MASTERCLASS: Active Management - July 2020
June 17, 2020
Eric Hundahl: Hello and welcome to BNY Mellon Investment Management exclusive masterclass featuring export portfolio managers from our investment firms. Our panel discussion, exploring forces shaping the markets today, how we can move past the bottom, and the outlook from markets moving forward. I am Eric Hundahl, Head of Portfolio Strategy for BNY Mellon Investment Management. And joining us to help break down some of the issues and opportunities in the market, I'm joined by three expert panelists.
Eric Hundahl: To discuss credit markets, Leland Hart, Co-Chief Investment Officer at Alcentra. We'll be joined by John Porter, he's the Chief Investment Officer, Head of Equities and Portfolio Manager at Mellon. Suzanne Hutchins, Investment Leader Real Return Team at Newton Investment Management Plus Products.
Eric Hundahl: Obviously an extraordinary period for the world, but not only a significant human toll, but also a market reaction that was quick as it was painful, something that will certainly be remembered in the history books. John, maybe we'll start with you. How would you summarize the current market environment for equities?
John Porter: I think we're in the midst of an incredible tug of war right now. You're seeing a staggering amount of stimulus, both fiscal and monetary, that has been put in place and was deeply needed to put up a safety net under this economy and under the capital markets; and it's doing its job, we've seen capital markets recover.
John Porter: But now we're faced with an uncertain economic outlook, and that's what investors are really wrestling right now with is the significant amount of stimulus, but the uncertainty about the economic outlook. And also, we're looking ahead to the fall and thinking about the virus and could it reoccur. And so that tug of war is really shaping the conversation around equity markets today.
Eric Hundahl: Leland, are you seeing that same tug of war in the credit markets?
Leland Hart: Yeah, absolutely. As John said, the massive demand shock that all of the markets encountered produced some pretty material price drops. The recovery has been specifically due to the massive amount of monetary and fiscal stimulus dwarfing what we saw in the previous financial crisis.
Leland Hart: Where we sit today is while it feels like maybe the market gets some of its sea lights back and volatility is somewhat dropped, again due to the amount of global stimulus, we're in the early innings from a credit perspective.
Leland Hart: The things that monetary fiscal policy can cure can have a different effect upon equity than it can on credit. So, for our part of the world, when we're looking at our lenders and what we're seeing from a number’s perspective, it's still very early days.
Leland Hart: So without many people having a strong view on what's going to happen next, the sort of the number one indicator for us as for branding security is what are companies telling us, what are they projecting on the year? Right now, no one's able to do that.
Leland Hart: So the level of uncertainty seems high from an actual performance perspective, the level of faith in each respect of government and administration supporting it, that's been quite strong. And that is, specifically by John, a very impressive tug of war.
Eric Hundahl: Suzanne, uncertainty seems to be the theme with Leland and John. You have the distinct opportunity of covering not only stocks and bonds, but multiple asset classes in your strategy. Would you agree with that uncertainty that John and Leland referenced?
Suzanne Hutchins: I would, and I think the challenge in markets today is that you've got very managed markets, financial asset prices by central banks and they've literally done whatever it takes and have, obviously, supported a significant rally in financial asset prices since the depths of the 26th of March.
Suzanne Hutchins: But the struggle that I have, particularly as I'm more of a fundamentalist, is that it's a long way from the reality of the economic system present day. We're talking about 15% drop quarter on quarter in GDP growth. And as Leland said and John had said, the corporate outlook is very uncertain, companies are not giving anything away in terms of clarity because they just don't know.
Suzanne Hutchins: And so the big question now is what shape is the recovery? Is it V, U, L, W; you name it? And nobody really knows because we still haven't really got a vaccine, and we still don't really know whether there is a second wave to this COVID crisis.
Suzanne Hutchins: So I think it's very challenging, but the volatility of markets creates always opportunity. And that's where I think as active managers you can really add a lot of value, particularly if your pool in which you're fishing is a very broad set of asset classes.
Eric Hundahl: John, I saw you shaking your head over there when she was talking about the shape of the recovery. So far right now the market, particularly the equity market, could probably be defined as large dispersion, narrow breadth. Do you think that can change, or what would be the catalyst for that change?
John Porter: I think the catalyst for that to change would be more confidence in this economic upswing. I think people need to be careful and not over interpret what's going on in equity markets in particular.
John Porter: Because as you implied in your question, this has been a very narrow rally. While the stock market has rallied, and the S&P 500 is now back to within 10 or 15% of levels pre-COVID virus, it's been a tale of haves and have nots.
John Porter: I mean, you've got the companies that are sort of leading the way in this digital transition I think is really shaping our economy whose business models are not just doing fine through this, but they're really flourishing in the midst of this crisis, and so you've seen some of those bellwether stocks rising to all-time highs in the midst of all of this uncertainty.
John Porter: But you're seeing a lot of what I would call sort of real economy companies, a lot of traditional businesses that are being left behind. And as Suzanne said, no one knows what the shape of this recovery is going to be. And I think that the market reaction makes it look like we're discounting a fee, and I think in aggregate it's probably a fee, but what it's really reflecting is strength that's only been improved for a certain element of the economy, and then the rest of the economy that has just a massive amount of uncertainty.
Eric Hundahl: Yep. Leland carrying on that conversation, in the credit markets you've seen that same dispersion within sectors of winners and losers. But during the selloff credit, in general, just did marginally better than equities. Where's that dispersion coming from across sectors in the rally, and what role does credit have in the portfolios going forward?
Leland Hart: So a couple of interesting points to answer. Has the role of credit changed? I don't think so. The role of credit, generally, in portfolios was to provide a balanced of income with some downside protection; that's the role of credit in a portfolio.
Leland Hart: Given that base rates have gone low and it's not lower, I would imagine that the need for income has only increased. So the role of credit, at least from what we're seeing from our investors in inquiry on a daily basis both before, during, and after, call it, the month of March, the low point of COVID, credit's not going anywhere; in fact, I think it will be increasing.
Leland Hart: But during the last two or three months, we have seen an interesting change in the relationship between credit and equity. Historically speaking, the volatility or beta of high yield tends to be half that of equity, and loans tend to be half that of high yield; so, a quarter of equity. That was one way you could think about what your portfolio might do in a dislocation like we've had.
Leland Hart: What we've seen during the cycle in the last month or two, especially on the downside, is that credit and equities were performing rather similarly with some equities doing even better than credit, some doing worse.
Leland Hart: If we look at where we are today, where we have the Russell down materially, north of 20%, yet the NASDAQ may be down a couple percent. Or we have, if you look maybe at the S&P versus high yield, there's not much of a difference. And the reason that these relationships have changed a bit, it's because the constituencies within each of those specific loan, bond, or equity [inaudible 00:09:33] result of smaller companies.
Leland Hart: Smaller companies have less cushion; they've thus far have been less impacted by the monetary and fiscal stimulus. Where big companies have not only been more impacted, but they tend to be growth and technology driven and actually, in some ways, benefiting from the crisis. The same thing is happening in credit; bigger companies are doing better than smaller companies.
Leland Hart: So the role of credit, which was to provide income and balance to a portfolio, I think will pick up as base rates remain low; and our view is they're going to remain low for some time. And then how specifically those exposures of credit react versus equities, I think some of those relationships have sort of morphed over time but that, again, is mainly driven by the constituencies within each of those equity indices or the credit indices.
Leland Hart: And when you bake it all in an oven, and take a step back and look, the relationships are what you would expect how you thought about big companies versus small companies, energy driven indices versus, call it, technology growth indices.
Leland Hart: So again, it's been an interesting period, credit's not going away, and I'd expect those relationships to continue to evolve as you have further bifurcation between winners and losers in the market; both on the equity and credit side.
Eric Hundahl: Yep, great point. And Suzanne, carrying on that conversation, core bonds didn't meet the diversification expectations that many people expected. What role does core bonds having in a portfolio given some of the points that Leland brought up?
Suzanne Hutchins: I think you make a really interesting point, because the selloff that we saw in the four weeks during March was even worse than the GFC in terms of the speed of the selloff, and the accelerating rates of that cell off in such a short period of time.
Suzanne Hutchins: And so I think some of it was liquidity induced where a lot of investors, perhaps, were reaching for anything that was liquid; and at times that was gold, and at times it was treasuries. I mean, the spreads between the bid offer on some treasury bonds was a 100 base points where normally it's just one or two basis points.
Suzanne Hutchins: So we saw very extreme conditions then, and as you rightly pointed out, bonds and the gold actually didn't really offer much support against risk assets. But I would argue now that bonds are actually a better place to stabilize that return seeking core of risky assets.
Suzanne Hutchins: And the reason why I say that is that I think the health of financial markets is better than it was because central banks have gone hell bent on trying to liquefy the financial system. And so, I don't really see liquidity being the main driver to those discrepancies in what should be quite a good risk of hedge.
Suzanne Hutchins: And particularly now, although government bonds ... And I'm specifically talking about us treasuries really, and also Australia and New Zealand. Whilst the yields aren't necessarily that attractive, I do think that ... And this is our view, that we are probably more likely to see more of a deflationary bust, if you like, even if it is very short term and you get a very deep V in the state of the economy, before you then head into an acceleration of growth and, perhaps, reflation once you get further down the road and fiscal policy really starts to kick in.
Suzanne Hutchins: So I wouldn't say that we are really excited about government bonds, per se, but from a portfolio construction point of view, I actually think that they may do quite a good job, particularly over the next six months.
Suzanne Hutchins: And in a diversified portfolio where we've had gold and that has been highly correlated with equities, you do need to find other levers in which you can try and preserve capital and reduce volatility.
Eric Hundahl: And when you say, "Other levers." Does that open the door for more alternative type strategies in investor portfolios?
Suzanne Hutchins: Yeah, I mean alternative, the term, covers a whole raft of different types of strategies. And our approach is very much understand what you own, why you own it, and make sure it's liquid daily valued, and no sort of hidden leverage.
Suzanne Hutchins: So we don't really get involved in alternatives down sort of structured product route, because that isn't our forte. But I do think, I mean, in the terms of alternatives, exposures to things like infrastructure, renewable energy, solar, and even investments that are perhaps not economically sensitive at all ... I mean obviously solar would be not economically sensitive.
