MASTERCLASS: Fixed Income - October 2017

As the Federal Reserve prepares to reduce their balance sheet and turn the clock back on quantitative easing, fixed income investors are trying to make sense out of this situation. Additionally, President Trump’s new appointments could change the entire philosophy of the Federal Reserve. Could there be a repeat of the 2013 Taper Tantrum, how are central banks around the world ending their QE programs, and how will natural disasters impact the U.S. economy? Asset TV brought together three financial experts to discuss the role of fixed income in a portfolio, and the areas of opportunity that investors should watch out for.

  • Kevin Gahagan — Principal and Chief Investment Officer, Mosaic Financial Partners
  • Travis Carr — Product Specialist at Western Asset Management
  • Bong Choi — Director of research, Wetherby Asset Management

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  • 56 mins 09 secs

San Fran Fixed Income MC AUDIO TRANSCRIPT Hoda Imam: Welcome to Asset TV. I am Hoda Imam. Yesterday, the Federal Reserve Chair, Janet Yellen, laid out plans for a rollback of crisis error stimulus, and hinted that another rate hike would come by the end of the calendar year. Where are top fixed income investors positioning in light of the current environment? And how can we make sense of the macro picture? Today I am joined by three experts, who will share their insights from the NASDAQ Entrepreneurial Center here in San Francisco. Welcome to the Fixed Income Masterclass. Thank you, welcome, for joining me here today, let’s get right into the thick of it. Janet Yellen’s comments, what’s your take on it? Travis Carr: [0:00:38] So I think not a lot of surprise as far as the announcements. It was well telegraphed that they were going to announce the start of the reduction in the balance sheet. That’s just made it official by putting it in the actual minutes. Our view on that balance sheet reduction is that we think it’s going to be a very, very slow process. And when you think about quantitative easing, when it started, it was supposed to be a very, you know, rapid program, and have a lot of impact. And so, and it had that intended effect. And, you know, a very quick build up in balance sheets across different central banks. Now, we’re at the end of this program. And now the messaging is very different. And now they’re saying it’s going to be a very, very slow process. She even mentioned it’s going to be working very, you know, quietly in the background. And it’s going to be effectively like watching paint dry. So we’re not concerned about that reduction. Certainly it’s an issue, and the size of central banks balance sheets is an issue. But we think that the pace of that reduction will be so moderate, and it’s been so well telegraphed that we are not really concerned about major disruption in the fixed income markets. Hoda Imam: [0:01:48] Okay. Not concerned. Bong or Kevin. Kevin Gahagan: [0:01:52] I think it’s a shared view. The, you know, as it relates to the rate cut itself. And as Travis was saying, there has been, you know, consistent signaling. At this point what I would say is I think The Fed is giving themselves some optionality as it relates to saying that we’re prepared to but without making a commitment that they will do so. And the messaging around we will wait and see, but with a bias toward continuing to increase is the one area that I think would be the other comment that I would add to Travis’s remarks. Hoda Imam: [0:02:23] Okay, and Bong. Bong Choi: [0:02:24] The only thing I would add is that what we saw in the markets is probably a re-pricing. But I would expect a little more volatility in the markets going forward, despite the fact that The Fed’s been very open and communicative about their plans to raise rates as well as the plans to reduce the balance sheet. You know, one thing that was comforting was really The Fed’s admission that the rate of inflation and its low levels was a mystery for them as well. And, you know, when you talk about uncertainty in the market, which is never really a good thing, you’ve seen the Wall Street odds of a December hike increase to 60/70%, whereas two weeks ago it was only 25%. And so that, I think, were the comforting uncertainty to investors out there. But I would expect when a transition from easing to tightening policy happens it’s rarely smooth. So we would expect some increase in volatility. Hoda Imam: [0:03:15] And what do you think that mystery is? Bong Choi: [0:03:19] There is a lot of theories out there. You know, a lot of people talk about the disinflationary impact of technology and the increased globalization, which reduces the cost of goods and services across the globe. That may have an impact. But, you know, I wish we had an answer. And The Fed is still trying to debate that. But what’s interesting is the question is, is this really a long term set of inflation rates that should be lowered permanently? And that remains to be seen. But that is a critical question because the biggest risk is The Fed and their potential mismanaging of their policy. Kevin Gahagan: [0:03:56] It’s going to be an interesting element to that too because there’s a number of Fed positions that are going to be replaced over the course, not the least of which is going to, in all likelihood, going to be Janet Yellen. And so how policy shifts or doesn’t in light of the new governors coming onboard, and potentially a new chair is yet, as yet uncertain. I think that’s going to add some of the volatility that Bong is speaking to. And volatility being most likely experienced in the short end of the yield curve, that’s where they rate control. But how that will play out again remains to be seen. Travis Carr: [0:04:32] That’s a good point. I mean I think there’s a lot of uncertainty about what that balance sheet ends up looking like. Hoda Imam: [0:04:38] Right, exactly. Travis Carr: [0:04:39] Those are questions we don’t have answered yet. They haven’t discussed, you know, what that ultimate size of the balance sheet reduction will be. Most people seem to believe that it’s going to be maybe trimming 1½-2 trillion. So keeping a much larger balance sheet than they did have previously prior to the crisis. We don’t know yet if they’re going to hold any mortgage backed securities or if they’re going to let those wind off completely. We don’t know if they’re going to buy, continue buying treasury notes and treasury bonds or just treasury bills. So I think a lot of that will depend on economic conditions and certainly the make-up of The Fed as we move forward. Hoda Imam: [0:05:17] Okay. Kevin, you mentioned the chairs that are going to be open and what next February is going to bring. So, Trump is appointing a large number of Fed officials. Could the tone of the institution become hawkish? Kevin Gahagan: [0:05:32] Well, that’s certainly the speculation at present. Probably of this group, probably the most agnostic on many of the questions that may come up and that speaks to the philosophy that we operate with and come back to that. But it is a reasonable conjecture that the positioning of The Fed and their approach to policy will in fact become more hawkish in light of the change. And again the key is I’m really interested to see what happens with the appointment of the chair. Hoda Imam: [0:06:07] Right. Bong or Travis. Travis Carr: [0:06:10] Yeah, I think our view is that, you know, we haven’t heard a lot from Trump as far as what he’s looking for. The only things we have heard are he’s looking for probably a republican and a low interest rate person. And so if you look at that combination, it seems to us unlikely that Yellen will be reappointed. So again we don’t necessarily think it’s going to turn hawkish. We think it may stay a bit more dovish. And it makes sense that he may be looking for a republican chair, someone who will be a little bit more supportive of his kind of deregulation agenda. Hoda Imam: [0:06:44] Okay, Bong. Bong Choi: [0:06:45] You know, frankly, no one knows. You look at the list of candidates that we’ve read about in the press, things could turn pretty quickly. And if you have Kevin Warsh or John Taylor, we would have been open hawks and tempered points then, things can change very quickly. And you know, we’ve recently heard about the nomination of Randal Quarles who really has been at odds with a lot of Janet Yellen’s policies. And so our concern is not necessarily about who specifically will be a republican or democrat, but really it is about changes in regimes and that’s what we’re looking out for. Hoda Imam: [0:07:21] Okay. Let’s talk a little bit about the Taper Tantrum from 2013. What’s your take? Are we going to see history repeat it self? Travis Carr: [0:07:34] I think our view is that we don’t expect to see that repeat itself. There’s a number of reasons why. I think if you go back to May of 2013, when Bernanke announced the plan to reduce asset purchases, the market wasn’t able to distinguish between asset purchases and the path of short term interest rates. And there was a mispricing of the path of short term interest rates. Almost overnight the market went from pricing one hike through mid 2015 to four hikes. And so that’s what caused a lot of that volatility was the market really kind of missed reading and mispricing that path of short term interest rates. I think this time around it’s been much, you know, the communication has been very good. And you’ve seen the pricing of forward interest rates has stayed relatively muted. And in fact it’s come down a bit as we’ve gone through the year, even after we’ve talked or gotten closer to this asset reduction. So that’s one reason why we think it won’t repeat itself. Another reason, I think it’s, you know, emerging markets was a real volatile asset class, certainly after that Taper Tantrum. People were saying, “Well, will that occur again?” I think certainly there could be some impact, if you do get a stronger dollar and higher yields. But I think the starting point is really important. Back in 2013 emerging markets had had a very strong run, the last prior few years, a lot of asset inflows. And so valuations were fairly rich, currencies had rallied. And then just after that point you had a real kind of global slowdown, deflationary risk coming out of China and elsewhere and a weakening in commodities. So we think that starting point is very different today. And so we think asset classes like emerging markets, we don’t expect that kind of same negative reaction that we had that time around. And I think one other reason why we think it’ll be different is, is again, I think what the biggest takeaway from the Taper Tantrum was that at this point – at this point in the environment, the economy we think that the fundamentals of growth and inflation really matter much more to long term bond yields than central bank policy and balance sheet changes. The Taper Tantrum again was Bernanke back in 13 talking about, worried about potential higher inflation but realized inflation was still very low. And inflation continued to surprise on the downside. And so we’re at a point now where we think that growth and inflation story ultimately will drive long term rates. And if you think about where we are today versus the Taper Tantrum, 10 year yields are lower, even after the fact that we’ve had four rate hikes and have started this balance sheet reduction. Not to say we can’t have volatility. And I certainly think that we will have some rate volatility. But I think long term the fundamentals of growth and inflation will rule the day. Bong Choi: [0:10:26] I think there’s a real reason why The Fed’s been so open and communicative, it’s because they do not want to [inaudible] the markets like they did in 2013. And so I think Patrick Harker was the one that first mentioned that The Fed’s policy was going to be boring and like watching paint dry months ago. And I think that was very intentional, because they do not want to disturb the markets. And so we would expect a more favorable reaction as we transition into a normalization phase. But again we do expect heightened volatility, particularly because volatility has been so low in absolute returns. Hoda Imam: [0:11:00] And the markets weren’t really affected as much as they could have been when Janet Yellen made the announcement, simply because we’ve known since June. So that goes back to what we’re discussing. US treasury debt is sometimes referred to as risk free, is that a misnomer? Kevin Gahagan: [0:11:21] Well, the simple answer is yes, it is. It depends on where in the yield curve. If you want to talk about treasury bills, yes, we could argue that that’s essentially risk free. But any time you start going out the yield curve beyond that you have the potential for volatility attributable to interest rate adjustments, even in market factors. Clearly, government debt as it relates to other issuance has a safety factor that calms investors and produces less volatility in that specific segment. But there’s no such thing as risk free. Hoda Imam: [0:11:59] What is your outlook for the 10 year? Kevin Gahagan: [0:12:02] You know, as I said I started out by saying I’m relatively agnostic. And so we don’t take a definitive view in terms of where it’s going. Is it reasonable to assume that it’s going to climb from where it is today? Absolutely. But my reminder when I talk with clients and when I talk with others about this is in 2006 and 2007 everybody was waiting for the interest rates to climb. They were certain it was going to happen, inflation was going to rise. And suddenly 2008 happened. And so the problem about any kind of longer term forecast is simply that the events that we can’t predict occur around us. It’ll be interesting to see and concerning just in terms of the impact on some of the climate events that are going on today. Hoda Imam: [0:12:46] Okay. Did you want to make a comment, Bong? Bong Choi: [0:12:48] No, I mean but The Fed did mention that in terms of long term terminal rates, they are revising their numbers down. And I think that’s an interesting observation that they have made. And so the good news is that it probably reduces the risk of over-tightening because they can normalize much faster. And the risk of a policy mistake is lower, so that is certainly good news from Janet Yellen’s messages. Hoda Imam: [0:13:15] And you mentioned the word ‘normalize’, what does that mean anymore when it comes to interest rates? I mean we talk about normalizing the markets, but what is a normal anymore, do we know? Travis Carr: [0:13:28] Yeah, I think when we think about the terminal short term rate, and historically if you go back to the 1990s and 2000s, The Fed would typically hike to roughly nominal GDP, which was roughly 5%. We think they stopped much lower than that this time around for a couple of reasons. One is that certainly nominal GDP is lower. Today it’s probably closer to 3-5%, maybe on the lower end of that range. Also if you think about those prior hiking cycles back 20/30 years ago, they were also trying to fight inflation. They were trying to bring inflation down and really anchor inflation expectations. Where we are today is really the opposite of that. And what they’re trying to do is actually boost inflation expectations. And that may be around for the next 10/20 years. And so for those reasons we certainly think that that terminal rate will be lower. We’re in the camp of probably 2-2½%. The Fed is saying probably 2½-3% is kind of their range. And I think the market pricing is on the lower end of that as well. Hoda Imam: [0:14:31] Terminal rate, what percentage are you looking at, what do you think? Travis Carr: [0:14:34] Where do you think they stop? Hoda Imam: [0:14:36] Yeah. Travis Carr: [0:14:36] Probably in that 2-2½%. Hoda Imam: [0:14:38] 2-2½, okay, yeah. Bong or Kevin? Kevin Gahagan: [0:14:43] I’ll go with that. Actually, well, I’ll stay with The Fed, The Fed says 2¾ as the mid point, that works for us. Hoda Imam: Okay. Bong Choi: [0:14:50] I’d probably, if I were to guess, probably around the 2½ range. Hoda Imam: [0:14:54] In the 2½ range, okay. Alright. So global central bank outlook and the wind down of QE. What are the implications? Travis Carr: [0:15:05] I think again this is a real big story in the market, and for good reasons. If you look at how rapid, how large that balance sheet expansion has been, it is a bit scary when you think about what that effect could be as they unwind that. But I think central bankers understand that concern. They understand that risk. And that’s why they’re being so cautious. And that’s why they’re being, you know, so it’s going to be a very, very slow process. You know, the US has just started on that, on that program. Again very, very slow kind of methodical program. But we think Europe and Japan are still probably a few years, you know, behind us. They have had persistent low inflation, very, very low inflation, in some cases, you know, fears of deflation. So we think that they’re later in that cycle. But also understand that that, when they do start, that reduction of balance sheets that has to be extremely … an extremely slow process. And they have to communicate to the market that they’re still taking a very accommodative stance, which I think they’ve been very successful doing. So again, not to say that this isn’t without risks, we’ve never had this type of balance sheet reduction. And some of these assets that central banks have held, we’ve never seen those before. So it’s certainly not without risks. But we think that it could be managed in a way that really does reduce any kind of turmoil to the fixed income markets. Hoda Imam: [0:16:33] Okay. Can you focus on Europe a little bit when it comes to comparing it to the US as far as markets, go back a little bit. Can you rephrase what you were just mentioning and then do a comparison between Europe and the US. Travis Carr: [0:16:46] The ECB has launched a fairly aggressive quantitative easing program as well. And we’re just starting to see some of that flow through to increases in extensions of credit and loan growth, especially in the peripheral countries, which had been lacking the last few years. That we hadn’t seen that kind of flow through coming from very low interest rates to an increase in credit extension. We’re starting to see that. And so the growth outlook is becoming a bit more positive in Europe. It’s actually an area that we’ve looked at a bit more recently. And so the political risk there, they’re not zero but certainly they have diminished. We’ve had a number of elections over the last few months that have been more market friendly than they might have been. And so I think that that political outlook has improved. Hoda Imam: [0:17:35] And what do you mean by that, more market friendly? Travis Carr: [0:17:37] So meaning that the French elections, the fact that Macron was elected instead of Le Pen. Le Pen had talked about really pursuing nationalist policies. And the fear was that they would move to maybe a referendum and looking to leave the EU. And if you had France leave the EU then really the EU was done at that point. So that was a real big risk. That risk has subsided now Macron is really, again, moving forward, wanting to develop more of a relationship within the EU and Germany. And so that political outlook is certainly much more positive. Kevin Gahagan: [0:18:12] I think except exclusive of Brexit, I think the elections that have occurred have tended to support or be sympathetic to globalization and global trade, much more so than Brexit would have. When that vote went through there was great concern that that was going to be the precursor for elections in Germany and France and Scandinavian countries. And that hasn’t played out in that way. The other thing to remember is that Europe, the EU, Japan as well came into and took measures in terms of quantitative easing and purchases, bond purchases much later than the US. The US was much earlier in that process. And so again they are seeing the effects. I think we are seeing positive effects in economic growth and some of the other measures. So you know, to Travis’s point, don’t think there is going to be any … as rapid a movement toward winding those initiatives down as will occur in the US. Hoda Imam: [0:19:19] Okay. Bong, you’re nodding your head, so I feel like you want to add something. Bong Choi: [0:19:23] Well, if you take a step back, there’s been something like $1 trillion