Rob Almeida

Welcome to another addition of the Strategist’s Corner Podcast. I’m Rob Almeida, Global Investment Strategist and multi-asset portfolio manager. In this episode, I chat with MFS’ Chairman and CEO, Mike Roberge, about where we are in the economic cycle, the dramatically shifting investment landscape, and how these shifts could advantage active managers.

DISCLOSURE:

The views expressed are those of the speaker and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as an offer of securities or investment advice. No forecast can be guaranteed. Past performance is no guarantee of future results.

Rob Almeida

Mike, thanks for joining me.

Mike Roberge

Good to be here.

Rob Almeida

So 2022, obviously dominated by inflation. But to me, the real narrative is it induced a policy response to push rates higher and cash became a competitive asset. So depending on where you live in the world, cash is now yielding two, three, four or five plus percent, which systematically de-rated all financial assets that compensate you for the opportunity cost of not earning a pretty decent risk free rate relative to the last ten years. So thinking a year from now, what will be the narrative on 2023?

Mike Roberge

2022 was a year of inflation central banks having to catch up because they were behind the curve. And I think 2023 is going to be much more around the economic cycle. Do we have a soft landing? Do we go into recession? Inflation is clearly coming down. And I think as we look forward, it'll be, you know, how poor was economic growth in 2023 and what does the next economic cycle look like? And I think that's what the narrative will be in a year.

Rob Almeida

Yeah, I agree. It seems to be a plethora of, let's call it recessionary signals, notably inverted yield curves and pretty steep inverted yield curves. But when you look at risk assets, it's not signaling that. And if we look at Wall Street consensus earnings, they're not signaling. I mean, earnings expectations are down 2, 3, 4 or 5%, but nothing consistent with what you would typically see in a recession, which would be earnings 10, 20, 30 plus percent down. So how do you maybe reconcile that?

Mike Roberge

Yeah, I think usually in the traditional cycle is equity markets don't tend to bottom until earnings bottom. And you know, I think companies are trying to signal that even though the economy's going to slow, they can protect margins. And by the way, margins are near all-time highs.

Rob Almeida

Right.

Mike Roberge

And so our view of that is it's I don't think companies quite know what's ahead of them in terms of what growth is going to look like. If you look over the next couple of quarters, I don't believe that earnings have bottomed yet, which may mean the equity market hasn't quite bottomed yet in this cycle. I think what is different at this part of the cycle is the differentiation between those companies that are more economically sensitive with higher fixed costs, which won't be able to protect margins relative to other companies. And this is an environment where active management matters. And looking through the economic cycle, identifying those companies that can relatively protect earnings. And I think that's where we are in the cycle now.

Rob Almeida

All right. Let's dig into a little bit more. So inflation's probably peaked, decelerating, but there's two sides to that inflation coin. So what is inflation? It's higher prices. So higher prices equals generally higher revenues. So companies are able to protect margins. To your point, margins still haven't come down. Profits are still really high, but the flip side to that inflation coin is as inflation decelerates, presumably it's lower prices paid equals lower revenues. So normally, though, in recessions, companies, let's say, tighten their proverbial belts pretty hard. So labor shedding, capital costs are falling. Are we going to see that type of performance in companies be able to protect margins like they have in the past?

Mike Roberge

Yeah, I think this as we look forward, I think the cycle is going to be different than what we've all experienced. We had, you know, decades of declining interest rates, which was a tailwind to earnings and profits. Labor, if you look at the labor share of GDP actually came down over that period of time and we're seeing that reverse some as companies have to keep labor, bring additional labor on and ultimately capital intensity came down dramatically as companies didn't have to invest in their businesses into property. And so all of that contributed to higher margins. And we believe most of that is now reversed and interest rates aren't going to be, first of all, central banks, we don't believe, are going to be able to bring rates down as dramatically as they have because we think inflation will be stickier, higher than it was in the prior cycle. Companies are going to onshore supply chains, and I think they learned that during COVID. That's going to create additional costs within their business, and ultimately capital intensity, we think, has gone up for many businesses as well as they have to replace plant. And so for all those reasons, we think those peak margins that we've seen likely are in the rearview mirror, not ahead of us.

Rob Almeida

It's almost the reverse of the last ten or 12 years. Right. So when you think about offshoring, globalization, which led to suppression of labor costs, accelerating margin labor share of GDP, all those things, if you if I can maybe summarize them as profit subsidies, right, and those profits subsidies against a backdrop of ultra-low interest rates. So you had peak margins on or - excuse me - peak multiples on peak margins, and that's going to be very different looking out over the next few years.

Mike Roberge

It's going to be very different. I think the cost environment for companies is going to be very different. I think some of the inflation we have today, what we're trying to do is what's cyclical, what's structural, and it's going to be with us longer. And I think we're likely to see that play out over the next several years.

