Pillars of Investing: Addressing your most immediate investment concerns

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  • 01 hr 27 mins 05 secs
Welcome to our Pillars of Investing Masterclass, this 4 part program is structured for Continuing Education credit and will dive into the how and why various asset classes and strategies should be considered for clients' portfolios in 2022.

Pillar 1: Alternatives
Pillar 2: Fixed Income
Pillar 3: Muni Bonds
Pillar 4: Equities

  • Eric Hundahl, Head of Portfolio Strategy, BNY Mellon
  • Suzanne Hutchins, Portfolio Manager, BNY Mellon
  • Albert Chu, Portfolio Manager, BNY Mellon
  • Gautam Khanna, Head of US Multi Sector Fixed Income, Insight Investments
  • Brendan Murphy, Head of Global Fixed Income, Insight Investments
  • Daniel Rabasco, Head of Municipal Bonds, Insight Investments
  • Brian Ferguson, Senior Portfolio Manager, Newton Investment Management
  • Roy Leckie, Executive Director, Investment & Client Service, Walter Scott & Partners

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Eric Hundahl: Hello, I'm Eric Hundahl, Head of Portfolio Strategy for BNY Mellon Investment Management. And welcome to our Pillars of Investing Masterclass. This is a four-part program, which is structured for continuing education credit. And we'll dive into how and why various asset classes and strategies should be considered for client portfolios in 2022.

Eric Hundahl: Turning our attention to alternatives, on top of mind for most investors has been inflation and the asset class implications. The reason why many are focused on inflation is that it's a major regime shift to what we've been accustomed to in recent years. To help discuss how investors can use alternatives to mitigate portfolio tail risk associated with inflation is [Suzanne Hutchins 00:00:54], Portfolio Manager for BNY Mellon Global Real Return Strategy, and [Al Chu 00:00:58], Portfolio Manager for BNY Mellon's Natural Resource Strategy.

Eric Hundahl: Both of you manage strategies where inflation is a considerable component to how you invest. But you do it in very different ways. Suzanne, can you share with us the objective of Global Real Return, and how you seek to achieve that objective?

Suzanne Hutchins: Thanks very much, Eric. Well, we don't call Real Return real for nothing. The objective of the strategy is to make returns that beat inflation over the longer term, plus four percent against cash. So the objective is an absolute return objective, which is obviously inflation-related. And it's also to seek to achieve that return with volatility between that of equities and bonds. So we're trying to achieve a very smooth ride in terms of the journey for our clients, in terms of the return generation and the distribution of those returns over the time scale.

Suzanne Hutchins: Now the strategy is a multi-asset unconstrained global approach. And the way that we think about the strategy is individual security selection, with a very nimble and flexible approach to asset allocation. And we have a dual objective, which is to generate returns, but also to help preserve capital on the downside. So the remit of the strategy is very unconstrained and very appropriate for an environment where the world is changing and shifting dramatically. And we are moving into a much more inflationary regime.

Eric Hundahl: Thanks Suzanne. Now, Al, natural resources has a very different approach to investing and inflation. Can you explain your approach?

Albert Chu: Sure, Eric. Yeah, our strategy's more unique. We invest in equities for natural resources companies. And this runs the gamut. It could be oil companies, refiners, agriculture, metals and mining, pretty much anything related to natural resources or the industries related to natural resources. The mandate is global. We look everywhere, as well as across various market caps. One of the, I guess, unique factors in this market is that our sectors are one of the direct contributing inflation, as much as the... Of course, CPIs excludes food and energy. Most part of inflations, right now, are affected by our areas. And this is the tip of the spear. You could look at it that way, the actual producers of oil, the actual producers of grain. So, in that sense, this is probably as direct touch to the inflation thesis as we can, right now.

Eric Hundahl: Yeah. You touched on that. But let's expand upon that, Al. Unless you've been around in the '70s, you've never really experienced inflation at these levels. So we really don't have real-life experience in managing inflation and portfolios. How are you thinking about this? How are you thinking about the drivers that you mentioned, both from an economic standpoint, but also from an investing perspective?

Albert Chu: Sure. the... In a certain extent, my job is simple. I look at two things only. I look at supply, and I look at demand. When I see the gap between the two narrowing, it's time to go look for something else that has a better risk reward. When I see the gap between supply and demand widening, that shows that we are still in the very early cycles of this commodity cycle. When we go look across the spectrum right now, particularly in energy and in food, being agriculture and grains, I think we are seeing only the tip of this iceberg, this commodity iceberg. We are seeing very little. And, in the next several years, we're going to really see, below the surface, what a decade of a bear market of policy mistakes, how it's going to manifest itself in supply chains, and pricing, and inflation, and volatility, and, honestly, just a new paradigm.

Albert Chu: And I think what you said about the seventies is probably the most accurate. This is a supply shock. Most of us have not invested through those periods. So, at this point, you probably need experts like Suzanne to help us navigate to this. But the commodities are definitely, I think, in a very interesting point, secularly and cyclically.

Eric Hundahl: Fantastic. And Suzanne, in some ways, the current market dynamics shouldn't have been a big surprised. We had high equity valuations, very low interest rates, and record stimulus. That's going to present challenges to the market. And BNY Mellon and you, in particular, have been expressing the need for larger allocations to alternative investments in portfolios, for some time. How important is it for investors to include alternatives in their portfolios today?

Suzanne Hutchins: Well, I think it's very important in this market where, I strongly believe we are in a bear market for equities, right now, where you do get very strong bull market rallies. But, if you're trying to generate a smooth return, what you need in that environment is diversification, diversification across a broad number of asset classes, a broad number of different companies and sectors. And the use of alternatives provides that diversification, as well, in terms of correlation to equity markets and the [inaudible 00:06:45] markets, and the diverse return streams that you can get from alternative assets.

Suzanne Hutchins: Now, alternative assets encompass a broad range of different securities. And I work very closely with Al on the commodity side. And he generates a great deal of recommendations within alternatives. And that would include things like gold, for example, and metals, and the equity miners, and other commodity-related plays. But there are other alternatives that we've got in the portfolios. So, for example, we've got exposure to renewable energy and infrastructure. And these are listed securities, closed-ended funds. Some of them are equities that very much have an inflation built-in component to them, contracted to the power price. And what they provide in the portfolio is a  higher income stream, because they pay out a lot of their return stream, plus also an inflation component because they are price and inflation-linked.

Suzanne Hutchins: And, when you look at the total portfolio's shape, and compare it with the equities that we own in the portfolio, you will find that this asset class actually does provide diversification benefits, risk diversification benefits, and lack of correlation to equity markets returns. So a much stabler part of the return stream.

Eric Hundahl: Thanks Suzanne. And, speaking of return assets and defensive, BNY Mellon Global Return Strategy is comprised of two broad and elastic allocations. This return-seeking core made up largely of risk assets, and this stabilizing layer made up and defensive assets. And, based on your outlook, you can flex between those two. What is the current balance between those allocations? And what's your outlook, going forward?

Suzanne Hutchins: Sure. So we think about managing the structure of the portfolio through the cycle. And, obviously, we use the framework of themes and structural trends, which help us to allocate risk and capital in the portfolio. And, as you've alluded to already, we are in a different regime shift, going on. And the backdrop for the market is much more challenged, given the higher inflation environment that we've referred to, due to supply chain disruptions, supply/demand issues around commodities, but also in other factors, such as, obviously, the Ukraine War and also China slowing down, as well, is creating a lot of challenges.

Suzanne Hutchins: And the liquidity backdrop is also tightening with the higher inflationary regime. So we've been reducing our exposure to risk assets primarily within the equity space, and taking it down significantly from 12 months ago. So net equity weight in the portfolio is closer to 39%, whereas it had been as much as around about 70%, through the middle of last year. And the mix and construction of those equities is very different, now, to what it was then.

Suzanne Hutchins: So the shape of the equity mix is much more defensive. So areas particularly within pharmaceuticals, aerospace, and defense, for example, short duration assets, energy, commodities, and the areas that we've taken money out of, are the longer-duration assets that are much more sensitive when interest rates go up. So that's the area of growth, particularly. And unprofitable growth, which would be very much impacted for this higher rate regime.

Suzanne Hutchins: Elsewhere, within the return-seeking core, we've got a further 12% to alternative assets, which is the renewable energy company's rates, for example, film rights, exposure to pharmaceutical companies, lending, as well as a small amount of risk premium strategies, which are structured products which generate a systematic return.

Suzanne Hutchins: So that portion of the portfolio has a lower beta to the equity market and provides very consistent returns to the overall income for the strategy. And then, on top of that, within the return-seeking core, we've got a further five percent in high yield debt. But it's a very specific area of focus, which is in contingent convertible debt, which is basically European banks capital, where we think that the banks are very well capitalized. The income generation around them is very secure and they provide a very good return stream, compared to other fixed-income instruments.

Suzanne Hutchins: And then, we've got a very small amount in emerging market debt. So it's a very focused portfolio, within stabilizing there. Right now, we've got a lot of cash. We think liquidity is key in this environment. We don't ever want to be a full seller. When markets go down, we don't leverage this portfolio. So we do never become full sellers. We have got quite substantial amount of gold in the portfolio, both through an ATC and gold miners, which helps as an inflation hedge. But it also helps as an alternative currency, where fear money is being devalued. And then we've just slowly started to introduce some developed market duration in the portfolio when yields reached around about three percent on the U.S. 30-year and 10=year.

Suzanne Hutchins: So markets forward-looking. They've already started to price in considerable rate hikes, to which power is already advertised. Inflation is probably the rate of change of it is starting to peak and probably likely to decelerate, although inflation rates will stay elevated. And that means, therefore, that you want more real assets in your portfolio. That bonds will start to become attractive, but particularly you want some inflation protection through the real estate investment trust alternatives and the commodity-related securities that Al Chu has already spoken about.

Suzanne Hutchins: So we think it's going to be a very challenging backdrop. You need to be nimble. You need to be flexible. And you need to have a good eye on capital preservation. Equities will be under pressure, where they are highly valued, and where margins are under pressure because of interest costs. Labor inflation and cost input costs will mean that margins were under pressure and, where companies are highly valued, there will be a D rating. And, when interest rates go up and your net present value of those securities go down, again, that will cause further pressure for the equity market. But, as active stock pickers, there are always, always great opportunity. And we love volatility for that basis.

Eric Hundahl: Thanks for that detail, Suzanne. And, Al, I think the market would agree with Suzanne, that we need more real assets and particular commodities, as we've seen a run-up in commodities lately. But, prior to the run-up, we actually saw a very long bear market in commodities, leaving investors to wonder what makes this time different. And is there still time to invest in commodities? What's your take on that?

Albert Chu: Yeah, that's the million dollar question. I think it's important to distinguish what drove this cycle. It started out as a normal cycle. Believe it or not, for the past two decades, commodities demand across the board energy, oil, natural gas, food metals, they've pretty much gone up on a pretty straight, steady demand trend. With exceptions of COVID and the GFC crisis, demand for commodities, our consumption of everything has gone up. That's been a long-term trend. