MASTERCLASS: Multi-Asset Investing - April 2021

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  • 01 hr 02 mins 25 secs
One year into the new bull market, stocks have rebounded 76% from their lows, bonds have had a horrendous quarter with the yield curve steepening, and inflation has replaced the pandemic as the #1 investor concern. Two panelists discuss market catalysts, the impact of monetary and fiscal stimulus, and their multi-asset outlooks moving forward. 

  • Malcolm E. Polley, CFA President and Chief Investment Officer
  • Adrian Helfert, Senior Vice President, Chief Investment Officer, Multi-Asset

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MASTERCLASS

Jenna Dagenhart: Welcome to Asset TV's Multi-Asset Masterclass. The coronavirus crisis shuttered the global economy and sent the US into its shortest bear market in history. Now one year into the new bull market, stocks have recovered their losses to touch new highs. The yield curve has steepened, and inflation has replaced the pandemic as the number one investor concern.

Joining us now to share their outlooks, we have Adrian Helfert, Chief Investment Officer, Multi-Asset at Westwood Holdings Group and Malcolm Polley, President and Chief Investment Officer at Stewart Capital Advisors.

Gentlemen, thank you for joining us. And Adrian, starting with you here. Looking at the economy big picture, we finally seem to be recovering after the worst year for growth since World War II. What are your expectations for GDP, and do you think we can achieve the six and a half percent growth that the Fed is forecasting?

Adrian Helfert: Thank you for having me. We do have very strong expectations for GDP growth on the order of 6% versus a consensus of around 5.7%. It's still a very strong estimate. We're looking for good economic growth, not just good, but great. You have to look back to the '70s and '80s to see the level of real GDP growth that we are looking for this year.

In my humble opinion, I would say the Fed is generally cheerleading. So they are going to lead the environment. Six and a half percent is higher than what our expectation is. But the fact that we're talking about the possibility of six and a half percent real GDP growth, is pretty dramatic in and of itself. As I say, it's not out of order that we might achieve that.

And several others have that level of expectation for us to achieve. Should we see a reopening dynamic that is that strong, then we could get there. So the fact that we're thinking about that is a possibility. Now I'll go and say that I often think of the economic cycle and where this real GDP growth comes from in a very simple framework, which is confidence, I feel good, I can walk across the street, I can get a new job.

My wages are going to go up. My bonus is going to come in. Well, I'm not going to lose my job. That's good. Confidence means that there's consumer spending. I'm going to buy that useless toy for my kids that I put in the backyard or the fancy new red car. So there's consumption, especially discretionary consumption, which then leads to capital expenditure, companies buy machines to make more widgets that they can sell for those useless toys, that go in my backyard.

Subsequently, they hire people to manage those machines and hire people that manage people that manage the machines. So there are more jobs and jobs are kind of supply and demand. So more demand and static supply mean wages go up. Wages go up and I feel more confident. I can go across the street and get a job.

That's simple framework allows me to say, where's the ticks in the armor? Where is the growth going to come from? Confidence is still a question mark. We have not gotten back to pre-COVID times as far as consumer confidence, but that's the number one area right now that we're seeing consumer surprise as far as the economic data coming in. So that's a positive that we're seeing.

And that's why I think the Fed is cheerleading a bit up to six and a half percent and why the market is looking for such extraordinary. Other areas are doing reasonably well. Now, last I'll say that, if I just look at contemporaneous data, the Atlanta Fed does, what's called a GDP now forecast, that's running right about 5.4%.

It's been coming down slightly, but from around 5.7 to 5.4 from the beginning of the year to now, it's still running really well, but this is very expectational. We're expecting consumer confidence to come back. We're expecting jobs to continue... Or unemployment to continue to drop. Should that materialize, we'll see this 6% or six and a half percent for the Fed possibly, but we're still very positive.

Malcolm Polley: And I would agree. I think that the Fed is largely cheerleading. I would be surprised if we hit to the fence expectation of six and a half percent, simply because the Fed has traditionally been wrong, either on the upside or downside on what they're expecting for growth.

I do expect that the growth will be somewhat front-end loaded as the stimulus spending that's been going on really over the last half of last year. And the checks that have just recently gone out will certainly goose spending. But I think there are some structural reasons why the spending may not in fact be as strong as some are expecting, because there's a certain demographic that simply doesn't need to spend. 

And I think you'll see a continued increase in the savings rate as we've had over the last year. So while we're expecting growth to be dramatically stronger than it's been in quite a while, I really don't expect that it will be near that six, six and a half percent range that the Fed's looking at.

Jenna Dagenhart: Yeah. Now that's an interesting point. That even if we don't hit that six and a half percent, it's still pretty remarkable that we're even talking about it. 

Malcolm Polley: Yes.

Jenna Dagenhart: Now, Malcolm setting the scene for us, how would you sum up the current market environment across different asset classes?

Malcolm Polley: You know the market has been really interesting over the last year. You had the lowest point in quite some time in the second quarter of last year, when the market really fell apart pretty much across asset classes. And you've had the opposite extreme here with equities coming back, not only to recover the losses that they had, but in some cases hitting new highs.

You have had some degree of leadership change as growth is now underperforming value really since November. And tech names have kind of fallen behind a little bit. But from our perspective, pretty much across asset classes, prices have moved up very dramatically to the point that it's very difficult to find value.

                                                            Now I know that the market really breaks itself into growth and value based on quantitative metrics, but even amongst value stocks, prices have moved up pretty dramatically to the point that it's hard to find things that look very attractive today, as expectations for the coming year have really moved forward pretty dramatically.

I know that second half of last year you saw the market really discount the dramatic downward move in revenues and earnings, et cetera, that most companies had, and really kind of assumed that last year didn't happen. And then the concurrent assumption that 2021 would basically pick up for 2019 left off. It really caused Marcus to move farther ahead of themselves and they need be.