Rob Almeida

So let's stick with - let's decompose capital costs and focus on interest costs. Where do you think or where do you see Fed funds? But more importantly, the shape of the curve looking out this year.

Mike Roberge

If you look at where Fed funds is now, it's at four and a half. You know, the market's pricing in terminal rate around 5%. So a couple more hikes and that's what controls the short end of the curve. So if you look at short rates, three month rates are a little higher than that, they're four and a half today. But what's interesting is what the ten-year part of the curve is telling you, because the Fed doesn't control that, the market controls ten year rates, and ten year rates are around three and a half. So the curve significantly inverted. Historically, when you get an inversion like this, the economy either slows significantly or goes into recession. So the difference between three months and ten years, about 125 basis points now. And so-

Rob Almeida

Which is a lot.

Mike Roberge

Which is a lot. So the curve is telling you inflation is coming down, that the economy is going to significantly slow if not go to recession. And frankly, the markets now pricing the Fed easing at the second half of this year. And so I think rates probably stay in that 3 to 4%. I think the Fed is going to be stickier longer than many people think because I think inflation's a little stickier. And a little higher than it has been historically.

Rob Almeida

Yeah. No, that - that makes sense. On the other side of capital cost. So we talked about labor a little bit and you also talked about capital investment. So if you look at U.S. companies, CapEx as a percentage of operating cash flow - it's at a four decade low. For non-U.S. companies, we can't easily go back, but it's all directionally the same. So you had declining capital intensity and tell me your opinion on this, just kind of how I think about it. So, you know, recession is just a rebalance of whatever was overbuilt over bought, overproduced, etc.. In the nineties we produced too many fiber optics and PCs and hardware. In nineties we built too many homes. And you know, in the two in the post GFC area two-thousand tens, I just thought it was about companies divesting capital to share repo and dividends and buybacks, etc. but maybe if you think about a little bit further capital went to a non-physical world? And I guess maybe really now it needs to shift back to a physical one right.

Mike Roberge

Yeah. Maybe building too many apps.

Rob Almeida

Right.

Mike Roberge

That would be this cycle. Right. And that appears the market's telling you that's what happened during that last cycle. Right. But I do think it is going to be, we are going to see more capital intensity. So investing in plant, the great thing about investing in plant, if it's productive asset is it produces growth over time and you can get a return on that. And I think we're going back to that type of world. The other thing that's going to happen, which I think is, you know, people think about it differently from a stakeholder perspective now is, you know, reducing capital or carbon intensity means more capital being put to work. And there are significant benefits to, you know, to the impact on the planet as part of that. Significant investments on diversity. So other social issues in a variety of things ultimately, which makes the world a better place we think produces better growth and creates a more balanced environment ultimately than what we probably experienced post-financial crisis.

Rob Almeida

Yeah. Better GDP, better labor equality, less GHG emissions at the expense of lower net profit margins for some. Right. Just more more dispersion, but a necessary adjustment. Let's -

Mike Roberge

And lower. And the other thing is lower profit margins. Again, if labor share of GDP goes up, that's ultimately better in terms of equality as well.

Rob Almeida

Right, exactly. Right. Okay. So let's talk about asset allocation. Yeah, it's a tough one because everyone has different risks. Your risk tolerance is different than my risk tolerance, maybe we'll keep it in general terms, but blank sheet of paper: MFS ask you to manage a 60/40 portfolio today. Stocks, bonds. How are you thinking about that allocation? Again, you know, age tolerance, all that aside.

Mike Roberge

The question of the last couple of years, people would ask is, is 60/40 dead? And I think what this means is 60/40 is back. And the great thing from an investment perspective is this is a much better environment than what we lived through. And that cash has a return. There's a real return in fixed income markets now, which is after inflation. And you can put risk premiums on those rates now and build an asset allocation, a portfolio that makes sense over time. And that wasn't the case when rates were around zero and you had very little volatility in the marketplace, it was very difficult to construct an allocation that you thought made sense from a risk perspective. And so I think for fixed income investors, you know, investment grade corporate bonds today make a lot of sense. High quality bonds where, you know, you're getting a three and a half percent with a reasonable spread for the credit risk that you're taking. And that's going to provide a reasonable through cycle return for investors within those markets. I think from a broader perspective, I think if you take the long view, you know, we talked a little bit about the challenges potentially this year for equities in some of the riskier parts of the fixed income markets.

Mike Roberge

If you look through the cycle, though, when you take that three and a half percent Treasury rate, you put a risk premium on equities at 3 to 4%. That's a pretty good return through cycle for investors as well. And, you know, it's never - we're never smart enough to know where the bottom is. And so I think averaging in and rebalancing to that 60/40 makes sense for investors. So if equities underperform for part of this year, which I think is reasonable to think as earnings come down. Yeah, it's rebalancing back to that 60/40 allocation or whatever the proper allocation is. So I think there are opportunities in the marketplace for investors today, which was much more challenged a couple of years ago.