Suzanne Hutchins: But in areas like [inaudible 00:15:08] and also maybe credit towards pharmaceuticals, I think it's a very attractive investment opportunity, because it diversifies your return stream, and it's not dependent on COVID or the economic recovery.
Suzanne Hutchins: What I would say, though, is that because our approach is much more buy things that are liquid daily valued, when you do get steep draw downs in the markets, there is no hiding place, and these things can sell off as much as anything else; beaters and correlations tend to go to one. So, you have to be longer term and stick through it, or even buy into it when you get those stress conditions.
Eric Hundahl: Thanks Suzanne. John turning to you really quick but continuing on with portfolio positioning. Small and mid-cap stocks continued to [inaudible 00:16:10] large caps. As investors are thinking about reentering into the small cap space, what should they look for and what's your view on the small cap space?
John Porter: That's a complicated question because I think, normally, if you're applying the traditional playbook how to invest in and coming out of recession, you're going to want to have small cap exposure, you're going to have want to have value exposure; that's typically what leads you out of a market.
John Porter: However, when you look at those indices today, it's important to understand the makeup. Part of the reason why small and mid-caps have lagged recently is the makeup of the benchmarks are just much different than the large cap indices when we're looking at this from a U.S. perspective.
John Porter: So there's much more exposure to financial services, much more exposure to cyclical businesses. You're much more exposed to the areas of the economy that are really in the crosshairs of this shutdown, and there isn't as much exposure to the areas they're continuing to flourish.
John Porter: So I think making a call on small versus large right now, as much as anything, comes back to sort of that earlier conversation about the shape of this recovery, and how competent are you in a broad base cyclical recovery.
John Porter: Now valuation is your friend, indisputably, for small caps. They're, again, from a U.S. perspective, they're at a 10-year low relative to large caps in terms of valuation. Well evaluation is not a very good timing tool, and right now I would focus on the economic uncertainty and be cautious on any meaningful move back towards small caps out of large caps.
Eric Hundahl: Thanks John. Leland on that point, small caps much like high yield, there could be a potential for a default cycle there. What should investors think about in terms of default if this lockdown continues on for much longer?
Leland Hart: Sure. So, defaults in our market are always a lagging indicator and, as I said earlier from a credit perspective, it is early innings. We have enjoyed a well below average default rate in both U.S. and Europe loans and bond market since the previous crisis due to a number of reasons.
Leland Hart: One just absolutely low rates, less real appetite to borrow on the [inaudible 00:18:25] companies and effect stable growth; that's not the story today. You can expect that the fault rate, which today is in the twos, four in the U.S. for losses in the fours for high yield to increase pretty materially.
Leland Hart: By the end of the year, we'd expect a high single digit number, and it'd be great if it were a mid-single digit. That will all depend on what continued support we get as far as monetary and fiscal stimulus, and what letter in the alphabet or even Nike swoosh recovery we have.
Leland Hart: But to be very direct, defaults take a while to happen. As I said before, in the lending world you owe money on a date certain. And when we're looking at companies that generally used to be on a performing basis or relative value, you look at 10 companies in the sector, you might want to own two or three of them, you're a five.
Leland Hart: You're a couple that are too rich and you do relative value, then you'd be trading in and out. Today the analysis is how much money does the company have in cash form or an unused revolver before it actually runs out of money and has to stop paying bills? That's not a typical analysis that has been done historically on every single company you own it's, "How much money do you have?"
Leland Hart: And so that's the mindset and as this continues, you're going to have a default rate go up. So, we expect it to go up materially from where it is today, not hit the peak that we had back in the financial crisis, and the curve ball will be how much support do we get and when do things open up?
Leland Hart: And it would be, obviously, fantastic if that number of default state in a mid-single digits, but given some of the sectors, energy for instance, where a large percent of those companies just won't make it based on total price alone, I think some of that is relatively inevitable and baked into current spreads and prices.
Eric Hundahl: But what about downgrades as the market is pricing in or expecting a lot of investment grade debt to become high yielding debt? What's your view on that?
Leland Hart: So the rating agencies, this time around, probably they took less time around on being slow, direct, or forward on downgrades. And what they can do is two things, they can downgrade companies immediately, or they can them on, call it, negative watch.
Leland Hart: And so the agencies have been very aggressive, call it a quarter of companies have already been affected by that in the non-investment grade world. In the investment grade world, half of the index is BBB, and BBB is the step before below investment grade.
Leland Hart: So half of the market is well it's starting off there, doesn't mean they're going to go there, but year to date in the U.S., we've had about 150 billions of fallen angels they're called, where you've got companies moving into the high yield index.
Leland Hart: The estimate is for more than that still to come this year; so, a decent chunk of the index. That's not as sometimes portrayed as scary or bad thing as a high yield investor; we like that for some basic reasons.
Leland Hart: They tend to be household names in a good way. These aren't the JC Penney's, this could be Hines, it could be Occidental, a Ford for instance. These are very big names and very big and liquid capital structures that are now something that high yield investor, who is more used to less liquid assets, can invest in.
