to at the moment?
Alessio, do you want to go ahead and start? And I'd like to hear from Kristina
as well.
Alessio de Longis:
Well, Kristina, I'm very curious about your opinion, but I am quite amazed by
the lack of interest and inquiries on non-US assets, on emerging markets, on
China, on Europe, despite the fact that a cycle has clearly ended, the growth
versus value cycle. The unconventional monetary policy cycle has clearly ended.
These were major factors that contributed to the US dominance, the US
excellence. All of these catalysts are, one by one, unwinding, and yet there is
so much skepticism around investing money in international markets. The euro
went from 95 cents to 1.10, almost, and nobody's asking. So what I think this
is, we always focus on tactical, tactical, tactical, but I think these tactical
rotations are probably signaling the beginning of a new long-term cycle of
rotation and diversification out of the home buyers in US assets into foreign
assets.
Brian Levitt:
Before we hear Kristina's opinion, Alessio, I just want... Obviously, Bitcoin
went from 16,000 to 18,000, so that's why nobody's paying attention in the euro,
but talk about Europe, because it's just been so negative, right? You have the
conflict that's existing in Eastern Europe, you have concerns that Germany might
not even be able to keep the plants operating because they don't have access to
the commodities that run it. How do you get investors to think optimistically
about Europe in that type of a backdrop?
Alessio de Longis:
Generally speaking, what you just outlined reminds me of a lesson that I learned
over the years, which is we always need to find comfort in a narrative, and a
narrative always obviously makes sense. The problem with narrative-driven
investing is that you also need to mark the market, and when the pricing
changes, the narrative is still in place, but the pricing is changing. What does
that mean today?
Europe remains the most geopolitically vulnerable and economically vulnerable
region through the current situation, but we have been pricing that for 12
months. In other words, as Kristina mentioned, the PMIs are in recessionary
territory, but they're starting to bounce back up. Consumer confidence has been
at all-time depressed levels, well past even 2008 levels, and they're bouncing
back up. The winter freeze that we were fearing, because of what the
implications will be for natural gas prices and energy provision, the winter is
turning to be much milder than expected.
So there is so many catalysts, one by one, that again, the narrative has not
changed, but the risk and the pricing around those catalysts is now improving
meaningfully, which is why European equities are reacting so positive. I think
that's really what the key question here is. And one more point: let's not
forget that Europe is the most cyclical region in the globe, and with China
reopening trade in the horizon, that remains one of the regions that is likely
to benefit the most from a global trade perspective.
Jodi Phillips:
All right. So Kristina, question comes to you then. What topics are flying under
the radar that you think people should be paying more attention to right now?
Kristina Hooper:
Well, I absolutely agree with Alessio that one topic that we don't hear anything
about, we don't see really very much interest at all in, is investing
internationally. Europe, emerging markets, it's just not a focus for investors
right now, and Europe, it's all about beating expectations, and that's what
we're seeing right now. I couldn't agree more with Alessio. The other topic that
I think I'm not hearing enough about is what Alessio called, and I love this
term, the golden opportunity to rebuild income, and it really is. I think some
have not realized just how robust yields are on investment-grade corporates, on
a number of different areas within fixed income, and I just think there's not
enough interest and focus there right now.
Jodi Phillips:
All right. Brian, do you think we've covered it? Anything else you want to ask?
Brian Levitt:
I'm just still happy that we turned that calendar page, Jodi. I mean, isn't this
such a better vibe than what we were talking about, call it mid-summer?
Jodi Phillips:
It does. It feels a lot better, so let's just watch how it all turns out and
shapes up. We've got a long way to go, but feeling a lot better after this
conversation, that's for sure.
Brian Levitt:
We're feeling a lot better, and we know that Alessio and Kristina are going to
be with us along the way to keep providing their insights as events unfold
throughout the year.
Jodi Phillips:
Thank you so much for joining us.
Brian Levitt:
Yeah, we thank you so much.
Alessio de Longis:
Thank you for having us.
Jodi Phillips:
Happy New Year.
Kristina Hooper:
Happy New Year.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of January 13, 2023, and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
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Should this contain any forward looking statements, understand they are not
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All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
In general, stock values fluctuate, sometimes widely, in response to activities
specific to the company as well as general market, economic and political
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effects of changing interest rates. Interest rate risk refers to the risk that
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yields-to-worst of the Bloomberg US Corporate Bond Index and the Bloomberg US
High Yield Corporate Bond Index as of December 31, 2022.
The Bloomberg US High Yield Corporate Bond Index tracks the performance of
below-investment-grade, US-dollar-denominated corporate bonds publicly issued
in the US domestic market.
Yield to worst is the lowest potential yield an investor can receive on a bond
without the issuer actually defaulting.
Duration is a measure of the sensitivity of the price (the value of principal)
of a fixed income investment to a change in interest rates. Duration is
expressed as a number of years.
Information on 2-year, 5-year and 10-year Treasury yields from Bloomberg as of
December 31, 2022.
Information on current and historical inverted yield curves is from Bloomberg,
as of December 31, 2022. Based on the spread between the 3-month and 10-year US
Treasury rates.
The yield curve plots interest rates, at a set point in time, of bonds having
equal credit quality but differing maturity dates to project future interest
rate changes and economic activity.
An inverted yield curve is one in which shorter-term bonds have a higher yield
than longer-term bonds of the same credit quality.
Information on the level of the euro from Bloomberg. Based on the move in the
exchange rate between the euro and the US dollar from October 2022 to January
12, 2023.
Information on the price of Bitcoin from Bloomberg. Based on the price change of
one Bitcoin from the beginning of 2023 to January 12, 2023.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
LOOKING FOR THE MARKET BOTTOM: ARE WE THERE YET?
Equity strategist Talley Léger follows eight indicators that help him gauge
whether US stocks have hit bottom. What are they telling him now? In short, he
believes this contraction may be shorter and shallower than some fear.
00:00
00:00
28:19
Listen29 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Invesco Greater Possibilities podcast, where we put your concerns
into perspective and the opportunities into focus. I'm Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. And today we have Talley Leger on the podcast. Talley's
an equity strategist at Invesco, and he's here to provide his views on whether
or not the US equity market has hit bottom and what might come next.
Brian Levitt:
Jodi, I hope he's going to tell us that the market has hit bottom or near
bottom. I mean, I think my 401(k) would appreciate that.
Jodi Phillips:
Oh yeah, mine too. My college savings. My blood pressure would like that a lot
as well. Look, I've heard you and Talley both call this an “everything” bear
market. So how did you manage your emotions during this time, Brian?
Brian Levitt:
Well, you're assuming I managed my emotions.
Jodi Phillips:
Yeah, big assumption there.
Brian Levitt:
But maybe the fact that it was an “everything” bear made it a little bit more
palatable. I mean, there just weren't too many places to hide this year, so you
didn't end up kicking yourself for not being in other spots. I mean, I guess
cash, I suppose, although it's not the greatest proposition when you're losing
8%, 9% after inflation in your cash.
Jodi Phillips:
Brian, the one thing I felt good about was I had that emergency cash stash, so
thanks for that perspective. But look, I know how much you love your historical
comparisons, so it has to help to know we've seen this before and that we've
come out the other side, right?
Brian Levitt:
Yeah. I mean, we've seen this a couple of times in the last two years now. I'm
trying to remember who said it. I don't know, it was one of those quotable
investment gurus when they were asked how it felt to lose 25% of their net
worth, and their response was, "Well, it felt the same as it did the last four
times it happened."
Jodi Phillips:
Oh, ouch. Yeah, not great. That's how it feels, it feels not great. But it also
feels not great to miss the upturn. And I know that there have to be some market
timers who weren't happy being on the sidelines in October and that big day the
market had around mid-November.
Brian Levitt:
Yeah, of course. And we've said it so many times that the great months, the
great days always seem to occur during challenging times. And so trying to miss
the worst days, oftentimes you end up missing a lot of the best days. And of
course, as you point out, October was like the 11th best month. November 10th
was like the 15th best one-day. And of course, that happened right after
investors pulled, according to the Investment Company Institute, $27 billion
from equity strategies. So we can't help ourselves.
Jodi Phillips:
Got to keep perspective. It's about staying above the noise. And that's why we
have Talley here. So Talley has a list of market bottom indicators to help keep
us focused on what really matters. And Brian, I've just got one question for
him: Are we there yet?
Brian Levitt:
I mean, you sound like the kids in the backseat of the car. "Are we there yet?
Are we there yet?" It's funny. I always answer them, "No, I wouldn't still be
driving." But then someone says, "Are we getting closer?" Yeah, I certainly hope
so, unless we made a wrong turn. And so I guess Talley will be our global
positioning system here to tell us if we're on the right path.
Jodi Phillips:
Excellent. How did we ever survive road trips before GPS? I don't know. But I
guess I'll add a few more questions to my list then. If the markets are
bottoming, what comes next? What does a stock market recovery typically look
like? What are you seeing now, and what kind of leadership do you expect in a
time like this? So let's bring him on, Brian, to answer.
Brian Levitt:
You know I love these conversations. Talley, welcome to the show.
Talley Leger:
Great to be back, as always. Lots of questions.
Jodi Phillips:
Absolutely. Lots to ask and lots to answer so thank you for helping. Look, can
we just start at the beginning and give us a little bit of context about what
happened this year with this “everything” bear?
Talley Leger:
Absolutely. So I think first and foremost, and this is broadly recognized, we
had some of the frothiest paces of inflation seen in four decades. So a very
different operating environment for most professional investors, and of course
individual investors included in that. And in response to hot inflation prints,
the Federal Reserve, our central bank, has been tightening financial conditions
to cool down this overheating US economy. And I would point out that we've been
in this environment of tightening conditions and slowing activity since the
first quarter of last year, so bordering on a year and a half to two years. So
we've been, I think until recently, in this kind of broad, general de-risking
phase of the market cycle.
Brian Levitt:
Basically, Jodi, what Talley is saying there is the US Federal Reserve wanted us
to feel less wealthy. And as you and I both said at the start of this podcast,
they have succeeded in making us both feel-
Jodi Phillips:
Mission accomplished.
Brian Levitt:
I'm not sure I ever felt wealthy, but I certainly feel less wealthy now.
Talley Leger:
Well, you know what they say, don't fight the Fed. And I think this was a
healthy reminder of that. And my point when I say financial conditions, together
we're talking about a dollar that was too strong, bond yields that soared in
response to the Federal Reserve's efforts in raising interest rates, the spread
between corporate bond yields and their Treasury counterparts widened. And of
course, as we're discussing, we had sharp drawdowns in stocks. So you put it all
together, the Fed did its job and tightened these financial conditions, and
that's the transmission mechanism for monetary policy. It's the channel through
which the Fed really engineers these desired economic slowdowns.
Brian Levitt:
Don't fight the Fed. Very good advice. Talley, when did you first get concerned?
I remember talking to you at the beginning of the year and I think we even wrote
a blog, what is the nightmare scenario? So when did you first start getting
concerned?
Talley Leger:
Yeah, so I would say that I started getting concerned at the tail end of the
first quarter of this year. Now technically, hindsight, as we know, is 20/20, so
I wish I nailed it in January. But at least I had a change of tone and heart as
we had this kind of counter trend bounce. I think it was an 11% rally in the
stock market in the context of what we would eventually recognize as a downtrend
in the market. And we've had several of these sharp bear market rallies. We had
another one in June into July over the summer. But yeah, that would be my long
answer. I started getting concerned around the end of the first quarter of this
year.
Jodi Phillips:
So Talley, as we mentioned in the intro, you have a list, a dashboard of market
bottom indicators that you look at, that you update to keep us focused, to keep
perspective. Can we walk through a couple of those? Can you point out a few that
you rely on and what they're telling you?
Talley Leger:
Yeah, so that's the problem with putting out these frameworks. You're married to
them, especially when they get popular and everybody asks you. And as a paranoid
analyst, I'm always second guessing myself and questioning myself, hey, was this
the right mix of indicators to serve up to folks? And I mean, look, it worked
well in 2020 and I thought it has done a pretty decent job of taking the pulse
of the downdraft in stocks so far.
Brian Levitt:
Talley just defined marriage. I'm always second guessing myself and questioning
myself as well.
Talley Leger:
That's right. A lot of lessons are healthy reminders here to be taken away. But
the point is, I think the answer is the market bottom really depends if you're a
glass half full or glass half empty kind of person. And I tend by nature to be
an optimist. And over time, I think, Brian, I don't want to put words in his
mouth, but would agree that that has been over time a proven successful
investment strategy.
Brian Levitt:
It has. And so walk us through some of these market bottom indicators and which
are your favorites and what are they telling you right now?
Talley Leger:
We've made a lot of progress, Brian. At the beginning of the year, we only had
one of the eight. The first one was the bull-bear spread, talking about the
investor sentiment survey. That sentiment survey has been deeply bearish, very
negative all year. It was the only one that we had back in January, and it
actually helped keep me disciplined in saying, nope, we're not there yet, all
year, until some of the others started to kick in. So this is important on the
checklist of market bottom indicators.
Another one, while sentiment is important, I think it's also good to have
positioning on side as well. And that would be what we call the equity
put-to-call ratio. “Put” meaning sellers, “call” meaning buyers. So when the
put-to-call reaches a trigger of one or higher, that means you've got
technically more sellers than buyers. In the past that's proven to be a very
useful contrarian indicator and helps us zig when others are zagging. So I
thought that was an encouraging one.
Jodi Phillips:
You had mentioned that there are eight indicators. Are there any other ones that
you would want to highlight?
Talley Leger:
Yeah, so sticking on the positive side of the checklist for now until we pivot,
Brian, I think you'd be happy to hear this one. The Economic Policy Uncertainty
Index actually peaked earlier this year and has come down. And I think getting
through or past the midterm elections has helped us, at least in terms of
removing, if we do have gridlock in Washington, some of that political discord
and allowing fundamentals and interest rates and inflation and monetary policy
to work their magic for markets.
Brian Levitt:
I'm comforted that we're making progress. I'd like to hear more about the
indicators that aren't yet flashing and what are those telling you right now?
Talley Leger:
Yeah, so the two... And I'll say this honestly in my heart of hearts, that while
I am an optimist, I'm being positive here, looking for reasons to be bullish,
there are two indicators that served me well in 2020 that I quite frankly have
not seen this time around yet that would give me a lot more, shall we say...
Brian Levitt:
You'd scream it from the hilltops rather than blog it on our website.
Talley Leger:
That's right. So the point is the VIX, so that would be the fear index, the
volatility index, while it has been on the rise and in motion, it didn't give me
a reading above 40 that I would prefer to see, meaning more blood in the streets
and fear in the marketplace that would be indicative or supportive of this
notion of a significant damage in the market that would get me excited as a
contrarian.
Brian Levitt:
Some big blowout volatility event that happens.
Talley Leger:
That's right. And we've seen this, and you talk about every generation facing
its set of challenges and the Time cover magazines. That's what we like to see,
the market kind of climbing the wall of worry and moving from the lower left
hand corner of our screens to the upper right hand corner.
Brian Levitt:
Ironically.
Talley Leger:
Yeah.
Brian Levitt:
Talley, the VIX hasn't gotten to 40. What's the second indicator that hasn't
flashed yet to give you more comfort?
Talley Leger:
So Brian, it's very similar to the VIX. It's high yield corporate bond spreads
above their Treasury counterparts. So again, very similar dynamics. Spreads had
been widening as a reflection of this general risk off tone, but we didn't quite
get the signs of fear or risk aversion that I would've preferred to see. And
this might be a little bit wonky, but I was looking for that spread to reach at
least 700 basis points above Treasuries. And it's a low bar, I'm not asking for
much, but we never quite got there. And I had been waiting for the major credit
event of the cycle. As I've said, when the Fed starts tightening, we were
discussing tightening financial conditions, things start to break. And perhaps
the crypto debacle, that major news, was the ultimate credit event for the
current cycle. And so maybe I got that, at least conceptually.
Brian Levitt:
So it's the crypto exchanges which probably are not sitting in the high yield
bond indices. And maybe otherwise it's a testament to the fundamental strength
of some of those businesses and those high yield bond indices.
Talley Leger:
That's right.
Jodi Phillips:
So Talley, you divided us into the glass half full contingent … the glass half
empty folks. All right, I'll ask you the glass half empty question then. So
what's the worst case scenario?
Talley Leger:
I think the worst case scenario, that the Fed in response to hot inflation
overdoes it in a kind of 1970s Burns or 1980s Volcker style, raises interest
rates too much and really breaks the back of the economy.
I think personally, I'm coming in with kind of a shorter, shallower economic
recession. And that gets to the point where we actually have seen some really
good moves in stocks.
Brian Levitt:
It's interesting you bring up Volcker, because when I think of Volcker, Paul
Volcker, of course, the Fed chair in the late '70s, early 1980s, what I think
about is inflation peaking in 1980, early 1980, Volcker raising rates through
the year. So similar parallels to what we're dealing with right now. Inflation
seems to have peaked in the spring. Right now, Jay Powell raising rates through
the year. You did have a recession in '81, but if you invested when inflation
had peaked, you were pretty happy over the next few years. And so do you think
that that is an interesting parallel? Is that one that we can hang our hats on?
And how would you start to think about positioning if so?
Talley Leger:
I think that's a really good point. Crazy markets, huh? Did inflation peak
before bond yields? And did the economy bottom before stocks? Usually you'd
think it'd be the opposite way. But yeah, I mean, look, on that score, and I've
got a whole host of different tools in my toolbox to help guide the outlook
here. I developed this proprietary supply chain disruption index, which has kind
of helped confirm this more strategic... Moving away from the popular technical
checklist to the strategic or cyclical bottoming process for stocks. And I think
that's really where it starts. And inflation is kind of public enemy number one
here, and it has been coming down with an improving supply chain outlook.
Jodi Phillips:
So Talley, thinking about what a recovery could potentially look like, I mean,
are we going to go back to the same big names that drove performance last time
around, or would we expect to see some broader leadership?
Talley Leger:
I mean, look, I think no two cycles are identical, and we've got our frameworks
and our indicators to help investors get their arms and minds around these
processes. But look, through it all, I don't think that the business cycle
disappears. I don't think that the central bank and all its wherewithal
disappears. And these are two really important forces or concepts that help
shape our decisions and choices when it comes to broad asset allocation. So
yeah, directionally, generally, the things that I would expect in a
type of scenario seem to be playing out.
And that really started, I would argue, back in October. So bonds starting to
fall at the wayside relative to stocks, meaning stocks have begun to improve and
lead the charge generally. Within stocks, the cyclical or pro-economy sensitive
sectors of the market have been breaking out here. And even the riskier,
smaller-cap value stocks have been perking up and responding to this general
improving risk on tone that we're starting to see in the markets.
Brian Levitt:
Now, if the Fed stops raising interest rates, or we get the pause, I don't think
any of us are thinking about an easing cycle, but if we get the pause, does that
change the environment for the US dollar, and what does that mean for
international investing?
Talley Leger:
Well, that's another really interesting point, Brian, that the dollar actually
so far, tentatively, is looking like it peaked in October as well, which would
confirm exactly what we're discussing about this... And I know it's early, but
we want to be forward looking, this general kind of about face in positioning
and firming in investor risk appetite. So if the dollar continues to come down,
and these are markets, right? They're forward looking, they're real time market
variables, they tend to get ahead of the Fed. And perhaps they are discounting,
at least a downshifting pace of interest rate hikes from the Fed. And remember,
this has been the most intense rate hike cycle that we've seen in decades. So to
me it's less about a pause or even rate cuts and really more about a
downshifting pace of those interest rate hikes.
Brian Levitt:
Do you know what the biggest challenge, Jodi, with recoveries is?
Jodi Phillips:
What's that?
Brian Levitt:
Everybody misses them. And you know why people miss them is because they're
still looking in the rear view mirror, believing that the world isn't good. And
by the time things are good, a lot of the market recovery has already happened.
It's really, and what Talley seems to be saying, it's really about things
getting a bit better relative to expectations, inflation better to expectations,
the Fed tightening starting to slow a bit. And that's how recoveries begin. I
guess they say it's always darkest before dawn, which isn't necessarily true,
but that's what they say.
Jodi Phillips:
More philosophical than I was expecting to get in this podcast, Brian, I have to
say.
Talley Leger:
Well, Brian, maybe this is sharing too much or oversharing, TMI as they say, but
in our personal investing conversations, as you know, I have stuck to the plan,
I stayed buckled in. So I did benefit from one of the, if not the best, Octobers
that we have seen in a long time, I think, months to be invested in stocks at
all. So I benefited there, but I'm still, as I've said to you, I'm still kicking
myself, this is the greed factor coming in here, for having not put new money to
work sooner to reap the rewards of that fantastic October.
Brian Levitt:
Well, and if we do see a recovery and the beginning of a new cycle, then I would
assume you'd have ample opportunity to take advantage.
Talley Leger:
That's right.
Jodi Phillips:
So Talley, before we wrap up, I always like to ask our guests, what didn't we
ask you that we should have? What else didn't we cover that you think is
important to point out?
Talley Leger:
Thank you. And I wanted to bring us back because there was something I was
playing around with, being a fan of building indices. And this goes back to my
point about being a paranoid analyst. So this time around, second guessing the
personal kind of human judgment and intuition, the assessment of the indicators
on the tactical side, the checklist, what if I got it wrong? What if my lens is
distorted or cracked? So I tried in that spirit to remove myself from the
decision making process by trying to coax out or introduce a sense of
statistical significance to the eight indicators. And the way I did that, not to
get too wonky here, but I used a Z score transformation to try and express each
one of these indicators in common units of standard deviation away from their
respective means.
Brian Levitt:
That's what I was going to do.
Talley Leger:
Yeah.
Jodi Phillips:
Beat you to it.
Talley Leger:
That's a dorky way of saying I just took myself out and I just let the data and
the statistics... We all remember our statistics from high school math and first
year-
Brian Levitt:
And what did it tell you?
Talley Leger:
Well, I'm happy to say that it told me that after having expressed this thing in
common units that we can all understand, standard deviations, it's a variability
concept, we actually had a north of 2-Sigma event in late September, which now,
again, in hindsight, as I said, is 20/20, looking back perfectly explains from a
contrarian perspective, we had so far peak risk aversion, and that was the setup
for a fantastic month of October.
Now, having said that, it wasn't the level of significance that we saw, say,
back in early 2020 or 2008 or 2009. Those were 4+ Sigma events, really massive
dislocations in markets. But again, I think the story here at the end of the
day, is this market draw down is probably shaping up to be something along the
lines of a shorter, shallower contraction.
Jodi Phillips:
Well, as a paranoid investor, I'm glad to know that paranoid analysts are
crunching the numbers the way that you are. Thank you for that.
Brian Levitt:
And we may not be there yet, Jodi, but it sounds like we're certainly getting
closer.
Jodi Phillips:
Yeah, that was my one question. We're not there yet, or we wouldn't still be
driving, but we're getting closer.
Brian Levitt:
Well, Talley, thank you so much for joining us. This was very informative. I
hope you can enjoy some time over the holiday season where you can step away
from your advanced statistics and maybe enjoy some time with friends and family.
Jodi Phillips:
Have some half full glasses.
Talley Leger:
That's right. Thanks, guys. It was great to be on. Good talking.
Jodi Phillips:
Thank you.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of November 22, 2022, and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
In general, stock values fluctuate, sometimes widely, in response to activities
specific to the company as well as general market, economic and political
conditions.
The risks of investing in securities of foreign issuers can include fluctuations
in foreign currencies, political and economic instability, and foreign taxation
issues.
Stocks of small and mid-sized companies tend to be more vulnerable to adverse
developments, may be more volatile, and may be illiquid or restricted as to
resale.
A value style of investing is subject to the risk that the valuations never
improve or that the returns will trail other styles of investing or the overall
stock markets.
Inflation prints refer to Consumer Price Index reports issued by the US Bureau
of Labor Statistics. In June 2022, US inflation reached a 40-year high of 9.1%.
According to the Investment Company Institute, investors pulled $27 billion out
of equity mutual funds and exchange-traded funds in September 2022.
According to Bloomberg, October 2022 was the 11th best month for the S&P 500
Index in 35 years, rising 8.1%. Nov. 10 was the 15th best day for the index
since 1957, rising 5.5%. The index experienced an 11% rally from March 8, 2022,
to March 29, 2022.
The American Association of Individual Investors Bull-Bear Spread is the net
percentage of positive minus negative respondents to the association’s sentiment
survey.
The Chicago Board Options Exchange Equity Put/Call Ratio is a measure of seller
relative to buyer positioning derived from the options market.
The Economic Policy Uncertainty Index utilizes US newspaper archives to gauge
the level of policy-related economic uncertainty.
The Chicago Board Options Exchange Volatility Index®, or VIX, is a key measure
of market expectations of near-term volatility conveyed by S&P 500 stock index
option prices.
The Bloomberg US Corporate High Yield Average option-adjusted spread measures
the spread of US dollar-denominated, below investment-grade, fixed-rate
corporate bonds above their Treasury counterparts. When the spread is wide,
investors demand high compensation for taking risk.
The Supply Chain Disruption Index includes the Institute for Supply Management
manufacturing and services supplier deliveries, backlog of orders, and
inventories; the Baltic Exchange Baltic Dry Index, which is a composite of the
bulk time-charter averages; spot prices for dynamic RAM chips measured by
inSpectrum; and the Drewry Hong Kong-Los Angeles container rate per 40-foot box.
A basis point is one hundredth of a percentage point.
A Z-score is a numerical measurement that describes a value's relationship to
the mean of a group of values. Z-score is measured in terms of standard
deviations from the mean.
Standard deviation, or Sigma, measures a range of total returns in comparison to
the mean. A 2-Sigma event, for example, refers to returns that are two standard
deviations away from the mean.
Risk aversion is the tendency of an investor to avoid risk.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
NA2617476
WHAT’S DIFFERENT ABOUT THESE MIDTERMS?
As the nation heads for the polls, Head of Global Public Policy Andy Blocker
talks about the issues that are energizing voters today. Plus, we discuss key
pieces of legislation recently passed by the current Congress, and what’s behind
this summer’s “outbreak of bipartisanship.”
00:00
00:00
31:27
Listen32 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Invesco Greater Possibilities Podcast, where we put your concerns
into perspective and the opportunities into focus. Hi, I'm Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. Today we're talking with Andy Blocker, Global Head of
Public Policy, and our resident expert on all things happening in DC. And
nothing's bigger right now than the upcoming midterm elections on November 8th.
Brian Levitt:
That's right, Jodi, the midterm elections. You know what David Letterman said
about the midterm elections?
Jodi Phillips:
What did he say?
Brian Levitt:
He says, "It's the day that Americans leave work early and pretend to vote."
Jodi Phillips:
Okay. All right, well far be it for me to argue with Letterman, but there's a
lot of speculation that we could break the modern day record for midterm turnout
this year, last set in 2018 actually.
Brian Levitt:
What was that, like half the country? 50.1% or something I think voted in 2018.
Jodi Phillips:
Yeah, I didn't say it was an impressive record, but it's a record nonetheless.
And for Democrats, there's an expectation that those high profile issues, the
overturning of Roe v Wade, the January 6th committee hearings, could bring more
Democrats to the polls this time.