pumped into the system from global banks this year alone. And so I do think that global central bank policy regime changes are a big risk because the, you know, introduction or the quantitative easing program globally has really suppressed rates. And if you take that away, again, you can see a pretty violent unwinding. And so that is something that is out there on the horizon, because despite the fact that global policy remains relatively accommodating, you know, we’ve seen what’s been going on in Canada. You’ve heard about the Bank of England, ECB is talking about potentially normalizing. Yesterday we had, you know, the Bank of Japan basically say, “Look, we’re just going to stay on the sidelines and not do anything.” And so there is over the next several years a shift to ‘normalization’. And that is something that we haven’t seen in this magnitude forever actually. And so we’re on unprecedented territory. Hoda Imam: [0:20:28] Okay. And really quick, let’s just move away really quickly from geopolitics and look at the news domestically. I’m interested in knowing your stance considering the recent hurricanes that have devastated parts of America. Do you think that this is going to affect the economy long term? Are we going to see gas prices spike for a while, unemployment because people can’t make it to work or businesses shut down, how is that going to affect our economy? Bong Choi: [0:20:56] I think in the long term it’s transitory. And then there are a lot of negative shocks because of the hurricanes. I mean five in a row, that’s unprecedented. But in the long term I do think the economy is very resilient. So we wouldn’t put what’s going on with the hurricane and the economic impact as part of a long term concern. You know, one can argue it’s an opportunity to invest capital as things are dislocated in the near term. Kevin Gahagan: [0:21:23] Yeah, it was interesting, we were having some conversation about this before we got here. And you know, four, and are clearly are some huge economic impacts in terms of the devastation that’s occurred in Houston, Florida. And with that what comes? There’s need for rebuilding. We were talking about automobiles. Every car that was submerged under water, that’s insured, it’s going to be replaced. So there are concurrent with the consequences and costs of these kinds of events, there’s also an economic bump that occurs as you start having to do the replacement, the rebuilding and the like. So it’s not a one for one and certainly not in an immediate term. But to, I think to Bong’s comment, over time it really does kind of equal out. Hoda Imam: [0:22:14] And that rebuilding is going to take a while. So we are not going to see these results any time soon, the results you’re talking about. Did you have anything to add? Travis Carr: [0:22:21] No. Very, very consistent kind of thought there is that, and The Fed talked about this that, you know, certainly it will have some short term negative impact, but longer term it shouldn’t have any material impact on the kind of the national economy, obviously very, very regional specific and industry specific effects. But on a national level, really not a material impact longer term. Hoda Imam: [0:22:44] Okay. Let’s move on to a little bit of a different part of the discussion. We’ve seen a surprising lack of volatility in equity markets in the recent months. What’s the role of fixed income in an investor’s portfolio and has it changed? I know you touched on this just a bit, but let’s elaborate a bit more. Kevin Gahagan: [0:23:06] Well, I’d like to jump in because now I am in my territory as opposed to the prognostications. But we’re strategic allocators in terms of our portfolio. So we don’t as a general rule, our objective is not to try and capture specific trends, but rather to stay invested over long periods of time. And so we don’t believe the fundamental purpose of fixed income has ultimately changed. And at our firm, the employment of fixed income is really there to dampen the volatility of growth assets. And it’s absolutely true that we have been in a period, a pretty benign period for equity volatility, at least in the US, not so much overseas. And then, you know, we also have volatility contributable, or contributed by currency. So from our perspective the argument for in favor of a continuing to hold a significant allocation to fixed income, for the purpose that I’ve described, to offset the volatility that we would reasonably expect from growth assets hasn’t changed. The price that we’ve paid in the short term is that with rates as low as they have been for the period of time that they have been, it’s made investors less satisfied to be holding fixed income in this environment. But the rationale for it has simply not changed. Hoda Imam: [0:24:33’] But what if volatility increases? Kevin Gahagan: [0:24:35] Well, from our perspective volatility will increase. Now, when you say volatility of fixed income, again, on a relative basis, you know, the volatility of a short or intermediate bond in relation to equity is a significant difference. And we can go back and look at past periods of rising rates and see how that’s played out in those sectors. And is there risk there? Absolutely. But does it compare to equity or other growth related assets? No. Hoda Imam: [0:25:06] Okay, Travis or Bong. Bong Choi: [0:25:07] We manage portfolios across all assets classes. And so within fixed income we’re looking for a few characteristics. Fixed income is a natural place for current income. It’s a diversifier away from equity market risk. And it’s also a flight to quality even. And when you look across those three factors it’s become very challenging. And because of that we have a relatively underweight allocation to fixed income versus what we’d say is our long term asset allocation model. But the flight to quality aspect remains intact. And so that is still a critical part of fixed income as it plays a role in our diversified portfolios. And it’s hard for me to get into more specifics because we customize our portfolios to specific client needs. But there are thematic consistencies, and from that perspective given where rates are going we are relatively shorter in duration from that perspective. And I’d say the primary role is intact, it’s just become much more difficult to, for example, produce attractive rates of current income. And so from that perspective we do have a more modest allocation than we’d like to have long term. Travis Carr: [0:26:16] So I’d say we’re lower biased because we only do active fixed income. So there’s always a role for fixed income. But I think when you look at an environment today where you do have low yields, and if you look at just some of the benchmarks, the bond benchmarks like the Barclays Aggregate, you have a yield closer to 2½% and a duration or interest