Leland Hart: And the performance of fallen angels post downgrade, it's actually quite positive. It's not fantastic if you're an owner of a 30 years four bonds that can downgrade a high yield, you're going to take a pretty big mark. But the high yield buyer tends to make money as an entrance to the index and moved up.
Leland Hart: So there will be a lot of names coming down, there's no technical pressure to buy actually the way the indices work. So, it's something where, as an investor, it gives us ... As Suzanne was saying, we get less for choice. We don't have to buy any one thing, and now we have more names of more companies we know that are more transparent. So, it's not all bad for the new buyer.
Suzanne Hutchins: I agree with Leland actually that ... I mean, actually one area where we are watching very closely is the high yield market. And we do actually think that spreads over treasuries, we'll revisit the March loads that we saw this year, which was about 1,200 over.
Suzanne Hutchins: And it wouldn't surprise us if we do get there, and default rates are definitely picking up. And we agree that you could see a default rate of 10% in the U.S., but that provides the opportunity again through careful stock-picking.
Suzanne Hutchins: And it was exactly the same in the GFC crisis when you saw spreads blow out. And in fact, at that point, I think you've got anywhere between 1,500 and 2,000 over; so, there will be opportunities to be had.
Suzanne Hutchins: And the other area I think that needs to be carefully watched is the leverage loan market. Where I think it's at $1.2 trillion in size, and the CLOs make up about $700 billion. And I think that's another area which will come under quite lot of pressure, which is not necessarily talked about that much.
Leland Hart: yesterday. Yeah, for our business, that's a large part of our business. The CLO market is like the default rate, a lagging indicator. The CLOs are made up of loans, and they have a certain number of tests. But they do, in this market, are tending to get a ton of, in fact, a large amount if you can look at headlines doing right now.
Leland Hart: A ton of press because you have a lot of price volatility inherently, they're levered vehicles. The secret there is to be picky, which is the mantra of all of us on this call, is being able to pick out idiosyncratic decisions on one asset versus the other.
Leland Hart: But they're generally less understood, less liquid, and the price volatility has been material. They've also lagged in the recovery, they haven't had the bounce up that loans and high yield have had, so people are looking at those as is that a good thing or bad thing? The previous crisis, as an example, it's a good thing as long as you can hold them through the period. If you have to sell at the bottom, just like everything else it tends to be disastrous.
Eric Hundahl:Got it, thanks Leland. Suzanne, the federal reserve and governments across the world have been stepping in to relieve some of the uncertainty in the market, but there's a lot of countries that are already pushing the upper bounds of debt. What's your expectations of how this debt load is going to play out in the future?
Suzanne Hutchins: I wish I had a crystal ball. So, I think that we, potentially, may be inflated out of the debt process, which is why obviously the central bank asset purchases over the last decade whilst they've helped financial asset prices, they actually haven't helped the real economy.
Suzanne Hutchins: And, therefore, we've always taken the view that they will be MMT, Modern Monetary Theory, where you get a fiscal response as well as the monetary response. And to our minds, we didn't know what the catalyst would be, and I think obviously this COVID crisis, along with the double black swan events with oil crisis, has accelerated MMT.
Suzanne Hutchins: So I think, ultimately, we could say reflation and debt being inflated away through an economic recovery, but I don't see that happening anytime soon. The other angle that, obviously, could be the channel that we go down is Fed money being debased.
Suzanne Hutchins: And so, obviously, the value of the debt goes down at the same time as the paper value of the currencies goes down. And you are seeing a lot more volatility in currency markets now, but the question would be, "Well if the dollar's going down, what does it go down against?"
Suzanne Hutchins: And there will be this race to debase amongst all developed market currencies; so, it's a conundrum. But, ultimately, longer term we are in a low growth, low inflation environment, and we have been for the last couple of decades, and I think that's going to continue.
John Porter: And if I can jump in there, I would just add I think Suzanne just highlighted what's probably the most important, most overarching issue for capital markets over the next few years. And that is are we going to see a return of inflation? Are we going to break free of this low growth, low inflation market? I think every capital market is wrestling with that.
John Porter: And I think there's an assumption, when you look at again, the staggering amount of stimulus that's being flushed into the system, there's an assumption, a belief, that inflation is inevitable; I'm skeptical of that.
John Porter: As Susan finished, I would agree with her summary which is this low growth, low inflation in market seems to be the market that we're going to be in for the foreseeable future. Now as an investor, you're always looking for a change in the market dynamic, and we're wary of it, we're aware of the ramifications. I just don't see the catalyst to break us out of this low growth, low inflation market anytime soon.
Eric Hundahl: John continuing on with that, in a low growth, low inflation world, a growth versus value, growth has largely outperformed for a considerable time. In that scenario, would we see a maybe resurgence of value, or what's your take on the growth versus value in that scenario?
John Porter: Yeah, and I think the question of growth versus value really does come down to do we see a return of inflation or not? As you said, there's been sort of a 10 to 15 year run of growth versus value that's really been significant, and I think that the catalyst has been multi-fold.
John Porter: Part of it is the economic backdrop, this low growth, low inflation is certainly supportive of hydration assets like these secular growth companies. But you have to look at the underlying earnings trends as well; I mean, fundamentals are a big part of the equation.