To the point that I really think we need to be cognizant of how much we're spending for the things that we're investing in, and cognizant that the moves that we have seen may cause people to make decisions that they wouldn't otherwise make for the sake of not being left behind.

Adrian Helfert: I'll just add to that, because that's a good point about not being left behind in this fear of missing out that we're seeing. Kind of tying that into the last question around GDP growth. It feels a bit like many of the valuations are reflecting a heightened growth arena for a longer period.

Where even if you just look at that Fed stat that you've mentioned around six and a half percent, 2021 real GDP growth, 2022 is only 3.3%, and it's some 3%, I believe for 2023. So we have to be careful not to get ahead of ourselves as he mentioned on projecting out this heightened growth beyond 2021.

Malcolm Polley: And that's something that over the course of my 30 plus years in this business, I've seen happen over and over again. The markets tend to extrapolate growth or recent expectations of growth indefinitely into the future. And as a result, you get kind of extreme pricing valuation differences. And I guess that's our biggest concern, at least at this point.

Jenna Dagenhart: Yeah, very valid concern and Adrian looking at value versus growth, where else are the effects being felt outside of equities?

Adrian Helfert:  Well, increasingly what we're seeing is that corporate bond investors are also looking at this, and these are corporate bond investors looking at yield spreads, because the effect has been so strong in growth over value in 2020. And as Malcolm mentioned, starting in about November of 2020 up until this year, it's been strong this year, moving the other direction in their value.

As interest rates have risen, corporate bond spreads have started to reflect a similar dynamic as equities often do. So corporate investors are looking similarly to energy corporate bonds to financial corporate bonds as outperforming in a heightened dynamic than they have in the past. 

Of course, we're looking at commodities as well and not just commodity-driven equities, but the actual commodities themselves, almost because of why this is happening. This is happening because of the heightened expectation of prospective economic growth, and driven by stimulus as well. 

That means corporate this year is up 15 plus percent. Oil is up 25 plus percent, lumber is up significantly probably around 50% this year. So this is being driven by perspective economic growth. Commodities are benefiting from that as well. 

Malcolm Polley: That's correct. I mean, commodity pricing has been very strong and copper in particular is highly correlated or has been highly correlated to GDP growth and concurrently inflation. We think that there might be some reasons why that concern about inflation might be somewhat overstated at least over the longer term. But that concern is certainly there as demand has outstripped supply. And you've got a lot of supply bottlenecks in place pretty much across the industrial commodity spectrum.

Jenna Dagenhart: Yeah. And we'll talk more about inflation later in the program, but before we get there, I want to look big picture at some of the market catalyst right now. Adrian, what do you think the biggest market catalysts are? Perhaps inflation?

Adrian Helfert: Besides inflation. I started my career in fixed income, which means given the asymmetric nature of fixed income, you can make that five points of upside, or you can be down by 40 points. I'm always looking for the downside risk catalyst. And if we look back and think what those catalysts have been over the last several years, they've been significant and we've kind of come through those.You think Brexit, you think Italy is too big of a boat, or I should say we need a bigger boat. You think of other areas like Chinese trade policy that we're just burgeoning out and every headline hitting was difficult, and the US elections. We're through a lot of those now, now we're going to be, I believe in 2021, digesting a new regulatory landscape as we have a new administration.

So we're going to be looking at how they're going to approach financials regulation. Obviously, we'll be talking at some point around corporate tax rate rise from 28 to prospectively 28... From 21 to 28%. That was a key part of the Democratic platform. And that'll have a significant impact on EPS or for companies as well. Those, I think are the lower catalysts.

 There's still the potential for gosh a new variant of COVID that isn't as by AstraZeneca or Moderna or Johnson & Johnson, or simply just a new lockdown created by an outbreak or something that happened, we don't achieve herd immunity. That's still a dynamic that we're seeing. But I think we're moving past that.

So the catalysts themselves... The largest catalyst is still COVID driven. Interest rates are one that are in the press. It kind of gets into inflation, which I look forward to later, because that's a key topic. But interest rates themselves rising. When we talk about that, we have to be clear that it's intermediate and long-term interest rates, not short-term interest rates. 

The Fed has said as clear as can be, that we're not thinking about raising finance interest rates. They are looking to let inflation go a little bit, to run hot. They are looking to continue to provide that monetary policy stimulus if you will, to the environment, which means the curve is going to steepen, intermediate interest rates are going to rise on the back of prospective economic activity. 

The reason I say that that's not the largest risk out there, is I believe we will see fits and starts from the equity market as they swallow a higher discounting rate, as they swallow a change in the portfolio balance channel from higher interest rates. But as long as it's driven by higher perspective economic growth, that's a different prospect than the Fed wholesale pulling a punchbowl.

So COVID is still a concern. Regulatory landscape, corporate taxes are something we'll be very mindful of. What happens with a potential move of Chinese tariffs, summit trade policy front over to diplomacy is something we'll be mindful of. And all of those are key catalysts. Now interest rates are that as well, but as long as that's driven by economic growth, I think we can get through that.

Malcolm Polley:  In my mind, I really think that interest rates are probably the biggest key, at least from our perspective in that, it really drives all returns, right? So treasury rates are largely viewed as a risk-free rate. Everything else is based on that, to the extent you expect yields to rise across the yield curve, specifically the intermediate and long-term range that raises the discount rate that equity owners need to use for valuing the securities or valuing the investments that they make.

As rates rise values come down, and you can, of course, offset that through higher earnings growth, but your biggest growth rate is going to be '21 versus 2020, because of the dramatic COVID downturn. The growth rate '22 versus '21 is not going to be nearly as high. And so I think, the big danger is that you're not going to be able to get over that longer-term, higher interest rate environment resulting in higher discount rates and therefore lower values and equities.

Jenna Dagenhart: Yeah. Malcolm with interest rates at historic lows and bond yields, practically nothing. What should income-oriented investors do? 

Malcolm Polley: So that's kind of the $64,000 question. You know? If you are an investor that requires yield you have always looked at bonds, because over the last 30 years, bond yields have generally been pretty good and you've gotten the benefit of declining interest rates. In fact, over the last 30 years, bond returns have been 10% or more on average per year.

                                                            We believe that we are at an end to this secular downward move in interest rates. And if that is the case, then the next secular move is up. And I'll bet there is a difference between secular and cyclical. The cyclical change in rates is really impacted by Fed rate policy on the short end and in shorter term economic issues on the longer end.

On a secular rate perspective, those moves tend to happen over 30 to 40 years. If that's the case, then those that are depending on income from bonds probably are not going to see very attractive returns. And so you're going to need to look at protecting the downside or an investment speak protecting against drawdown.

And you're probably going to want to look at investments that can at least provide you with above average income and the potential for growing income. And in our world, we really believe that means dividend paying stocks where you got companies that have had a history of paying dividends, have the capacity to pay dividends and have the capacity to increase dividends over time, which should mean much better cash flows to the investor. 

Jenna Dagenhart:  Adrian, how can investors capitalize on the steepening yield curve?

Adrian Helfert: Sure. Well, I mean, number one is this value versus growth dynamic. And I think Malcolm spelled it very well, is what the actual impact is. When I think about it, simplistically a big part of that is, these companies that we have extrapolated this large amount of free cash flow growth, not tomorrow or next year, but way out into the future. 

Think Square, think PayPal, some of these things that are transformational that... Well Tesla would be number one in the book of... Gosh, they're going to... Blade Runner 2054 their name is going to be across all the cars flying through the sky. That's the kind of valuation, which means large amounts of free cash flow, much into the future.

Without any change in the revenue trajectory of these companies, higher discounting rate means those future cash flows are worth a little bit less, which means growth could underperform. So as intermediate interest rates rise or yields go up, then growth is going to be more impacted than value. Value could perform well. So you look at those near-term cash flows.

You look at the cash flow profile of those companies in your portfolio. I think banks can do well. Not just because of that, but because of their business model, especially for the money center banks, they borrow short and they lend long. That means they want a higher net interest margin. They want a higher differential. 

So arising a steepening interest rate curve means a higher net interest margin for them. That's a strong source of possibility. Regulation is on the other side of that. We'll see how regulation is going to come down. We just saw some of that with the SLR regulation on the banks, and pulling back on their leverage capability. But banks are due to benefit from this.

Energy companies and commodity companies are potentially going to benefit. Gosh, I think I sweat a little bit when I even say that they're going to do well, because they'd been experiencing such a downturn. But we are in a period where we don't need energy prices to go higher. We need them to remain know minimally just stable. 

They can be cash flow positive where we are, and these are near term cash flows. We are seeing a steepening interest rate curve, because we were seeing perspective economic growth go up. As we have seen after every single recession cycle for the last seven turns of the cycle. 

I'll step back for a second and say, normally what happens is, and the reason we talk about the interest rate curve, the difference between a 10 year yield and a two year yield is when it goes to zero, when the yield on the 10-year government rate is the same as the two year government rate, it is supposedly a prognostication factor for an upcoming recession.

One paper published by Dr. Kim Harvey, my old professor on this, shows that this is a relationship we should observe. And after every single recession that interest rate curve, the difference between those two yields goes up to the north of 250 basis points, two and a half percent.

Now from where we are now, it could go further and I do believe it will go further from here. So we should be opposed to steepening interest rate factors. Now, commodities, real asset classes. So housing, other areas will benefit from this. Energy companies and banks can benefit from this, in part because of respective economic activity increasing, in part on the aspect of banks and especially regional banks having a better net interest margin impacting their income statement.

Jenna Dagenhart: Yeah, you raise some interesting points too about equity valuations particularly with growth. We talk a lot about the left tail risk, but not as often about the right tail. Do you think that there are any upward surprises that are not being baked into current valuations right now?

Adrian Helfert: Kind of as we discussed before and I'm interested to hear Malcolm how come on this. I believe as it sounded like he does, that we're projecting out a pretty good upward surprise as stands now. So we have to be careful on thinking there's going to be a 6% economic growth coming into 2022 kind of area. Now, we don't believe that's going to happen.

Other surprises could be truly more fiscal response, a Fed that is potentially even more dovish than they have been, but that's hard to really even see. They've gone down the path that said, "Don't worry, the punchbowl is there and we're going to spike it if need be". Now I do think we're already pricing in and we are near enough to the last downturn that those tools in the toolbox... The toolbox is still open and out.

And they're saying, "If we see a systematic risk emerge, we're going to add to the balance sheet, we're going to provide financial conditions to companies as we see financial condition closure or credit crunch". So I think we've already priced in a lot of the true right tail risk. That doesn't mean we can't capture upside from here. And I do believe we will, but I worry more about the downside risk. 

Malcolm Polley: And I would agree. I think that, with modern monetary theory being largely adopted around the world from Central Banks, we've had in this downturn and response to the downturn, $5 trillion plus in stimulus spending since May of last year to the most recent spending. As I look at responses over recessions in times past, this is the largest response to a recession other than the Great Depression that I can see in history.

It's just mind boggling the amount  of response that we put in place. And so I think the biggest concern should not be right tail risk. It should be rightfully left tail risk. And what happens when the Fed or when the Federal government has to start unwinding this? That's the one thing that keeps me awake at night. I don't have the answer for it. 

If you look at the debt service as of July and the Federal debt, it was $550 billion. And that's with an assumed average coupon rate on the entire yield curve of Federal debt of just over 2%. If you double the rate from two to four, which really isn't outside of the realm of possibility, your debt service payment goes from 550 billion annualized to 1.1 trillion.

Relative to a government budget of call it 25, $30 trillion a year. That's pretty dramatic. And it really means that there's a lot less room for discretionary spending outside of the spending that's being pushed toward non-discretionary things like government debt service. That really is going to be an issue that's going to need to be addressed at some point. But it's anybody's guess as to when that's going to happen.

Jenna Dagenhart: Yeah, on that note with all of the liquidity being injected into the system, Malcolm with more than $5 trillion in stimulus spending in the last 12 months to fight the economic impact of the pandemic and the national debt approaching 30 trillion, what impact, if any, will it have on future economic and market performance?

Malcolm Polley: I think that it really limits the impact that you can have from a fiscal standpoint. You really need to look from a monetary response and with interest rates at zero on a monetary standpoint, there is no powder left there. And so you're going to have to have interest rates from a monetary perspective, normalized, and it gets some spread above zero, so the Fed has some move to run.

If you're looking at traditional Keynesian economics in terms of deficit spending in order to correct economic mismatches, the key is not necessarily the deficit itself, but it's the size of the deficit relative to the size of the economy. Hence, $5 trillion in deficit spending, stimulus spending relative to an economy that is pre-COVID of 23 trillion or at the COVID trough of $19 trillion. That's a very, very, very large response. 

I don't know if we get into a recessionary environment in the next, say three to five years, which is kind of normal. Do we have the room to create a similar fiscal response? I think that the amount of powder that's available to do something certainly has been minimized, absent some kind of fiscal and/or monetary correction. So I think that it's really limited the responses. 

We don't know what happens on the other side of modern monetary theory, as you unwind. You saw the taper tantrum that the fixed bond markets had when a previous Fed share decided they were going to try and taper their interest rate environment, that could probably turn out to be a cakewalk based on expectations for further tapering at some point in the future, which will have to happen. 

So there's a lot of unknowns. We don't know what the responses to modern monetary theory are longer term. And I guess this is going to be kind of a wait and see. But my concern is as a strategist from years ago said, this is going to work until it doesn't. And when it doesn't work, it's probably not going to be real fun to be around.

Jenna Dagenhart: Yeah. Adrian, what are your thoughts on the long-term impact of fiscal stimulus?

Adrian Helfert: I agree. Do we have two hours for this?

Jenna Dagenhart: We need two hours, right?

Adrian Helfert: It's a great question, and just hearing Malcolm talk its great insight. I think similarly, what I would say is, I think we still have some powder to use in that, do I think we could have negative interest rates? I think we could have negative interest rates. Jerome Powell would disagree with me and he said so publicly.

But there's a tool in the toolbox for that. There is a tool in the toolbox for twist or buying longer-term maturity treasuries on the balance sheet to push down longer-term rates to push out the portfolio balance channel, if need be. Obviously, we could do larger repo operations and more short-term loans. That's been a large part of the liquidity impact that we've seen, not just the lower rates.

But the question which I know he's thinking as well is, does it really matter? Or have we reached a place where if we were to go to minus one on the short-term interest rate, would that have any effect at all? Or would it even scare people further out of risk assets and cause further downturn? I don't have the answer to that, but I do think about it quite a bit. So short-term, I would still say, I mean, what we have done is we've done short-term loans. We've done large-scale repo operations, we're holding down the front-end rates. This is why we are seeing a six and a half percent projected GDP growth from the Fed. This is why I'm thinking of 6% as an outlook for 2021, but that's short-term. This is still making its way through the system.

Medium and longer-term, I worry as he does, that, how in the world are we going to pay this back? How in the world... This is on our fiscal side. What does this lead us down? I don't have the answer. I think about modern monetary theory every day, and I can't tell you what's going to happen in the future. It's hard to think about how that manifest. We're globally already effectively going down that path. I think Japan has kind of led the way. And what they're doing is effectively helicoptered money. They are saying, "We're going to peg the interest rates at a certain rate". So the government could effectively say, "Okay, well, we're going to go out and spend 25 trillion yen of new projects," where the Central Bank would have to lend to them at a certain rate, would have to provide them with cheap financing. That's the definition of helicopter money.

They're kind of leading the way and it hasn't led to a crash, but nor has it led to high inflation or high growth. So medium and longer-term, I think this is a potential to restrain growth. 

If we actually do find a way to repay our debt, that's a really narrow path to go down because of what's called Ricardian principle, which is this idea that consumers like yourself and Malcolm and myself, they start to think, you know what? I may push out my savings, right?

To prepare for higher tax rates to come, because I know my liabilities to help repay the national debt load are going to be higher in the future. There's a mass psychology. That you have this balance between growth and our national debt, that is going to be a very narrow pathway.I think it keeps us from having a higher growth rate in the future. It's going to keep us subdued, but we'll try and navigate that. It probably pushes us further down the modern monetary theory path of effectively monetizing our debt.

Malcolm Polley:  I think it's interesting that you bring up Japan, because it is truly the Petri dish that we should be looking at in many regards. I mean, Japan's issue is structural demographic problems. I mean, their birth rate has been below replacement rate for decades. They have, for all intents and purposes, have not had any net immigration into Japan ever. We've started to see a little bit of immigration, allow a little bit of immigration recently. But as you age, your need to spend it because you want stuff declines and Japan's age is over that hump. So it's kind of like pushing on a string. You can give them more money to spend, but if they don't need to spend, they're not going to spend it. And we're starting to see that in the United States.