Brian Levitt:
Yeah, that would be a bit of a push against what we've seen historically if the
Democrats were to maintain. I think historically the midterms haven't been very
good for the president's party, and we'll see. I mean, we'll see. Biden's
approval rating had fallen pretty low but maybe coming back up a bit, so we'll
see if this time is going to be different than what Obama experienced, what
Clinton experienced, what Trump experienced.
Jodi Phillips:
We'll see. But Brian, before we get into that and before we bring Andy on, I do
want to ask you a question about the historical trend for markets in the
midterms. Is there a particular outcome that markets would clearly prefer?
Brian Levitt:
Yeah, it's a good question, Jodi. I mean if you look at the performance over the
last 121 years, and that's as far back as we can go on the Dow, it shows a
preference for divided government over single-party rule. That's a comment that
I think is well-known in the industry. I've always heard that for as long as
I've been in this industry that markets like divided government. It's kind of
hard to even discern if that's a statistically significant statement. I'll give
you an example. One of the potential outcomes from this election would be
obviously a Democrat in the White House, a Democrat Senate, and a Republican
House. Now, that's not a foregone conclusion, but it's a possibility. That has
actually been the best for markets over the last 121 years. But you know what's
funny about that, Jodi?
Jodi Phillips:
What's that?
Brian Levitt:
It's only happened in four years, so it only happened from 2011 through 2015.
Jodi Phillips:
Four out of 121, that's it?
Brian Levitt:
At least as I can tell. Maybe Andy will tell me I'm wrong on that, but I tried
to go through the Wikipedia page and look at it.
Jodi Phillips:
Well, there you go.
Brian Levitt:
Yeah, so it doesn't seem that statistically significant, but maybe it's a
similar environment where maybe we'll be coming out of a little recession like
we were 2009, '10, into '11, and maybe it will be a good time for markets.
Jodi Phillips:
Well, let's hope, let's hope. So on that note, let's bring on Andy to get the
scoop on which particular combination of government rule we might see after
these midterms. And I also want to talk about some of the legislation that our
current Congress has passed over the summer, the past few months, and what that
could mean for investors and for taxpayers.
Brian Levitt:
Andy Blocker is back. Welcome.
Andy Blocker:
It's good to be with y'all. Thanks for inviting me back.
Brian Levitt:
You're like our returning champion. I don't think anybody's been on the Greater
Possibilities Podcast more than Andy Blocker, but it really is a statement about
how interested investors are in politics and policy decisions. And so Andy,
let's just start with the bigger picture. What are you expecting to see in
November?
Andy Blocker:
So, that's a great question because expectations are changing day by day. This
is a different year than I think we've ever seen. I mean, conventional wisdom
is, look, we are a rebellious lot. What I mean by that, our country, we started
by rebelling against the Brits, and we really don't like any one group of people
or party holding the levers of power for too long. So historically, we just
throw the bums out or we recreate or at least put some other people in to hold
it back.
Andy Blocker:
So whenever one party has all levels of power vis-a-vis the Presidency, the
House, the Senate, we like to at least take one or both the House and Senate
away from that power that holds the Presidency. And the numbers are pretty
stark. So I think in the last 30 years, which is a tight window, but I think the
average is like 47 seats in the House are lost by the party in power and four to
five seats are lost in the Senate. So that's history, and I think a lot of that
is true for this election cycle.
Brian Levitt:
That's what Obama called the shellacking, right? I think Obama in, was it 2010,
had the worst outcome of any of those presidents over the last 30 years?
Andy Blocker:
That's right, and it was a shellacking partly, and look, I think each party in
power has a little bit to blame because usually when they come in the office,
they overreach. They focus on their agenda and aren't as bipartisan as they
should be, but I think it's just our natural reflection and natural inclination
to be like, "Okay, you had a couple years with all of it. I'm not certain I want
to give you any more time." And all the facts is that the party out of power is
more energized, much more energized because they're the ones feeling aggrieved.
Jodi Phillips:
So Andy, what do you think is energizing voters this time around? What is the
latest polling telling us about what issues are most important to voters right
now? And in particular, where would economic issues land on that list?
Andy Blocker:
Yeah, so that's the key question. What's going to motivate people to get out the
polls? So I just gave you one, just the inclination to "Hey, get those guys out
before they destroy our country." The second is, yeah, economic issues. My
former colleague James Carville, he said, "It's the economy, stupid." And it
holds true today. It's basically this is a tough time for both, if you look
historically for Democrats in the midterm and if you look at the economic
numbers. So inflation is much higher than you would want going into the
election. It looked like it was waning, and then the last month's numbers didn't
do that. And the question is, where is it coming into November? But the
practical ones are like, "Forget the top line number, gas prices." I mean that's
what impacts people's lives every day.
Andy Blocker:
There's a almost directly inversely proportional correlation between gas prices
and Biden's approval rating. It's like as gas prices go up, these numbers go
down. So that's a very motivating factor. It's like, "Hey, these guys are in
office and look what's happened," whether it's totally their fault or not. We
got Ukraine/Russia. You've got coming out of the pandemic. You've got all these
factors, but it doesn't matter, you're in charge and my life isn't as good so I
want somebody else.
Andy Blocker:
But I do think there's some interesting counter-veiling forces this cycle, which
we haven't necessarily seen. We've seen one of them. So the first one is Donald
J. Trump. The more that Donald J. Trump is in the news, the more it motivates
the people who don't like him, and so that's something good for the Democrats.
You name your investigation or whatever he's saying, it doesn't matter. He's
front and center in the news. I think net-net is going to motivate Democrats to
get out more than it's going to motivate Republicans because he's not on the
ballot. When he's on the ballot, he has record turnout. He did it in 2020. He
helped Republicans actually gain seats in the House in a year when Biden won the
presidency. But in 2018, he did a lot more damage to the Republican party. Not a
record number, but a large number of seats taken away from the Republicans. They
lost majority in the House. And so, I think that's a real element, but I think
the one that's even bigger this year is abortion and Roe v Wade.
Brian Levitt:
Right, right. Well, I was just going to say Carville also said that he wants to
come back in life as the bond market so he can intimidate everyone, and that was
kind of to your point about inflation. I don't know, Jodi, if you ever heard
that one. He's like, I don't want to be a rockstar. I don't want to be a-
Jodi Phillips:
No, that one's new to me.
Brian Levitt:
I don't want to be an All-Star baseball player. I want to come back as the bond
market so I can intimidate everyone. And that's clearly been what's happening
this year. The rate's up significantly, equity valuation's down, and that's all
part of this inflation story Andy's talking about. So yeah, I do want to hear
about Roe v Wade and abortion and what that's going to mean for the getting out
of the vote.
Brian Levitt:
But I'm also curious, before we even get to that Andy, you were talking about
gasoline prices and Biden's approval rating. Is there a cutoff point on approval
rating that matters? Biden was in the low forties, I think. Has he come up from
there as gas prices have come down a bit, and do you expect that to roll over in
the next few weeks, given what OPEC has just done to cut oil production?
Andy Blocker:
No, I think that's right. So he has come up as it's continued to... He's in the
what, mid-forties now? I think depending on what you use, if you use
RealClearPolitics or if you use a particular poll. But no, it's still been in
his favor and that's why this OPEC announcement is, I think, that's why the
administration was not very happy with that because they know what it means.
There's reports that, I think, Ron Klain admitted the first thing he looks at,
the Chief of Staff for Biden, he looks at gas prices because he knows that's how
it impacts people's lives. And for those who are more well off, it doesn't
impact their lives as much. They might get annoyed, but for people who are on
the lower end of the income spectrum and people who have to travel greater
distances... In a lot of these metropolitan areas, you might not have to travel.
You might have to travel 5, 10, 20 miles, but in the rural areas, you're
traveling 40, 50 more miles.
Andy Blocker:
And so I do think it has a huge impact, and we'll see what the impact is. They
say they're not going to reduce production until November, but I think it's
already hit the markets. I mean I think the futures markets, it's already hit.
And so, the question is how fast does it get down to the pump?
Jodi Phillips:
So to the point that you were making a little bit earlier about the Roe v Wade
issue energizing voters potentially, are we seeing any signals to help support
that idea? I mean when it comes to either voter registrations or anything else
that might give us insight into what the turnout could look like.
Andy Blocker:
So we were very cautious on that. We knew it would have an impact, but we were
kind of like well, seeing is believing, right?
Jodi Phillips:
Right.
Andy Blocker:
So we see a lot of news reports, we see a lot of things going out there. So the
first signal that this was real, the first real signal, was the Kansas
referendum on abortion. Kansas is a Republican state, a majority very
conservative state. And so, when it came back 59% to 41% for the right to have
an abortion, that was a pretty clear signal that this was going to be a big deal
because it wasn't just Democrats coming out, but you needed Republicans and
Independents and you saw that in Kansas.
Andy Blocker:
Then the next question was, okay, okay fine, it's going to be a big issue, but
it can't have a one-to-one translation to, “If I'm anti-abortion, that means I'm
going to all of a sudden vote for a Democrat.” And I don't think it does. But we
did see another data point in the New York special election for congressional
seat where the Democrat ran solely on this issue, ran solely on the issue of
abortion rights and won the race. I think it was 51/49. It wasn't a big win, but
it showed that this is a winning argument.
Andy Blocker:
But the bigger data point for me is that Republicans who have, up until this
point, had (said) “I'm totally pro-life, no exceptions for the life of the
mother, rape or incest.” All of a sudden their websites have been scrubbed, and
they are no longer purporting that or at least advertising that loudly. And so,
that's a sign to me that when you are moving how you're positioning yourself,
that you recognize this is a threat to your candidacy.
Jodi Phillips:
So Andy, I want to talk a little bit too about the Congress that we already have
and the summer that they had the past couple of months. I saw in your LinkedIn
article recently, you called it an “outbreak of bipartisanship,” and it seemed
like they were checking a lot of things off the list in terms of infrastructure
and energy and veteran health care, manufacturing. What happened? What's behind
all that?
Brian Levitt:
We finally had a good outbreak, Jodi.
Jodi Phillips:
Oh my goodness. Yeah, seriously. So what prompted that?
Andy Blocker:
My theme for the year has been this concept of politics, Trump's policy, and I
think this goes right underneath that. So under that rubric, some people get
upset when I say that. They're like, "No, that's not the way it should be. The
best policy should win." Well no, I agree with you the best policies you should
win, but since we're in a democratic republic, the voters have a say. And so, if
you want your good policy to become real, you make a good politics. So that's
the job there.
Andy Blocker:
So I think a lot of the things that you mentioned, a lot of the different areas
that passed, look, voters wanted safer communities, they wanted better roads,
they wanted modern manufacturing, they wanted US competitiveness globally. So I
think that allowed a lot of these things to come just as a baseline. They're
generally popular. And then also, there are certain constituencies that were
pushing for it. You need the right constituencies pushing for it, and you need
the, how should I say, not just the macro polling to go your way, but you need
the micro polling. You needed the key members in the different chambers, the
House and Senate, who are going to be in favor of it. And a lot of these things,
Senator Schumer, the majority leader and Senator Mitch McConnell, the minority
leader, supported. And once you got that, that kind of paved the way, but they
weren't just doing that in a vacuum. They were looking at the polls, and a lot
of it was the pushback or the consequence of inactions in some of these areas
outweighed the potential pushback against any action.
Brian Levitt:
If we get to the beginning of next year and the composition of the government is
what many people believe it to be, which would be divided, let's just say for
example, are there other things to tick off here where we're going to see more
outbreaks of different strains of bipartisanship, Jodi? Or should we expect it
to be more of a lame duck couple of years?
Andy Blocker:
Yeah, I think between those choices, I'll use the word lame duck, I think is the
most likely scenario. And I say that because I think 2018 is more the model
here. I mean in 2018 after their Democrats won back the House, they spent the
next couple years the way they do. They impeached President Trump twice. I think
this Republican House is going to definitely, if they're not successful, they're
going to try to impeach President Biden. And you also saw the government shut
down because there was divided government. It was Trump and the Democrats going
at it last time. This time it would be Biden going at it with the new House
Republicans, who are going to probably want to extract a lot of things from him,
holding that over his head. And then you've also got late next year, you're
going to have to deal with the debt ceiling. So I think it's going to be very,
very, very contentious, I think, between impeachment, all the different
investigations. They'll have subpoena power. So it's going to be pretty raucous.
Brian Levitt:
Is this the country now? We're just going to do rolling impeachments? I remember
that chapter we learned in, what was it, 11th grade where I think we were going
through the, I'll give up my age, the Clinton impeachment at the time. And then
you had to learn about Nixon's resignation. I think before that you had to go
all the way back to, I don't know, maybe Andrew Johnson or maybe I'm missing a
couple. Is this just how it is now?
Andy Blocker:
I think at least coming up in this next year, it's going to be tit for tat. It's
like, "You got my guy, I'm going to get your guy."
Brian Levitt:
As my grandmother would say, "Oy."
Andy Blocker:
You know what? It's not even about “I disagree with you.” It's “I don't like
you” and “I don't like, you know ...”
Brian Levitt:
It's a shame. It's a shame.
Andy Blocker:
So it's not about we have a difference. No, you are the enemy within. And so
look, that's why I think things like the Cold War, we had a common external
enemy, and that mitigated a lot. Didn't mean we didn't have differences inside
the country, but most of our energy and our ire was focused outside and we
didn't have as much time inside. Now that we don't have as much time outside and
who knows, I mean there's been some unity, vis-a-vis anti-Russia with Ukraine.
There's growing unanimity vis-a-vis China. I think that's the one bipartisan
thing we're going to see. I mean the CHIPS and Science Act doesn't come to pass
unless 82% of the American people have an antagonist view of China. It just
doesn't happen. And so, that was seen as a move to be more competitive with
China, and I think there will may be opportunities even in the next Congress to
do some things there. But that's the one area where there's kind of unanimity by
pushing your animosity outside, but yeah, it's going to be a rough couple years.
Jodi Phillips:
So Andy, you mentioned that the CHIPS and Science Act to boost US semiconductor
competitiveness, production. What could that mean for manufacturing jobs here?
Andy Blocker:
Well, I mean we've already seen it. Intel was the first. They got out of the box
quickly. They announced $20 billion investment for a couple factories in Ohio.
You saw more recently Micron announcing a $100 billion investment in upstate New
York, and IBM came in with another $20 billion investment announcement in
upstate New York. So you've already seen it, and I think you're going to see a
lot more of that because the incentives are really good. That's what the bill
was meant to do was incentivize, bringing a lot of that manufacturing back to
the US because we saw during COVID that that put us at risk. It's the fact that
some of the challenges of having global supply chains, they're fragile, and then
on top of that, the fact that China's relationship with Taiwan and the threat of
that semiconductor production not being able to get back to the US when we're
still relying on it. So I think you're going to continue to see more and more
announcements out of that.
Brian Levitt:
And then the other big piece of legislation I think to talk about briefly is the
Inflation Reduction Act. I love how they name these things. How much of this was
really meant about reducing inflation in the near term? But that's certainly a
catchy name for what's going on. So give us a sense of what that means for
businesses, for taxpayers. What does it mean? Is it really a panacea with
regards to the environment, and what perhaps may be flying under the radar with
that bill?
Andy Blocker:
Yeah, no. Well first of all, so the three major parts are taxes, health-related
provisions, and then the energy and environment that you just mentioned. I think
politically the prescription drug part is really, really important. The question
is whether or not people see that or pay attention to that before this election.
But the fact that Medicare can negotiate on a lot of these prescription drugs
and they've capped some of the payments for your prescription drugs going
forward is a huge deal. But going back to the energy and environment, I think
look, there's a bunch of tax credits and rebates to help lower energy costs, to
strengthen supply chains of critical minerals, and to increase domestic
production of clean energy. And I think this is the largest investment we've
seen in those areas.
Andy Blocker:
And the one thing going forward, the supply chains for critical minerals and the
increasing domestic production of clean energy, those are obviously important,
but in the short term, it's interesting that to lower energy costs coming into
this winter, that's a big deal. So no, I don't think anything's "under the
radar." I think these are real things. This is bipartisan. Everyone's going to
try to take credit for it, and I think they did a lot of good. I think the one
thing, if I were going to say under the radar, is the long-term science
investment because you don't see it right away. But we really need that as a
country to be competitive long term because it's not just about having the best
technology now. It's having the leading edge science now that can lead to the
continuing of our supremacy in that technology arena, which I think is
important.
Brian Levitt:
I keep hearing you use the word investment, and that's after the federal
government spends $6 trillion to support the economy through the pandemic. And a
lot of investors, a lot of people I speak with are very concerned about the type
of money being spent. The national debt now over $31 trillion. What I've tried
to talk about is these investments in the future don't all hit at once. This is
not $4 trillion from the Trump administration, $2 trillion from the Biden
administration. This is money over a longer period of time. So can you put that
into some perspective?
Andy Blocker:
No, I think you hit right on it. I think first of all, it's the investment
versus spending. So I think we were propping up the economy by giving people
money, and the money was flowing out fast to keep the economy going. So even the
$1.9, $2 trillion you talked about from the Biden administration early in their
tenure, I mean a trillion dollars went out in six months. So that is
inflationary. Sorry, we're seeing the effects of that now, but that's a lot of
money to go out really, really fast.
Brian Levitt:
You forgot to tell Jay Powell.
Andy Blocker:
Exactly. Well he was in the middle of... Well, we're not going to go down there.
I have so many … But yes, investment doesn't hit the economy right away. You see
it on the back end, and these bills weren't as big. I mean, Inflation Reduction
Act... Even saying it, it's funny. But it's actually, and most economists agree
with this, it's not as inflationary as the other things. That's the whole point.
It's really about investment. And so, it's got a longer term spend. Even in the
infrastructure bill, that was a longer term spend. We talked about that, how
it's over a 10-year period. I think these are investments we need to make now. I
don't think there's inflationary, but they're going to be immense benefits down
the road.
Brian Levitt:
Jodi, it reminds me of when the American Tax Payer Relief Act increased my
taxes.
Andy Blocker:
Don't even talk to me about that.
Jodi Phillips:
Good times.
Andy Blocker:
I don't want to know. I'm in one of those states where they got rid of the SALT
and that's just been very, very painful.
Brian Levitt:
Exactly, exactly.
Jodi Phillips:
So Brian, is it time to ask Andy what I'm sure his favorite question is?
Andy Blocker:
Don't do it.
Brian Levitt:
Let's do it.
Jodi Phillips:
2024, what's going on? Who's running?
Andy Blocker:
We're not even past 2022. Why are you... Come on. All right …
Jodi Phillips:
I have you here. I'm taking advantage. I want to be the first to know.
Brian Levitt:
We ask the question that people want to know on Greater Possibilities.
Jodi Phillips:
That's right.
Brian Levitt:
We don't ask what you want to answer, we ask what we want to know.
Andy Blocker:
My problem is I actually answer this question. So I want to give you what I've
been saying for a year, and no one likes what I say but that's okay. Just got to
give it to you straight.
Jodi Phillips:
At least you're consistent, that's good.
Andy Blocker:
So here we go. I'm going to start with the answer, which is going to have a
bunch of moans and groans, and I'll explain why. Trump versus Biden. Okay,
here's why.
Brian Levitt:
Are you groaning? I didn't groan.
Andy Blocker:
You didn't groan. I think they're the default case. I'm not saying that's what's
going to happen, but if you had to put money and bet today, those are the two
candidates. Why? Because each of them is in control of whether that happens. So
if Trump decides to run for the nomination, the Republican party, he will win
it. If Biden runs for the nomination of Democratic party, he will win it, and
that's where I start with.
Andy Blocker:
So are there counter-veiling pressures on each of them? Yeah, sure, and there's
a lot that can happen between now and then. I will say for the record, despite
all of the investigations of former President Trump, being indicted is not a
disqualifier to run for president or be president. Now being convicted is. Even
if he's indicted, I'm not sure how fast the court system works where that could
even happen. So that's why I'm saying if he wants it, he gets it, and I'm not
sure all these investigations do anything for it.
Andy Blocker:
On Biden, I think Biden is equivocating. I mean he's gone back and forth between
keeping it open and then also saying, "No, I'm definitely running," in the last
few weeks. So I think that's going to see what it looks like coming into the
year 2024. We will not hear from him until that time, but if he runs, he's a
leader of the Democratic party, and you're going to have multiple candidates
against him. And he'll have his solid 30% to 40% just like Trump would have on
his side, and the math will work out that way where they get there. So there you
go.
Jodi Phillips:
All right.
Brian Levitt:
My last question on that, Andy, is okay, so it's January, 2025, it's
Inauguration Day. We've had a contested election. Is there any risk that we
don't know who the president is on that day? Is there any risk? Bill Maher
talked about this a lot on his show of two candidates showing up to take the
Oath of Office.
Andy Blocker:
So I think that's why the Senate's working on this Electoral Count Act to
prevent that. And so, they're being bipartisan about it, trying to make sure
that the Vice President's role is ceremonial and that there's different
guardrails against that.
Jodi Phillips:
Well, the next question on my list is about 2028. So we better cut this off now.
We'd better cut it off now. Andy, thank you so much for joining us once again
and entertaining all of our questions, and we'll see how this all turns out
quickly enough.
Brian Levitt:
Thanks, Andy.
Andy Blocker:
All right, thanks, guys.
Jodi Phillips:
Thank you.
Important information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of October 6, 2022, and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
2018 midterm turnout data is from Roll Call.
Historical analysis of the Dow Jones Industrial Index under different types of
party rule is from Bloomberg, L.P., and Strategas Research Partners as of
12/31/21.
The Dow Jones Industrial Average is a price-weighted index of the 30 largest,
most widely held stocks traded on the New York Stock Exchange.
Historical analysis of past midterm election results and presidential approval
ratings are based on Invesco research.
According to Real Clear Politics, Joe Biden’s approval rating was 41% in August
2022.
James Carville’s quote about the bond market was repeated in Bloomberg News
1/29/18.
Kansas referendum results reported by Reuters, as of 8/3/22
New York special election results reported by the Associated Press as of 8/24/22
Data on Americans’ view of China comes from the Pew Research Center as of
7/29/22
Information on semiconductor manufacturing investments from Intel, Micron and
IBM come from company announcements.
Figures on federal pandemic support spending are from Bloomberg News.
US national debt data is from The New York Times as of 10/4/22
OPEC stands for the Organization of Petroleum Exporting Countries.
SALT stands for State and Local Taxes.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
DRIVING BY THE REARVIEW MIRROR
The Federal Reserve appears to be setting forward-looking monetary policy based
on backward-looking inflation indicators. So what does that mean for the
direction of the economy? Rob Waldner joins the podcast to talk about how far
the Fed may go to get inflation to its target, and what this could mean for
fixed income investors.
00:00
00:00
28:19
Listen29 min
Show transcript
TRANSCRIPT
Brian Levitt
Welcome to the Invesco Greater Possibilities Podcast, where we put your concerns
into perspective and the opportunities into focus. I'm Brian Levitt.
Jodi Phillips
And I'm Jodi Phillips. And today we have Rob Waldner on the podcast. Rob is
chief strategist and head of macro research for Invesco Fixed Income. Fixed
income. Not a lot going on there, right, Brian?
Brian Levitt
Yeah, we seem to get the timing right, coincidentally, or maybe not
coincidentally with these guests. There's a lot going on in every market, Jodi,
but for fixed income it had been particularly rough. I think equity investors
have probably become somewhat conditioned for bad environments. We've seen this
a lot over the years, even in my career, just 2000, 2008 … I mean we've seen
this, but for the bond investors to be down, I think at one point, 14.5%, if you
look at the aggregate bond index, in the same year that equities are down 25%, I
mean that's a tough pill to swallow.
Jodi Phillips
Well it has and you can see that in the numbers, right? You look at the
Investment Company Institute, look at their flow numbers. And there's been about
$260 billion in outflows from fixed income mutual funds and ETFs this year. And
around $30 billion or so of that has been in the past five weeks.
Brian Levitt
Yeah, I mean investors tend to bail at inopportune times. But remarkably, equity
flows have actually been positive over the year.
Jodi Phillips
That's a little surprising to me, honestly.
Brian Levitt
Yeah, I mean maybe, and maybe we're learning, maybe equity investors are
realizing how badly they've been burned by selling at those inopportune times in
the past. Well, we'll see.
Jodi Phillips
We learn but we learn the hard way, right? So we'll see how this works out. But
you know what, it has been a remarkable year for interest rates and inflation,
no doubt.
Brian Levitt
Oh, I mean remarkable is, I mean this is one for the history books, right? I
don't even know is remarkable the strong enough word?
Jodi Phillips
No, probably not.
Brian Levitt
Probably. Even the two-year rates started below 1%. I mean that was like the
market was expecting only a couple of interest rate hikes this year and surged
above four. I mean the 10-year was what had climbed from a low of around 1.5% to
what, 3.75% or so. So I mean it's been remarkable.
Jodi Phillips
Yeah. And those 10-years that were 1.5% at the start of the year just aren't
that valuable when you're looking at three and three-quarters right now. So it
is an interesting situation for sure. Not a lot of places to hide.
Brian Levitt
Yeah, there hasn't been. It's not only Treasuries. We've seen borrowing costs go
up for corporations as well, but we start to think, look, perhaps a decent
amount of the worst is behind us for rates — if we're certainly getting closer.
And so at this point, it's really about the market getting more clarity on
inflation, on the Fed. How tight does the Fed need to be?
Jodi Phillips
That's the question.
Brian Levitt
Yeah, that's probably the 200 trillion dollar question.
Jodi Phillips
200 trillion dollar question. No pressure there. So that is definitely Rob's
cue. Yes?
Brian Levitt
Yeah, that's his cue. I want his view on rates, inflation, credit, how far he
thinks the Fed is going to go. Are we finally generating income in fixed income?
Is this what we've been waiting for? And now investors are bailing on it. So
there's just so much to talk about. Let's bring Rob on.
Jodi Phillips
Great. Welcome, Rob.
Rob Waldner
Thank you, Jodi. Thank you, Brian. Thanks for having me on.
Brian Levitt
Yeah, it's our pleasure. Let's just characterize, Rob, what's going on. What's
been driving markets here?
Rob Waldner
Well you've spoken about the poor total return performance we've had this year
in fixed income. And I think it's helpful though to disaggregate it into what
kind of really drove it. And I think there's a narrative out there that it's all
about inflation and that inflation really picked up and therefore fixed income
had such negative returns. That's partially true. But really what happened, I
think if you're going to look at this, what really drove fixed income this year
is that after years of being sort of excessively loose, with monetary policy,
the Fed took a total pivot and went all the way from the loose side — as loose
as possible — to now being essentially as tight as possible.
Rob Waldner
But the reason I say that is if you look at what happened in real yield, so in
fixed income we like to talk about real yields, which are the yields that you
get by comparing inflation-adjusted securities, or TIPS (Treasury
Inflation-Protected Securities), to Treasuries and what the implication is for
inflation. That TIP gives you the real yield. Real yields have risen by almost
250 basis points. So we started out at negative in the 10-year sector, we
started at negative yields at a year ago, about minus 1%. We're now at plus 1.5%
percent. And that's really not inflation, because the inflation compensation
component of that has moved kind of sideways. That's really driven by the Fed
getting very aggressive. And so that's the story, is that the Fed is pivoted
from being super easy with QE (quantitative easing) to being very tight with QT
(quantitative tightening).
Jodi Phillips
So Rob, talking to you the other day, just to put a point on this, you mentioned
that you hear so often from investors, "What do I do about inflation? What do I
do about this?" And that that's really not necessarily the right question to be
asking. So what should investors be asking right now?
Rob Waldner
Well, I think with what the Fed has done, what the Fed has told us is they are
going to get inflation back down to 2% no matter what. So the question really
isn't, “How do I protect my portfolio from inflation?” It's “How do I protect my
portfolio from the Fed?” Because the Fed told you what they're going to do,
which is they're not going to rest until they have clear signs that inflation is
headed to 2%.
Rob Waldner
And by the way, that's what the market is implying. So market breakevens, again
looking at TIPS versus nominal Treasuries, tell you that the market has
confidence in the Fed. And so what we need to do is figure out exactly how far
the Fed is going to go and to cut to the chase. We think that we're getting
pretty close to the time when it's a good opportunity to buy fixed income and
that the Fed has tightened policy quite a lot. We see signs that inflation has
peaked. It may take a while to come back down, but we think that this narrative
that is out there — “This is the 1970s, and we’ve just got to keep raising rates
and raising rates” — is just not the right narrative.
Brian Levitt
I mean that's good from an investment perspective, but not from my wardrobe. I
just went out and I bought a polyester leisure suit and Jodi's been crocheting
sweaters.
Jodi Phillips
I'm so glad this is audio only.
Brian Levitt
But to that point, Rob, I mean when I think of ’73, ’74, ’75, I think of the
idea at the time that the Fed had kind of lost the narrative, whether it was
previous to Arthur Burns, William McChesney Martin doing the bidding of Lyndon
Johnson or then Arthur Burns doing the bidding of Richard Nixon and long-term
inflation expectations getting out of whack. The bond market is telling you that
this is a very different situation. Is that what you're saying?
Rob Waldner
Exactly right.
Brian Levitt
And so when we think about them pushing so hard on this, even with inflation
expectations pretty benign. What starts to happen with growth expectations? What
starts to happen with financial conditions? I mean how worrisome is what's
transpiring to you?
Rob Waldner
Okay, so let's break this down because I think that's a great question, Brian.
So when we think about this, thinking about how the market's going to behave, we
like to break it into three components, which is what's inflation going to do,
what is growth going to do, and what is central bank essentially policy going to
do? Right? And we already talked about inflation. We think inflation's peak is
going to come down slowly, but will be maintained. This is not the 1970s. So
then the question is, the Fed’s tightening policy, what is that going to do for
growth? And so we have a bit of a horse race here between tightening policy and
growth, and how much will the Fed slow growth, when will they pause to see how
much tightening they’ve put into the system? And so the thing that worries us a
little bit is that with longer-term inflation expectations remaining
well-contained and the Fed just continuing to deliver for global central banks.
Rob Waldner
That's just like, global central banks continuing to deliver hawkish surprise
after hawkish surprise after hawkish surprise. And really we've never seen,
globally, central banks raise rates at this pace. There's really a real risk
that we could see something break, or that they overtighten. And I think we
could point to a couple of things that might point to that: tightening financial
conditions, the dollar is on a tear, real yields are rising globally. So that's
kind of what we're worried about.
Brian Levitt
Okay, Rob. So Jodi's Jay Powell, what do you say?
Jodi Phillips
Sorry.
Rob Waldner
Well, so the message for Jay Powell is you've set up this narrative where you
are the new (Paul) Volcker and you are going to raise rates essentially until
you see the whites of the inflation eyes. Right? And the problem with that is
that we know that inflation is a lagging indicator, and we know that the
inflation that we have today is about what we did two years ago in terms of
fiscal policy and monetary policy, that really juiced the economy and gave
people money to spend on cars, and houses, and they had low mortgage rates.
Rob Waldner
All of these things are what's driving inflation now. So that's gone, right?
Those stimulus checks have been cashed, you can't get those back. Those
mortgages at 2.5% or 2.75% — we never thought we'd see — people took them out.
Those are all in place. You can't undo that. So that as well is one of the
things that's really driving our inflation now. So those are trailing
indicators, if you like, right? That's something that did happen. Meanwhile, the
Fed has monetary policy and so I'd say Jodi, you're setting a forward-looking
instrument which is monetary policy based on a backward-looking indicator. And I
wouldn't recommend driving looking in the rear view mirror, just not a good
strategy.
Rob Waldner
And so we would say, hey, maybe it's time to see, with all this tightening, to
see what ... take a bit of a pause. We've been calling it pivot, and we've been
hoping that they would pivot over the last several months. No signs of it yet.
But they would take a bit of a pause.
Jodi Phillips
Absolutely. So do you have a sense, or I know everyone's looking, listening to
every word that's spoken in every press conference, at every release, looking
for signs of that pivot. What do you think it's going to take or what do you
think they're looking for before they begin that process?
Rob Waldner
So I think it's either something breaks, right? And we have two recent examples
of things that, well two minor, maybe, could start to chart the path. One, we
had this whole episode in the UK last week where we basically had, for a variety
of reasons, we had the gilt market come unhinged, the bond market there become
unhinged, and put quite a lot of – that created quite a lot of collateral calls
in the pension system there, due to the structure of the pensions, and really
the Bank of England was forced to come in and stabilize things. So what they did
is they bought bonds, they went back to essentially, it's not really QE, but
they bought bonds the same thing basically as QE. And that is after they'd been
planning on doing QT. So they really did a sort of pivot towards a more dovish
stance, not a big pivot but that's that something was breaking. The liquidity in
the market was deteriorating, causing a breakage in the market and they came in
and stabilized it.
Brian Levitt
The market told us we shouldn't be lowering taxes on the wealthiest people in an
inflationary environment or at least the British shouldn't be.
Rob Waldner
Yeah, well yes. That, and also it told us that with rates, when rates are moving
this quickly and this aggressively, it doesn't take much for portfolios to get
twisted, for these total returns to really become a problem. And so I think it
said to the UK, you need to calm down, you need to take it a little bit slower,
you can't move rates that aggressively. That was one. And the other is we've got
the Reserve Bank of Australia recently and they delivered a dovish rate hike
which is only 25 basis points. So I think the narrative there is that a little
bit, maybe they are, we'll see whether the Fed might do something similar. We'd
certainly love to see that.
Brian Levitt
Rob, how would you position, so many investors when they built the 60/40
(portfolio), the 40% was going to be longer-duration ballast in the portfolio,
maybe not the highest yielding securities you could find in the fixed income
market, but certainly protection or the perception of protection. When Jodi and
I were talking about the flows data, it seems that that's probably where, or a
good amount of it has come out of what was to be the ballast. If you're talking
about excessive tightening, slowdown in the economy, dare we say a recession, is
that a return back to longer-duration assets?
Rob Waldner
Well I think I agree with the way you kind of characterized it in the beginning,
Brian, which is just when I can tell you there's some value in fixed income, for
the first time in many years, the flows are still out. So I'm getting hoarse
going out and talking to people about the value that fixed income can bring to
your portfolio now. Because if you go back to the way I set this up a moment
ago, we have tightening policy and we have growth. These are the two things
we're worried about. Well if we game this out and let's say that the Fed does
what we hope it will do, which is or that we think they should do, which is sort
of take a pause, that would be a little bit dovish received by the market,
overall level of rates would stabilize, might come down a bit, and you'd see
probably credit spreads coming because that would be a better liquidity
environment, less recession risk.
Rob Waldner
The bad scenario there would be the Fed continues to tighten and continues to
tighten, and then we get a recession and we get a nasty recession. And the
advantage in that environment though, I still can see fixed income performing a
decent role in your portfolio relative to some of the other choices. I'm not
saying investment grade bonds are going to give great total returns, but they're
going to hold up relatively well to most of the other assets that you could put
in your portfolio such as lower quality credit or equities. So I really do think
bonds are back to being a great investment here for the first time in quite a
few years. The investment grade index is yielding about 5.4%. So you can buy a
basket of investment grade bonds, collect 5.4%, which by the way, everybody
thought that a year ago people would've been falling all over themselves for
5.4%.
Brian Levitt
Absolutely.
Rob Waldner
Got 5.4% and you don't really have an investment grade index, you don't have the
worries about near-term defaults, et cetera. And you have duration in that
index. So if you do get the recession, the duration will help offset some of the
spread widening, and if you get the dovish Fed pivot, that's going to be a great
entry point.
Jodi Phillips
So Rob, you mentioned that you were going hoarse a little bit spreading that
message out and I'm glad you regained your voice in time to join us today. But
when you are talking about this story out there, what kind of questions are you
getting, or what kind of concerns are you hearing that maybe you're having to
work through, and really communicate to investors what they're looking at right
now?
Rob Waldner
Well I think there's two things. One, the US Agg is down 12%, 13%. So your fixed
income portfolio is really taking a beating. And so I think that makes one
cautious. Two, while we think we've seen inflation peaking out, you haven't seen
the decisive turndown that the Fed is looking for. And it's going to be messy.
We know that there will be some persistence in inflation in housing, and so
you're going to have to look through some noise really. So you have to look
through the noise and ignore the negative total return so far this year, if
you're going to buy into that story that I just gave you.
Brian Levitt
Are you surprised where credit spreads are today? And by that, I mean
historically low relative to where they typically are in an environment where
growth is slowing?
Rob Waldner
Yeah, I think the answer would be yes. I think we haven't really priced a
recession in the credit markets or in probably some of the other markets as
well. Even if I do a very simple look at, I think what we've largely priced into
a lot of these markets is the rise in real yields and what the discount rate
that that implies for companies and others. And so that means you got to take
down your multiples in equity market and it means slightly wider spreads, but it
doesn't seem to us that you've priced in a recession. Certainly, particularly in
lower quality credit, you can see much wider spreads in a recession that we have
now. And that's why I've been talking about investment grade, I was talking
about investment grade and not high yield.
Brian Levitt
Yeah.
Rob Waldner
The other areas that, there are going to be areas in credit that could be
challenging, or if you're a company, in a recession, if your funding costs are
going up, let's say your floating rate debt and your top line is under pressure,
your revenues are under pressure because of recession, we could get a default
cycle there or at least a downgrade cycle picking up.
Rob Waldner
So that would bring you wider spread. So we're not positive on credit overall,
but I think we like higher quality credit.
Brian Levitt
And to your point, you start to compound those attractive income level or that
attractive income stream that we haven't been able to compound in a very long
time.
Rob Waldner
Right. I think there's some benefit from that duration, buying fixed rate
assets.
Brian Levitt
And in terms of the currency, it's all part and parcel of the same trade, is it
a dollar trade until the Fed pivots?
Rob Waldner
Yes, I think that's what's driving it here is the Fed.
Jodi Phillips
So Rob, you had talked a little bit earlier about how it's not just the Fed,
it's global central banks really almost working in tandem on this. Looking at
this regionally, are there any spots that you would particularly highlight maybe
in emerging markets or elsewhere?
Rob Waldner
Yeah, I think that that's one of the stories about this cycle that's
interesting, is that while the Fed was quite late, not all central banks were
late to the cycle. So particularly there's some central banks in emerging
markets and in LatAm (Latin America) for instance, who really have been hiking
rates for a while, increasing rates were out ahead of the Fed. And so there are
some situations where the cycles are a little bit more divergent from the
typical scenario. And we think that's quite positive. And actually some of these
countries, like a Brazil for instance, has actually had relatively good
performance in this year. I think partly because they got out in front of it,
started raising rates sooner. So there is some divergence in the cycle. Another
place is China, where China's kind of been in recession and the policymaking has
been much more stable.
Rob Waldner
I.e., real rates never really went negative. They haven't really moved much,
interest rates haven't really moved up with China for a number of years. So
they're at a different point in the cycle. So I think we're really starting to
see some real benefits of diversification globally. If you look outside of the
western US/European bloc, you're starting to see some benefits from
diversification. So I think that's a really interesting thing. Now it is clear
though that the Fed is, it can really realize a lot of value here. From some of
these markets, you probably do need to get the Fed to pivot or just to slow down
the rate hikes.
Brian Levitt
Okay Rob, we're going to put you back in Fed Chair Jay Powell’s seat. We're not
going to make it 2022 though, we'll make it Powell's retirement day, whenever
that may be. And we're going to have you look back on how this all played out.
How are you feeling? Did you emerge with the Powell name intact?
Rob Waldner
Well I'm going to feel a little bit uncertain about it, I got to say, because I
know that kind of already, I made a policy mistake in sort of 2021, 2022 by
keeping rates too low, too long. I bought into the lower employment forever kind
of narrative that I made a mistake in 2022, 2023 by hiking rates too
aggressively and keeping them too high. I bought into the “inflation is the big
problem” narrative. And so hopefully the US economy will continue to power
forward, so it will do great over this longer term period. But I think I won't
feel that good about that period, this period here. And when I express that to
my wife and say I feel kind of bad about that, she'll say, "Well, honey, you
remember how much pressure you were under. Remember all the political pressure
and the narrative of the time," and she'll try to make me feel better. And all
that's true that tremendous amount of political pressure to get unemployment
low, then to keep rates low, then now deal with inflation. But I do think that I
will, with hindsight, I would have implemented a different policy.
Brian Levitt
Implement a different policy. But the key takeaway I'll take there is we'll get
through it, and the US economy will continue to be a growing concern and an
ongoing investible opportunity.
Rob Waldner
Absolutely.
Jodi Phillips
We'll get through it. It sounds like the perfect place to wrap up to me. Thank
you so much, Rob, for joining us and for taking our questions and putting
yourself in that hot seat, putting yourself there for a time. Not an easy
question, Brian.
Brian Levitt
He needs a hug. Thanks, Rob.
Rob Waldner
Well, thank you all.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of October 4, 2022, and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
Diversification does not guarantee a profit or eliminate the risk of loss.
Data quoted for the aggregate bond index refers to the Bloomberg US Aggregate
Bond Index, an unmanaged index considered representative of the US
investment-grade, fixed-rate bond market.
Equities performance data refers to the S&P 500 Index.
Data for US two-year and 10-year Treasury yields is from Bloomberg, L.P.
Yield data for the investment grade index refers to the Bloomberg US Corporate
Bond Index, which measures the investment grade, fixed-rate, taxable corporate
bond market.
Fund flow data from the Investment Company Institute.
All data as of October 4, 2022, unless otherwise specified.
Breakeven inflation is the difference in yield between a nominal Treasury
security and a Treasury Inflation-Protected Security of the same maturity.
Statistics on the 10-year, 5-year, and 2-year breakeven inflation levels are
from Bloomberg and the US Treasury.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates. Interest rate risk refers to the risk that
bond prices generally fall as interest rates rise and vice versa. An issuer may
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market issuers, can include fluctuations in foreign currencies, political and
economic instability, and foreign taxation issues.
Investments in companies located or operating in Greater China are subject to
the following risks: nationalization, expropriation, or confiscation of
property, difficulty in obtaining and/or enforcing judgments, alteration or
discontinuation of economic reforms, military conflicts, and China’s dependency
on the economies of other Asian countries, many of which are developing
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or securities to cover movements in the value of derivatives contracts.
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The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
THE CONTRACTION HAS BEGUN
Just two years after entering a recovery regime, the Invesco Investment
Solutions macro framework has entered the contraction stage. But what does that
really mean for investors? Alessio de Longis returns to the podcast to discuss
what his model is telling us and what it could mean for portfolio positioning.
00:00
00:00
28:51
Listen29 min
Show transcript
TRANSCRIPT
Brian Levitt
Welcome to the Invesco Greater Possibilities Podcast, where we put your concerns
into perspective and the opportunities into focus. I'm Brian Levitt.
Jodi Phillips
And I'm Jodi Phillips. And today, we have Alessio de Longis making his return to
the Greater Possibilities Podcast. Alessio is Global Head of Tactical Asset
Allocation and a great friend to the pod. So Brian, we last talked to Alessio
for our midyear outlook podcast, which seems like only yesterday. It posted in
June. But you reached out to me a few days ago and said, we have to get him back
now. So what is going on?
Brian Levitt
Yeah, I sure did. And that's because the tactical asset allocation model, the
framework that we all support, that Alessio uses, that we all follow, moved into
contraction territory.
Jodi Phillips
Contraction territory. That doesn't sound very good, Brian.
Brian Levitt
No, I guess it's not ideal. I mean, it's what we always say though. High and
rising inflation leads to the type of policy tightening that can end cycles.
Jodi Phillips
Yeah. I've heard you say that more than a few times this year. I mean, starting
back in January, you wrote a piece. I think the headline was, What Keeps me up
at Night? Am I remembering that correctly?
Brian Levitt
Yeah. I'm glad you remember that. That does sound familiar. I guess it's time to
break out the warm milk then, if we're officially in contraction.
Jodi Phillips
Or a white noise machine to block out the market rumblings, that might be
helpful. But look, the question for investors is, does a contraction have to be
a nightmare?
Brian Levitt
Yeah, it's a good one. I mean, look. This has been a very, very unique cycle. We
haven't really had time for big excesses to build in the economy, and perhaps
maybe a contraction could even be mild by historical standards.
Jodi Phillips
That would be great, right? So, all right. One question answered, the
contraction is here. More questions, how long will it last? How damaging could
it be for markets? And how might investors think about responding to it? So
let's bring on Alessio to discuss all of that and more. Welcome, Alessio.
Alessio de Longis
Jodi, Brian, always a pleasure to be with you.
Brian Levitt
Alessio, thanks for joining. You talk about the different regimes that the
economy goes through in a cycle, whether it's recovery, expansion, slowdown,
contraction. What's so stunning about this is I feel like we're going through
all of them at a very rapid pace. So I guess first, how rare is that? And then
second, how do you define a contraction?
Alessio de Longis
Yeah, Brian, certainly this has been a rollercoaster cycle that seems to have
started only two years ago. And we are approaching its end when we look at the
sequence, right? Just for our audience, we registered the last contraction
between February and May of 2020. We entered the recovery June 2020, and here we
are. Two years later, we have moved back into contraction. Really a two-year
cycle, basically. What is a contraction? A contraction we define as, very
simply, as growth expected to be below its long=term trend or its potential, and
to continue to decelerate.
Alessio de Longis
So to be clear, a contraction includes recessions, but is not limited to
recessions, right? When we think about recessions, we think about negative
economic growth across a wide spectrum and indicators. And so in other words, a
contraction in our case includes also periods where the economy is still growing
positively, slowly, and growing below its long-term trend. So it's a little bit
more broad ranged.
Alessio de Longis
So this goes into the other question that Jodi was asking. Does every
contraction mean a nightmare? Does every contraction mean a financial crisis?
Absolutely not. Just like, as we said, not every contraction that we register in
our framework even means a recession, so to speak. Can mean a period of
weakness, but not necessarily a recession. And certainly, not necessarily a
global financial crisis.
Jodi Phillips
So Alessio, were you surprised that your model is signaling a contraction right
now? Or was this something that you would've been expecting at this point in
time?
Alessio de Longis
Not surprised because if anything, this is one of the few instances where I feel
our model has lagged the actual perception on the street, right? And needless to
say, of course, we haven't categorized the first two quarters of this year as a
recession yet. But technically, we did have very soft growth, two negative
quarters of GDP (gross domestic product) growth. Even though we can explain them
statistically through some anomalies, they certainly don't feel like a
recession, but they are clear evidence of weak economic growth.
Alessio de Longis
So this contraction does feel a little bit pre-announced, so to speak. Not
really a leading signal this time around. Doesn't mean it has to be a wrong
signal, but I don't think anybody was shocked when we printed the blog this
month, compared to other instances.
Brian Levitt
Alessio, help me square it, though. So the market applauds a Consumer Price
Index (CPI) showing that it looks like the pace of growth, or the rate of growth
of inflation slowing a Wholesale Price Index, which was actually negative for
the month.
Brian Levitt
So the markets seem to be applauding this peak in inflation. Is the idea that
the economy's in a contraction or the regime is contraction, does that tend to
suggest that the market's not going to continue to applaud this?
Alessio de Longis
Yeah. A great question. And to me, it's the biggest question mark right now. So
what is the typical behavior of a contraction, right? Brian, as you always say,
every contraction or every recession is usually brought by the Fed, right? It's
brought by inflation and the tightening cycle that the Fed needs to extend in
order to slow the economy. It's exactly where we are today. Like, even if you
read word for word what Chair Powell said in the last FOMC (Federal Open Market
Committee) press conference. He said, we need to get the economy to grow below
its long-term trend for a prolonged period of time in order to get the
unemployment rate to rise and build slack in the economy.
Alessio de Longis
Obviously, this is what we're trying to do. So what do you typically see in that
environment, from a markets perspective? Which is the nature of your question.
We tend to see during a contraction that inflation has peaked already, or is
falling ...
Brian Levitt
Do we want to stop there and applaud, all of us? Do we have streamers or the
horns that you blow ... what are the horns, Alessio, they blow at the soccer
games? The vuvuzelas?
Alessio de Longis
Oh, yeah. The vuvuzelas, yes. Yes. Those will make a great sound for this
podcast. I don't feel yet as excited to celebrate, I think ...
Brian Levitt
A peak in inflation?
Alessio de Longis
I'm going ... yes. Look, I think it's a good sign to see a peak in inflation.
The part that is still not ... let's look at a glass half full. A glass half
full would be one where we are in a contraction that doesn't turn into a
recession. How does that happen? Inflation begins to roll over, which is
probably what we're beginning to see. The economy actually holds up. The
unemployment rate rises, just modestly. It turns out that the Fed, even though
it hiked aggressively, the economy was more than able to handle it. We continue
to grow below potential. The inflation comes down. In that environment, the
markets are actually going to trade more like a recovery, right? Eventually the
market is going to rally, substantially led by credit spreads, which is exactly
the reaction that we saw after the CPI report. And we basically are able to say,
yeah. We printed a contraction. It never turned out to be a recession. The cycle
moves on.
Alessio de Longis
There is another side. The glass half empty would be one where this rollover in
inflation is still driven predominantly by rolling of supply factors. Rolling
over in supply factors and the well-known supply chain issues. But that we
haven't even begun to see the demand-induced slowdown by the Federal Reserve.
Even though we know mortgage rates are at cyclical highs of 5.5% coming from
2.5%. Affordability in the housing sector is down to the all-time lows of 2006.
And consumer sentiment is already very weak. But by-and-large, the unemployment
rate is still at all-time lows. It hasn't even begun to move. So it's very hard
to say that this rollover in inflation is due to the demand side of the
equation.
Alessio de Longis
Now, if the supply side of the equation for inflation rolls over very quickly,
the Fed may actually be able to stop very soon. So that is the glass half full
scenario. I think we are dancing a very, very difficult tango here, and it takes
two to tango, right? It's the Fed, it's the economy. All right, let's say three.
There is the market involved as well. I think monetary policy is a very powerful
tool, but it's not a precision tool. And there is the lag by which the Fed will
impact the economy and that the Fed will be able to see the response from the
economy. I think that's the balance. That's the equilibrium. That's the tight
rope that we're trying to walk at the moment.
Brian Levitt
And Jodi, you and I have discussed this, the demand that exists out there. I
mean, even just in our everyday lives. The restaurants being packed, the hotels
being packed, the airlines being packed. And it does seem like the consumer's
hanging in there.
Jodi Phillips
Well, yeah. Well, I bought some vuvuzelas for this podcast, but it doesn't sound
like I'm going to get to use them yet. So Alessio, I'm curious, is this
contraction signal unique to the US, or is this something that you're looking at
globally?
Alessio de Longis
So at the moment, this is a fairly broad-based observation. We find that
basically all of the developed markets, UK, eurozone, the US, of course, China,
emerging Asia in general, they are growing below trend. And our expectation from
a market sentiment standpoint, as well as the rate of change in some of those
leading economic indicators is that basically, we expect these regions to
continue growing below trend and decelerate. So that's a contraction in our
playbook. Where we see growth still holding up better is in Japan and the rest
of emerging markets, Latin America. The smaller parts of emerging markets.
Alessio de Longis
But let's say that on a forward-looking basis, by our metrics about 80% of world
GDP can be considered to be growing below trend, and therefore being at risk of
a contractionary or potentially recessionary regime. So it's broad-based. And
what we typically see is the average duration of this state of the world is
about seven months. Now, we're talking really just models and technicalities,
right? Just sticking to the facts, right? So if we want to be overly precise,
take it with a grain of salt. But on average, we see these type of regimes
lasting seven months. The shortest instances have been about two months, which
we would call basically a fake. A fake signal, right? A scare that didn't
materialize.
Jodi Phillips
Got it.
Alessio de Longis
Which can certainly still be the case. But in some instances, we have seen
contractionary regimes that have lasted for a year and a half. So look at
instances in the double-dip recession of the ’70s or the double-dip recessions
of the ’80s. So those have lasted a little bit longer. It's hard to say where we
are going today, because frankly, I think that it's all dependent on this latent
supply factor that Brian and Kristina (Hooper) have discussed at length
recently. That if energy prices, if food prices, if some of the supply chain
bottlenecks were to resolve themselves unexpectedly well, inflation may actually
fall more rapidly than we think. And the adjustment, the growth adjustment, the
growth sacrifice that the Fed has to induce might be shorter lift, or less
severe in magnitude.
Brian Levitt
And it actually does look like we're starting to see some signs. Actually, not
some signs, pretty good signs that the supply chain challenges are starting to
ease. Maybe we'll get that short one. I guess I can quote Green Day then and
say, "Wake me up when September ends." And we'll get back into this recovery.
Brian Levitt
But Alessio, I know you're a long watcher of the Fed. Is what they're doing ...
I mean, they already seem to have made the policy mistake, right? That's the
9.1% inflation. Is what they're doing now doubling down or creating another
policy mistake? And the reason I ask that, it almost seems like at some point,
the medicine, i.e., tight policy, higher unemployment rate. May be worse than
this disease, given that long-term inflation expectations still remain very well
anchored in this country.
Alessio de Longis
It's a great question. And it's the question that you could answer in many
different ways. So at the cost of being a little bit dogmatic about it, what is
the definition of a policy mistake? Especially for a central bank that has a
dual mandate. And if you take the letter of the law, as of today, they're
failing on both mandates. So I would say that I ...
Brian Levitt
But why are they failing on full employment?
Alessio de Longis
Because the idea is that they, at steady-state ... which is obviously a
theoretical concept. But on average, they want the economy to grow at the NAIRU
(non-accelerating inflation rate of unemployment). They want the economy to grow
where the unemployment rate is at the non-inflationary level. And we know it's a
very difficult concept to estimate, but if you look at the CBO (Congressional
Budget Office) or the Fed, these estimates for the natural rate of unemployment
that does not generate excess inflation, is somewhere around 4.5%, maybe 5%.
Take it with a grain of salt. It's an estimate, with error bands. But we are at
3.5% (unemployment rate), and so we are at all-time lows. And inflation, to your
point, core inflation, core PCE (Personal Consumption Expenditures) is at 4.8%.
Core CPI's at 5.9%. We're two to three times higher than what the desired target
is.
Alessio de Longis
So as a confirmation of why I would give slack to the Fed and say that maybe the
policy mistake was certainly in the past, but they are remedying it now. And
this is a point that you, Brian, has made very eloquently in the last few
months. Inflation expectations read in the market are coming back in. Six months
ago, 12 months ago, two year breakevens, five year breakevens were at 4%, at 5%.
The 10 year was at north of three, three and a half. Now, the entire breakeven
curve ... so the spread between nominal Treasuries and real Treasuries. Has come
back in below three across the spectrum. So it's telling us that ... so if
anything, there was a policy mistake when we were above three across the board.
Both on a cyclical and on a long-term basis, right? And now all of those
measures have come back in.
Alessio de Longis
A further confirmation is the surveys on inflation expectations have peaked and
are beginning to roll over. So even consumer surveys are responding to that. And
another positive sign in my mind ... and this is a point that, Brian, you and I
have discussed for the last 12 months. The consumer sentiment surveys were at
recessionary levels when the economy was booming, and this rise in interest
rates hadn't even begun. And we were scratching our heads and saying, wait a
minute. The economy is booming. Consumer sentiment surveys are at the
recessionary lows because they're complaining about things being too expensive.
So there was a message from the consumer: “I don't like this. I am losing
confidence on the price signal that I see in the economy.”
Alessio de Longis
What happened today? We are seeing an uptick in consumer sentiment for the first
time in three months. Which is ironic, when you think that rates have risen so
much, and usually we associate it to a sign of trouble. So it's a very
interesting message that we're getting from the market. So I prefer now to give
some slack to the Fed and saying, they're doing what the letter of the law wants
them to do. And if there will be a policy mistake, it will probably be later the
time to evaluate that.
Jodi Phillips
So Alessio, what do we do with all of this information? When you think about it
from that asset allocation perspective, portfolio positioning, what should we be
thinking about right now in a contraction?
Alessio de Longis
So again, knowing that any macroeconomic analysis, any regime analysis does not
carry 100% certainty, right? Over the long term, you're a very successful
investor when you are right 60% of the time. But that still means you're going
to be wrong 40% of the time.
Brian Levitt
Wait, wait, wait. We're not guaranteeing future results here?
Alessio de Longis
No, I didn't see the banner come through. But I think it's an interesting
perspective, right? I tell everybody, especially people that enter this
industry, the younger generations and say, look to be an investor, you need to
be prepared. Even when you are a rockstar investor, you need to be prepared
being wrong, let's say 40% of the time. And assuming you have a 30-year long
career, that's many, many years to be wrong. And you have to be prepared to
handle that.
Alessio de Longis
So with that said, let's assume that ... it's not a silver bullet, but let's
assume that we are more in that 60%. So if we think that we have better than a
coin toss of being right in identifying this recessionary or growth scare
regime, what is an investor supposed to do? Well, the first question, as Brian
always says, the first question is, remind yourself of your template and your
playbook. If you have a long-term horizon, maybe the best thing to do is do
nothing. If you are sensitive, let's say to an outcome over the next 12 months,
two years, and you want to do some adjustments to your portfolio, I think the
first question to always ask oneself is, “if the market were to sell off today
or over the next few quarters by 15%, would my portfolio be able to handle it?
Would I be able to stomach it?”
Alessio de Longis
I think that is, first of all, a behavioral question. The market gives us what
it gives us, right? Are we prepared to handle a 15% drawdown in the market? Just
to say a number – it can be 20%. If the answer is yes, maybe the answer is do
nothing. Or maybe the answer is even, you look for the opportunities to keep
adding to your portfolio. Now, if the answer is no, I would not be comfortable
with that outcome over the next 12 or 24 months, now typically what we see in
contractionary regime is that it is appropriate to reduce portfolio risk,
typically by reducing marginally your exposure to equity and to risky credit.
Increasing the allocation to quality credit and government bonds within your
equity portfolio. But alternatively, together or alternatively, other wise
decisions in the portfolio historically have been to increase the defensiveness
within your equity portfolio.
Alessio de Longis
For example, you may decide not to reduce your equity allocation, but you can
increase the defensiveness in your portfolio by allocating to defensive sectors,
away from cyclical sectors. So that suggests consumer staples, health care. In
this environment, possibly even technology and communication services, because
they have quality characteristics. And maybe reducing your exposure to cyclical
sectors, such as financials, industrials, materials. Or you can act in the
factor space, in what is the so-called beta space. And investors are very
familiar with low volatility stocks being more defensive than value or quality
stocks, being more defensive than small caps, right? So those are ways in which
you can build defensiveness. You can reshape the risk of the portfolio, build
defensiveness in your portfolio without necessarily selling equities outright.
Alessio de Longis
Obviously, if you have a short-term horizon, or if you are concerned about the
next 12 to 24 months, in a recessionary environment, you have to worry about
defaults, right? So the ability of getting your principle back. So worrying
about your exposure or the maturities in your high yield portfolio, in your EM
(emerging market) credit portfolio. So the riskier parts of your credit markets,
because if by definition, you don't have the period ... the time to wait. You
may be subject to realizing losses that can be very short lived, but somewhat
painful.
Brian Levitt
I enjoyed that answer so much.
Alessio de Longis
Thank you, Brian.
Brian Levitt
I just love the way you went through that from a longer term perspective, to why
you may want to make adjustments in your portfolio if you can't stomach a 15%
decline. That was really well done, Alessio. My ask of you, and I think Jodi's
ask for you as well would be, will you come back on to tell us when the
recovery's starting to form?
Alessio de Longis
I'm available anytime to come, and to deliver good news, especially.
Jodi Phillips
That would be wonderful. And hopefully, Brian won't have to write a sequel about
what still keeps him up at night, right? I think this podcast has definitely
helped me a lot in that regard, for sure. So thank you, Alessio, for joining us
once again, so soon after your last appearance. But it was really great to get
this update from you and figure out what you're looking at and what you're
seeing and what we should be thinking about too.
Alessio de Longis
Thank you, Jodi. Thank you, Brian.
Brian Levitt
Thank you.
Alessio de Longis
And really looking forward to the next update and what the market will bring.
Brian Levitt
As are we.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of August 12, 2022, and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
All investing involves risk, including the risk of loss.
Past performance is not a guarantee of future results.
The 30-year fixed-rate mortgage averaged 5.51% in the week ending July 14, up
from the same time last year, when it was 2.88%, according to CNN.
According to the Wall Street Journal, the National Association of Realtors'
housing-affordability index fell to 102.5 in May, the lowest level since July
2006.
The minimum, maximum and average length of contractions is based on Invesco
analysis of proprietary leading economic indicators as of July 31, 2022.
A double-dip recession refers to two periods of economic contraction that are
separated by a brief period of expansion.
Gross domestic product is a broad indicator of a region’s economic activity,
measuring the monetary value of all the finished goods and services produced in
that region over a specified period of time.
The Consumer Price Index, or CPI, measures change in consumer prices as
determined by the US Bureau of Labor Statistics. Core CPI excludes food and
energy prices while headline CPI includes them. Headline CPI rose 9.1% over the
12 months ended June 2022. Core CPI rose 5.9% over the 12 months ended July
2022.
The Wholesale Price Index measures changes in the price of goods before they are
sold at retail.
The Federal Open Market Committee, or FOMC, is a committee of the Federal
Reserve Board that meets regularly to set monetary policy, including the
interest rates that are charged to banks.
NAIRU stands for non-accelerating inflation rate of unemployment. It is the
lowest level of unemployment that can occur in the economy before inflation
starts to inch higher.
The actual US unemployment rate hit 3.5% in July 2022, according to the US
Bureau of Labor Statistics
CBO stands for Congressional Budget Office.
Personal consumption expenditures, or PCE, measures price changes in consumer
goods and services. Expenditures included in the index are actual US household
expenditures. The PCE rose 4.8 % in June 2022 according to the Bureau of
Economic Analysis.
Breakeven inflation is the difference in yield between a nominal Treasury
security and a Treasury Inflation-Protected Security of the same maturity.
Statistics on the 10-year, 5-year, and 2-year breakeven inflation levels are
from Bloomberg and the US Treasury.
In general, stock values fluctuate, sometimes widely, in response to activities
specific to the company as well as general market, economic and political
conditions.
Investments in companies located or operating in Greater China are subject to
the following risks: nationalization, expropriation, or confiscation of
property, difficulty in obtaining and/or enforcing judgments, alteration or
discontinuation of economic reforms, military conflicts, and China’s dependency
on the economies of other Asian countries, many of which are developing
countries.
The risks of investing in securities of foreign issuers, including emerging
market issuers, can include fluctuations in foreign currencies, political and
economic instability, and foreign taxation issues.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates. Interest rate risk refers to the risk that
bond prices generally fall as interest rates rise and vice versa. An issuer may
be unable to meet interest and/or principal payments, thereby causing its
instruments to decrease in value and lowering the issuer’s credit rating.
Many products and services offered in technology-related industries are subject
to rapid obsolescence, which may lower the value of the issuers.
The health care industry is subject to risks relating to government regulation,
obsolescence caused by scientific advances and technological innovations.
The profitability of businesses in the financial services sector depends on the
availability and cost of money and may fluctuate significantly in response to
changes in government regulation, interest rates and general economic
conditions. These businesses often operate with substantial financial leverage.
Junk bonds involve a greater risk of default or price changes due to changes in
the issuer’s credit quality. The values of junk bonds fluctuate more than those
of high quality bonds and can decline significantly over short time periods.
Factor investing is an investment strategy in which securities are chosen based
on certain characteristics and attributes. Factor-based strategies make use of
rewarded risk factors in an attempt to outperform market-cap-weighted indexes,
reduce portfolio risk, or both.
Beta is a measure of risk representing how a security is expected to respond to
general market movements.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
HIGH YIELD BONDS, RECESSIONS, AND … CANARIES?
The high yield bond market has been referred to as the “canary in the coal mine”
for the economy. So what’s it telling us about the prospects for recession?
Niklas Nordenfelt, Head of High Yield, joins the podcast to discuss this and
much more. Find out the economic data points he’s watching most closely, how
he’s positioning for volatility, and why he believes the high yield asset class
is about as healthy as he’s ever seen it.
00:00
00:00
27:17
Listen28 min
Show transcript
TRANSCRIPT
Brian Levitt
Welcome to the Invesco Greater Possibilities podcast, where we put concerns in
to perspective and opportunities in to focus. I'm Brian Levitt.
Jodi Phillips
And I'm Jodi Phillips. And today we have Niklas Nordenfelt on the podcast.
Niklas is the head of High Yield for Invesco Fixed Income.
Brian Levitt
Yeah, this is great, Jodi. With all the recession talk, to me, it just makes
sense to bring Niklas on to talk about the high yield bond market. The high
yield bond market has often been referred to as the canary in the coal mine for
the economy and for the markets. This early indication of danger.
Jodi Phillips
Yeah. I've heard you use that phrase before, Brian, and so I thought you might
be glad to know that they haven't actually used canaries in coal mines since
1986. Technology has given us a few more humane ways of detecting toxic gases in
mines.
Brian Levitt
Well as you know, my formative years were in the eighties, so maybe I just
haven't learned a lot since 1986.
Jodi Phillips
Well, that's all I know about mining, so don't ask me anything else.
Brian Levitt
Yeah, I didn't know you had any mining knowledge.
Jodi Phillips
Nope. That's it. That's all of it. That's all of it. But you know, more
applicable to this conversation — nothing has replaced the credit market as an
early warning sign, has it, Brian? I mean, I hear you talk about it pretty
often.
Brian Levitt
Yeah, I mean, as far as I can tell. An old mentor of mine used to tell me if you
get the credit cycle right, then all else should take care of itself.
Jodi Phillips
Okay. So where are we in the credit cycle? Don't they usually end with high and
rising inflation and policy tightening and all those things that are sounding
pretty familiar right now?
Brian Levitt
Well yeah, that's correct. It's the old saying, markets don't die of old age
they die when the Fed murders them with interest rate hikes. So, we're going to
pose those exact questions to Niklas. It's interesting though, for all the talk
of recession, is that corporate borrowing costs have risen but the yield spreads
over Treasuries while up quite a bit from last year, don't look particularly
disconcerting. To go back to our canary in the coal mine reference, it doesn't
seem like they're squawking about a recession yet, but hopefully Niklas will
give us more color.
Jodi Phillips
The carbon monoxide detector isn't beeping just yet?
Brian Levitt
Yeah, exactly.
Jodi Phillips
Okay, for one second, explain that to me. Because we've had two consecutive
quarters of negative GDP growth, right? I thought that was how we made the call
on recession.
Brian Levitt
Actually, I'm not even sure where that comes from. I'm guessing you don't
either?
Jodi Phillips
No. No.
Brian Levitt
No.
Jodi Phillips
If you don't, I don't.
Brian Levitt
I mean, we've all heard it. I go by the National Bureau of Economic Research
definition, which is, "a significant decline in economic activity that is spread
broadly across the economy." And so yeah, we've had two down quarters, but it
was more related to weaker inventory accumulation. I think businesses had
feverishly worked to rebuild inventory in prior quarters, and then you're
feeling the effect of it. So I don't know if we've yet seen the broad decline in
activity.
Jodi Phillips
Yeah, no. I mean, anecdotally, consumers seem to be in pretty good shape.
Restaurants are, you're waiting for tables, and back to school shoppers are
definitely crowding the stores around here, and the traffic's always terrible,
but it doesn't feel like a recession. I guess the question is, what do the
credit markets have to say?
Brian Levitt
That's right. And that's why we're so excited to have Niklas. And plus,
investors are always looking for ways to generate income.
Jodi Phillips
That's right.
Brian Levitt
And so at the very least, yields and corporate bonds are more attractive than
they were last year. So, let's bring Niklas on to the show. Niklas, welcome.
Niklas Nordenfelt
Thank you, Brian and Jodi for having me.
Jodi Phillips
Thank you for being here. Let's go ahead and just start with the big, broad
question and we can narrow it down from there, but how would you characterize
your views on the high yield market right now?
Niklas Nordenfelt
There's been a lot of moving parts during the course of the year, but today I
would characterize fixed income investing more as a “yes to carry and a no to
risk.”
Jodi Phillips
Yes to carry a no to risk. All right.
Brian Levitt
Yeah, say more about that.
Jodi Phillips
Taking notes here, Brian.
Brian Levitt
Yeah, say more. I like that. I feel like we should put it on the wall in the
office, but I'm trying to figure out precisely what it means.
Niklas Nordenfelt
First of all, I would say that we have a number of built in cushions that I
believe significantly improves the total return outlook for high yield. And one
of them is the overall yield. So, that's the carry, in other words. And another
is the average dollar price of high yield bonds. Yields themselves have improved
sufficiently to provide a fair amount of cushion for price volatility. So prices
are likely to move up and down from here, but yields have reached nearly 8% for
high yield. And I think the carry from that cushions a lot of the price
movements and provides a nice floor to absorb challenges.
Brian Levitt
Niklas, when we try to assess the health of the market or what indicators it's
providing to us, you talk about yields at 8%. Typically, you compare that to a
similar maturity bond of lesser risk to get a spread. And since higher quality
bonds have also moved up in yield, spreads actually don't seem that
disconcerting. Is that worrisome to you or what do you think that's telling you?
Niklas Nordenfelt
I think spreads have definitely moved up. If you think about where they were a
year ago, they're significantly higher in high yield. And that's the good news,
because now we're being compensated a little bit more for risk. But they're not
so high that the market is pricing in any kind of significant refi risk. And
refi risk is the area where it becomes more challenging for high yield, when
issuers can't refinance their debt and that increases default risk and then you
get sort of the bottom falling out. We don't have that. We kind of have the,
sort of a Goldilocks situation right now, where the investment opportunity is
better, but it's not so challenged that companies are going to be struggling any
time soon with refinancing the risk.
Brian Levitt
On that point, you talk about how spreads have widened. Agree. Fact. But I just
look back even at the last cycle, whether it was 2011 with the European debt
crisis or 2015 into '16, when the Fed raised interest rates for the first time
and China devalued their currency, you saw spreads even wider, call it maybe 600
basis points, than they are today. And yet, those were periods where the economy
did not go into recession. What I'm hearing you say, or is what I'm hearing you
say, that maybe this is giving us less of a signal because of the fundamental
strength of corporate America?
Niklas Nordenfelt
I think it's a number of things. First of all, when you think of previous
widening of spreads and during recessionary times, the two most recent
recessions we have, I don't think, provide fantastic data points for us. When
you think about them, a few people foresaw the financial crisis, for example,
and no one predicted COVID, as far as I'm aware of. Both of those occurred when
prices were high, valuations were elevated, corporate spreads were tight.
Niklas Nordenfelt
So in both cases, you had this massive disruption to the economy, and really,
functioning of the financial system. Spreads blew out in results quite
dramatically, and central banks had to come to the rescue. The reason I'm saying
that is that I'm not sure that those episodes provide us with good baselines for
how wide spreads normally go in a recession. Because I don't expect the
financial system to grind to a halt in any kind of coming or potential
recession. I don't think the extreme wides are particularly insightful.
Niklas Nordenfelt
When I talk about cushions, because that was kind of my first point, one of the
really good things about the current environment is that we do have a lot of
cushions to absorb. I think it's certainly a shallow recession. The first
cushion is, as I talked about, where yields are, where spreads are. But really,
the most important is that corporate fundamentals are about as good as we've
ever seen them. And I say the high yield asset class is about as healthy as
we've ever seen it. We're definitely a higher quality than we typically are in
this part of the recession, less triple C. So I think the ability to absorb a
shallow recession is largely priced in at this point.
Jodi Phillips
Okay, great. Well, definitely Brian corrected my assumption about what a
recession means or how you measure that. I think you're getting to this point,
but I did want to get your thoughts on whether you were in the recession camp or
not and what you would need to see to either confirm your view or change it?
Niklas Nordenfelt
Yeah. The first thing I'd say is that, as investors, I don't really care about
recessions or the definition of recessions, because that's backwards-looking.
Jodi Phillips
Right. Right.
Niklas Nordenfelt
What we care about is, what's going forward and am I being paid for that risk on
a go-forward basis? The question, am I in the recession camp? I do think the
odds are high that we will have a recession. What we tend to be focused on,
especially at this point, is on the consumer. So far they've held in exactly as
you said, exceptionally well, especially the upper end. But we think much of
that is backward-looking. People enjoying their summer, plans they were largely
committed to prior to the effect of very high inflation and the pessimism that,
I think, that's generated.
Niklas Nordenfelt
So, a couple of things that we're looking at. Employment data for one,
specifically claims. If people become concerned about their primary source of
income, then spending would likely decline pretty rapidly from here. And the
second thing is back-to-school sales, to see if the consumer is pulling back.
Overall, we see discretionary getting squeezed by inflation. Inflation that's
evident and persistent in rents, food and fuel. So disposable income is coming
down and we expect that to flow in to less spending, even on less discretionary
items, which I think back to school will provide a good clue on.
Brian Levitt
Well, the Levitt and Phillips families will certainly be doing their best to
support back to school.
Jodi Phillips
Doing my part, 100%.
Brian Levitt
These kids grow like weeds. I cannot keep the clothes fitting everyone, so
hopefully we'll have some hand me downs. But I did like your point about
backward-looking. I always feel like when I'm watching the economic data
releases, it's like, "Breaking news... from last month or last quarter," right?
You had mentioned the fundamental strength of corporate America, and I think a
lot of us have been hearing this over time. Can we get more specific in to it,
whether it's leverage ratios or income coverage ratios or is there really no
wall of maturity with which to speak of?
Niklas Nordenfelt
Yeah. Like I said, corporate fundamentals are quite healthy. Leverage ratios, so
it's kind of the first point, they've returned to pre COVID levels, and pre
COVID economic corporate fundamentals were exceptionally strong. Interest
coverage ratio: So this is a company's ability to pay or meet their interest
expense, that's at all-time highs. Now, some of that of course is a function of
having borrowed very cheaply, but that's also a positive. They've termed out
their maturity, so they had these low borrowing costs for a prolonged period of
time.
Brian Levitt
So just like homeowners. Just like the homeowners rates go to 2% or 3% on a
mortgage. You refinance, get that lower rate, push that maturity out in to the
future.
Niklas Nordenfelt
Exactly. Exactly. And when you think about the recent default periods, most of
that has been concentrated in energy and commodity sectors. And those sectors,
today, are benefiting from elevated commodity prices and they're less likely to
be areas of concern this time around. You also asked about the wall of maturity.
So the first thing I'd point out there is that defaults and bankruptcies,
they're primarily driven by liquidity challenges. Market liquidity is important
when it comes to the ease of refinancing debt, but market liquidity crunches do
not typically force issuers, especially with valuable businesses or positive
free cash flow, to file for bankruptcy. And we have a lot of those companies. So
even if we have a liquidity crunch, I think a lot of, the majority of companies
will survive quite well.
Niklas Nordenfelt
What this means is that we don't believe maturity walls are as important as the
press makes it out to be. One of the key tenants to our credit underwriting
process is to invest in solid businesses that don't require liquid capital
markets to refinance maturing debt. That all said, maturities were extended
significantly over the last two years. And only about 6% of the high yield and
bank loan market comes, debt comes due in the next two years. So, that's really
low by historical standards. I'd summarize that we have one of the most benign
maturity schedules on record.
Jodi Phillips
So this all sounds pretty positive, right? I mean, does all this add up to mean
that even if there were a recession, that high yield could still do okay? I
mean, will Brian have to retire his canary in a coal mine phrase to describe all
this?
Niklas Nordenfelt
As a product of the eighties, I know exactly what he's talking about. Look, I
feel quite comfortable saying high yield will do reasonably well. I would argue
that adding to the asset class, should it weaken, will move the outcome from
pretty good to very good. And some of that is just the math behind it. The math
behind investing at higher yields, which we have today, is quite powerful.
Similarly, the power behind buying bonds at discounts is very powerful. And the
current average price for a high yield bond today is about 90.
Jodi Phillips
I appreciate a good math-based argument, Niklas. So, what aspects of the high
yield bond market would you say are be underappreciated by investors today?
Niklas Nordenfelt
For one, investors tend to be too fearful of defaults. This is why we get this
excess spread as compensation. Most defaults are reasonably well telegraphed and
priced into the market before they happen. That's one.
Niklas Nordenfelt
The second is, high coupons do matter. They generate a reliable and high level
of current income.
And then third, when high yield does sell off, the market tends to recoup those
losses quickly. And the reason for that is we're dealing with bonds, not stocks.
Now stocks have kind of these uncertain outcomes, but with bonds, we know what
the terminal value is and that's par. So unless the bond goes in to default or
restructures, the price will be pulled back to par. And since high yield has
relatively short maturities, that pull back to par is actually pretty quick.
Niklas Nordenfelt
And finally, this is important and it's often missed. High yield bonds come with
call protection. So people don't appreciate that enough, but if you buy skill or
luck, choose a bond that improves its credit profile. These bonds can move up to
110 or 120 or even higher. Bonds and bank loans for example that don't have this
feature, when they improve, you simply get paid back at par and refinanced
through a lower yield. So that feature has really given high yield an extra
boost over the years, which in many ways has offset the losses we do absorb
through defaults over the time.
Brian Levitt
Do you worry that there will be some idiosyncratic blowup? Is there something
lurking? It seems like any time the Fed has to raise rates pretty significantly,
something breaks. Is there anything lurking that you worry about? Whether it's
like a Drexel Burnham Lambert or a Bear Stearns or something along those lines?
Niklas Nordenfelt
It would certainly come as a surprise today. What's comforting for me, is that
high yield has been unloved for a long time. So the good news on that is, that
kind of aggressive type of financing, that has really been occurring outside of
the high yield market. And issuers have generally been behaving conservatively,
especially since or in response to the pandemic. What's really changed going
back 10 years or so ago is, because yield opportunities were so lacking, a lot
of investors traded liquidity for yield. So the demand shifted from high yield
to bank loans in private debt, for example.
Niklas Nordenfelt
And that lack of demand has meant that our market hasn't been the primary source
of financing. So we haven't really built up the kind of froth we typically see
at later stages of economic cycles, like the kind that becomes a troubled area
in the downturn. I'd also say the banks, the financial plumbing, in other words,
they're well-capitalized and not at risk of derailing the markets this time
around. I do fully expect it will be one-off defaults in a more difficult
environment, but I don't see systemic issues that cause the high yield market to
experience kind of the technically driven sell off.
Jodi Phillips
Well, that's definitely good news. Thinking about all this, how are you
positioning in light of all these views? Are there particular sectors or
industries that you're avoiding? Are you moving up in quality? How does this,
from a broader level, impact your positioning?
Niklas Nordenfelt
The primary driver of today's challenges are higher rates in response to
elevated inflation. Margins would be squeezed for those companies with less
pricing power. Ironically, inflation can be a modest positive for issuers that
are able to pass through costs. Principle payments are fixed costs, so inflation
actually lowers real borrowing costs.
Brian Levitt
Yeah, pay it back with cheaper dollars.
Niklas Nordenfelt
Exactly. Exactly. So what we're most concerned are with the highly leveraged
issuers that have tight labor supply, low margins, and exposure to lower-end
consumers. These are the issuers that face the risk of much higher interest
expenses when they attempt to refinance, and their customers are those that are
at most risk of food and gas inflation. So sectors that we think are most
vulnerable include retailers, especially those without hard assets, real estate
supporting their debt. Travel, leisure, and some discretionary goods producers.
That's kind of what we're avoiding. How we're positioning for this, to be
honest, the volatility and uncertainty, those are unique opportunities for us to
differentiate by virtue of being active managers.
Niklas Nordenfelt
First of all, we significantly reduced exposure to a number of lower quality
issuers a number of months ago. And even before that, beginning of 2022, we had
scrutinized our holdings too, on the notion that selectivity was going to matter
much more this year. Where we've been allocating towards is, we've been buying
low dollar longer duration bonds. So those are bonds that were impacted by
higher Treasury rates rather than credit weakness. Those have offered the dual
benefit of being higher quality issuers and offer better downside protection by
virtue of their lower dollar prices. And we've also increased our exposure to
pipelines as the year has progressed on the positive demand dynamics for both
oil and natural gas.
Brian Levitt
And the yields we can get today, I think I heard you say, in high yield,
somewhere close to 8%?
Niklas Nordenfelt
Yes. A year ago, yields were 3.5%.
Brian Levitt
Right.
Niklas Nordenfelt
Just to give you a sense for how attractive it is. And beginning of this year,
they were 4%. Recently, they reached 9%, that's towards the end of June.
Brian Levitt
9%.
Niklas Nordenfelt
Yeah. June. And then we had a pretty strong rally in July. I think there's a
fair amount of optimism that the Fed would pivot and come to the rescue with
rate cuts in early March. A little optimistic or pessimistic, depending how you
view it. But today, we're looking at yields of around 7.5% to 8%. And like I
said, the average price is about 90, which is down from about 104 at the
beginning of the year.
Brian Levitt
I think this would be my final question for you. How do we get investors to buy
high yield bonds when the yields are elevated rather than when the world looks
great, the economy is humming, and yields are historically low? That just seems
to me like anytime they blow out, that's when we're selling. And when they come
back in, as you said quickly, that's when people are buying, and then they
complain for the next five years that there's no yield to be had.
Niklas Nordenfelt
Yeah, no, you've nailed the challenge. Too often I've heard investors say that
the market's too tight, they're waiting for better, cheaper entry points. Then
when they're there, "Well, it's too risky, I prefer to wait for calmer times."
And the ironic thing is that high yield is the asset class you shouldn't bother
timing. And then the reason for that is the high income it produces through its
coupons. It's the one asset class where the opportunity costs of trying to time
it is quite high, since you're actually forgoing a relatively high income as you
do that. And trying to time it is also hard since the rallies can be, as you
mentioned, quite strong and quick and you're likely to miss it if you're trying
to time it, time the bottom.
Niklas Nordenfelt
I always argue that high yield has an important place strategically in
portfolio. You should increase your exposure up to your max tolerance when
spreads widen. And I think we're in that stage where increasing from sort of
your baseline makes a lot of sense, but at the same time, be prepared to add
should conditions deteriorate meaningfully from here.
Brian Levitt
Jodi, a yield of 8%? And what I hear Niklas saying and what I have identified
over the years, is his point. Is that over time, the return, 95 to 100% of it is
going to come from compounding the income. As some say Einstein said, the most
powerful force in the universe.
Jodi Phillips
Very powerful indeed, if that's the case. Brian said that was his last question
for you, but I want to ask you, what didn't we ask you? What did we miss?
Anything in this conversation that you'd like to highlight that we haven't
addressed so far?
Niklas Nordenfelt
One of the things I always like to point out is how much is priced in, what kind
of default rate is priced in. This kind of just amplifies what we can absorb.
What I would say, is that at current spreads, which are about 470 basis points,
the market's priced in a default rate, an annual default rate, about 4.5%. And
in calculating that default rate, what I'm assuming is investors still get paid
a reasonable excess return for just being in high yield, kind of the nuisance of
absorbing less liquidity and dealing with the fear of defaults. And I feel 2% is
a pretty good compensation for that.
Niklas Nordenfelt
So the way to look at this default rate, is that if the current high yield
market defaults at 4.5% per year, essentially, 25% of this existing market would
default over the next five years. And in doing so, the market would still
deliver 2% excess return every year. In other words, about 10% over five years.
And to put that in context, the worst five year default rate we've ever seen is
32%. So if you can either ignore the volatility or better yet, just take
advantage of it by adding on weakness, I don't project or foresee an all-time
worst default cycle.
Jodi Phillips
Great. Brian, are you feeling better about the canaries?
Brian Levitt
I feel good about the canaries. To Niklas's point, while we might not have seen
the wide spreads like we saw in past recessionary environments, they have
widened out. The bond market does provide a lot of information and they have
suggested that the economy is going to weaken. But to Niklas's point, that's
what creates opportunity for investors.
Jodi Phillips
Excellent. Appreciate the insight and putting our minds at ease, Niklas. It was
great having you on the podcast and thank you so much for joining us.
Brian Levitt
We thank you.
Niklas Nordenfelt
Thank you. Thank you.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of August 3, 2022, and are subject to change without notice. These
opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
Past performance is not a guarantee of future results.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates. Interest rate risk refers to the risk that
bond prices generally fall as interest rates rise and vice versa. An issuer may
be unable to meet interest and/or principal payments, thereby causing its
instruments to decrease in value and lowering the issuer’s credit rating.
Junk bonds involve a greater risk of default or price changes due to changes in
the issuer’s credit quality. The values of junk bonds fluctuate more than those
of high quality bonds and can decline significantly over short time periods.
The reference to high yield spreads in the last cycle is based on the
option-adjusted spread of the Bloomberg US High Yield Corporate Bond Index,
which measures the US dollar-denominated, high yield, fixed-rate corporate bond
market. The option-adjusted spread is the measurement of the spread of a
fixed-income security rate and the risk-free rate of return, which is then
adjusted to account for an embedded option, such as calling back or redeeming
the issue early.
The estimation that 95% to 100% of the return of high yield bonds, over time,
comes from compounding is based on a hypothetical $100,000 investment in the
Bloomberg US High Yield Corporate Bond Index from 1990 to 2021. Over that period
the price return fell to $85,070 while the total return grew to $1,206,276.
More than 100% of the return came from the income. An investment cannot be made
directly in an index.
References to high yield bond yields and average prices at various points in
time are based on the Bloomberg US High Yield 2% Issuer Cap Index, an unmanaged
index that covers US corporate, fixed-rate, noninvestment-grade debt with at
least one year to maturity and $150 million in par outstanding.
The discussion about a 4.5% default rate being priced into the market is based
on the option-adjusted spread of the Bloomberg US High Yield 2% Issuer Cap
Index; Invesco assumptions of excess return; and data from JP Morgan. The worst
five-year default rate is from Deutsche Bank. Data as of July 31, 2022.
Statistics about the percentage of high yield and bank loan market debt coming
due in the next two years is from JP Morgan as of June 2022.
A basis point is one hundredth of a percentage point.
Free cash flow is a measure of financial performance calculated as operating
cash flow minus capital expenditures.
Excess return refers to the return from an investment above a benchmark.
Call protection is a feature of some bonds that prohibits the issuer from buying
the bond back for a certain period of time.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
OUR MID-YEAR OUTLOOK: WHERE DO MARKETS GO FROM HERE?
A lot has happened since we issued our 2022 investment outlook. To mark the
midpoint, we stop to briefly assess how much the world has changed over the past
six months and, more importantly, what we expect for markets and the economy for
the rest of the year.
00:00
00:00
37:03
Listen38 min
Show transcript
TRANSCRIPT
Brian Levitt
Welcome to the Greater Possibilities Podcast, a podcast from Invesco, where we
put the concerns into perspective and the opportunities into focus. Hi, I'm
Brian Levitt.
Jodi Phillips
And, I'm Jodi Phillips. And we're here talking about our mid-year outlook with
two returning guests. We have Kristina Hooper, Chief Global Market Strategist at
Invesco, and Alessio de Longis, Global Head of Tactical Asset Allocation. Brian,
so much has happened since we released our annual outlook at the end of last
year. Everyone's talking about, "How is this all going to play out?"
Brian Levitt
And Jodi, I think the operative word there is “all.” How is this all going to
play out? I thought maybe I would start with quoting Vladimir Lenin. Is that
okay?
Jodi Phillips
Lenin? Yes. Sure. For a minute, I thought you were going to say Vladimir Putin.
Brian Levitt
Yeah. I mean, that may have been apropos, but if only we can get into the head
of Vladimir Putin, learn what comes next. But I don't think we can do that. The
quote I'm thinking about is this from Lenin. "There are decades when nothing
happens and there are weeks when decades happen." And it certainly feels like
through the start of the year, that since the start of the year, that there have
been weeks, where decades feel like they're happening.
Jodi Phillips
Yeah, absolutely. The question though is, which decade has been happening over
the past several weeks, right? It certainly doesn't feel like the 2010s. So I
think we can rule that one out.
Brian Levitt
Yeah. I'm afraid not. Actually, I've been telling people I'm nostalgic for the
2010s. Slow growth, benign inflation, accommodative policy. I mean, it wasn't
always easy, but you knew that monetary policy stood ready to support the
economy, if necessary. I suspect it's a little bit different right now.
Jodi Phillips
Right? The Fed put — we knew we'd miss it when it was gone. So, does this make
it more like the '70s, then? High inflation, high oil prices, waiting on Godot
to raise interest rates? Although, in Beckett's play, Godot never shows, whereas
the Fed is set on fighting inflation.
Brian Levitt
Right? And I think that's the challenge. As we say, inflation hastens tightening
cycles and cycles are ultimately killed by the Fed. And, we spelled this out in
the 2022 outlook. Of course, it wasn't the base case, but certainly highlighted
as one of the main risks.
Jodi Phillips
That's right. We called that risk “persistent inflation” — inflation hastens Fed
tightening. But it's hard to believe that when that was written, the two year
rate was at 20 basis points, and the Fed was preparing the market for one or two
rate hikes this year.
Brian Levitt
Yeah. If only, right? One or two rate hikes this year would've been nice. So,
there's challenges to the cycle. Let's not sugar coat it. However, there's a
potential path out of it as well. Can the Fed quell inflation without killing
growth? I think if you answer that question correctly, all else should be able
to take care of itself. Although, certainly not an easy question to answer,
though.
Jodi Phillips
No, no, it's not. And speaking of difficult questions to answer, the outlook
also brings the conversation back to Putin and what may come next with Russia.
On one hand, how does it impact our outlook if hostilities in Russia deescalate?
But on the other hand, what if Europe is cut off from Russian energy, either by
embargo or by boycott? How does that affect the outlook?
Brian Levitt
Yeah. Let's bring on Kristina and Alessio to talk about their views on all of
this. Talk about a base case. Talk about alternative scenarios and most
importantly, what are the asset class implications?
Jodi Phillips
Yes. Welcome Kristina and Alessio.
Kristina Hooper
Thanks for having us. Brian, I don't think that having you quote Lenin was on my
bingo card for this week.
Brian Levitt
You didn't see that coming?
Kristina Hooper
I did not.
Alessio de Longis
Brian, Jodi, also a pleasure being with you.
Brian Levitt
Thank you, Alessio.
Jodi Phillips
We’re here to look ahead. But before we do, just for a few minutes, let's look
back at the annual outlook quickly that came out at the end of 2021. And, like
we said, a lot has happened since then, but how have the first six months or so
of 2022 tracked against the base case and the alternate scenarios that Invesco's
outlook posed for this year?
Kristina Hooper
Ah, great question, Jodi. So when we released the outlook back in early December
of 2021, the world was in a different place. Our expectations, our base case for
2022 was an environment in which global growth normalized, remaining above its
long-term trend, but decelerating to a more sustainable rate as fiscal stimulus
was gradually removed. We anticipated inflation peaking by the middle of 2022,
but of course, at a lower level than anywhere near where we've seen it go. And
then, start to slowly moderate, backing down towards target rates by the end of
2023, as supply chain issues were resolved, vaccination levels increased, and
end of course, more employees returned to the workforce. We expected the Fed to
actually remain patiently accommodative. Do you even remember that term? It was
bandied about for a long time. I haven't heard it in about six months.
Jodi Phillips
Oh, memories.
Kristina Hooper
With a rate lift off, if you can believe this, in the back half of 2022,
although we anticipated that other developed countries, central banks might act
more quickly. We anticipated volatility would increase, as markets digested that
transition to slower growth and that gradual tightening in monetary policy.
There's another word that we haven't heard much of recently, which is “gradual.”
Kristina Hooper
Now the good news is we also, as usual, contemplated two alternate tail risk
scenarios. One was what I would call the more positive scenario. We titled it
“transitory inflation” risk, where we saw current inflation fears proving to be
overblown. Then of course, there was that persistent inflationary scenario. And,
dare I say, we got a lot closer to that scenario than the base case. In that
scenario, we thought developed central banks’ messaging would fail to convince
markets that inflation was transitory, that we'd see further elevated prints
throughout 2022. Of course, the difference is that, it wasn't that I think there
was a loss in confidence in central banks, so much that this unforeseen event
occurred, which is Russia's invasion of Ukraine. That really altered the entire
macroeconomic environment for 2022. But, in that persistent inflationary risk
scenario, we anticipated inflation expectations to become unanchored. And I
don't think they have over the longer term.
Brian Levitt
Alessio, when we talk about inflation and policy tightening, it tends to speed
things up in the cycle. It also tends to create, as Kristina said, volatility.
How surprised are you by what transpired in markets over the first, call it five
months of this year? And what worked? How would you categorize market
leadership?
Alessio de Longis
Yeah, it was, the world really turned upside down. I mean, we went from thinking
about, thinking about, thinking about raising interest rates, to a race to the
top. There was a competition about who would have the craziest call: 50 basis
points. How many 50 basis point hikes? And 75 basis points.
Brian Levitt
I remember saying, actually our friend, Matt Brill said, "If you want to get on
TV often, just say there's going to be 25 interest rate hikes this year."
Alessio de Longis
Exactly. So, what worked and what didn't? We had modeled more for a loss of
confidence in central banks and unanchored inflation expectations. That
certainly didn't happen, right? The 10-year, the third year break-evens widened
somewhat. But it certainly wasn't out of the ordinary. The way markets priced
this inflation shock was not a 1970s style but was rather a really serious
cyclical overshoot inflation. But ultimately, we do have central banks that will
come in. That's why 30 year-inflation expectations stayed below 3%. Right? And
the stress was really in the front end.
Alessio de Longis
So, what happened to our asset class predictions, based on this difference? In
that scenario, we advised investors to reduce portfolio risk well below
benchmark. I think that definitely played out. I think we argued for a short
duration stance. I think that certainly played out. What we saw, in my opinion
was, a fascinating shift higher across global discount curves everywhere around
the world. But when you look at the performance of risky assets, be it equities,
be it cyclical sectors relative to defensive sectors, equities versus fixed
income, high duration equities versus low duration equities, we did not really
see a pricing end of a substantial growth deterioration. The bulk of the impact
was a resetting of the duration effect on asset prices.
Alessio de Longis
So, we argued that fixed income would outperform equities. Did that really
happen? If you look under the hood, I don't think that that happened. Long-term,
long duration bonds, or long duration investment grade credit underperformed
equities. Defensive equities underperformed cyclical equities. Value, which is
cyclical, underperformed quality. So, we got a few things wrong because our
assumption was that this monetary shock, this inflation shock, would've also
carried with itself a meaningful pessimism around growth. And I think that
actually did not really happen, which actually brings in interesting dimensions,
I think, for the outlook going forward.
Jodi Phillips
Absolutely. Brian, you definitely picked the right quote to start off the
podcast. Because it certainly feels like there's been decades that have passed
since the last outlook. So, I do want to look ahead to what the mid-year outlook
is calling for, for the next six months and beyond. And we took the same path
this time of articulating a base case, and then exploring two alternate
scenarios that could potentially happen, and could potentially have an impact on
how this outlet plays out. So, Kristina, if we could start out with that base
case, right? If you could kind of just explain to us where the base case is at
the moment, looking ahead through the end of the year and into 2023.
Kristina Hooper
Sure. So, think of us as having returned somewhat to our outlook at the start of
2022, of course, with some alterations. So, our expectation in our base case is
that hostilities continue, but without escalation, any kind of significant
escalation that might cause an abrupt disruption to Russian energy supplies to
Europe. So, with uninterrupted energy supplies, but still high energy prices,
Europe would face high inflation and slowing growth through 2022 and into 2023.
And so, that would limit the number of ECB (European Central Bank) rate hikes
we'd see in 2022.
Kristina Hooper
Now, it's a different story in the US, where we would expect continued momentum
from the post Omicron reopening that could help sustain growth, despite the
Fed's aims to achieve a neutral policy rate as quickly as possible during 2022,
in addition to really zealously shrinking its balance sheet. Now, it's a
different story in China. In contrast with major developed Western economies,
China continues to be in a substantially different cyclical position, driven by
continuing challenges resulting from the pandemic. That zero COVID policy is a
difficult one, in a world in which the Omicron variant is spreading really
rapidly. Having said that though, we expect a re-acceleration of Chinese growth
in the back half of 2022, largely driven by policy support. We think volatility
is likely to remain higher than it was in 2021, as markets digest tighter
monetary conditions.
Jodi Phillips
So, Alessio, from your perspective, looking at the base case that's laid out,
what are the asset class implications, if that base case comes to pass? What
would you say the impact is for investors and what should they be watching out
for?
Alessio de Longis
From a high level standpoint, especially given the current market narrative that
is very prevalent, we think it's way too early to position your portfolio for a
recession risk. Way, way too early. And we know that positioning for recessions
can be very costly in terms of the missed opportunity. Being a year too early
can really cost much in investor target objectives. We think, nonetheless, that
the cycle is maturing, growth is slowing and is slowing to trend rates. We think
2023 is likely to be a more challenging year from an economic standpoint than
2022.
Alessio de Longis
But, going back to what we said earlier about the interpretation of what
happened in the prior six months, I think we have all learned, and so has
monetary policy, that the economy is way more resilient than we assumed. I mean,
there is a reason why now we are assuming eight, nine rate hikes, which were
unconceivable six, seven months ago. The labor market situation and the
strength, the tailwinds among consumers are meaningful. That's what inflation is
telling us. So, it's important to factor that in our asset allocation. We think
it's appropriate to reduce portfolio risk to about a neutral stance relative to
benchmark, that running an outsized, overweight risk posture at this point is
not as appropriate as it was a year ago. At the same time, the question is
where? Where do you go and reduce risk?
Brian Levitt
Before you get there, can I ask a follow-up question on that? So, put on the
mindset of a lay investor or any of us, having this conversation. At one point a
few weeks ago, the S&P 500 was down about 20%, right? And how would you
categorize that? So, you're sitting here saying, "It's too early to position for
a recession." If I just lost a fifth of the value of my portfolio, do I care
whether we're technically in a recession as defined by the National Bureau of
Economic Research? Why does that matter to me? And so let me ask, was that just
a valuation adjustment based on rates? And then, if there is a recession
forthcoming, how much worse would it have to get than that?
Alessio de Longis
Brian, excellent question, and I think you're hitting the nail on the head. In
my opinion, the narrative has started with an inflation scare, then moved to a
growth scare, and it's still largely there. But in my opinion, we have gone from
an inflation scare to a de-rating of US growth tech stocks, especially the
growthier parts of the market, which are not necessarily the mega caps that we
all think of. When we look under the hood, and we look at the relative
performance between sectors, between asset classes, within credit sectors, it
really comes down to that duration play. And the de-rating that was caused by
that increasing in global bond yields, the de-rating of valuations that are of
course, sensitive to that duration, to that interest rate move.
Alessio de Longis
When you look at the outperformance of value, when you look at the
outperformance of the most cyclical parts, what do we mean by cyclical? Parts of
the economy that have more operating leverage to the cycle from an economic
standpoint, not just judging the performance, the top-level performance of asset
classes. The outperformance of value over growth, the outperformance of small
and mid-caps over large caps, over the last six to 12 months speaks for that
lack of contagion effect and lack of panic
Alessio de Longis
A recession risk implies dislocations, implies freezing in markets, freezing in
trading and the less liquid parts of the market that literally have gap risk. I
don't think, frankly, that we've seen that in the typical way that we see that
in other recessionary environments.
Alessio de Longis
Six months ago, we talked about reduction in portfolio risk in the base case. We
are maintaining that stance, today. A neutral exposure in total risk to
benchmark. And how do you accomplish that? We think an investor can still be
overweight equities over fixed income. So that risk reduction, in our opinion,
should come by being overweight the more defensive assets in the portfolio.
Alessio de Longis
It's sort of a rinse and repeat of what we said six months ago for the base
case, with the difference now, to your point, Brian, is that the valuations and
the pricing of that scenario is much, much more favorable. If we can this time
get our policy call a little bit more in line with our expectations, we think
that the argument for a defensive tilt in sectors, in styles, can help maintain
a lower risk profile. Now, so the question is, how do I build in more
defensiveness in case we do get more of a recessionary type of risk, rather than
just a mild slowdown?
Brian Levitt
Right, does that extend to government-related bonds, given that people have
gotten hit pretty hard in long duration bonds, munis, government related. Well,
of course, munis are government related, right? So, are you suggesting that when
everyone's trying to flee anything long duration, that they may be doing so at
an inopportune time?
Alessio de Longis
I think that investor behavior can go through excesses to the downside and the
upside, whether it's in equities or government bonds, right? We never associate
government bonds to greed and panic like we do for equities, but I think there
can certainly be an element there. To be frank, none of us has ever experienced
the bond market like the one that we are seeing. That has to play a role in
investor psychology, as well. So, I think the price now is a little bit more
appropriate for picking up again some yield in credit and in government bonds.
One way to build defensiveness, to be honest is, if we are right, that we are
approaching the end of the cycle. And if we are right, the monetary conditions
will tie them with the risk to go slightly into restrictive territory. A way to
prepare and place defensiveness in the portfolio for that, is to underweight
risky parts of the credit markets.
Alessio de Longis
Ultimately your typical recession trade, your typical recession risk, tends to
manifest itself first in the weaker, less liquid parts of credit markets, before
it shows up in equities. And that's another example to your point, Brian. It's
not what we saw in the last six months, right? Equities, high duration, high
quality equity markets actually led the way, rather than risky credits such as
high yield or bank loans, or even emerging debt for that matter.
Brian Levitt
Kristina, so much of this seems to be grounded in this idea that inflation will
peak or it may even already be peaking and moderating, so that the Fed can
ultimately back off some of this tightening stance and not take the (federal)
funds rate to, some people suggested 4%, 5%. More along the lines of a, of a 3%
neutral rate. What gives you some confidence to suggest that inflation may
actually now be peaking? And, what do you need to see as the year progresses?
Kristina Hooper
That's a great question, and there are so many factors. One of course, is that
more people are entering the labor market. And so that should take some pressure
off of wage growth. In addition, of course, if we start to see layoffs because
the Fed is actually tightening monetary policy conditions, that could also play
a role in helping to tamp down wage growth. So, that is one way. Another way, of
course, is in general, we're just going to be, we have very high comparables at
this point. So, we should see some level of improvement from here. And, of
course, there are some issues that are being worked through with supply chains.
Now, some are going to continue to be problems, Russia, Ukraine as well.
Russia-Ukraine crisis is clearly going to create pricing pressures. That's going
to be a continued issue. But if, for example, we see China continue to roll back
stringency, which I think is going to be the case. We've already gotten some
positive signs already. That can alleviate pressures as well.
Brian Levitt
Jodi, I just want my pound of Boar's Head Turkey to go from $14 back to 10.
Jodi Phillips
I hope that happens for you, Brian.
Kristina Hooper
And, Brian, I didn't even talk about perhaps the most important reason why, and
that's because inflation has a funny way of solving for itself, right? We're
seeing consumers not as interested in buying goods. I mean, you've been really
great about citing University of Michigan consumer survey questions like, is it
a good time to purchase a car? Or a big ticket item. And what we're hearing from
consumers is that it's not a good time to be purchasing these things. And so, I
think unlike the 1970s, when there was an assumption that next month, prices are
going to be higher, so we need to buy today, that's not the way consumers seem
to be operating right now. And of course, longer term inflation expectations
seem to support that.
Jodi Phillips
So, Brian, all you have to do is cut back your turkey consumption and that
problem will solve itself, it sounds like. So, we move on to the alternate
scenarios. Was hoping to start off with the option that I definitely hope we
see, which is the alternate scenario of de-escalation between Russia and
Ukraine. A reduction of hostilities. How does that scenario play out in your
outlook?
Kristina Hooper
So, that would reduce, of course, geopolitical risk. We'd likely see key
commodity prices go down. This would likely result in improved growth. I don't
think we'd get back to estimates for 2022, that were laid out before Russia
invaded Ukraine, but certainly we'd see some improvement in economic growth. And
of course, it would enable most Western developed central banks to have more
flexibility in terms of raising rates, if they chose to do it, because their
respective economies wouldn't be as fragile. So, that would likely be the best
case scenario for us.
Alessio de Longis
Yeah, I would agree. I think there is so much risk premium that has been built
in factoring in basically, the end of the cycle as imminent. I mean, I don't
know if ... I have never been in my entire career, in a situation where there's
been such a rush to join the consensus that a recession was imminent, and that
it was unavoidable. In every other cycle prior to this one, there was always
this reluctancy to ever embrace the worst case scenario, to always postpone it
to the end. And, doesn't mean that it's not going to occur, but I think it
certainly speaks to how much is priced in.
Alessio de Longis
So, this is, in other words, I think the scenario that Kristina lays out of a
reduction in geopolitical tensions creating somewhat of a more benevolent
inflationary boom, that type of market scenario may play out. There is a decent
probability that, that scenario plays out also under the scenario, no news is
good news. As the market becomes, unfortunately, from a humanitarian standpoint,
as the market begins accustomed to the fact that there is a war in Europe and to
the fact that we have to live with uncertainty, without new fuel to the fire,
valuations and risk premium may give actually a boost to market confidence. We
saw a bit of an appetizer of that in the last couple of weeks, right? So, market
sentiment can change on a dime, even just because of the lack of further bad
news.
Brian Levitt
So what would you attribute, everybody trying to pile on all at the same time
with this recession call? Is it simply, go back to everybody's taught when they
join this industry, don't fight the Fed?
Kristina Hooper
I think it's an allure that is created by pessimism. And, so yes, of course
there is this view that we shouldn't fight the Fed. But I don't know if many
market participants are really asking themselves what the Fed will ultimately do
this year, and what might happen if we fall just a little short of where market
expectations are right now, for Fed rate hikes this year. So, to me, it's a
combination of things that is creating this incredible drive to join a consensus
expecting a recession.
Alessio de Longis
Well, I think the canary in the coal mine in my mind, Kristina, I don't know
what you think, is isn't it fascinating that if you look over the last two
months since mid-November, emerging market equities have meaningfully
outperformed developed market equities, meaningfully outperformed US equities.
And this is despite the fact that if you, in mid-March we knew about at that
point, the Russia-Ukraine conflict, and we could assume a persistently higher EM
premium. And there were a lot of analogies to what happens after Russia, if this
geopolitical tension escalates. But also, we had a renewed zero-COVID policy in
China. I mean, we have seen many, many pieces of negative information in the
last two months, pertaining to emerging markets, pertaining to the aptitude
towards capital flows. And yet, we're seeing a weakening dollar outperforming EM
equities. In other words, is that is a reminder that their narrative may stay
the same and may seem very intuitive, but prices have already adjusted. So, I
think, I'm hopeful that we can have some positive surprises in the next 12
months.
Jodi Phillips
I do want to at least mention the final alternate scenario in the outlook so
that we can bring it to a full circle. And that's the alternate scenario about a
cutoff of Russian energy supplies to Europe. Whether that's from Russia cutting
off supplies, Europe boycotting supplies. Can you step us quickly through that
alternate scenario and what you would see in that instance?
Kristina Hooper
Sure, Jodi. Well, this would be an energy shock, right? Created by a Russian
embargo or European boycott of energy. And of course, that would result in
significantly higher inflation, especially in Europe. We think that would result
in a stagflationary environment in Europe, and really have reverberations
throughout the globe, biting into real incomes and resulting in lower overall
global growth. It's certainly not an ideal scenario by any stretch of the
imagination. I think, drives up recession risks everywhere.
Brian Levitt
Alessio, as we come towards the end of this conversation, I would ask you, how
do you view what we've just lived through in the last two years? You say ... I
will even extend it. We went from a pandemic to inflation, to a growth scare in
a very short period of time. Is this just a unique pandemic cycle, and then
things get back to normal, or has something meaningful changed in the global
economy? And if the answer to that is yes, then is there something different
that we need to do to our portfolios than we did in the 2010s?
Alessio de Longis
The secular side. So, there are many challenges there. I would say that there
has never been a better labor market environment to really bring back all of the
hidden unemployment, all of the hidden labor force. If there is anybody that has
felt being outside of the labor force, this is the time where everybody can
probably find a much higher propensity to join back the labor force. So that
actually argues favorably in terms of long-term growth potential, long-term
growth rates. Those are not conversations we hear much about. The conversations
around higher productivity rates due to technological innovations, I think those
have not changed.