Rob Almeida

And maybe getting to that point, what could be a little bit different to go alongside that is much higher dispersion of returns, all the things that you talked about, right. So companies having to acclimate to higher capital costs, higher labor costs, a very different operating environment brings challenges and opportunity. So if you put a three or 4% risk premium on a ten year treasury for equities, or that might be five or 6% for one company and maybe 2% for another, right?

Mike Roberge

Absolutely. Yes.

Rob Almeida

So very different environment. All right, Mike, you started your investment career almost 30 years ago. So you go back in the time machine. What are you going to tell a young Mike Roberge to do or to not do?

Mike Roberge

I think the hardest thing when someone's early in their investing career is tuning out the stuff that doesn't matter in the short term. I think it's just there's information coming at you all the time. You're trying to sift through it, trying to figure out what to do with it. And I think we get caught up in what's right in front of us and we overact to much of that short term noise. And so the thing that I've learned over my career that I would give myself advice is tune out those things that don't matter over the long term, only focus on those things that matter over the long term. So if I think about asset allocation, it's pick your portfolio and rebalance back to it. And don't worry about ultimately what the markets are doing.

Mike Roberge

And when I think about individual security selection, identify something that's valuable over the long term and don't worry about what the entry price is. Yeah, because it's easy to think, well, I'll get it cheaper tomorrow or if I own it, I'm not going to sell it because it's running. It's like if it doesn't make sense at a particular price, sell it. If it does make sense at a particular price, buy it and don't worry about what the price is tomorrow.

Rob Almeida

Yeah, yeah. No, it's interesting. We love to maybe romanticize the past in all aspects of, like sports and finance and what have you and, you know, it's always seemingly more difficult now or harder now or more challenging now, and it's probably not. But I think where there is a maybe a point of differentiation from when we started was less information.

Rob Almeida

And I think the challenge today is maybe 30, 40 years ago, you had to maybe create a research advantage or create information advantage. And now it's almost the opposite, which is we're all overloaded with information, we're drowning in information, but we're starved of knowledge. And that knowledge, to your point, is what's relevant, right, in sifting out that noise. So it's not just the blockers because you can't block it because it's all coming in, but then it's: okay, this is irrelevant. Push that to the side.

Mike Roberge

Yeah, I think the advantage now isn't information advantage because everyone has it.

Rob Almeida

Everyone has it.

Mike Roberge

It's time horizon advantage. It's how do you use the arbitrage of time horizon? Because, you know, everyone is really churning the short term and trying to figure out what to do about that information right in front of them. And it's like sift through it, think about those things that drive long term value. That's the advantage in the marketplace today.

Rob Almeida

What does a company do? How do they do it? What is the terminal value of that asset? Right. Right. And that's what drives asset prices. Right. I finally Mike, what haven't I asked you?

Mike Roberge

I actually think this is an environment this is a renaissance of active management as well.

Mike Roberge

I like that term

Mike Roberge

It's you know, we live through this environment where central banks took rates to zero, they suppressed volatility. The Fed put every time something bad happened, they stepped in and provided liquidity. We're no longer in that environment. And so central banks are going to have to keep policy rates higher, which is going to create more economic volatility. Interest rates are going to be higher; inflation is going to be higher, volatility is going to be higher. That creates massive opportunity for dispersion and active management. And so the era of cheap beta in passive management I think is behind us. And this is an environment where differentiation matters and having an edge from a time horizon perspective makes a difference. And that definitely lends itself to active management.

Rob Almeida

Yeah, it makes a ton of sense. We if you strip away everything, so markets and ETFs and mutual funds, all the noise and what is investing, you're right, you're funding a business. You're funding a business. And what that business is worth is a function of its cash flows. And I think that's what we're shifting back towards.

Mike Roberge

Yeah. And at the peak of the market there was a significant share of small cap companies that didn't produce enough operating cash flow to pay their debt off. Right. And you know, they call them zombie companies. That's capacity that should and needs to come out of the system to allow those healthier companies to have pricing power, to have an advantage.

Mike Roberge

And those are the companies that are going to win. And that's what active management can do, is identify those and provide risk adjusted returns for clients.

Rob Almeida

All right, thank you, Mike. Thanks so much for being here.

Mike Roberge

Thanks Rob, I appreciate it.

Rob Almeida:

I think Mike encapsulated the way we at MFS are approaching what is likely to be a more volatile investment backdrop than the one we experienced over the past fifteen years, and the opportunities that will come with it. Thanks for listening and join us again for the next Strategist’s Corner podcast.