So even though, our birth rate has been below replacement rate for a couple of decades, it has been trending lower and the pandemic has pushed it lower yet. But the baby boomers who had been the largest generation in history are now... We're over 55, we don't need to spend a whole lot more. And in many cases are not. And if you give a demographic that already doesn't want to spend and doesn't need to spend more money, they're simply not going to spend it. They're going to put it into savings. Which is why I think you've seen the savings rate move up pretty dramatically over the last year. The last numbers I saw was at 20 and a half percent, but more interestingly, the savings rate has been trending up since the mid 1990s, because the boomers have been aging. So yes, as long as we keep saving, we'll be able to fund some of that and protect ourselves a little bit. But we don't know the end game because we haven't seen it yet.

Jenna Dagenhart: And $30 trillion today is not the same as $30 trillion in the future when you factor in all those interest payments, et cetera.

Malcolm Polley:  Not at all. Not at all.

Adrian Helfert: That's right.

Jenna Dagenhart:  I'm looking at monetary policy a little bit more closely here. Malcolm, how can investors protect themselves against these rising rates that we're anticipating, not in the short-term, but perhaps after 2024?

Malcolm Polley: Yeah. So if we are correct and we believe we're in a secular increase in rates, which means that you're going to have upward and downward moves in interest rates, both in the short and long-term from a year over year basis. But if the general trend is up over the next 20 or 30 years, then you probably want to move out of assets that are highly impacted by those downward moving rates, i.e. bonds.

So if you look at how bonds did in the last secular increase in rates from 1940 to 1980, fixed income returns on average were about 2%. Dramatically lower than what we've experienced over the last decade. It also really dramatically decreases the expected return from what we really have come to look at as a balanced portfolio and drags it down below kind of the 8% target that we have come to expect.

And in fact, have more than realized over the last few decades. It means that we probably need to focus more on risk assets, i.e. equities and looking at asset classes that limit drawdown. So it may mean looking at alternative assets like merger arbitrage and things that generate a positive, smaller, but generally positive return over time by limiting the downward move in the investments themselves. It may make people a little nervous in that it's going to move them out of their comfort zone, but if they want returns that are going to be even close to what we have come to believe as normal, they're going to have to shift their asset allocation mix. And de-emphasize fixed income assets that because of the structure of fixed income today and where we are in a normalized rate environment today, generally mean that the returns from those assets are going to be well below normal for quite some time.

Adrian Helfert:  I do believe that as well. What's been interesting and he talks about the 60/40, the traditional balance, which has included fixed income. Is that 40 pieces in part, because why do you hold fixed income? Generally you hold it for the income and you hold it for the insurance policy. 

The insurance policy means when equity markets drop, not all the time, but generally that means yields drop as well on risk-free rates. And thus, their prices go up, it benefits or it offset some of the volatility in your portfolio. If we experience a time like I think we will experience at least in 2021 of rising rates, along with rising economic output, that is concurrent or coincident with rising equity markets, then that is not going to be good for those investors. 

If we see a dramatic downturn or a swallowing of these rising rates by the equity markets, you have rates stay elevated, once again, that's not a good outcome for them. That's the key area there. I think the insurance policy can still be attractive to some degree. And I'm careful to not hold any exposure, because we've seen this story over the last several years of... I remember starting out 2020 with investors asking this question around, "Well, why do I hold fixed income at such low rates? I mean, how much lower can it go if equity markets sell off, is it really going to go down?" And of course, then it dropped dramatically during the global virus crisis, when Central Bank stepped in. Could that happen again? It could. So could they provide some buffer? Yes, they could not. It's less likely though. And we do live in a probabilistic world where we're looking at assymetry. 

Where we're looking there's more likelihood that it's going to provide you less of a buffer, and they are going to rise coincident with equity markets, than they're going to be your insurance policy. Which as Malcolm points out, leads us down the path of we're going to hold some interest rate duration or some fixed income for our investors, but we're going to look at alternative assets. I think he points to merger arbitrage, which is very precious and good. We look at convertible arbitrage in similar vein. It's income like, it's decorrelated with traditional interest rates that provides good return and income stream. So that's something we actively use in what we are doing as a sub-plantation of having your interest rate exposure for that income.

Now, it doesn't necessarily provide you with the insurance policy, but it moves you out of asset classes that are assuaged by markets going up or down. For the insurance policy, it's going to be an interesting question of, what the nature of the next downturn is and where we get to with that. So what asset classes will perform or not perform during that period.

Malcolm Polley: Right. And I think that, where we're at from an interest rate perspective is that insurance policy that bonds had traditionally filled, the potential return has gone... What you're trying to protect against is a negative result. And bonds have a lower likelihood of protecting against a negative result today than some alternative asset classes do.

Jenna Dagenhart: If interest rates do rise, do we need to worry about stock prices Malcolm? Will stocks do better than bonds? 

Malcolm Polley: Well, I guess it depends on the time period you're looking at. So in the short period as interest rates rise, discount rates drop, prices come down or values come down. So equities and fixed income securities are hurt in a rising rate environment.

Having said that, if we go back and look for instruction, the last time we had a major secular rate increase or increase in interest rates, which was 1940 to 1980 in particular, looking at that first 10 years, we see that even though discount rates rose, equities outperformed fixed income by a very wide margin. 

So the return profile and equities is still going to be preferable to fixed income over the long-term. If your time horizon is short term that's less of a positive potential there, because equities certainly see their valuations discounted very dramatically, and those valuation changes get reflected in equity prices extremely rapidly. But they also come back fairly rapidly. 