Alessio de Longis
So, these are all factors that arguably create a very favorable potential
backdrop for long-term trend growth rates. To Kristina's points, maybe reduce on
the margin inflationary pressures over the long term. And, I would say what you
and Jodi said earlier makes, it's probably the most important point. The bar for
central banks to quickly go back to unconventional easing tools and bring in
policy rates back to zero. The bar is going to be extremely high. We have played
successfully with those tools for a very long time, but now we are confronted
with the fact that eventually they can be difficult to unwind, especially given
the interaction with fiscal policy. I think that's a structural change. And for
asset allocation, that means that the assumptions on discounting cash flows, the
assumptions of the present value of long-term cash flows, it should be very
different going forward. Not to mention obviously, the Fed point.
Jodi Phillips
All right. anything else that you would want to say about the base case or any
of the scenarios that we haven't covered? Anything important to note?
Brian Levitt
Well, my big takeaway is that the cycle likely has room to run. The fundamentals
of this economy are stronger than many people suspect. The risks are elevated,
but a lot of that, a lot of those risks appear to have been priced into the
market.
Kristina Hooper
I think that's a great summary, Brian, and I would add that we still anticipate
inflation peaking. And I think they're around now — it's either happened or will
be happening very soon. And, there are a lot of reasons for that. I should also
include in there, the big drop off in fiscal stimulus in the US and other
Western developed countries will help with that effort.
Brian Levitt
And, we're all looking forward to that declining rate of inflation. And we're
looking forward to monitoring it with both of you, as the weeks and months
progress. So, Alessio, Kristina, thank you both so much for once again, joining
the Greater Possibilities Podcast.
Jodi Phillips
Thank you.
Kristina Hooper
Thanks so much.
Alessio de Longis
Thank you.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of May 31, 2022, and are subject to change without notice. These
opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
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Should this contain any forward looking statements, understand they are not
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assumptions. There can be no assurance that actual results will not differ
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Past performance is not a guarantee of future results.
In general, stock values fluctuate, sometimes widely, in response to activities
specific to the company as well as general market, economic and political
conditions.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates. Interest rate risk refers to the risk that
bond prices generally fall as interest rates rise and vice versa. An issuer may
be unable to meet interest and/or principal payments, thereby causing its
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Stocks of small and mid-sized companies tend to be more vulnerable to adverse
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The risks of investing in securities of foreign issuers, including emerging
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On May 20, the S&P 500 Index was down 20% from its peak earlier in the year,
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The ”Fed put” refers to the belief that, when the economy falters, the Federal
Reserve will jump in to support it through monetary policy.
The two-year US Treasury rate was at 20 basis points in September 2021,
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A basis point is one hundredth of a percentage point.
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Quality companies are those with strong measures of financial health, including
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The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
MLPS: WAKING UP TO A ONCE-SLEEPY PART OF THE MARKET
Once upon a time, master limited partnerships were a “sleepy” part of the
market. Today, they’re in the spotlight thanks to a variety of factors: From
their potential to help hedge against inflation, to the geopolitical conflicts
that are redrawing the map of energy imports and exports around the world.
Senior Portfolio Manager Brian Watson walks us through the case for MLPs today.
00:00
00:00
39:25
Listen40 min
Show transcript
TRANSCRIPT
Brian Levitt
Welcome to the Invesco Greater Possibilities podcast, where we put concerns into
perspective, and opportunities into focus. I'm Brian Levitt.
Jodi Phillips
And I'm Jodi Phillips. And today, we have Brian Watson on the podcast. Brian is
the senior portfolio manager for the SteelPath team. They invest in midstream
energy infrastructure through master limited partnerships (MLPs).
Brian Levitt
Jodi, it's a sign of the times. I don't know about you, but I've been in the
industry long enough to remember really when energy infrastructure was all the
rage. If you remember the mid-2010s, a lot of excitement around US energy
independence. I actually even visited the Marcellus Formation in Pennsylvania. I
remember meeting an advisor there, asking me if I wanted to go for a ride, and I
made a trip to Fargo. And that was also a sign of the times. New money around
The Bakken Formation.
Jodi Phillips
I love a good oilpatch story. So, in a former life, I visited Pascagoula,
Mississippi to tour an offshore drilling rig. Took a ride on a helicopter.
Brian Levitt
Show off.
Jodi Phillips
... Well, the biggest thing I remember is that helicopter rides don't agree with
me very well, but that is neither here nor there. What's important today is
MLPs. Investing in the midstream infrastructure that transports and stores
America's oil and gas, whether it comes from the Bakken or the Deepwater Gulf.
In essence, it's a toll road model. It's a part of the market that offers the
potential to earn income, hedge against inflation, and participate in oil and
gas plays like the shale revolution.
Brian Levitt
Yeah. I think, as you say that, I'm sitting here saying, I think this is going
to speak to investors. I mean, everyone's looking for income, everyone's looking
to try and help mitigate inflation these days, so it sounds good. Who doesn't
want that? And actually, the reality is, we talk about the excitement around the
mid-2010s. The reality is, the enticing features of this asset class have not
changed.
Jodi Phillips
No, they haven't, but we went through a period where it still became out of
favor. A global pandemic and a collapse in oil prices will do that. But it
started even before then.
Brian Levitt
Right. And massive investment — Brian will talk about this — massive investment
led to a lack of financial discipline for some of the midstream companies, some
of the drillers. Strong dollar environments certainly didn't help commodity
prices. And of course, to your point, a pandemic doesn't help.
Jodi Phillips
No, but that was then, and this is now. So, year to date, MLPs are one of the
few parts of the market, posting strong returns. There's a lot to talk about:
What does Russia-Ukraine mean for the US energy patch? If there's one thing we
know, it's that the world needs oil and gas. So, how quickly can the US bring
production online? And importantly, are the midstream operators better
positioned this time around?
Brian Levitt
And how can this help me in my portfolio?
Jodi Phillips
Yes. Let's get to that. Let's be sure.
Brian Levitt
So, let's bring on Brian Watson to discuss. Brian, thank you so much for joining
the Greater Possibilities podcast.
Jodi Phillips
Welcome.
Brian Watson
Of course. Yeah. Thank you for speaking with me.
Jodi Phillips
So, Brian, to start out, could you just set the stage for us in terms of the
supply and demand picture for US oil and gas? How much are we producing versus
how much we're using?
Brian Watson
Well, so now, we are amongst the globe's largest exporters of crude oil and
products, and are the world's largest, by LNG (liquefied natural gas) anyway,
exporters of natural gas. So, when you talk about the balance, it's really
global now. OECD (Organisation for Economic Co-operation and Development)
inventories, or those nations that are more economically developed and are most
likely to have inventories, are sitting well below five-year averages. Natural
gas inventories are similarly very low. We are, by all measures, very tight
globally. And that occurred before any of the Russian-Ukraine issues and the
potential for some of those barrels to leave the market.
Brian Levitt
How should American consumers think about that? I mean, we're all being hit
pretty significantly at the gas pump every time we go, we're being hit with our
electricity bills. And yet the US is a big exporter of commodities. How do we
make sense of that as consumers?
Brian Watson
Right. Well, obviously, the price is set by the market, and it's a global
market. So, whether we are exporting or not, the market's going to be set based
upon these global balances. And I can offer no really easy solution to the
prices. Starting in 2014, we had, of course, the rollover of crude from the
shale revolution kind of swamping the market. We had gotten used to $100 crude,
and suddenly, we got used to $40 or $50 crude. When that happened, global
capital spending really took a hit because it was cut in about half and hasn't
recovered since. So there isn't an enormous amount of latent production just
sitting there ready to go. OPEC (Organization of the Petroleum Exporting
Countries) spare capacity is not that robust, not nearly as robust as I think
some people hope.
Brian Watson
So, there isn't a great immediate solution. Probably, the quickest to market is
US shale. A decision today to invest an extra dollar, begins to really bear
production fruit in about 12 months, but that's five to eight years quicker than
an offshore platform that someone decides to build. So, West Texas is probably
the quickest place to find new production of any place in the world. And
obviously, the price signal is very good today, and you are seeing growth, but
it's the physics of it, it takes time to emerge.
Jodi Phillips
You talked about upstream capacity. Looking at the midstream capacity, is there,
currently, enough to support projected growth from places like the US shale and
other basins? Or how much build-out are we looking at for being able to handle
that capacity?
Brian Watson
Right. Well, the whole reason why we can bring new production online within 12
months is because there is some capacity. So, if we were capacity-constrained,
it would be however many years it would take to build a new pipeline. But today,
there is capacity out of the Permian in West Texas. It can move substantially
more crude oil. Natural gas out of the Permian is going to become challenged in
probably about a year, but projects are already underway. The largest
gas-producing basin in the globe, in the United States is the Northeast, which
you mentioned earlier. That is capacity-constrained. There is no way to move
more today. There's a pipeline that has been attempting to get through the
regulatory and legal challenges for many years now, that potentially comes
online in early '24, but that's the first real relief there. But for the next 24
months, at least, Permian can grow and be an important part of solving this
problem.
Brian Levitt
When you say solving this problem... And let's speak specifically to what's
going on in Europe, in particular, in Eastern Europe, with Russian troops in
Ukraine, Europeans trying to determine what they can do to stop filling the
coffers of one Vladimir Putin, who can then use that money for further military
adventures in Ukraine, or dare we say, other parts of that region. And so,
what's the reality of this, as the US or as the world looks to places like
Germany or other countries in Europe to lessen their exposure to Russian oil and
gas? What's the reality of it? And is there a swing producer coming to the
rescue? Sounds like you suggest that can't happen overnight, unfortunately.
Brian Watson
Yeah, I think we are the swing producer, but the ability to come to the rescue
quickly is challenged just by the physics of it. So, Europe is consuming about
three and a half million barrels per day of Russian crude and products. Russia,
in total, is exporting seven and a half. To put this in perspective, the
Permian, which is the biggest US-producing basin, is producing about 5 million
barrels per day. So, that's a lot. You can tell you'd have to really move the
Permian higher to fulfill what Russia is delivering to Europe. So, it's a big
deal. And obviously, on the natural gas side, it's even more acute as Europe is
even more dependent on Russia for its natural gas, because, it has direct ties
through pipelines.
Brian Watson
And the answer, again, appears to be largely US basins that can grow and deliver
that. We have just surpassed to become the largest LNG exporter, as I mentioned
earlier. We've had a rash of new LNG commitments to US facilities to start the
year. So, US LNG could potentially double by the time we get to the end of this
decade. And from there on, it just depends on the new commitments, but it can be
very significant, but it just takes time. There's debate now, within EU
(European Union), about formally rejecting Russian crude and products, that
hasn't been decided or the details haven't been planned out, but it certainly
seems as if that's the way it's going. And I think the initial discussions here
are six months to stop crude. And at the end of the year, to stop delivering or
receiving products. I don't know how realistic that is. There is not some just
well of products and crude that can be delivered, that that market or the
European Union would have to bid for that against a global market.
Brian Watson
So, you've seen natural gas, of course. They're trying to wean themselves from
Russia. And LNG cargos have been diverted from Asia to Europe. You've seen
Europe's LNG imports increased dramatically, but it's come at a cost. I mean,
they've had to bid that away from Asian markets. So, there's no cheap solution
to it, but it does seem as if that is the way this is going to go. And I would
say, all else equal, the call on US production, versus just a few months ago, is
incredibly inflated. I mean, as I mentioned, just replacing Europe is almost
doubling the Permian basin in total. So, it's an enormous call.
Brian Levitt
Brian, how surprised were people in your world, over the last number of years,
at how exposed the Europeans left themselves to the whims of the Russian
leadership and to the Russian energy market?
Brian Watson
Yeah. I think the whole globe has watched it. Obviously, it was a lot of debate
on Nord Stream 2, which would've further linked that economy with Russian
exports. So, it's been something that's out there, and everyone has recognized
it. Obviously, I don't know anybody who really foresaw Russia doing this six
months ago.
Brian Levitt
I certainly didn't. I certainly hoped, at least.
Brian Watson
I think most assumed it was posturing, but it wasn't. And so, Europe, natural
gas pricing really took off over the winter, as just their level of storage
proved to be inadequate to winter weather. It's not clear why they let
themselves get in such a low storage position, but it highlights... This is all
happening at a time where things were already tight globally; gas, products,
oil, and in particular, tight in Europe as being the most hit. So, you look at
today, I think natural gas in the US hit $8. We haven't seen that. And I have to
click my chart back quite a distance to find it.
Brian Levitt
It's so hard to believe.
Brian Watson
It's been a long time, and yet, it's 2, 3, 4 times higher, depending on the
country in Europe.
Brian Levitt
See, Jodi's lucky. She lives in Houston. Us Levitts here in the Northeast, we're
bringing out the sweaters. This is like Jimmy Carter bring out the cardigan
time.
Jodi Phillips
Oh yeah. Well, we're firing up the AC as much as possible. It's getting to be
summer. Brian, talking about LNG, liquified natural gas, it takes about four
years, am I right, to build an LNG terminal? They're very complex. What does it
require to get the certainty needed to build these projects? I mean, obviously,
the US isn't the only place that's looking to build them. What does that require
to have the visibility and the certainty needed to really put money into these
LNG terminals?
Brian Watson
Right. Well, so originally, these guys wanted 20-year commitments. They wanted
to have 80%, 90% of the capacity committed for, and then they would break
ground. And then over the past four to five years, you saw fewer commitments as
customers, particularly in Europe, began to balk at providing such long-term
guarantees of offtake. So, that has suddenly changed. And we've had a number of
20-year commitments be delivered, just to start the year. And, you'll see a rash
come online, but as you say, there's a gap. We are adding LNG capacity that was
already underway, is coming on stream this year, coming on stream next year, but
it'll take time for these new commitments to result in building.
Brian Watson
These liquefaction facilities, they take four or five years, many billions of
dollars, so it just takes some time. But you are seeing those commitments now,
and it's coming. Obviously, from preventing Russia benefiting from their
exports, these commitments, they'll displace Russian exports for the foreseeable
feature, because, as I mentioned, they're 20-year commitments. So, it is a
significant blow to the future of financials of Russia's ability to make war,
but it will take time.
Brian Levitt
Isn't it also a blow to the climate transition folks, the green energy
revolution. I mean, we're talking about four to five years of planning, plus
20-year commitments. Is that now setting the clock back significantly, in terms
of this climate revolution or this energy revolution that we've heard about?
Brian Watson
I don't know if it really changes that. I think some of the expectations that
the globe wouldn't need oil or gas, or whatever, within 20 years, they weren't
really realistic assessments of the demand and where it's coming from, and how
it's emerging. So, I don't know that it really changes much, particularly,
Europe's efforts to continue to increase their wind and solar. I don't know that
it changes that, but certainly, I think it helps to de-risk the underestimation
of the need for oil and natural gas. And in part, Europe got to the position
where they were, this past winter, because, there was an unrealistic assumption
of the reliability of wind and solar. They had a less beneficial wind period,
leading into winter, which was part of the reason why they had such low natural
gas storage. It just wasn't there like it was originally thought. So, I really
don't think it does. I think it just, hopefully, removes some of the price shock
and economic damage that comes from underestimating the reliance that still
exists and is likely to exist for some time.
Jodi Phillips
We talked about, obviously, Europe and the natural gas imports from Russia. Just
to kind of level-set with the US — I mean, the US banned imports of Russian oil.
We weren't getting any gas from Russia. But a fairly modest amount, in the
bigger picture, that we were getting. But does replacing those barrels have any
kind of midstream impact? I know I've read a little bit about Hawaii was getting
a lot of those barrels that were coming from Russia; the shipping situation. Is
there anything that you're watching with that midstream impact?
Brian Watson
It all does. I mean, so all else equal, Europe saying, "We don't want to buy
Russian crudes or diesels and gasoline, natural gas, whatever it is," all this
begins to shift logistics more than it does really, ultimately, impact
production, because, likely, there will eventually be a buyer. But now, you're
having pathways of commerce that didn't exist before, you're using export
facilities that were underutilized prior, now they're going to be utilized. Even
supplying Hawaii is resulting in a shift in domestic use of the vessels that it
takes to get there. You've seen East Coast versus Gulf Coast product margins
blow out, materially relative to just a few months ago, that's incentivizing
large traffic and other infrastructure traffic. You're seeing it happen between
pricing points domestically. So, all of this is driving midstream utilization
and the need to access it, because it's just disrupting the patterns that
existed before. So, now, suddenly, you need capacity where you didn't have it
before. So, it's all feeds into it.
Brian Levitt
It's so interesting. As you were talking about that, it kind of struck me. Does
the listener, do we all understand, Brian, how you make money on an investment
through this? So, talk me through, talk Jodi and I through this process. So, the
United States is sitting on what we call the treasure trove of natural gas; the
Europeans need it, it takes a process to get it there. How does Brian Watson and
the Invesco SteelPath strategies make money through that process?
Brian Watson
Right. So, the most obvious is just, the gas is coming out of the ground from
West Texas to the East and Northeast from the Bakken, South Texas. And as you
can imagine, there is this enormous pathway of pipelines and processing plants
and treating facilities. All comes out of the ground, you've got to strip out
this thing that doesn't go to market, this product that needs to go to a
different market. So, all this stuff is happening, and then finally, it takes it
to LNG facility to be exported. It's frozen to -200 degrees, and then that
condenses the volume. It's loaded on a ship and it heads over overseas.
Brian Watson
And obviously, the LNG facility itself gets its fee for providing that
liquefaction and providing the dock space for the boat to come up and fill up.
But it's all of the assets upstream that are going to benefit from that volume.
So, put it in perspective, we broke a record, we're something close to 11 and
half, 12 BCF (billion cubic feet) per day of LNG export. And we produced around
100 (BCF), so that's about 10%. Well, on the current path of new LNG facilities
and their commitments that we're seeing come in, that could double by the end of
the decade. It might double again by the end of the next decade. And that's real
volume. That significant volume increases throughout the whole system.
Brian Watson
And of course, one of the reasons why we like infrastructure, particularly, in
the midstream model where we see good dividends and flow through these cash
flows, so investors can benefit real-time, is that operating leverage is very
real. In other words, a pipeline that's already built in the ground, it moves an
extra dollar of tariff product, it doesn't cost a dollar extra to move it. That
almost all falls to the bottom line. There are some maybe fuel expense for pumps
and pressures, and that kind of stuff, but mostly, that falls to the bottom
line. So, it can be, a very gradual unexciting growth profile coming from
Europe's attempt to lessen its dependence on Russian gas, results in a very
healthy, we believe, underlying EBITDA (earnings before interest, taxes,
depreciation, and amortization) or cash margin benefit to all those
infrastructure assets that help feed that new supply.
Brian Levitt
Jodi, do you speak billions of cubic…
Jodi Phillips
Cubic feet? Yeah. Billions of cubic feet. I don't know how many light bulbs
that'll power, but I know it's a lot.
Brian Watson
That's a lot.
Brian Levitt
I only know 1.21 gigawatts in order to go back in time.
Jodi Phillips
So, we've talked a lot about geopolitics, of course. I want to bring the
conversation around to the environment that we're facing in the US, in terms of
rising rates. Is that a headwind for the midstream sector?
Brian Watson
So, for those who really care about the numbers, I would encourage, we put out a
few blogs here recently, and so we can look through it. But we looked at every
period, over the last 15 years, where rates had risen more than a 100 basis
points. And you'll see that, in most of those instances, midstream was positive,
provided positive performance. And I think two of the six, it was negative, but
just barely. So, generally, it's a good environment for midstream equities. I
think there's a few reasons for that. One is just they're relatively
high-yielders. So, midstream average yield today, I think is right around 7%.
That, compared to other yielding equities, is pretty meaningful. And so, I think
you do get some rotation into that, into the sector, when the underlying yields
increase and people are looking to beat it by a little bit.
Brian Watson
I think also, the businesses themselves have within them some mechanisms that
often allow improved revenues with inflation, which is typically the reason why
rates are going up. If you look at the swath of assets, we estimate somewhere
between 65% and 75% of cash flows are coming from assets with some sort of
inflation-linked mechanism to the tariff or to the revenue stream. So, it's
pretty widespread. So, you're getting an asset class that has a good yield
relative to other asset classes. And you have assets that typically benefit from
some sort of inflation-linked revenue increase mechanism.
Brian Levitt
You say some sort of inflation link. Is that usually consumer price index (CPI),
or is it any different metric or any number of metrics on inflation that could
potentially be used?
Brian Watson
Right. So, it depends on the asset. So, if you are a FERC-regulated petroleum
products pipeline, so you cross state boundary, FERC (Federal Energy Regulatory
Commission) is your regulator, FERC says this, "You don't have a lot of
competition, so we're going to manage your rates." They allow annual increases
at the PPI minus finished goods. I think today, it's -21 basis points. So, on
July 1st of this year, we'll see about an 8.7% increase to the tariff rate for
pipelines that follow that mechanism, which is of course enormous and it's high
because the PPI's been so high.
Brian Levitt
And PPI, of course, being the producer price index.
Brian Watson
Exactly. Right. So, we'll see that come. Pipelines that do that same service
across state lines, also regulated by FERC and which are deemed to have
competitors, they don't get that automatic, but if you ask management teams,
most of them follow a very similar pattern. On the individual contracts, if you
look at all the revenue earned, a lot of it is not coming from a FERC-regulated
contract, but individually signed commitments to producers. And that's where I
came up with my estimate before, 65% to 75%, because, this is more based on
conversations with management teams' disclosures during earnings calls. You got
to kind of add it up, but most contracts have some sort of inflation link
mechanism within it, often PPI, sometimes CPI, but it's a very common mechanism
that exists across all these individually negotiated contracts. So, you see it
as it comes, but it's pretty widespread.
Brian Levitt
So, you paint such an interesting picture for the future; one that sounds quite
optimistic for the area in which you're invested in. Talk to us a little bit
about those mid-2010s periods and why it became a bit of a loss period for
energy and energy infrastructure, with regards to performance. And what were the
lessons learned and what were some of the takeaways you have from that
environment?
Brian Watson
Yeah. I think the biggest issue the sector had during that time, was that it was
established originally as these sleepy pipeline companies. So, a bunch of big
oil and gas companies, refiners, whatever, had these pipelines, they weren't
very exciting. We weren't producing more of anything in the United States, so
they spun them out into these standalone little entities. And they were supposed
to just sit there and deliver dividends. That's all they're going to do. The CEO
was the operations guy from the conglomerate, and that was it. And then
suddenly, we wake up and we figure out that Mitchell and the Barnett Shale has
figured out how to crack these Shale rocks. So, suddenly, the US went from being
in perpetual decline of production, to being the Globe's quickest grower of
production.
Brian Watson
And suddenly, all these producers, who were these pipeline operators' customers,
said, "Hey man, I've got a huge amount of crew coming in West Texas or in the
Bakken. I need a couple thousand miles of pipeline." So, they went about trying
to satisfy these customer demands, but had to spend a lot on a model that was
paying dividends. And so, management teams tried to balance this. They attempted
to build the pipes while still paying their dividends. They knew their investors
wanted that. And really, when 2014 hit, we had the price collapse, stocks got
beat up. It really removed their ability to use equity to pay for building these
new pipelines. And so, these guys had to decide what to do. And most of them had
to make the decision to cut their dividends in order to fund this capital, and
that upset the market as you would expect. And so, that was really the big
thing. That disruption, this misalignment between dividend commitments and
capital-spending commitments, caused that friction. At this point, we've got two
events that we think have removed that.
Brian Watson
One was these midstream guys, either already cut or were doing well, but didn't
grow their distributions, so they've got themselves into these excess cash flow
positions that are pretty robust. We measure it as coverage ratios — so, the
amount of cash being earned minus that amount that's needed just to maintain
assets, what is that relative to their distribution or dividend rates?
Historically, it was 1.0x or 1.1x. They're paying out most everything. A
difficult position to be in if you had to spend a bunch of money. Today,
everybody's about 2x. So, significant improvement. And then the other thing is
we've just, mostly, finished building out all these multi-thousand-mile pipeline
arteries that needed to get built. We've kind of done it. I mean, it's a handful
as we discussed, that need to get done, but mostly, it's done. And so the
capital spending has come down a lot.
Brian Levitt
So, it becomes sleepier again.
Brian Watson
Becomes sleepier again. Yeah. And we've actually entered a phase now, we're
starting to see companies that... Particularly, during COVID, you had some guys
that cut again, mostly to keep creditors happy, because, no one really knew how
that was going to unfold. Began to grow their dividends back pretty materially.
I don't expect the group will ever go back to 1.0x. I think that no one wants to
be faced with the specter of having to cut again, but we'll see dividends, I
think, begin to rise overall, pretty healthily from here on.
Brian Levitt
I guess if we get to 1.0x, that's when I start to get invited to have lunch in
Fargo. That's when we know we've gone too far on this idea.
Jodi Phillips
So, Brian, when you're looking to put together a portfolio of these different
companies, what is it you're looking for? I mean, are you looking for
diversification among all the different energy basins in the US? Are you simply
looking at debt level and free cash flow? Or how do you put all of these
components together in a portfolio?
Brian Watson
We've got a good-sized team that we believe are the best out there on
understanding these companies and their industries. And so, we start from the
bottom. We model every company, we understand the business as well as anybody,
and then we look at the world through a series of scenarios. So, where we say it
is... We don't have a base case. We have this range of understanding, where we
look at what happens if pricing is where it looks like it's going to be. You can
call that our base case, but that's the most likely scenario. And then we look
at what happens in a world where pricing is much less healthy than we think it's
going to be.
Brian Watson
And what does that do to rig counts, what does that do to margins? And so, then
we create this kind of range of valuations we think is reasonable, based upon
the unavoidable uncertainty of commodity prices. And we want to buy asymmetric
exposure. And that's how we figure out which names appear most attractive to us.
We try to go make our positions accordingly. And then on a portfolio level, you
do, as you mentioned, look at, "Is this bottoms-up method lead us into some sort
of overexposure to some trend or another?" And if it does, you try to diversify
against that. But mostly, we're just looking at these companies individually and
their prospects individually.
Brian Levitt
Brian, thank you so much for all that. As we come to the end of this
conversation, one that has me very interested in the prospects for your asset
class, what keeps you up at night? What do you worry about, that could go wrong,
given the optimistic outlook that you've presented for midstream energy
infrastructure?
Brian Watson
Yeah. Things seem to be heading the right direction well, but there's always
something you worry about. I think recently, it would be made political. You're
not sure what's going to happen with the administration. Obviously, leading into
the election, there were some talk coming from, one of the candidates that
sounded pretty harsh? Potentially, action on federal leases or actions on
permitting processes. So, you have to keep that out there. I think probably, the
specter of doing something that would significantly impact global supply and
then cost prices to go up, is probably lower today than it was six months ago or
whatever, when prices were...
Brian Levitt
Isn't that ironic; prices up significantly in a Democratic administration, and
down in a Republican administration?
Brian Watson
Right. Yeah. Obviously, we were headed here before Russia-Ukraine. That hasn't
improved the supply outlook any. So, I do think that's lower, but you still have
to put it out there. And then just the good old commodity pricing, I think the
sectors, as we mentioned before, you got very high coverage ratios versus
history, and we didn't really get into it, but the leverage ratios are much
lower today than they were back in '14.
Brian Levitt
Sleepier.
Brian Watson
Sleepier. So, I don't think a turn in commodities would be as impactful as it
used to be, but you have to put it on the list. That's why we still put it in
our models. So, political and the typical commodity cycles, I think you still
have to consider those potential risks out there.