John Porter: Part of the reason why growth has outperformed value over the last decade plus has been significantly stronger fundamentals. So, the fundamentals are the driver of markets over the long term, and that has been the catalyst for growth. I think the growth versus value equation is at the tip of every equity investor's tongue right now because of the dispersion in the returns has been just magnificent.
John Porter: I mean, you look at the Russell 1000 growth benchmark is close to flat for the year. The Russell 1000 value benchmark is down by more than 20% this year. And that's a monument dispersion and one that short term could see some consolidation, but I don't think it's going to be meaningful unless there's a belief that the economic backdrop changes sustainably.
Eric Hundahl: In that scenario, Leland, Fed and the U.S. government would have to step in. But they're already stepping in right now with an enormous amount of supply of debt. What should investors expect with the supply of bonds coming in the market from the U.S. Treasury and also from investment grade?
Leland Hart: I think that they should expect ... Again, assuming we're staying in this low growth environment, that the curve doesn't actually move too much and we're in such a managed environment, volatility is what scares the market scares equities, hits enterprise values, hits consumer competence.
Leland Hart: So I think what you're going to have is hands on the wheel for an extended period of time. It used to be called financial repression, now it's called the safety net. So, it goes from something, either a good thing or a bad thing, sort of like Dr. Fauci, I guess.
Leland Hart: I don't think you can expect much movement for a couple reasons: A) Like I said to keep competence up. B) You also, just taking the U.S. for example, or any other country, we're not just managing our own funding and our own yield curve, but that also affects how competitive we are from a trade perspective. And while everyone's economies for PDPs are frail today, no one's going to let rates escape, cause an appreciation, cause their trading counterparties to, therefore, put them at a disadvantage.
Leland Hart: So even if you wanted rates to pop up, I don't believe it would happen so quickly simply because our rates would have to move along with all our major trading counterparties. So, we're in a managed situation for quite some time. I think the pads stay on the wall, and we're at the beginning of that, not the middle, certainly not anywhere close to a change.
Eric Hundahl: And Leland, when you talk about creating partners, also we have to manage other central banks. If we look at what the Fed is doing versus what the ECB is doing, are they on the same course, or are there differences between the U.S. and what's going on in Europe in the credit markets?
Leland Hart: I think Suzanne said it before, an ECB started with any means possible a year plus ago, whatever, everyone's on the same page. Right now, it's keeping things afloat, I think everyone is on the same page. You obviously have, structurally, some differences between U.S. and Europe in two instances, but the amount of support has been unprecedented, and I believe it will continue that way.
Leland Hart: I also think from a rate perspective, notwithstanding different current rates, that people are sort of going to be in lockstep. And I don't think anyone's rates escape up or down because of those trading applications.
Eric Hundahl: Yep. And Suzanne talking about trading implications, currencies don't make the headlines that much, but there's obviously implications for currencies here. What's your view on the currency market?
Suzanne Hutchins: So I think, ultimately, with the amount of stimulus that has been undertaken by the U.S. Federal Reserve that the dollar does weaken, and that actually is quite beneficial, particularly for the emerging markets, for example.
Suzanne Hutchins: But the question is what currency does it weaken against? And I think that's really challenging, because Sterling isn't in great shape, and we've still got Brexit, which people seem to have forgotten about but towards the end of this year.
Suzanne Hutchins: And then with the Euro, I think that's quite an interesting one, because I think, ultimately, the Euro might strengthen versus the dollar if you get a north/south divide in Europe between hard core Europe, Germany, France, and the rest of Europe: Spain, Italy and Portugal. And I think that this divide may grow and, ultimately, you could actually even get a bit of a breakup of Europe.
Suzanne Hutchins: In which case maybe Euro would harden against the dollar, but I think that's actually quite a long way down the road. Currencies that we would favor more now are things like the Indonesian rupiah, and even the Mexican peso, and the Czech currency.
Suzanne Hutchins: But I mean don't be fooled, you can't really make much money in currency markets, there's a person on each side of the bed, so we don't try to. But what we do try to do is when we're investing globally is think, "Well, we're trying to generate returns to our dollar-based clients, so we got to make sure that our dollar values are being protected." And it's quite interesting from a volatility angle as well, there is opportunity to use currency to reduce risk and volatility in the portfolios.
Eric Hundahl: Thanks Suzanne. John, turning back to you and turn it back to the U.S., first quarter earnings season is well underway, almost over. What does any forward guidance tell us about what firms are expecting going forward?
John Porter: Yeah, well when it comes to guidance, I think the most telling thing is the lack of guidance. I mean, the vast majority of companies, for completely understandable reasons, are just choosing to pass on giving any guidance, and that's the prudent, rational thing to do.
John Porter: Again, coming back to the shape of the recovery, no one has a crystal ball to see what economic growth looks like for the next couple of quarters. Now there are businesses out there, don't get me wrong, that are not just surviving but thriving in this time.
John Porter: So you are seeing pockets of companies that are able to give guidance, those that are benefiting from this remote life situation that we're all experiencing. But the vast majority of companies are sitting here with a wide degree of uncertainty.