So if your time horizon is short-term, you probably don't want to move out the risk spectrum simply because you have less time to correct yourself and make up for a downward move. If your time horizon is longer-term, then equity certainly provide a much better risk return profile than fixed income asset classes.

Adrian Helfert: I think spot on. What's interesting here to me is that... And I mean, I go back to defining rising interest rates in the near term and rising interest rates in the near term is in immediate and longer-term interest rates. It's not the short rate to me. I think the Fed has given about as strong a statement as they can give. So we'll see that rising interest rate curve. And we put that at rising interest rates because of the impact of maturity or duration. 

Now on a portfolio, as long as that impact happens, a rising interest rate curve coincident with our perspective economic growth coming in, equities now will lead bonds certainly. And pointed to as well income oriented equities I believe similarly on that front. So high dividend equities will be a key area to be in, especially if we see rising inflation, not coincident with that.

When the Fed decides to pull the punchbowl or insinuates they're going to pull a punchbowl or starts even stopping drinking the punch, whatever the next analogy is, then we'll start to get concerned. And historically, we've seen that concern after about the first hike when you see those tantrums happen. And right now that's still a bit of weight. So equities, I very much agree with what Malcolm said, on the side of equities are a better place to be on a medium and longer-term basis over fixed income. When we see a correction that is due to the Fed stepping back or restraining potential growth by saying they're going to reign in the economy, that's where we see the risk on, risk off effect, moving to a risk-off.

Malcolm Polley: Right.

Jenna Dagenhart: Yeah. And looking at performance so far on the first quarter of 2021, it's been one of the worst periods in history for bonds. What's causing this Malcolm, and is this something that we should expect to be more normal?

Malcolm Polley: Well, what's causing it really is the interest rates environment. So as I have taught in finance classes, as rates tend towards zero, then duration trends toward maturity. So by definition, the longest duration bonds are zero coupon bonds. They're also the most volatile in terms of absolute performance based on interest rate moves.

So as interest rates have moved towards zero pretty much across the yield curve there, it really means that if interest rates go up, you're going to get a dramatic downward move in price. And that's really kind of what we've seen so far this year. As you have seen, particularly the longer end of the yield curve moves up from sub 1% on a 10 year to now 1.6, 1.7% on the 10 year, you really had very little protection against the rate rise. I think that over the longer-term, you will see that continue. As interest rates continue to go up, durations across the interest rate spectrum are as high as they have ever been, which really means very little wiggle room as interest rates rise. 

You may have some short-term opportunities where you can capture perhaps some price appreciation based on shorter-term interest rate movements. But the longer-term general trend is up in rates, we believe. Again, longer-term, not necessarily the Fed's perspective. And if the longer-term trend is up, then the return profile of bonds pretty much across the yield curve is down. 

Jenna Dagenhart: Yeah. And with the steepening yield curve and significant fiscal stimulus that we've discussed, there seems to be an increasing concern about inflation. In fact, inflation has replace the pandemic as the number one investor concern according to a new Bank of America survey. Malcolm, in your opinion, are these inflation fears warranted? You mentioned earlier, they might be a bit overblown?

Malcolm Polley: Yeah. I think people point to the rise and dramatic rise in M2 as the reason why inflation is going to be a problem. Now M2 is a money supply. Yes, it has exploded this year. But it has generally been rising for quite sometime. The most recent increase not withstanding. We think the real issue, the real thing you need to focus on is the velocity of money, which is basically the speed with which money moves through the economy. The velocity of money has been declining for quite some time. MZM, which is the broadest indication of money supply has been declining for probably 20 years. Now they have discontinued use of MZM because the definition of institutional money market has changed, so that's no longer going to be a part of that series. But even if you look at M2, M2 velocity has been declining quite dramatically. You had a huge downward move in velocity last year, and while it's ticked up ever so slightly, it really hasn't been enough to create that much concern in our mind. So over the intermediate term or over the short to intermediate term will inflation tick up? Probably. But we're not talking from zero to two, to 5%. People are concerned about the last major inflation epidemic, which was in late 1960s, 1970s and 1980s. When you had fed funds in double digits. I don't think we have to worry about that. That was a statistical outlier.

It's much more likely that inflation goes above 2%. In fact, the Fed has said they're going to let it trend above 2% for awhile. And quite frankly, 2% inflation should not give people that big a cause of concern. It does mean interest rates will rise, it does mean the yield curve will steepen, but it was just a year ago when the yield curve flattened that we were concerned about a recession. What people forget is an upward sloping yield curve is normal. That simply means the expectation is that the economy will grow. And if the economy grows, then inflation will probably be a positive number, not a flat or a negative number.

Adrian Helfert: I was going to add as well that when you look at the inflation curve on the back of that as well, you can look at the break evens, or the difference between a nominal bond and an inflation like bond. So that's your expected inflation. And your two-year expected inflation right now is about 2.7%. Gosh, the amount of questions I get from investors around 2.7% inflation, pretty dramatic. Where we're talking 2.7% inflation, and as Malcolm mentioned, this is not the 1970s. But I suppose it does come into the conversation when we think about the response of the federal reserve, of are they going to react to higher inflation? It's over the 2% metric. They've said they are going to let average inflation run its course so let it run hot.

When you think about that breakeven curve though, that's 2.7% for a two year breakeven or expected inflation, but it's downward sloping. And you look five years out, you look 10 years out, 10 years out, it's around 2.3%. So the general expectation or the concern is short-term is all of this flood of liquidity that we've been talking about. Is that going to lead to heightened inflation or is that left tail going to materialize out of the 1970s and strong input? I follow the same indicator as Malcolm does on velocity of money. All that liquidity is still finding its way into the hidey holes and not moving around. And until it moves, until it transacts, until it changes hand, until it leads to real prices going up, then the last velocity of money is something we're going to watch.