Brian Levitt
And for an average investor, do you typically think of it as equity exposure, or
do you think of it as something that goes into income exposure, as a way to
augment income and diversify some of your interest rate risk of the income part
of your portfolio?
Brian Watson
I know we have investors that put it in that income bucket. I say, "That's
fine." But these are equities. So, I think in reality, people treat it as maybe
a hybrid between the two, because, the yields are so significant, but the caveat
to the buyer is, these are equities, they trade on exchanges, they have
volatility measures that are equity-like. So, just know what you're buying.
Jodi Phillips
All right, Brian. So, let's wrap it up with this question. Brian's been to
Fargo, I've been to Pascagoula. Do you have a favorite oilpatch town or trip
that you've been able to go on?
Brian Levitt
It's like his children. He loves them all equally.
Jodi Phillips
That's the right answer.
Brian Watson
How can I pick? Well, when you go to the Rockies, you can also go fly-fishing.
So, that's got some advantages there.
Jodi Phillips
All right. You win. Great. Well, thank you again for joining us. We really
appreciate your perspective,
Brian Levitt
Brian Watson, thank you so much.
Brian Watson
I appreciate it.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
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conditions as of May 4, 2022, and are subject to change without notice. These
opinions may differ from those of other Invesco investment professionals.
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Past performance is not a guarantee of future results.
The Alerian MLP Index had a total return of 18.7% for the first quarter of 2022,
compared to a 4.6% loss for the S&P 500 Index. The Alerian MLP Index is a
float-adjusted, capitalization-weighted index measuring master limited
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Statistics about European energy imports from Russia are from the International
Energy Agency as of April 2022.
Statistics about Russian exports are from Capital One as of May 2, 2022.
Statistics about Permian Basin gas production and US LNG exports are from the US
Energy Information Administration as of April 2022.
Statistics about natural gas prices in the US and Europe are from Bloomberg
L.P., as of May 3, 2022.
Statistics about midstream yields and coverage ratios are from Wells Fargo
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Alerian MLP Index. Distribution yield refers to the earnings generated and
realized on an investment over a particular period of time. The most recent
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Statistics about pipeline tariff rates are from the Federal Energy Regulatory
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Over the past 15 years, there have been six periods when interest rates have
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OECD stands for the Organisation for Economic Co-operation and Development.
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Producer Price Index (PPI) measures the average change over time in the selling
prices received by domestic producers for their output.
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prices paid by urban consumers for a market basket of consumer goods and
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amount of liquidity, MLP interests may be less liquid and subject to more abrupt
or erratic price movements than conventional publicly traded securities. The
risks of investing in an MLP are similar to those of investing in a partnership
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The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
ECONOMICS IS NOT FOR THE FAINT-HEARTED
So says Meral Karasulu, Director of Fixed Income Research for Invesco. Meral
joins the podcast to talk about Russia-Ukraine, China’s zero-COVID policy, the
path for the Federal Reserve, the case for emerging markets today, and much
more.
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34:17
Listen35 min
Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Greater Possibilities Podcast. A podcast from Invesco, where we
put the concerns into perspective and the opportunities into focus. Hi, I'm
Brian Levitt.
Jodi Phillips:
And I'm Jodi Phillips. We're assessing the world today. So that puts it into
focus. Right, Brian? Narrows it down just a little bit?
Brian Levitt:
Just the world?
Jodi Phillips:
Just the world. Just the world. But we have Meral Karasulu here. Who's the
Director of Fixed Income Research of Invesco. And she has a deep background in
macroeconomic analysis and a long history of providing macroeconomic policy
advice to policymakers across the developing world. So with all that's going on
in the world, who better to bring on?
Brian Levitt:
Yeah. As Bill Maher usually says, "Those things were my old jobs." So yeah,
we're thrilled to have Meral here. Having someone with Meral's background,
Jodi's, such a great opportunity for us because there's so many topics that are
on investors' minds right now. And Meral has great insight into so many of them,
whether it's Russia-Ukraine, whether it’s concerns about China COVID policy and
a growth slowdown. The path for the US Federal Reserve (Fed) and so much more.
Jodi Phillips:
That's right. Meral has a line on her LinkedIn page that I love that says,
"Economics is not for the faint-hearted." It is really apropos, isn't it?
Brian Levitt:
Oh my God. It is so apropos right now. And I'm going to admit, I'm starting to
think that maybe my heart is a little too faint.
Jodi Phillips:
Yeah. Yours and mine, both.
Brian Levitt:
Yeah. It has been such a challenging couple of years: A pandemic, an
inflationary environment, which of course is being exacerbated by the war in
Eastern Europe. Now expectations of policy tightening, which Jodi, as you know,
briefly inverted the yield curve – raises concerns of recessions. So just so
much to talk about.
Jodi Phillips:
But still markets have been relatively resilient, right? I mean, we are down for
the year, but one might have expected things to be a lot worse given everything
that's going on. Right. I mean, if I had told you last year, everything we would
be facing, you'd be surprised.
Brian Levitt:
Yeah. I know exactly where you're going with that. I mean, I think we rightly
would've expected worse. I mean, it has not been fun to see stocks and bonds
down together, but credit has largely held up. Stocks have bounced back, even EM
(emerging market) assets excluding Russia performing relatively well. All with
everything we talked about: Russian troops in Ukraine, what's going on in China.
Gas prices where they are, food prices where they are. The Fed signaling
multiple rate hikes. You're right. The market has been reasonably resilient
given all that's happened.
Jodi Phillips:
But for how long, right? How long do we handle each of these challenges and what
are the risks we may not even be considering? Where does the global economy go
from here? So let's bring on Meral to discuss. Welcome.
Brian Levitt:
Yeah. Meral, welcome to the podcast.
Meral Karasulu:
Hello Brian. Hello, Jodi. Thanks for having me. And now that you told all about
me, I feel I have to also solve the world hunger and bring peace and everything
else.
Jodi Phillips:
No pressure, no pressure.
Brian Levitt:
We've got a lot on your shoulders today, Meral. I wanted to start first with
Russia and Ukraine and just get a sense of your thoughts when the Russian troops
started to amass on the border of Ukraine. Were you surprised by the decision
that Vladimir Putin made? And how surprised are you by the challenges that the
Russian military has faced?
Meral Karasulu:
Yes. After being a COVID expert, now I'm a military expert on Russia, nonstop on
Twitter spaces, nonstop with military experts. To be honest, to be fair, we were
as surprised by the invasion as pretty much everybody else. And I think that
goes back to the sort of inherent assumption we make: Economic cost to Russia
will be so insanely high, it would not make sense. It was all in our tail risks
scenarios. We were surprised basically. At best with the amassing of troops,
people were thinking, including us, myself, "Okay. Maybe the activity in the
Donbas region, which has been ongoing for the last eight years anyway, will pick
up. Maybe they will sort of expedite things over there." But a full-scale
invasion and the scale of the war as we see it impacting the civilians was on
nobody's mind.
Brian Levitt:
No.
Meral Karasulu:
And in terms of how I look at the military side of the story, as I said, I
literally spend the last four weeks just studying military strategy and what's-
Brian Levitt:
You and me, both. Yeah. You and me both.
Meral Karasulu:
My take from all these numerous calls, reading, etc. Clearly the giant man is
not as giant as everybody assumed, right? I mean, logistic problems, everybody
knows them. And interestingly enough, this is an excellent point to bring ESG
(environmental, social and governance), into the discussion. Governance. I think
the level of corruption was so intense, including in military procurement. You
have seen the tires, right? I mean, unexercised truck tires getting blown out on
the field and all the machinery, basically stopping to work.
Meral Karasulu:
And their super secure communication networks not working because they blew up
the towers that they would have needed. Things of that nature. Having said that,
they have the numbers. They have the tanks. They have the ammunition. So this
can go on for a very, very long time and it can get way more bloodier than it
is, unfortunately.
Jodi Phillips:
So Meral, help us put into perspective some of the challenges that this creates
from a global economic perspective, right? And I'd like to start with the
question on food supply. When this all first happened. Immediately you saw
headlines about wheat production, given how much wheat is grown in Russia and
Ukraine. And more recently I've been seeing headlines about Brazil, for example,
and how dependent Brazil is on fertilizer imports, especially from Russia. So
soybeans and coffee and sugar grown in Brazil, it's staggering, right? Just the
ripple effects that this has. So how do you think about this and how would you
frame that particular challenge?
Meral Karasulu:
Yeah, I mean, in terms of the impact on food. We are already seeing that in
terms of the prices, right? It's already there. Today I think it was FAO
announced the prices for the first quarter. We haven't seen this kind of price
increases over the last 90 years. I mean, this is a global one-time event that
hasn't been experienced in our lifetimes. The repercussions we believe felt
across the board. No question about it. And unfortunately, especially for
emerging market economies, where you tend to have a higher share of food in your
CPI baskets. That's going to be really one of those really bad outcomes because
it's really goes back to not only just availability of food, but also the price
impact on poorer households where most of the money is spent on food.
Jodi Phillips:
That's right.
Meral Karasulu:
These things do not unfortunately change overnight. It's not like there is some
sort of a stockpile. There are stockpiles in India, especially. In Thailand,
China, there are significant grain stockpiles. They will be utilized, but I
don't think that the priority will be to satisfy global markets. Everybody will
be looking at their own food security. In the initial instance, we will see that
playing out one or two years. Definitely. I don't think that you can avoid that
impact. That's just one of the ugly outcomes of the war.
Brian Levitt:
And so which countries are most adversely affected by it? And I wonder when you
think through the scenario, a couple of years of us dealing with these
challenges, how bad does it get? Do you start to feel a global recession type of
feel given how much of the world's consumption is going to now move to towards
food?
Meral Karasulu:
Not at all, actually. I just want to sort of stop that discussion right in
tracks. We are not calling, we are not expecting a global recession.
Brian Levitt:
Okay.
Meral Karasulu:
And there are few reasons for that. This was the year for a lot of EMs to
finally come out of the doldrums of COVID. And that is already ongoing, by the
way. It's not like it stops in its tracks because of what we are seeing in
Ukraine. And so that process of recovery, especially in consumption, I think
will continue. And of course, EM households didn't have the same type of fiscal
drop from the government to supplement their paychecks. But there was quite a
bit of fiscal effort, right? So households in general are not in a very highly
leveraged position where consumption will go down significantly when you had the
additional risk of coming from inflation.
Meral Karasulu:
It will be more problematic in places such as India, where income levels tend to
be lower. Larger group of people live close or below the poverty line because
inflationary effects over there are definitely more contractionary in terms of
consumption. But broadly, when we look at different regions, that's the
interesting thing. The impact is very, very different across the regions. And
that tells me, "This is not a time to think of EM, just as a unitary monolith."
I think this is the time where actually active managers will shine because the
differentiation, I mean, I don't want to bore in a podcast because it's really
very detailed. But the differentiation is actually intense. I'll give you just a
regional broad brush.
Brian Levitt:
Yeah. And if you think I'm bored, I'm on the edge of my seat. So certainly don't
worry about. I can't speak for all the listeners, but I'm on the edge. This is
great. So please keep going.
Meral Karasulu:
I mean, it is a commodity price shock, right? And EMs actually, a lot of EMs
tend to do quite well during commodity price shocks because they are net
commodity exporters, if you think of EM as a monolith. But when you dig down,
it's actually mostly LatAm type of places and the oil or oily credit, as we say,
oil exporting countries that tend to directly feel this positive terms-of-trade
shock.
Brian Levitt:
Meral, what does it mean for parts of the world that are not the commodity
exporters take Asia, for example, some of the bigger economies in Asia.
Meral Karasulu:
Yeah. Asia as a region is a net importer of commodities. So that's definitely a
negative terms-of-trade shock. But again, if you look at it as a monolith, you
miss the variety that is embedded there. For some of the Asian countries, that's
actually positive. One of them is Indonesia. The other one is Malaysia. And
there are gainers and losers from different fallouts of this crisis. Jodi was
just mentioning fertilizer for instance, right? China is one of the biggest
fertilizer producers. So the picture is very much different. And in terms of
Asia, yes, we already reduced our growth forecast for the region a little bit
and we increase our inflation forecast a little bit. I think as I was saying
earlier, the bigger impact the contractionary growth, contractionary impact, I
expect in poorer countries, such as India, but the rest those of Asia actually
is quite fine.
Meral Karasulu:
And keep in mind, this is still a manufacturing, an export-driven region. And
that engine of growth is there. That's why I didn't want to go into the global
recession arguments because I squarely believe that, especially in Asia, we are
seeing the delayed recovery that we haven't seen last year because of their
COVID restrictions. But now Asian consumer is coming back.
Jodi Phillips:
Well, Meral, we can't have an emerging markets conversation without focusing in
on China. So I'm hoping that you might be able to characterize the macro
backdrop there for us. For example, how big of a concern is the property market
or how are you thinking of China at the moment?
Meral Karasulu:
Yes, China. Oh, the big elephant in the room in every conversation. China is
actually slowing down and there is a big macro divergence at the global scale.
You see US economy still doing well. Yes, Europe will be probably slowing down
into one, but we are not talking anywhere other than China slowdown. Whereas
China, we are seeing it slow down and there are several angles to it. One, as
you mentioned, Jodi is the property market. Property market almost drives a
quarter of the GDP (gross domestic product) of this country. It is humongous and
it impacts household balance sheet. It impacts household consumption. It impacts
investment – huge. A property market slowdown was already in the making from
last year obviously. If anything, the property market aspect of this China
equation is on the margin getting better in my view, because in terms of all the
restrictions that they had imposed. They already relaxed several of them.
Meral Karasulu:
So far, we have not yet seen a sensible increase in home purchases, etc., but
I'm actually expecting it to come through in April, especially after this COVID
wave, the Omicron wave that Chinese currently experiences, passes. We will see
that. But of course, when you talk about Omicron wave, we have to also talk a
little bit about that. It's not just the property market. It's not just about
regulatory tightening that we have seen. I mean, currently of course it's
Shanghai. Shanghai is only 4% of China's nominal GDP. So if it stays in
Shanghai, the impact is likely to be very little and then consumption will
bounce back with a vengeance, right? We have seen that.
Meral Karasulu:
But there is obviously a tail risk scenario here that you would see the same
scenario that is in playing out in Shanghai now will repeat itself in more
economically important places as well. That's not my baseline because you can't
even travel out of Shanghai. So I don't see that happening. So all the risks
still, I think I would say, [point] to a slower growth in China. But what that
means is, whereas the rest of the world is in hiking mood, we are constantly
pricing up the Fed (Federal Reserve), now ECB (European Central Bank), all the
emerging markets. We're already doing that. In China's case, we are expecting
after the policy easing to continue and if anything, most likely to accelerate.
So it's very interesting dynamics.
Brian Levitt:
Meral, can you explain for the US audience in essence, what's going on in
Shanghai? Why is it where, the world is still grappling with coronavirus, but I
was at a conference this week in Austin, Texas. It was very widely attended.
We're all back traveling. The offices are open again. Why is it that China is
still grappling with this? And why do the policymakers there seem intent on
keeping the zero-COVID policy where a lot of the rest of the world seems to have
at least some success moving away from what we had to deal with over the last
couple of years?
Meral Karasulu:
But I have to make a distinction, Brian. When you make the reference to going
back to office, travel, conferences — if you were to see China last year,
Brian Levitt:
Yeah.
Meral Karasulu:
there was no COVID. People... There was no lockdowns.
Brian Levitt:
Right.
Meral Karasulu:
There was no nothing. Right?
Brian Levitt:
Okay.
Meral Karasulu:
Actually, everything is still open, right? The exception is when they do have
COVID, the reaction to it in the region where they do have it is gargantuan.
That's the distinction. Even now, if you were to go to Beijing, everything is
open. Everybody's in their offices as if they never had COVID. It's not the “new
normal” by the way, as if they never had it because they never actually went
through the trauma of COVID as we did with the number of deaths, etc. We are
approaching 1 million here. Not even comparable.
Meral Karasulu:
So what is happening right now? Why they still keep the zero-COVID policy? Part
of it is very political, but part of it is scientific. First, they are very
aware that their vaccine probably does not have the same level of immunity that
mRNA vaccines do in part. Second, they have actually a huge, large aging
population, right? That's one of the demographic challenges of China.
Brian Levitt:
Right.
Meral Karasulu:
Well guess what, for whatever reason, the resistance to vaccines in that age
group is huge. And on top of it, they don't have the acquired immunity that a
lot of people got here through, basically actually getting sick and surviving
it. They have pretty much none of it. So the reaction to that has been, okay if
we find one COVID, we lock down the apartment building. If we find two people in
this street, we lock down the block. And Shanghai unfortunately, is taking the
brunt of it. And keep in mind, Shanghai last year was raised as the poster child
of all the cities because even when they did have some minor outbreaks, they
were actually very good keeping the lockdown super limited.
Meral Karasulu:
Let's say just one building, just one apartment, that kind of thing. Now it's
pretty much extended to the whole city. And let's see how long that will last.
The political aspect of it, I would say, Brian is because President Xi owns it.
Owns the zero COVID policy. Chinese feel very proud of it that they didn't have
the same death rates. They didn't have the same run to the hospitals. They
didn't have any of the trauma that we lived through. But as a result, they don't
also have the experience we have.
Jodi Phillips:
So Meral, you mentioned the difference in the atmosphere of COVID between last
year and this year. What about the regulatory atmosphere? How concerned are
investors following last year's regulatory changes compared to what the
environment looks like and steps that are being taken now?
Meral Karasulu:
I think the worst part of regulatory tightening is definitely behind us. I am
very certain of that. But does that mean that they will not go after some
special network companies that may be doing, quote unquote, "unpatriotic
things?" Yes. That risk will be hanging out there, but in terms of the
coordinated push from the bank regulators, securities regulators, central bank,
finance ministry. It was a regulator, the whole regulator's system ganged up.
Right?
Jodi Phillips:
Mm-hmm.
Meral Karasulu:
And that was mostly on network industries on education also, and health. I think
the worst part of it is over. We, if anything, we would be seeing significantly
more supportive commentary from the state council, which is their cabinet level
meeting. We have actually started seeing that because they are concerned that it
is getting a little bit out of hand. The domestic investor sentiment is turning.
Meral Karasulu:
Keep in mind. Foreign investor sentiment is turning. China has been receiving
inflows nonstop last month actually for the... Now this is the second month in a
row. They have more than 30 billion of outflows. So that's, a wake up call. So
to carry it short, I would say we may still see some selective elements of the
system perhaps disturb, let's put it this way, but more broader regulatory
tightening, the worst part of it is over. And Jodi, I just want to mention one
thing. When we look at it from US, we think, "Oh, there is some sort of
madness." No, there is actually a logic to this madness. They call it the three
mountains and it is health, education. Oh my God, I'm forgetting the la...
Housing. Sorry. Okay. The three mountains, how can I forget the most important
one. Housing, education, health.
Meral Karasulu:
These are the things that as income inequality has increased in China that
people feel most slighted about as a population at large and it's part of the
social contract. The communist party delivers on an improving life standard,
better education opportunities, upward mobility. If those promises somehow are
to be undermined, that's not going to cut it because it's not the same type of
democratic system but it has its internal checks and balances with regards to
the social contract. So that's why they were focusing on these things. So it is
a logic to this whole madness.
Jodi Phillips:
Good. There's a method to the madness, Brian. Does that serve as a good segue
for the Fed conversation?
Brian Levitt:
Yeah. And maybe Meral will tell us if she were Fed chair, what her approach
would be right now. So Meral, before we get to that, I wanted to talk about how
EM countries are positioned for what's now going to be a series of Fed interest
rate hikes because I remember in the last cycle, anytime we saw some shift in
Fed policy whether it was the end of quantitative easing, where we had a
so-called taper tantrum, whether it was the rate hike in 2015 or the multiple
rate hikes in 2018. We saw capital largely sucked out of the emerging markets in
a strong dollar environment. Does that have to happen again this time?
Meral Karasulu:
I say no. And for various reasons, let's just start with the fundamentals. And
when we say fundamentals, we are looking at the current accounts of emerging
markets, the growth and inflation dynamics, whether their economies run better.
Where are the growth prospects, etc.? On all those metrics, all these fragile
countries that we used to associate with the taper tantrum are in a much, much
better shape. But beyond that, we are coming out of the shock of COVID during
which time we had seen capital outflow event from EMs. So EMs have already in a
sense, got pre-penalized almost. And when you think about it, up to March, after
the invasion by Russia, we have seen yet another wave of outflows because
obviously everybody’s become risk-aware. So we had seen another leg of it, but
this is still the month where we have seen EM markets doing just fine. Just
fine.
Brian Levitt:
It's been resilient.
Meral Karasulu:
Exactly. And I was just looking for our benchmark, GBI-EM, I weighted the
inflation and the 10 year and compared it to US. The difference between the two
could not be more historic. What I mean is the real 10 year rates in these
economies are multitudes of higher. And that's part of the whole attractiveness
in this environment. If anything, I think EMs in a sense, foreran the Fed and
they are in a much better position to absorb the risks.
Brian Levitt:
We do like real yields.
Meral Karasulu:
Yeah. We do.
Brian Levitt:
How would you advise the Fed? Are you surprised at how slow they've been to
tighten policy given a nearly 8% Consumer Price Index on a year, over year
basis?
Meral Karasulu:
We are all armchair Fed chairs.
Brian Levitt:
Right.
Meral Karasulu:
It is very easy to criticize, expose when you are sitting here.
Brian Levitt:
Right.
Meral Karasulu:
But you can't ex-ante have foreseen how, for instance, the impact would have
played out. First, the narrative was about the supply shock, right? I mean,
supply delays, etc. Inflation was going to be temporary. But at the time it
would have been super difficult to make that call. And preemptively start
reducing the stimulus. But now Fed already, basically delivered the message to
us. Now we know where things are going. We are talking about six, seven hikes
this year. And when you look at long term inflation expectations, I don't think
we should be that worried. I mean, Fed delivers.
Brian Levitt:
And you've seen it looks the bond market largely start to price a lot of this in
with the two year moving from 20 basis points in the third quarter of last year
to something two and a half percent as we record this.
Meral Karasulu:
Yes, exactly. And if anything, the risk may be still to the upside a little bit.
I mean, we have seen the market price it, but let's face it, this is the second
stagflation and the shock we are seeing right after the earlier supply shock
arguments. So there may be still some time to run through this and we may need
to reprise even some more. That risk is there. But what that means is really,
the value of the curves may have to go up again, but you end up having more
flattening.
Brian Levitt:
Right.
Jodi Phillips:
So Meral, to borrow your quote from the beginning of the podcast, right? When
investors are feeling faint-hearted, given all of these events that we've been
talking about throughout the past 30 minutes or so. What is the current case for
emerging markets, assets and currencies?
Meral Karasulu:
The current case for emerging markets is for me predominantly the resilience of
EMs as we have never had before. That's one thing. Much better policy making
macroeconomic frameworks. That's why they are ahead of the curve. They didn't
say they could have done the same argument, right. They could have said, "Oh.
This is a transitory inflation, etc." No, they stuck to the literally letter of
their inflation targeting framework. So the credibility is definitely improved
in EM policymaking. Valuations are cheapest and growth is coming back. What else
do you want?
Jodi Phillips:
I wouldn't ask for anything more.
Brian Levitt:
Meral, I could sit and listen to you all day, but just want to thank you so much
for joining in this podcast. It's such a pleasure to hear you walk through and
provide context to so many of the complex issues with which investors are
dealing with in the world right now.
Meral Karasulu:
Thank you so much for having me, Brian. I appreciate it.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of April 8, 2022, and are subject to change without notice. These
opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
Past performance is not a guarantee of future results.
The risks of investing in securities of foreign issuers, including emerging
market issuers, can include fluctuations in foreign currencies, political and
economic instability, and foreign taxation issues.
Risks related to Russian invasion of Ukraine. In late February 2022, Russian
military forces invaded Ukraine, significantly amplifying already existing
geopolitical tensions among Russia, Ukraine, Europe, NATO and the West. Russia’s
invasion, the responses of countries and political bodies to Russia’s actions,
and the potential for wider conflict may increase financial market volatility
and could have severe adverse effects on regional and global economic markets,
including the markets for certain securities and commodities such as oil and
natural gas. Following Russia’s actions, various countries, including the US,
Canada, the United Kingdom, Germany, and France, as well as the European Union,
issued broad-ranging economic sanctions against Russia. While diplomatic efforts
have been ongoing, the conflict between Russia and Ukraine is currently
unpredictable and has the potential to result in broadened military actions. The
duration of ongoing hostilities and corresponding sanctions and related events
cannot be predicted and may result in a negative impact on performance and the
value of Funds investments, particularly as it relates to Russia exposure.
Investments in companies located or operating in Greater China are subject to
the following risks: nationalization, expropriation, or confiscation of
property, difficulty in obtaining and/or enforcing judgments, alteration or
discontinuation of economic reforms, military conflicts, and China’s dependency
on the economies of other Asian countries, many of which are developing
countries.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates.
Commodities may subject an investor to greater volatility than traditional
securities such as stocks and bonds and can fluctuate significantly based on
weather, political, tax, and other regulatory and market developments.
Discussions about the performance of the stock market this year refer to the S&P
500 Index. Discussions of credit market performance refer to the Bloomberg US
Corporate High Yield Index Option Adjusted Spread. Discussions about emerging
market performance ex Russia refer to the MSCI Emerging Markets Index.
The Bloomberg US Corporate High Yield Index is an unmanaged index considered
representative of fixed-rate, noninvestment-grade debt. The option-adjusted
spread is the measurement of the spread of a fixed-income security rate and the
risk-free rate of return, which is then adjusted to account for an embedded
option, such as calling back or redeeming the issue early.
The MSCI Emerging Markets Index captures large- and mid-cap representation
across 26 emerging markets (EM) countries.
Statistics regarding China’s property market and GDP are from China Briefing, as
of January 14, 2022.
Statistics about Shanghai as a part of China’s nominal GDP are from China
Briefing, as of February 7, 2022.
Statistics about foreign investor outflows from China are from Deutsche Bank
Research, as of April 8, 2022.
The Consumer Price Index, or CPI, measures changes in consumer prices as
determined by the US Bureau of Labor Statistics.
The FAO Food Price Index is a measure of the monthly change in international
prices of a basket of food commodities, published by the Food and Agriculture
Organization of the United Nations.
GBI-EM refers to the JP Morgan Government Bond Index – Emerging Markets Global
Diversified. This is a composite index representing an unleveraged investment in
emerging market bonds that is broadly based across the spectrum of emerging
market bonds and includes reinvestment of income (to represent real assets).
A tail risk is an event or outcome that has a small probability of happening.
Quantitative easing is a monetary policy used by central banks to stimulate the
economy when standard monetary policy has become ineffective.
Taper tantrum refers to the market panic that occurred in 2013 when the Federal
Reserve started to wind down its quantitative easing program.
The yield curve plots interest rates, at a set point in time, of bonds having
equal credit quality but differing maturity dates. An inverted yield curve is
one in which longer-term bonds have a lower yield than shorter-term bonds.
Terms of trade is the ratio between the index of export prices and the index of
import prices.