rate sensitivity closer to six years. So we think that there are some good opportunities to look outside of the benchmarks to find some interesting sectors where you do still get paid a decent yield and maybe taking a little bit less interest rate risk. We always think it’s important to have some of that core fixed income in a portfolio, as mentioned earlier, having that kind of anchor [inaudible], when you do get the volatility in some other asset classes like equities, like alternatives, having that ballast in your portfolio is extremely important. And again, we’re not really expecting rapid kind of spread compression; we’ve had a pretty strong rally in spread sectors, meaning corporate credit, some of the mortgage markets. And so we aren’t expecting a lot of additional spread tightening. But that doesn’t mean you can’t still add value. And it’s more about clipping coupon today and looking for areas that do have kind of an attractive yield. So that’s where we’re really focused is looking areas around the fixed income markets that we still find attractive and still represent good wealth to buy. Hoda Imam: [0:27:49] Would you say that across the board that’s your overall risk management philosophy? Travis Carr: [0:27:54] Yeah. I’d say when we think about risk management, it really is, it’s a few different groups that are involved in that. And how we approach that, it starts with the portfolio management team. And we think about risk management as how they’re constructing a portfolio. The way that we try to approach that is having first of all been a long term value manager, if we’re investing in assets and sectors that we think are mispriced and we have a different view than the market that again, we think reduces risk long term. Also having really multiple diversified strategies, another core tenant in our philosophy, we’re going to be positioned given our view, our base case view. But we also want to have some strategies in the portfolio that will offset that, if you do get a big risk off move, if we’re wrong. So we want to have multiple strategies in the portfolio that will help to complement each other and hopefully mute any downside volatility when you do get a big risk off move. So from a portfolio construction standpoint, that’s an important part. But obviously the input from a risk management team is incredibly important. They do an incredible job of analyzing the risk in the portfolio, what sectors that’s coming from. We want to make sure where we’re taking the most active risk is where we have the highest conviction strategies. And if those aren’t lined up then the trade doesn’t size properly. So really important interaction between those groups looking at a lot of scenario analysis, you know, what if, or replaying the tapes, what happens if an event happens in the past happens today. And how will our portfolio respond? So a lot of good quantitative input, but at the end of the day it comes down to the quality and the judgment of our investment management team. Because you look at a risk system today and it’ll tell you that that risk is low, because volatility has been low. But we know that that won’t persist forever. We do expect volatility to pick up. And so you don’t necessarily want to add a lot of risk, even though the risk system may be telling you there’s not a lot of risk in the portfolio currently. Hoda Imam: [0:29:54] Okay. So let’s move on to areas of opportunity, evaluating sectors of opportunity, Bong, do you want to go ahead and start? Bong Choi: [0:30:04] Yes, even like this is all relative because I think the overall environment of fixed income is quite challenging given where spreads are. On average spreads are still below their historical averages. But on a relative basis we are still constructive on the securitized sector, particularly non-agency. We do think that the fundamentals and technicals are still relatively strong in that market, despite the fact the overall market is shrinking over the next several years. We are attracted to relative valuations in EM. They’ve got healthier growth prospects; the leverage levels that you find in EM are relatively lower than their developed market counterparts. And real yields are actually much more attractive than what you find in the US. And so from that perspective, we are looking for opportunities more globally than just simply in the US. And then in terms of other spread product sectors such as corporate credit or bank loans, it’s a relative game. But we are concerned that there are cracks in the foundation. And we are very late cycle. And so you’re seeing a lot of things such as relaxed underwriting standards, defaults increasing in things like CMBS. You’ve got auto loans where it’s sort of this version of subprime, in modest levels. But those are the kinds of things we’re paying attention because there is indications that maybe we’ve gone too far in terms of corporate debt levels and underwriting standards being relaxed, etc. Hoda Imam: [0:31:37] Okay. I’m going to bounce to Travis really quick. Emerging markets, US dollar comparison, what would you say? Travis Carr: [0:31:45] That is one of our favorite sectors right now, emerging markets. And there’s really three different markets there. There’s dollar denominated, sovereign debt. There’s local currency sovereign debt, then dollar denominated corporates. And so we really look at those three areas when we’re putting together our emerging market exposure. I’d say local currency is our favorite right now. It is an area, as investors look across different sectors trying to find yield, EM, especially local currency EM is probably the most attractive. And you look at valuations compared to developed markets, that spread is back to where it was kind of at crisis levels and so inflation is actually coming down fairly significantly in some of those emerging markets. So those real yields again are still compelling. Even though nominal yields have come down, real yields are still very attractive. So valuations are compelling. And again, our view is that, you know, US growth is firming, but global growth is probably the bigger story that we have seen a real turnaround there. The last five years or so we have seen declining global growth. And now we think that that trend is reversed. And now we’re looking at, you know, probably 3½% global growth compared to roughly 3.2% last year. And so that growth story is really compelling. Hoda Imam: [0:33:02] But where would you stand if the US dollar appreciates? Travis Carr: [0:33:06] So yeah, I think if you look at … we always try to look at is the market kind of overreacting? And as a value manager we think the markets do kind of tend to move too far in other directions. So if you think about post election, there was a real concern about rates were going to rise materially, the dollar was going to strengthen. There was a lot of growth expectations built into the market very quickly, a lot of expectation of a lot of stimulus. And because of that, emerging markets were under pressure. There was concern that if you had the dollar rally, that would be negative for emerging markets, if that does service dollar denominated debt, it’s going to be more expensive. And also just maybe capital outflows. But again, our view was that, yes, there’ll be some stimulus down the road. But it’s going to take a lot longer for those things to happen. And it’s going to be more muted than maybe what people think. And so we actually still liked EM even though the outlook for EM was a bit cloudy. What we’ve seen is that the policies haven’t been as harsh as people have expected, meaning that trade policies haven’t been as protectionists, so we’ve seen a more friendly kind of trade policy movement we think. And again at the end of the day it really comes down to that growth story. And when you’re investing in a country that has, you know, attractive yields and it’s really the highest bid asset class to the global growth story, and then you add into the effect that that central bankers in a lot of these countries have become much more credible, much more independent the last few years. And so they’ve really been able to tackle inflation. Hoda Imam: [0:34:42] Why? Travis Carr: [0:34:43] Investors have really demanded it. And so that in order for investors to invest in these markets we have to believe that the Central Bank is going to be responsible and take action. And we had, you know, areas where inflation was getting out of control. And central bankers, you know, did the responsible thing and raised rates. And so we think that they have been able to tackle inflation, stabilize their currencies and investors feel much more comfortable investing in those markets today. So a lot of, you know, fundamental reasons as well as the valuations are pretty compelling. Kevin Gahagan: [0:35:13] Well, the other thing I would add to that on the EM side is that, and now we’re going to talk about local currency issuance, which is that, you know, as Travis’s remarks, is touching on investors are looking at those markets. You know, with kind of an emphasis on external investors, US investors looking at EM as opposed to, for many of those markets, whether it’s Mexico, Brazil, where you now have an internal demand that 15 years ago, 20 years ago didn’t exist to this level. And so they can absorb a lot of local issuance and are. And so for those governments that are able to, those countries that are able to issue in local currency, it gives them a lot more flexibility. So I mean in our portfolios we do have EM, we, like, Bong, I think we look at that favorably as distinct perhaps we put that in our alternatives bucket. So I was commenting earlier, it’s not a widows and orphans type of fixed income. It has much more volatility. But looking at the trend line for EM, one of the things that really is true is that the balance sheets of those countries has improved significantly. So their risk profile, from a credit risk profile their profile is a lot more attractive. Now, that should over time bring rates down. But it’s still going to be a premium relative to what you see available through US markets. Hoda Imam: [0:36:42] Okay. Continuing with areas of opportunity, corporate credit, Bong, what is your take on that? Bong Choi: [0:36:49] We probably have a relatively conservative stance, partly because of what we’re observing at a macro level in terms of corporate credit. And if you look under the hood in this sort of environment where we’re very late cycle, you really want to make sure what you’re getting yourself into. You’re seeing things such as Libor floors not being part of underwriting standards. And I think 20% of new issuance doesn’t have Libor floors, versus just 5% a year ago. And that’s a dramatic change. And so those are the kinds of things that give us concern. If you look at high yield and other markets, one thing that people always say is, “Well, spreads look like they have compressed but there’s still some wriggle room.” But if you look at the broad credit index, what you’re seeing is a deterioration in credit quality. And that really masks the actual spread compression that you’re seeing. So right now the BBBs represent something like half the credit index, 20 years ago that was less than 30%. So if you normalize credit quality and you look at the spreads where they are now, they’re actually in very similar levels that you saw in the market peak in 2007. So those are the kinds of data that we feel is a bit concerning. And so we probably have a more muted view on the opportunities of corporate credit going forward than some other investors. Hoda Imam: [0:38:15] I think, Kevin, corporate bond issuance, do you see a shortage or will it continue? Kevin Gahagan: [0:38:18] No, you know, again, and our focus has been because of the approach that I’ve articulated with really looking at that as a risk. Our focus has been primarily in government issue. So we are not as insight, don’t have as much insight to be able to share specific to the corporate. We’ll come back, I want to table and ideas just come back and talk about municipals which is kind of an interesting area that we’re looking at a little more closely. But, I mean, let me punt on that one if I may. Hoda Imam: [0:38:44] Sure, I’ll come back to you. Travis Carr: [0:38:46] I think our view on corporate credit is, is that, again, valuations certainly have compressed. Meaning if you go back to first quarter of 2016 you had a real negative kind of environment. You had deflationary concerns, kind of real GDP maybe being negative, energy, oil prices in the 20s. And so we saw spreads really widen. And at that point we thought corporate credit, whether it was investment grade or high yield was very attractive. And as a value manager we held our positions and actually added to some positions in that environment. You fast forward to today and we’ve had a pretty consistent rally in corporate credit, investment grade spreads were over 200 basis points back in the first quarter of 16, now they’re right around 100 basis points. High yield went from 800 over to roughly 375. So we’re not necessarily concerned about any fundamental concerns. We think that corporate credit continues to do well in this environment where growth is decent and maybe improving, inflation’s muted. But the valuations just aren’t as compelling. And so we have actually reduced some of our corporate credit exposure. We’ve shifted a little bit of our high yield bond exposure into bank loans. So we’re getting a bit more defensive, move from an unsecured bond into a bank loan where you are secured by real assets you’re seeing on the capital structure. And it’s a floating rate off of Libor. So I’d say corporate credit we’ve gotten a little bit more defensive. We think it’s important this year, it’s going to be much more about where you’re positioned, not necessarily just expecting a material spread compression at the index level. So kind of clipping coupons and picking individual names that you think will do better than the index. Hoda Imam: [0:40:36] Okay. And, Kevin, you wanted to mention… Kevin Gahagan: [0:40:38] Well, no, we’re in interesting environment with respect to municipals, relative to when you look at the nominal returns on municipals today, are at and above in many cases what you see in government issue. It’s an interesting phenomenon. And that’s on a nominal basis, when you start looking at after tax returns. And particularly when you have a market as diverse as California and so, you know, we are California based investors for the clients that we work with predominantly. It has been an area that we’ve been, you know, again, thoughtfully and carefully, but expanding our exposures in. Hoda Imam: [0:41:16] Okay. Bong, what’s driving the interest in high yield and do you think it’s a good place to be? Bong Choi: [0:41:23] I think it’s the search for yield remains unabated. That’s really driven high yield down to where it is. We again, we’re relatively conservative in our stance. So whether it be high yield, or corporate credit or bank loans, we do have broad exposure across all major food groups, if you will. But we are really emphasizing higher quality across the board because we do believe that it improves protection because of again, these cracks in the foundation. So high yield is probably an area that we’re not going to rush overweighting any time soon, given where spreads are. And they are significantly lower than historical standards. And as I mentioned, if you look across the average quality of the major indices and things like that, we find the risk return trade off relatively uncompelling versus other sectors. Hoda Imam: [0:42:13] Okay. Travis, what sectors to avoid in 2017? Travis Carr: [0:42:19] I’d say as far as fixed income asset classes, there’s no asset classes we’re avoiding completely. But I would say that, as I mentioned earlier, it’s going to be really important this year, kind of where your subsector positioning is. There’s a lot of talk about where we are in the credit cycle. And the way that we think about that is that each industry is really is different, has its own credit cycle and is really at a different point. So as a fixed income manager we want to be in industries where companies are being much more conservative and maybe are coming out of a recession environment like energy, like, oil firms, metals and mining. They had a pretty rough kind of a recession environment over the last couple of years. And so they’re doing things that are very bondholder friendly. They are keeping leverage down. They’re not doing equity friendly things like raising debt to increase buybacks or raise dividends. And so those are more conservative sectors we’re going to be overweight. And so areas we want to avoid or underweight are those industries that are kind of leveraging up and are at a different part of their credit cycle. So areas, for instance, like telecom, we’re seeing a lot of M&A activity, a lot of debt issuance. And so as a bond investor those are areas that we want to be underweight. So I wouldn’t say there’s any sectors that we’re avoiding in fixed income. But certainly it’s subsector positioning. Issue selection is going to be much more important this year as opposed to just being positioned for just a, you know, broad kind of credit rally. Hoda Imam: [0:43:54] Kevin, are you surprised by Travis’s forecast? Kevin Gahagan: [0:43:57] Well, surprised and agree is two different things. Again, we tend to have a pretty agnostic view. The one comment I would make and consistent with some of the remarks that the panelists have made. If we assume that, you know, inflation is going to be relatively benign in the near term. Then the argument in favor of TIPS really becomes questionable. And while we hold TIPS in the portfolio, I think to Bong’s comments, as it relates to at what level of exposure do you maintain that. And so, you know, that’s kind of a simple one. You know, is TIPS really more of a shock type of hold or is it a strategic hold? We do hold it strategically but probably to a lesser extent than previously. Hoda Imam: [0:44:43] Okay. I see you nodding your head a lot so I presume you agree with everything Travis and Kevin just said. Bong Choi: [0:44:48] Yeah. You know, the only thing I’d add is in this environment we do believe that active management in the fixed income space is much more important. And so we are concerned about holding passive core bond exposure, as Travis mentioned earlier, the yield and duration tradeoff and holding the agg has been more and more unattractive. And so in terms of sector rotation or credit quality rotation, things like that, we do believe that active managers who can maintain flexibility going across sectors is going to be more important. Hoda Imam: [0:45:24] And what is your due diligence process? Bong Choi: [0:45:28] In terms of seeking out active managers? Hoda Imam: [0:45:32] Yes. Well, yes. Bong Choi: [0:45:35] Well, it all begins with you need to know what you’re solving for, right. And so fixed income plays a certain utility or role relative to other asset classes in our portfolios, and so again we are relatively underweight the sector and within that relatively shorter duration on the taxable side with an emphasis on higher quality. And we seek out managers that have probably a similar philosophy to help us position our portfolios that way. And beyond that it’s really about understanding behavior of returns going forward in various economic cycles. So the persistency of returns is something that’s very important to us in understanding how a manager would position their portfolios in certain interest rate environments and credit shocks etc. So that really is infusing our DNA. The other part that I’d say is increasingly important in the due diligence is we’re big supporters in impact investing. And so we are integrating the impact or ESG philosophies into our normal due diligence process. And fixed income is an area where it’s actually, we believe, improving our decision-making because it improves the general quality of the credits that we hold in our portfolios. And we do think it’s an asset class that regardless of the relative evolution of where impact is going, it’s a pretty healthy sandbox for managers. Hoda Imam: [0:46:57] Okay. And, Kevin? Kevin Gahagan: [0:46:58] From a portfolio standpoint, and I’m kind of the outlier here as I mentioned before, our approach is to own markets broadly. And so we do take largely a passive approach in the implementation of both our fixed income and our equity. And part of that philosophically is, is that we do, if our conviction is that we will see positive returns over longer cycles in any of the asset classes in which we invest, the challenge that we see from a due diligence standpoint is identifying those managers who can sufficiently add value to overcome the cost of doing that, Travis, notwithstanding. And that is a challenge. If I can buy a market at 8 or 9 basis points, that’s a significant hurdle that an active manager has to compete with. And I don’t disagree with Bong’s comments, viz-a-viz the relative relationship in terms of risk and return etc, of the index. Part of that comes back to what do you look at to track, and is it the Barclays Aggregate? Is it some other subsector? And so we think that there are opportunities to invest in fixed income in a passive low cost manner that can contribute to return over time. Hoda Imam: [0:48:20] Okay, and Travis. Travis Carr: [0:48:21] You know, I think how we approach kind of due diligence and portfolio construction in general is again trying to marry some top down macro strategies with a bottom up, sector, subsector and issue selection. And as I mentioned earlier, really important that we have multiple strategies, that they aren’t all … we’re not just relying on one particular strategy, not making just one big rate bet or we’re not just making one big bet on a certain sector. That it’s spread across a lot of different sectors. And again, by design we want them to be diversified. It’s been interesting recently, you know, normally you have this negative correlation between treasuries and risk assets, whether it be equities or corporate credit. And we’ve used duration, especially long treasury duration, 30 year part of the curve as that kind of risk off hedge. And so when you do get that risk off move, if you do have more kind of spread exposure than the benchmark, that treasury component will provide some downside volatility. So we’ve always tried to be positioned where we have kind of offsetting strategies to reduce that. What’s been interesting this year, I think because we’ve had a global growth story that’s been picking up US and globally, but at the same time inflation in contrast has been coming down. And again, we are firm believers that inflation is really the main driver of long term rates. And so you’ve had an environment this year where that correlation really hasn’t held up as much as it normally has as far as that negative correlation. So treasury yields have come down, although they’ve bounced a little bit recently, they’ve come down the year while equities and credit have done well. But I think that, so kind of our macro strategies and our sector strategies have worked at the same time. But I think that that negative correlation, when you do get a real risk off event, a meaningful event, I think that negative correlation pattern will hold and you’ll have that kind of offset from a long treasury position. So we really try to look at our duration and our curve positioning, where we have more duration of the long or the short end of the curve and really try to kind of combine that with some of our sector and subsector strategies. Hoda Imam: [0:50:27] Okay, great. And then wrapping up our very interesting discussion I’d like to just have each one of you quickly comment on what you would advise investors and how investors should approach fixed income considering the recent news from The Fed. And we can just start from Bong. Bong Choi: [0:50:43] I think the most important part is make sure you’re diversifying your risks within fixed income. And it’s really about balance, and despite a lot of my comments seem very bearish, we are exposed to fixed income because of the qualities that the asset class represents relative to equities and other asset classes. But our main focus is really to make sure that whatever risk we’re willing to take within the sector is increasing diversified, because we do believe it’ll increase the optionality we have. We are raising some exposure in short duration assets, partly is dry powder because we do expect some dislocations to present themselves and we’d like to participate in those when they happen. Hoda Imam: [0:51:25] Okay, Kevin. Kevin Gahagan: [0:51:26] I would echo Bong’s comments as it relates to first off, fixed income remains a core holding, a core allocation within a portfolio, that shouldn’t change, as it relates to The Fed’s recent actions and proposed actions. I think that argues to holding, to being toward the shorter end of the yield curve, short and intermediate. You may, in the short term be giving up some yield opportunity. But we think from a portfolio management and risk management standpoint that that’s a reasonable tradeoff. And like, Bong, certainly advocate looking at the diversification of the fixed income that you do hold. Hoda Imam: [0:52:11] Okay, and Travis. Travis Carr: [0:52:12] Yeah, I think it’s important to really have a really good conversation with the client and understand what they’re trying to solve for. And again, as mentioned earlier, we think having that kind of core higher quality duration to service that ballast is really important, if you do have more equity exposure and alternatives exposure. But then also solving for other issues, like some clients we have, have very long term liabilities and hedging that with liability driven investing. So really having a lot of good conversations with clients and consultants, “What are you trying to solve for? Are you looking for income? What are you comfortable with?” And making sure that the strategy is consistent with their objective and their risk profile is consistent. When you think about areas like unconstrained, which is moving away from benchmarks, but it’s a very kind of nebulous concept. Nobody really understands what unconstrained means, it means a lot of different things to a lot of different people. So we’re having a lot of good conversations trying to frame that and saying, “: Okay, manage to a certain volatility target, which one are you comfortable with? What types of assets are you comfortable that we invest in? And where are you looking for more of that return to come from? Is it more kind of macro strategies or more kind of spread sectors and income?” So really having, I think, very good conversations with clients about what they’re trying to solve for, what they’re comfortable with and making sure that the strategy is really lined up with those objectives. Hoda Imam: [0:53:40] Fantastic. Bong, Kevin, Travis, thank you so much for joining me here today to share your insights. And thank you to the viewers for tuning in. Please be sure to take the corresponding quiz on assettv.com for your Continuing Education Credits. From San Francisco, I’m Hoda Imam for Asset TV.