It is interesting though, when you do it. I ran my own basket for inflation and just view it across various prices, there is some inflation here and it's in a basket of goods, which is certainly commodity driven. And when we look at stimulus, that's no surprise. 

So I'm not saying inflation is not a risk from my perspective. Now we'll see when it makes its way into a real basket of consumer products. That's when we have more of a concern of it leading to a restraint on economic activity, that's where it really hasn't hit so much yet. Wage inflation is stronger than core CPI, so your balance sheet is looking a little better. What we'll watch for is when that commodity inflation, when that house price inflation makes its way into your core basket of goods enough that it's going to impact your relativity to your wage increases, that's where it's a concern on economic activity.

Malcolm Polley:  Right. You know, it's interesting to note as you look at expected inflation, if you look at forward expected inflation, it has always overshot reality. So, we tend to fear a lot more what inflation might be than what it actually turns out to be. I would concur that, what we need to worry about is when housing inflation takes over. The median home price is now some like $318,000, which brings some concern in terms of affordability. That doesn't necessarily lead into the inflation figures because that's owner equivalent rents. If rental prices start moving up, which that will have a bigger impact on inflation, because owner equivalent rents make up such a large component of the inflation number.

Jenna Dagenhart: Malcolm, is gold a good investment if you believe that inflation will rise? What about commodities in general?

Malcolm Polley: So, I get that question a lot about gold. People believe that gold is a storehouse of value. In actuality, it's a horrible storehouse of value. If you believe it's a storehouse of value, you're not a student of history. Gold can be devalued and has been devalued over time. When the United States was on the gold standard really prior to the Bretton Woods or better yet prior to the Great Depression, you had runaway inflation when people started worrying about a weak currency, moving from gold to silver, et cetera. And back in Roman time is you devalued gold by mixing it with some other type of metal and getting a lower quality alloy. Gold is a bad inflation hedge. Gold is a good hedge against the declining dollar. So if you're looking to hedge against currency, you're really trying to make a decision is the dollar going to be strong or weak? And if you believe the long-term direction is weak, then you probably want to own gold.

I mean, look, gold has no intrinsic value. There is no cashflow. The only cashflows are when you buy it and you sell it. And so if you are buying it today at whatever price is today, the only way you're going to make money in it, is if you're able to sell it at a higher price than what you paid for it.

In the investment world or in the equity world, that's called the greater fool theory. So from a cashflow perspective, it's not a good investment. Having said that, we're probably one of the few economies in the world that does not have gold as a specific portion of their investment portfolio.

Commodities probably are just a broader based commodities like copper and oil and platinum and so forth, are probably a better hedge against inflation than gold specifically. And therefore a basket of commodity is probably a better bet than simply focusing on one.

Jenna Dagenhart: What about cryptocurrencies, Adrian? I know Venture J. Powell recently reiterated that he thinks there're an unstable store of value, but many investors seem to think otherwise.

Adrian Helfert: Well, I would agree broad cryptocurrencies are difficult. You could see a washout where we lose that correspondence with confidence in those currencies. And that's the scary aspect. What Malcolm just said a lot of that is very right. I believe there is no intrinsic value. There's no cash flow associated with these things.

It's a finite supply that is driving the valuation on these. But a finite supply doesn't necessarily mean it's worth a billion dollars. I mean, I've got a finite supply of the old Budweiser glass in my cabinet, but that doesn't mean it has any worth to me. It's just what we ascribe to it with our confidence as a storehouse of value.

Or secondarily, in a broad systematic event, kind of storehouse value. But I think gold will experience an upswing if we were to see a broad loss of confidence in the US dollar which is exactly what Malcolm was saying on the downtrend of the dollar valuation. So cryptocurrencies as a broad asset class, I worry about the washout that could happen there. Bitcoin is a little bit of... I mean, well, they are first-mover advantage and they have put themselves in the economy enough now with banks facilitating with several companies, putting our balance sheet into Bitcoin.

Tesla came out this morning and said they were going to accept payment for Tesla cars in Bitcoin, and not subsequently sell Bitcoin but hold it. That increasing usage of that cryptocurrency individually could mean the acceptances there that takes away one of my greater fears, which is that the Central Bank would come out with an alternative cryptocurrency or a store of value or some kind of blockchain implementation, that would take confidence away from everything else.

I think that's unlikely. But that would obviously take confidence from 80 to zero very quickly. And that's a concern for broad cryptocurrency investments.

Malcolm Polley: Yeah, it's interesting. I get that question a lot about cryptos. And what I go back to is what is the definition of money? It's the medium of exchange? At one point in a barter system, you were exchanging commodities. If you need a cow, you could exchange wood or other food for that cow. People use precious metals as a medium of exchange. There is a society that uses very large stone spheres, not real practical to carry around, but that as a medium of exchange. It was easier when we moved from using a hard currency, like a Goldback currency or a Silverback currency to a currency that used Fiat money, which is backed by a promise to pay, but it is backed by something. The question I often put to people in regards to cryptos is, what backs cryptocurrency? And the answer is nothing. There's no promise to pay. There's no hard asset behind it. It's simply an electronic digit, if you will. Whose price goes up based on supply and demand. Because supply is limited, as demand goes up price goes up. That in my mind is not something that makes sense to be used as a medium of exchange. 

Jenna Dagenhart: As you alluded to earlier Adrian, asset allocation is a lot more complicated these days, no longer just 60/40 portfolio. How are you employing different alternative strategies and diversifying as you construct your portfolios?