A basis point is one hundredth of a percentage point.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
THE CASE FOR MUNICIPAL BONDS
2022 got off to a rough start for the municipal bond market as the anticipation
of rising interest rates led to significant outflows from the asset class. Is
this an overreaction? Mark Paris, Head of Municipals, and Stephanie Larosiliere,
Head of Municipal Business Strategies and Development, join the podcast to
discuss the fundamentals of the muni market, their approach to finding value in
the marketplace, and the parts of the market that look most attractive to them
right now.
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Show transcript
TRANSCRIPT
Brian Levitt:
Welcome to the Greater Possibilities Podcast, a podcast from Invesco, where we
put concerns into perspective and the opportunities into focus. Hi, I'm Brian
Levitt.
Jodi Phillips:
And I'm Jodi Phillips. And we're talking about municipal bonds today. I have to
say, Brian, I've got a little nostalgia about this topic. It was the first
subject we tackled on the podcast way back in December 2020.
Brian Levitt:
That's a nice memory.
Jodi Phillips:
I thought so too, but I always thought that munis were a sleepy part of the
market, but they keep finding their way back into investors' concerns. Of
course, these are not the same concerns today as they were back in December
2020, are they?
Brian Levitt:
No, and you bring up a good point. It actually makes you realize how quickly
we’ve moved through this cycle. Where when we first were discussing municipal
bonds in our first ever podcast, people were worried about COVID-era fears. Like
was there going to be a collapse in tax revenues? Was there going to be
devastating budget cuts and crippling public service cuts and today, what are we
talking about? Today, everyone's really focused on the fear of rising interest
rates.
Jodi Phillips:
Yeah, that's right. We were worried back then about whether our garbage was
going to be picked up and mine was. I'm assuming yours was too?
Brian Levitt:
Yeah, mine still is. Mine still is.
Jodi Phillips:
But like you said, now we're worried about inflation and interest rates spiking.
So are today's worries more on point than the ones we had back then?
Brian Levitt:
Well, interest rates started very low, and they have moved up pretty
significantly across the yield curve. And if you think about where the two-year
rate was, it was virtually nothing at the start of the third quarter last year
to climbing to somewhere between 150 and 160 on a given day. 10-year rates are
up as well. Obviously not as much as the two-year, you've seen this flattening
of the yield curve, but interestingly, not much place to hide. Treasury indices
across maturities are down roughly the same amount. That's just how the math
works out.
Jodi Phillips:
So what is this environment doing to muni investors psyches? We've seen some
selling this year, investors seem pretty concerned about getting the duration
call right. But I wonder Brian, if they're overlooking the point. To me, the big
draw of munis is to earn tax-free income over time, not to time the market and
jump in and out. Am I thinking about this right?
Brian Levitt:
Yeah, you're right. A little bit of Albert Einstein there, the most powerful
force in the universe is compound interest or compound growth. It does seem like
investors are getting a little bit frantic. Rates move up, a shift up across the
yield curve. I think most people recognize six months ago that rates were
historically low and probably not reflective of the growth-inflation environment
with which we were in or going to be in. A move up makes sense. But again,
investors are frantic trying to figure it out. Seems to me like the much better
plan would be to focus on the income and focus on what you're trying to generate
over time. But it's certainly a conversation that we want to have with our
guests. So why don't we introduce them and let's bring them on to discuss it.
Jodi Phillips:
Now's the time, now's the time. We have the right people to help us. We have our
original two guests back from that December 2020 podcast, Mark Paris, Head of
Municipals and Stephanie Larosiliere, Head of Municipal Business Strategies and
Development. Welcome back Mark and Stephanie.
Mark Paris:
Thank you.
Stephanie:
Thank you, thanks for having us.
Brian Levitt:
Mark. I want to start with you. You heard the way we frame this, how are you
thinking about it? Do you get the sense that investors are overly concerned
about the shift up in rates that you've seen across the US Treasury yield curve?
Mark Paris:
Yeah. So first of all, thank you, Brian and Jodi for having us. We were on the
first podcast, things were very different then. Absolutely investors are
concerned. We hear on TV, the newspaper, there's this inflation concern, the
bottleneck and the supply chain rates are going up and the Fed is getting very,
very aggressive. And I know Brian, you spoke a lot about this recently as well,
and we're still not yet at the first Fed move.
Brian Levitt:
Hasn't even happened yet.
Mark Paris:
Hasn't even happened yet. And yet, we have all this volatility in the
marketplace. The important thing to remember is that munis are part of the fixed
income world. It is a fixed income asset. If rates are going up, municipal
prices are probably going to be going down. It doesn't exactly have to move in
lockstep though. And what we're telling investors is exactly what you and Jodi
first mentioned. You're still getting really good tax exempt income. Nothing has
changed in the muni market, except that the credits are actually better year
over year. And that's from the federal stimulus, and we can talk more about
that. And your taxes yes, they haven't gone up, but they also haven't gone down.
And so you really need to look at your portfolio, decide what you have in the
taxable arena, how that compares to on that basis of what you're getting tax
free versus what you're getting taxable.
Mark Paris:
And I think that investors have learned over time it usually pays to ride these
periods out. It's hard to get out and then decide what is the bottom to get back
in on. And we see way too many investors get out and then get back in at higher
levels once the market starts recovering. So that's always my concern. My
friend, Stephanie always says it best: It's a hard ride to higher interest
rates. Everybody wants them, but it's a hard ride to higher interest rates. And
if investors can ride it out, I think that they'll be okay. There's some
different products that they can look at and things like that. But at the end of
the day, it's about your portfolio, how much tax-exempt income you're getting.
And the reality is right now, all of the fixed income markets are taking it on
the chin.
Stephanie:
Yeah, I'd probably add to that the last thing the Fed wants to do is curtail the
growth we've seen. That is on their radar. The last thing they want to do is
have a Taper Tantrum Part Two. So that's on their radar. The one thing markets
don't like, markets don't like uncertainty. So right now the fact that we're
waiting for the Fed we're all in bated breath on the sidelines waiting to see
what the Fed's going to do. That's causing all this volatility. And I'm in the
camp of once we actually see the Fed make a move, we'll start to see a lot of
this subside because people will now have less room to prognosticate on where
they think things are going. That really adds to a lot of the volatility.
Stephanie:
And then when it comes to the municipal bond market, the one thing I always
stress is why are rates rising? If rates are rising for the quote, unquote, what
I like to think of as the right reasons, which is the economy's getting better,
we can withstand the rate hike. Well, these projects that we like to talk about
as being a pure play on the US economy, those projects do well as the economy
does well, our projects see price appreciation. So definitely want to make sure
we get that story to folks and that they understand that munis are here and part
of this economy and will do well as we continue to do well.
Jodi Phillips:
Absolutely. So when you look at your approach and of course, we talk about the
anticipation, people trying to figure out what's going to happen next, people
trying to figure out the reasons behind what may happen next, how much does that
factor into your approach? Do you forecast rates? How do other people's
forecasts factor into what you do? How much of that is an issue for you and how
do you think about that when you're managing your strategies?
Mark Paris:
Yeah. So I think we look at everything. We certainly take in a lot of things
that are going on. I'm on the investment strategy team on Invesco Fixed Income.
We talk about rates, we talk about the economy, we talk about inflation and all
those things get factored in. But where it really comes down to at the end of
the day is really strong, active management. I've talked on this podcast and to
folks at Invesco for years about the fact that we have a very experienced group
of portfolio managers and analysts who do things in a very thoughtful way and
because of COVID and now this rate rise, it continues to be a bond picker’s
market in the municipal bond market. There continues to be these anomalies that
consistently exist. We are not a quoted market. You don't go on a screen and go
buy municipals off a screen the way that you do treasuries or some corporate
markets.
Mark Paris:
You can get very different prices when you go to different parts of the market
and different broker dealers. So what we're looking to do in our portfolios is
look for the anomalies that exist in the marketplace, see where a potential
credit that we like, whether that's a double A credit, a triple B credit or an
unrated high yield credit. If that credit is not trading as to where we believe
it should be, then what do we want to do? Do we want to buy it? Do we want to
sell it? Do we want to lighten up? Do we want to add to a particular position?
And the fact that the volatility is here means that the anomalies get wider and
wider in the marketplace. Some days you just want to ride it out. But core
positions are very important. The core positions that we believe are good, solid
credits may have a little bit of volatility because rates are moving but are
still paying us a lot of income.
Mark Paris:
Having parts of the portfolio that are long and short and barbelling certain
portfolios, so that we have a little bit better ride out. But again, as interest
rates and volatility hits in certain days in the short run, you can see a lot of
volatility. As Stephanie said, we believe rates are rising because the economy
is getting better. That means our projects are getting better. In addition to
our projects, getting better, we get a rate appreciation, double B's become
triple B's, triple B's, become single A's and so on. And so that's something
that we're focusing on a lot in the portfolio as well.
Stephanie:
When I think about rates, and I think about the muni market, we are the most
idiosyncratic market you can find. Over 1 million outstanding issuers, over 1
million outstanding bonds, over 70,000 issuers. One of our PMs likes to say that
we are a credit market driven by technicals with an interest rate problem. And I
think that's a great way to describe this market. You know what I mean? If you
think about it, it's all about the bottom-up, fundamental research, but rates
are going to matter. They're going to matter. We are a bond market. But when you
look at it over the long term, rates are not what drive municipal performance,
what drives municipal performance are the underlying fundamentals. And once we
can get out of this short-term volatility that we see in rates, muni credits
tend to do well in these kind of environments.
Brian Levitt:
Mark, 70,000 issuers. Do you ever have time to have fun? Do you get out, do you
do anything?
Mark Paris:
We cover about 5,200 credits across our entire municipal complex. And we have a
great analyst team, 25 strong, dedicated just purely to municipals. So we touch
about 70% of the overall municipal index. But we understand the way muni credits
work. We understand the way muni governments work, very different than the way
the federal government works. Things actually get done at the muni level. They
pass budgets, Republicans and Democrats seem to get a little bit better along
and pass some bills. Yeah, have some problems. We had some big problems in
Illinois, five, six years ago that lasted nearly a decade.
Mark Paris:
But doing that research, finding the bonds that you want to find, pairing that
up with really experienced portfolio managers who are looking for value in the
marketplace. It's a lot of credits to follow, but we feel like we have that kind
of experience. I think we average around 20 years’ experience between the
portfolio managers and the analysts. And that to me gives me a lot of comfort in
knowing we know what we're looking at. We know what we're looking to buy, and we
know what we want to sell.
Brian Levitt:
I wanted to ask you about the realities of those fundamentals. We now came
through what was a boom year in the economy in 2021. So what do those
fundamentals look like now that we are 18, 20 months away from the earliest days
of the coronavirus pandemic?
Stephanie:
So it's completely different than when the pandemic started. When the pandemic
started, we really didn't know because these are projects that are tied to the
economy. With everyone sitting at home, what was going to happen to these
projects? What was going to happen to usage fees? Were we going to see mortgage
delinquencies and things like that. And people wouldn't be paying their property
taxes and water/sewer. But we didn't see any of that. This economy, I think the
fact that we now have technology that allows most of us to work from the place
that we sleep and we do everything else, has certainly helped us quite a bit.
But when we think about the federal government and what they did for the munis
in 2020, it was pretty insane. They supported the muni market in a way that
we've never seen before.
Stephanie:
We didn't get advance refundings coming back. We didn't get a lot of stuff we
wanted, but we certainly got the federal stimulus. We certainly got the dollars,
350 billion dollars to state and local governments. There is actually a total of
1.6 trillion dollars that is earmarked for muni issuers related to various
stimulus bills. When we look at that, that triggers for us what we've been
talking about as being the golden decade of munis. And we think that what we're
seeing right now is causing some volatility in the market, but that doesn't
change the long-term perspective that fundamentals are on the rise here, and
money didn't go out on an as-needed basis, it went to everyone in the muni
market.
Brian Levitt:
Golden decade.
Stephanie:
Golden decade.
Brian Levitt:
This is going to be the golden decade for Jodi Phillips as well.
Jodi Phillips:
Oh, I can't wait to hear about that. Let's talk about that. Stephanie, you
mentioned all of that money that came to the municipalities. Where are they with
spending that? Are we still looking at projects coming down the pipeline? How is
that flow looking as we sit here at the beginning of 2022?
Stephanie:
Where are they are spending it is under the mattress right now. So it hasn't
been spent. And that's what makes these projects in really good positions
because they are sitting on more cash than they've ever been. They have access
to more cash than they've ever needed. When we look at hospitals and things that
had to weather this COVID storm. Yes, they did have to utilize some of those
funds, but there's a lot more behind it. And we're also looking at the fact that
elective surgeries and other things that hospitals did to actually earn revenue
is back on the table. And so the need to have to use those funds isn't
necessarily there. What we are seeing is some infrastructure that we're likely
to see get monetized into the muni market. We think that's going to come in a
measured pace.
Stephanie:
Infrastructure's been a hot topic since, I would say the 2016 presidential
election, we heard about it a ton then, we heard about it in 2020. President
Biden's made it clear that it's something he wants to focus on. The muni market
is the most seasoned market for financing infrastructure. And it really allows
the state and local governments to make the updates to infrastructure that they
need to make without having to go into their coffers. Because the federal
government basically said, "We will help you. We will make sure that you can
fund this to ensure that Americans have the infrastructure that we need."
Brian Levitt:
We used to hear about these troubled spots in the municipal bond market. They
were always few and far between, but you would hear about whether it was the
State of New Jersey or the City of Chicago or the State of Illinois. When you
talk about the money that the federal government has provided, A, and then B,
the extent of the economic boom that we had last year. Are we now looking at a
situation in where those previously perceived trouble spots of the market look a
lot better than they once did?
Mark Paris:
I think you look at some of the names that you mentioned — so Chicago schools is
actually in a much better position than it's been in probably over a decade. And
that is a lot of the federal stimulus. Some of it is some of the things that
have happened at the state level. There's been a little bit more accommodating
state government. The State of Illinois has just announced that they're going to
be giving back rebates on property insurance, they're stepping back some of
their sales tax. That's a direct result of the stimulus money. And it's good to
see that the money's not just being spent frivolously. It's actually being done
in a way that says, "Hey, let's give you a little bit of a holiday on certain
taxes." So I think that's a great thing.
Mark Paris:
Puerto Rico is in a workout situation. A very positive workout situation where
it was seen as the Netherlands of munis. Now we're getting back to a point where
GOs are having agreement. The General Obligation bonds have an agreement. The
sales tax bonds got redone a couple of years ago. We're waiting for the
electricity bonds to come back. The water bonds never went into default. So
that's been done. And they also got some money. So there's still a pocket here
or there, but that's where the research comes in. That's where our research
comes in and says, "Wait a minute, they're having a problem. Demographics are
changing. People are moving in. People are moving out. Tax base may have
changed, political changes as well." But what we're seeing right now,
specifically from the third stimulus bill that happened, I want to say February,
March of last year, is that even the deeply problematic areas of muni credit
have really soared back to a place where we're very comfortable fundamentally,
not just for this year, but for a couple of years going forward as well.
Brian Levitt:
Mark. So do I have your word? My wife's New Jersey teacher's pension - that's
it's going to be good?
Mark Paris:
I can't give you my word on that.
Stephanie:
Okay, Mark. I think that's the caveat we got to say. So that was all great, what
Mark said, but the one thing that the federal stimulus did not change is pension
funding.
Brian Levitt:
Oh, come on.
Stephanie:
Yeah. There's no crisscrossing of the funding there. Pensions are still going to
have to be dealt with the old-fashioned way.
Brian Levitt:
Alright, Jodi, you're stuck with me for a while.
Jodi Phillips:
All right. All right. Thanks Stephanie. So last time you visited us on the pod.
I know that we took some time to take a quick tour of revenue bonds, and Brian
got to lament that he hadn't been on a plane in a while, and hadn't been on a
train in a while. And Brian, you want to go ahead and revisit some of these
areas? See where things stand?
Brian Levitt:
I've been on a couple of airplanes here and there, masked up. I still have not
been on a train. So you're right on that one.
Jodi Phillips:
So where do you want to start? We can start with airlines. I know that was a big
topic of conversation last time. How are we looking where we are today?
Mark Paris:
Yeah. So I think airports, airlines, the reopening trade, a lot of it has been
followed through. It's going to continue to follow through. I think if you look
at the inflation numbers, Brian, I know you pointed this out - airline fares
still aren't all the way back, I think, to where they were. So that's going to
probably continue to be something that happens in the economy. We love the
transportation sector. We know that that's the way this country is going to get
back. People are going to get back on airlines. Look, maybe we're not going to
do a day trip from New York to Chicago any longer. We'll probably do that one on
Zoom. But if it's a two-day, three-day trip, the business trips are going to
come back. The leisure is certainly going to come back and we've already seen
that in some ways. Airports get a lot of revenue from the departures and
origination flights that happen out of them. We have great research on all of
the airports in this country. We know how to look at them. We know how to judge
them. We know how to look at the demographics of how things are changing. And we
are still very bullish on the airport and the airline sector, as people will
continue to increase the amount of time that they spend on planes. I know
Stephanie, I, Brian, I'm sure Jodi, yourself. We all used to travel a hell of a
lot more than we do now. It's coming, it's coming. And I think even if we get to
75%, 80% of those kind of numbers where we were at, I think airlines and
airports are going to be just fine and they're great investments. And I don't
think we've seen a full price pop in certain types of names in the airport
sector.
Brian Levitt:
And should I assume that same narrative applies to other parts of the revenue
municipal bond market, whether it's convention centers or dormitories, is it all
part of this story of we've either gotten back to the way we used to live or
were incrementally getting back to the way we used to live?
Stephanie:
I think it's all going to be about credit research. So Mark said it before, when
we start to look at the nitty gritties of these individual sectors, it's going
to be about our analysts, understanding the demographics, geographics. You might
have a convention center in one area that can pick up the pace and have that
reopening trade. And you have another area where that convention center's not
going to make it. So that's where you really rely on the experience and depth of
knowledge of credit research to make that assessment,
Mark Paris:
The warm spots, Las Vegas, Florida. I think those are, those are going to be
fine. Some of the other areas are going to struggle in areas like that. The
dormitory sectors definitely coming back as more and more students are coming
back to campus. I think a year ago you had a choice, go back to campus or do it
online now. More students are back at campus. So that's a very positive
development as well.
Brian Levitt:
And we know your family, Mark, is doing its part to support the dormitories,
right?
Jodi Phillips:
I haven't been on a plane in a while, but I can tell you, the traffic in Houston
is worse than I've ever seen it in my life. And I don't know where everyone's
going, but if there were potentially a way to profit off of that, I would love
to know about it.
Stephanie:
We have a couple of toll roads there.
Jodi Phillips:
All right, good. Good to hear.
Brian Levitt:
So, Stephanie, let me ask you a question. Where have flows been going and do you
see that investors are trying hide out in different parts of the municipal bond
market? And if you were to think about ... I know we don't want to talk to
people about timing markets, but if you were to just try and give them some
sense of where they could be this year, if you were to assume a further shift up
in interest rates, what would you do to, do we call it “hide out” for a little
bit in the municipal bond market?
Stephanie:
Yeah. So you ask where flows are going. I'll tell you they're not going to munis
right now. So right now, February 2022, we're taking a respite. We had a really
nice 2021. We actually hit a 102 billion dollars worth of inflows into our
market, which is actually a record since 1992, when we started keeping track of
that number. But here year-to-date, everyone was on the sidelines. Everyone was
waiting to see what was going to happen. So we didn't have that quote unquote,
January effect that we normally have in the muni market. We had quite a bit of
volatility. We saw what rates did, and we had our first couple weeks of outflows
in the muni market. So I would say there's lots of money on the sidelines
waiting for entry points. And we started to see some of that.
Stephanie:
We've seen rate volatility pick up, but I do think, I feel very strongly once we
get that transparency, the Fed meeting, we're going to see a lot of the slow
down because we're going to have that finite, what is the Fed going to do? What
have they outlined and what can we have in terms of concrete, go-forward
expectations in terms of rates? Now, in terms of where to go in this point in
time, one of the things we've been talking about has been the front end of the
curve.
Stephanie:
Bonds that are actually pegged to what we call the SIFMA rate, which is
essentially the muni LIBOR rate for us. And it finally saw that move. It's been
at five basis points for as long as I can remember. So this most reset actually
went to 17 basis points. It doesn't sound like much, but it's a pretty nice
uptick. And it shows that the muni market is finally acclimating to those higher
rates that we're seeing in the Treasury market.
Stephanie:
I also like high yield. For people that might want to dollar cost average into
this market, look for ways to take advantage of these lower NAVs as entry
points, you can dollar cost average because when we talk about this golden
decade - high yield munis and the projects we own, we own the non-rated bonds.
We own the bonds that are going to be the most correlated to what's happening in
the economy. And I really think that's another nice spot for people that want to
barbell some of that risk - front end and then high yield.
Mark Paris:
And I would add in, if you own a long high yield fund, you may want to own some
of the short duration high yield.
Mark Paris:
We've tried to be thoughtful about the fact that we do think the short rate is
going to rise first. We do anticipate a flattening of the yield curve. And so at
some point, floating rate short paper is a good thing to own. Shorter duration
paper is a good thing to own. And as Stephanie mentioned, we believe in the long
run through this cycle, high yield is going to be very good to own because it's
going to be less sensitive in the net of the whole cycle. It'll be less
sensitive to duration.
Brian Levitt:
So does anything keep you up at night?
Mark Paris:
Yeah, I'll start off on this. Look, I know investors are worried about interest
rate moves, and I know that this is a difficult period of time. However, our job
is to be an active manager. Our job is to go in and look at the market and
figure out how. Now as rates rise, one of the things we can do is we can buy the
higher yielding bonds and then hopefully eventually pass on that yield to
investors. Another thing that we can do, and Stephanie knows me now for a long
time, I've been here nearly 20 years. I love to make sure that we don't
distribute any taxable income.
Mark Paris:
I do worry, Brian, and I know you have this concern too, that the Fed's going to
overstep. I think Powell's done a wonderful job. I like Brainard a lot. I do
have a lot of faith in our Treasury Secretary Yellen.
Mark Paris:
But we know how this, how this ends and it's ended in an ugly way. So I'm a
little bit worried that they might overstep. However, I'm comforted by the fact
of what Stephanie was talking about before, municipalities have a lot of money
in their coffers and they can ride out if the Fed does go too far. So at this
stage of the game, I know my investors are on a roller coaster and I'm worried
about everything. And that's the beauty of having an active manager. I can tell
you all of the portfolio managers on my staff, all of our analysts, all of the
people on Stephanie's team. We are very, very active in our thoughts right now
on what to do, where to position us so that when the market does stabilize and
come back, we're in a great position for our investors.
Brian Levitt:
Thank you both very much. And let's hope we have a long cycle ahead of us, and
let's hope that the Federal Reserve recognizes that they can't solve a supply
chain problem with rising interest rates. But we really appreciate your insight.
We're happy to have you at the helm in what is a great municipal bond business.
So on behalf of Jodi and myself, thank you both very you much for being our
first guests and now our latest guests.
Jodi Phillips:
Thank you.
Stephanie:
Thank you, Brian. Thanks Jodi.
Important Information
You've been listening to Invesco's Greater Possibilities Podcast.
The opinions expressed are those of the speakers, are based on current market
conditions as of February 11, 2022 and are subject to change without notice.
These opinions may differ from those of other Invesco investment professionals.
This does not constitute a recommendation of any investment strategy or product
for a particular investor. Investors should consult a financial professional
before making any investment decisions.
Should this contain any forward looking statements, understand they are not
guarantees of future results. They involve risks, uncertainties, and
assumptions. There can be no assurance that actual results will not differ
materially from expectations.
This is not intended to be legal or tax advice. Investors should seek advice
from a tax professional.
Fixed-income investments are subject to credit risk of the issuer and the
effects of changing interest rates. Interest rate risk refers to the risk that
bond prices generally fall as interest rates rise and vice versa. An issuer may
be unable to meet interest and/or principal payments, thereby causing its
instruments to decrease in value and lowering the issuer’s credit rating.
Municipal securities are subject to the risk that litigation, legislation or
other political events, local business or economic conditions or the bankruptcy
of the issuer could have a significant effect on an issuer’s ability to make
payments of principal and/or interest. Municipal securities can be significantly
affected by political changes as well as uncertainties in the municipal market
related to taxation, legislative changes or the rights of municipal security
holders. Because many securities are issued to finance similar projects,
especially those relating to education, health care, transportation and
utilities, conditions in those sectors can affect the overall municipal market.
In addition, changes in the financial condition of an individual municipal
insurer can affect the overall municipal market.
Junk bonds involve a greater risk of default or price changes due to changes in
the issuer’s credit quality. The values of junk bonds fluctuate more than those
of high quality bonds and can decline significantly over short time periods.
Statistics on the two-year and 10-year Treasury rates from Bloomberg L.P. as of
February 11, 2022.
Statistics about the number of outstanding bonds and issuers are from the
Municipal Securities Rulemaking Board as of 2021.
The reference to the “overall municipal index” refers to the Bloomberg Municipal
Bond Index, an unmanaged index considered representative of the tax-exempt bond
market.
Data about the amount of fiscal stimulus given to municipal issuers is from the
US Congress and J.P. Morgan Research as of November 22, 2021.
Data on the amount of inflows into the muni market is from Strategic Insight and
Bloomberg.
The yield curve plots interest rates, at a set point in time, of bonds having
equal credit quality but differing maturity dates. A flat yield curve is one in
which there is little difference in the yields for short-term and long-term
bonds of the same credit quality. In a normal yield curve, longer-term bonds
have a higher yield.
Duration is a measure of the sensitivity of the price (the value of principal)
of a fixed income investment to a change in interest rates. Duration is
expressed as a number of years.
Tapering is the gradual winding down of central bank activities that aimed to
reverse poor economic conditions. Taper tantrum refers to the market panic that
occured in 2013 when the Federal Reserve began to taper its activities.
LIBOR, or the London Interbank Offered Rate, is a benchmark rate that some of
the world’s leading banks charge each other for short-term loans.
SIFMA stands for the Securities Industry and Financial Markets Association. The
SIFMA rate is the most common measure of short-term tax-exempt rates.
A basis point is one hundredth of a percentage point.
A credit rating is an assessment provided by a nationally recognized statistical
rating organization (NRSRO) of the creditworthiness of an issuer with respect to
debt obligations, including specific securities, money market instruments or
other debts. Ratings are measured on a scale that generally ranges from AAA
(highest) to D (lowest); ratings are subject to change without notice. NR
indicates the debtor was not rated, and should not be interpreted as indicating
low quality.
For more information on rating methodologies, please visit the following NRSRO
websites: www.standardandpoors.com and select ‘Understanding Ratings’ under
Rating Resources on the homepage; www.moodys.com and select ‘Rating
Methodologies’ under Research and Ratings on the homepage; www.fitchratings.com
and select ‘Ratings Definitions’ on the homepage.
The Greater Possibilities podcast is brought to you by Invesco Distributors Inc.
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The opinions referenced above are those of the speakers and are subject to
change without notice. These comments should not be construed as
recommendations, but as an illustration of broader themes. Forward-looking
statements are not guarantees of future results. They involve risks,
uncertainties and assumptions; there can be no assurance that actual results
will not differ materially from expectations.
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