John Porter: I mean, what we're telling our analysts to focus on, because it's guesswork on what the economic transition looks like over the next three to six months, our focus is thinking about the other side, sort of a simple question. Sort of, "Give me a red, yellow, green. Is a business model improved as a result of this virus, weakened as a result of this virus, or largely unaffected?" And the reality is there's going to be very few business models that are unaffected by this virus.
John Porter:So our analysts are focusing on that question. That's where I think we can really have some really insightful work done to analyze the implications of this virus and who comes out of this stronger on the other side.
Eric Hundahl: Carrying on that conversation, John, we've also seen companies that, potentially, could be impacted by this cut dividends. What's your view on the dividend outlook moving forward?
John Porter: Yeah, but from a short-term time horizon you have to be very cautious on an expectation of dividends. I've seen analysis that we can expect is much as half of the dividend payout from the S&P 500 to be cut before the year end.
John Porter: I mean, the reality is ... And this is part of the sort of the growth versus value conversation, the companies with the highest dividend payouts tend to be more mature businesses. Businesses that probably aren't as in strong of a position to function well in this remote life environment that we're all experiencing, and so I think that's going to put an awful lot of pressure on dividends in the short term.
John Porter: Stepping back longer term, I think corporate balance sheets were in pretty good shape coming into this. I mean there was a lot of debt, but it had been termed out, it was at low rates. Liquidity wasn't bad for the average corporate company, I think we'll see a relatively quick return to paying those dividends out once there's an improvement in the economy, but that's not going to happen anytime soon.
Eric Hundahl: Leland, were you seeing the same thing, balance sheets better positioned coming into this?
Leland Hart: Sure. Like the case of the statement as John was just saying, the positioning of the borrowers, the investors, and the bank is relatively materially different today than where we started in the previous crisis.
Leland Hart: Some borrowers have borrowed on an absolute amount, it's more capital in the last, call it, 10 years and I've referenced before half of the investment grade market is BBB. And the reason that it's having a BBB, it wasn't because they were A companies getting downgraded, it was with rates being so low, cost of capital being so low, it made sense to borrow at that level; it was a very efficient capital structure. Borrow money, buy back your shares, that is what causes the BBB part of the market to grow.
Leland Hart: In the lower and below investment grade as well, leverage stayed moderate and really didn't move. But with rates moving lower, the average company's free cash flow, the amount they actually had to pay interests do CapEx dividends has been at an all-time high.
Leland Hart: So think about what bailed out most homeowners in the previous crisis. People took a big mortgage, more than they should have in retrospect, but when rates dropped down, their mortgage payments actually was reduced.
Leland Hart: And so for the last 10 years, companies remained actually relatively moderate on borrowing, but their cost of debt went lower giving them more free cashflow for the same amount of debt.
Leland Hart: So when it comes to the shock that we're seeing today ... You have to have customers in order to exist, but if you do have customers, and you're one of those companies that's still rolling, that cost of debt is actually not the hindrance it was when we started the previous crisis when the curve was plus or minus 5%. So better situated today than they were, certainly, as long as their front sign says, "Open." And not, "Closed."
Eric Hundahl: Okay. Suzanne, do you got anything to offer that? I see a smiling down there.
Suzanne Hutchins: Yeah, I do actually think that this COVID crisis has accelerated some of the trends that we are seeing around environmental, social, and governance issues, and I say that in reflection to some of John's comments about dividends.
Suzanne Hutchins: I think there's going to be a lot of focus on governance and capital allocation. And the sort of companies that, historically, have been doing extremely well are the companies that have been doing lots of share buybacks because of the cheap debt available that Leland's spoken about and haven't actually been investing for growth.
Suzanne Hutchins: And I think that there's going to be a lot of focus on governance. And I think as we come out of this crisis, whilst the private sector is actually being bailed out with individuals being furloughed and that's being, at the moment, subsidized by central banks, ultimately, I think the private sector is going to have to pay for a lot of this COVID crisis cost.
Suzanne Hutchins: And it may be through reduced dividend payments, it may be through reallocating capital. And so, I do think that ... I mean, this change was already happening before the COVID crisis, and we saw all this sort of social unrest rising.
Suzanne Hutchins: But I think it's being accelerated going forward and, obviously, on the environment angle, it's very pertinent, obviously, with the carbon emissions, the fact we're at home, less travel, I think there's going to be structural changes that are going on here. And on the S side, social changes. The way we go about doing business, the way we work from home; I think has significant implications on all of those fronts.
Leland Hart: I think Suzanne's raised an important issue. I think these ESG issues are really going to move even more to the front of investor's minds. This is what I've been talking to the Mellon equity team about, is this is really a stress test to really see how companies behave when their backs are really against the wall.
Leland Hart: And I think how they behave, what you see in terms of what they do for employees, what happens to corporate compensation schemes, and on, and on, and on with all these issues. I think this is a real opportunity to really evaluate these companies under duress, which is a much more telling time to see how they behave, what priorities are in the organization. It's easy in good times to do the right thing, what are they doing in this challenging time?
Eric Hundahl: That's a great point. So, let me stick with there, John and Suzanne. Obviously, this year is probably going to go down on record as the largest decline in CO2 emissions. Where are you seeing opportunities, or how are you reframing your ESG outlook in how you look at firms? I'll put that to John and to Suzanne.