Adrian Helfert: Good question. On asset allocation, I am increasingly looking for decor-related, not just anti-correlated, but decorrelated income areas when I look for income. As we spoke about earlier looking at merger arbitrage, convertible arbitrage, high dividend equities is an area that I weight greater. And the one thing that is going to be interesting about asset allocation and the future that it always has been. But I think we're seeing more of that transition today in part, because of what we have talked about with rising rates, is when you think about asset allocation, it is an objective exercise and a subject of exercise. It is one that uses data to say these past relationships will lead to the best asset allocation across a broad mix of assets. And then the subjective insight to say, this is what I think is going to perform the best. The objective component of that relies on past relationships.

Those past relationships may change because interest rates are rising. Now, if we move from what has been a 30 plus year bond yields falling cycle to the reverse, then we may be looking at changing our asset allocation models and we should be doing so quickly because we're not going to capture that and looking at past data. So that's an important thing for asset allocators to think about. We put maybe more weight on the subjective element of asset allocation of thinking about what relationships are going to look like going forward, using decorrelated asset classes in our asset allocation in order to move away from what could be a risk and the asset allocation model itself.

Malcolm Polley: It's interesting because we, as investors use historic data to create our asset allocation models or mean variance optimization models. Back when modern portfolio theory was incepted in a paper in 1952, you really basically had three asset classes, stocks, bonds, and cash.

You can fast forward to today. We have taken in my mind, the law of diminishing returns to ridiculous extremes, and we've created sub-asset classes of sub-asset classes in order to try and justify diversification. And the reality is there's not a long enough timeframe of historical data across a wide enough variety of economic and market scenarios to understand what exactly happens if you get a secular upward move in interest rates, for example. Quite frankly, I think more than half of all asset classes or investment categories in existence today were created since 1980, which is basically when interest rates peaked. And so you have no clue what's going to happen to them as interest rates decline. We in the investment community get so focused on the risk being a variability of return that we've forgotten that for the most average people in their mind risk is loss.

And as you move toward retirement, as we boomers are doing, risk of loss really becomes a bigger concern than variability of return. And if that's the case, you need to really focus what you're doing and try and take away those risks. So we would agree, focus on non-correlated assets, assets that minimize as much as you can the risk of drawdown or risk of loss and coupling that with asset classes that should over time provide above average returns, which in this case means equities.

Jenna Dagenhart: And as we wrap up this panel discussion, I think the big question that's back on a lot of people's minds Adrian is, where does it end? And when it does end, how deep is it? What do you think are going to be the best and worst performing asset classes in the next downturn?

Adrian Helfert: Oh gosh, that is a question on every...myself included. Where does it end? Well, hopefully it ends at a much, much higher level, because we're prepared for that, as is the market. What is the cause of that end? What is the catalyst that leads to the risk-off scenario that we're concerned about? We've talked a lot about interest rates, and as I say, whenever we talk about rising interest rates, I'll get back to that. I do believe that rising economic conditions or prospective economic growth will... That's okay. We can swallow that as risk-on conditions. So, commodities rising, equity markets rising.

When the Fed decides to restrain economic growth by effectively pulling the punchbowl and saying, "Well, we're concerned as we were in 2014, 15, and Lael Brainard came up with this paper around financial market bubbles, and that kind of concern. That's going to be a concern and a correction, maybe not unhealthy as a correction in the long-term. As we've been talking about here, markets are extrapolating out already a pretty extraordinary growth potential. So it may not be unhealthy to have a bit of a drawdown in the market, I don't think it ever is. But when that happens, the biggest concern in catalyst is the Fed coming in and trying to manage what has been an extraordinary monetary policy cycle and elevated ballooned up the balance sheet. The fiscal responsibility, modern monetary theory, those things, those conversations will continue. I don't know where we're going to get to, or what the catalyst is going to be there. The usual, where does it end or concept, it could be that we have these zombie companies walking around that have just been just keeping on their footing because of good credit market conditions after the Fed decided to buy corporate bonds out of the balance sheet and underwrite systematic risk, and so we see an elevated default cycle.

Historically, that is one area of concern. An elevated default cycle, that's not a true systematic risk could lead to a credit crunch, could we do a downturn? We would be concerned about that. As of now, we're still near enough. As I say, the toolbox is still open and they're still shiny. You've got the crescent wrench still kind of hanging out. The Fed is prepared to manage systematic risk. The further we get away from that, the further these potential zombie companies kind of limp along, the worst the downturn could be. So as of now, I think we are still in an area that the potential drawdown risk is... Well, the probability of it happening is higher than the actual drawdown itself, because of the amount of control that has been exerted by fiscal authorities and monetary policy authorities. 

The further we get away from that, the more that the Fed is willing to swallow a drawdown, because they're concerned about financial market bubbles, then the worst of drawdown could be.

Malcolm Polley:  I mean, there are three real things that the market concentrates on. It's the known knowns, the known unknowns and the unknown unknowns. The first two, you can discount, you kind of have an idea of what they are going to be. The third you can't, because you don't know what they're going to be. When markets are concerned, they always look at the cause of the last major downturn as the biggest risk. And that in reality is never the biggest risk. So, I think we can probably discount that as a potential. So, what the next cause of the next major downturn is going to be, it's kind of anybody's guess.

But the best defense, in this case, is keeping your eyes and ears open and questioning everything which is a good practice to have.

Jenna Dagenhart: Well, I wish we had two hours, but unfortunately, we don't. So, we better leave it there. Thank you both so much for joining us.

Malcolm Polley: Thank you very much.

Adrian Helfert: Thank you Jenna. Thank you, Malcolm.

Jenna Dagenhart: And thank you for watching this Multi-Asset Masterclass. I was joined by Adrian Helfert, Chief Investment Officer Multi-Asset at Westwood Holdings Group and Malcolm Polley, President and Chief Investment Officer at Stewart Capital Advisors. I'm Jenna Dagenhart with Asset TV.

 

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