John Porter: Yeah, I would say we're not really reframing it, I would say it's a matter of emphasizing. Because, again, this is a point in time to really evaluate corporate priorities and are they doing the right thing? And the right thing cuts across a lot of different dimensions; the environment is, clearly, an important part of it, but it goes well beyond that.
John Porter: Look, it's irrefutable when you step back and look at why people are evaluating the ESG framework around investments, the point of ESG, from a simplistic standpoint, is really that identify companies their long term value creators, companies are doing the right thing for their entire ecosystem, their supply chain partners, their employees, as well as their customers, are the ones that are going to add the most value for investors over a long period of time. I think this framework is a very elegant framework to look a company through.
Suzanne Hutchins: Yeah, I mean, I agree with John. And also, through this lens, it's important to understand the areas that you actually want to avoid. And, I mean, certainly we don't have to buy aviation companies and airline companies, we don't have to get involved in energy, particularly.
Suzanne Hutchins: And also, I do think that if you think about behavioral changes in the workplace, perhaps commercial real estate isn't, necessarily, a place that you want to invest in. so I think, actually, in many ways it does argue for the strong getting stronger.
Suzanne Hutchins: And, to your point, John, about the big debate around when you move into value, or do you move into value. I actually think that this environment is much more akin to the sort of nifty 50, structural growth, companies that are doing good for their employees, for the environment, and so are governed well as well.
Eric Hundahl: Thank you then. Leland turn it to you. You mentioned energy earlier and Suzanne just did, the energy sector is one of the largest sectors in the high yield bond market, and that suffered a little bit of double jeopardy there, what's your take on the energy sector? Is there permanent impairment there?
Leland Hart: Yeah, I guess it would be; the short answer. The longer answer is ... So, certainly, what we have to happen at the same time as the COVID crisis is a precipitous drop in oil, which has really put at risk maybe a quarter to a third of the energy companies in the index to begin with.
Leland Hart: But just as was being discussed by John and Suzanne, there's also what felt maybe at a slow current, but has picked up massively is first ESG matters, and rhe number of investors who globally own energy, not just in the high yield market in the U.S., but Europe as well also on the loan side, investors are really having an overlay of ESG onto their investments. And even if you, yourself, aren't a proponent of that, say, you also know that the number of investors who may be in that syndicate with you is dropping.
Leland Hart:And so you may not believe in ESG but you know others do, and given the market is not always perfectly efficient, but it gets there, that knowing that hey, if you want to own an energy company or a firearms company, or something like that, you might be okay with it, but not everyone else is; you're going to have to charge a premium for that, so we've seen that happen.
Leland Hart: And then finally, as I mentioned before, people are, quite frankly, tired thinking about energy because to be blunt, sort of like the currency comment made earlier, it's really hard to predict. It's really hard to have a macro view on every single producer. So, to get the supply side, demand side and then the macro curve ball that comes, it's difficult.
Leland Hart: And so what we're seeing is some energy companies that, historically, if you looked at their balance sheet would have no problem refinancing, it's becoming tougher; people are less willing to rollover.
Leland Hart: And so what this crisis has done is it's taken something that's already happening, a secular shift that's happening, and materially accelerated it. So, there are some decent energy companies, and I'm not saying it's going away, but that cost of capital has obviously increased, and the survivability of the average company has gone down depending upon what part of the energy process it's in. Again, it just accelerated a trend has already continued for vari- ... Not just one reason, but a number of reasons.
Eric Hundahl: Yeah John, something that's already happening, but potentially accelerating is just really the pace of innovation, which has been incredible. But, historically, that innovation has been concentrated in tech names, but now other sectors are experiencing that rapid increase of innovation. How does that impact the names that you're picking, and what's your view on that?
John Porter:Yeah, that's a really interesting point, because if you step back over the last 20, 30 years, we've been in this global macro environment of sort of a slowing growth. But underneath the covers, the pace of innovation has been picking up, and today it's happening at a speed that we've never seen before.
John Porter: So you have this sort of two contradictory forces of a very slow macro environment, but a lot of change underneath. What that means as stock selectors analyzing individual companies, which we do, is market share is more fragile than it's ever been before.
John Porter: This pace of innovation is putting market share at risk. Partly it's just with the raw pace of innovation, but partly it's the changing of our economy. I mentioned earlier sort of this digital transition. Every business, it doesn't matter whether you're an energy services company, or a medical devices company, or retailer or whatever, every business is becoming more data intensive.
John Porter: And you know that data intensity is leading companies to collect more information, analyze that information, make different business decisions; whether it's pricing products, choosing which products to launch. So, every company is becoming more data aware, and that's putting market share at risk.
John Porter: So what it means when you're analyzing these traditional industries is entrenched players maybe aren't so entrenched anymore. And then when you look at this innovation working through the economy, the winners of this digital transition aren't just the tech enablers, it's the companies that are leveraging these tools effectively.
John Porter: I mean, just look at as an example like Target. Target announced a week or two ago that their eCommerce sales were up 275% year over year; just a staggering amount. If companies like Target and Walmart hadn't ... Maybe they were late to the game, but once they realized they needed to pivot to eCommerce, they did it in a big way, and it's allowed them to continue to do well in this uncertain time. We've seen a lot of businesses that are like Target that have been thoughtfully making this transition to more digitally aware of businesses.
Eric Hundahl: John, we've talked a lot about, and we've heard a lot about winners and losers here. As you make active decisions, one area that investors have is that choice between active and passive. What's your view or role of active versus passive in this type of market?
John Porter: Look, I'm an active manager, so I'm going to believe in it. And I can't just use the academic evidence. So, when you look at academic evidence, broadly speaking, over a long period of time, active managers are having a tough time justifying their fees.
John Porter: That being said, active managers are much more aware of their need to deliver value on a number of dimensions for clients that you're seeing a lot of downward pressure on fees among active managers which is important. And then I think active managers do have a potential in a time like this, which is such a wildly uncertain time, to really sift through the carnage and identify the winners from the losers.
John Porter: So this is just a prime point in time where active managers can really add value for their clients. And I think when you look across the landscape, certainly at Mellon, we're seeing a significant number of our strategies that are really separating themselves from the pack in this uncertain time.
Eric Hundahl: Leland, would you agree? Have anything to add on the active, passive in the credit markets?
Leland Hart: Yeah. There's certainly a role in below investment grade where there is much more idiosyncratic, call it, noise and news and liquidity is less. There's still a role for passive, they haven't become passive funds, whether it's loans or bonds, haven't become such a driver, they're actually a hedge tool more than an outright ownership, call it, item for some investors.
Leland Hart: But our market it tends to be characterized by sometimes bouts of volatility and that when you look at the performance of passive within the space, they always seem to be buying at the high or selling at the low. But nonetheless, over a period of time when you're looking for pure exposure, it certainly has a role.
Leland Hart: But we're in a market, as I said earlier, where analysis is literally digging in and deciding, "Does a company have 10 days, 10 weeks, 10 months?" And making that decision, and that's something that, thankfully, hasn't been able to get scaled, but it's the nature of less liquid assets that we cover. So, there's a role for it as a compliment as opposed to a giant shift to passive within loans or bonds below investment grade in U.S. or Europe.
Eric Hundahl: Awesome. Finally, Suzanne. Any final thoughts as we wrap up here? Where do we go to from here?
Suzanne Hutchins: So it's not the end of the world, obviously, there are great opportunities. I do think there's a bit of a reset that's going on, and I do think that the next 10 years are not going to look like the last 10 years. So, we are going through some sort of transition, transformational change. And, hopefully, it will be good for society as well as, obviously, financial markets as well.
Suzanne Hutchins: So I'm a strong proponent of being active, but not only just at the individual security level, but I think that if you can explore a really broad opportunity set across multiple asset classes, then you can really diversify your income streams, reduce your volatility, and generate superior returns over the longer term.
Eric Hundahl: That's good advice. Leland any final thoughts?
Leland Hart: I'm agreeing with Suzanne very much. We're all going to get through this, but where we're all sitting individually a year from now, like a year from today? Maybe the same spot, may not be, but it will be different than how it was.
Leland Hart: I don't think there's any doubt in anyone's mind that you ... There're cycles and then their secular shifts. This is going to be both professional and sort of personal behavior, hopefully it should be for the better.
Leland Hart: That said for all of us, we're paid, our craft is picking winners from losers, thinking about how the bifurcation occurs, and looking for value. And nothing gives you the opportunity to prove that than a market dislocation.
Leland Hart: The worst thing for us is a market that's stable, everything does the same, and you're playing for a little basis points. Today all yields are increased, all the upside is increased, quite frankly, and doing your homework pays off.
Leland Hart: So I'm not sure whether I'll be in my office or my home office a year from now, but I know start going forward from an investing perspective, it's given a lot of opportunity to make a return that's greater than the risk by sort of digging in.
Leland Hart: And I think a lot of people are realizing, maybe for the last eight to 10 years, you could have been not asleep a lot of the time, but there was very little volatility, there was very little to truly take advantage of. Today it's not a bad place if your skill set's digging in and making choices.
Eric Hundahl: Okay, fantastic. John we'll give you have the last word here.
John Porter: Oh, it's a lot of pressure, thanks Eric. Look I'm a growth investor, the strategies I manage are growth oriented, so I'm an optimist by nature. And I'll sort of express that optimistic view, much along the lines of what Suzanne and Leland said.
John Porter: I think this is a reset for our economy that, in the long run, is going to be very powerful, positive trends. I know when I look at what's happening within our economy, we've seen an acceleration of tools like Telehealth or video conferencing that are very powerful, compelling tools that probably wouldn't be utilized nearly to the degree that they're being utilized today because of this crisis.
John Porter: I think on the backside of it, you're going to see some transformations in a lot of dimensions of both work and personal life that I think are going to be very positive for the economy in the long run.
Eric Hundahl: Well Suzanne, Leland, John, it's been a pleasure discussing the markets with you. Hopefully this provided our audience with ideas on how we could position portfolios as we, hopefully, move past the bottom here. Thank you so much for your time and your incredible insights. I really appreciate it.
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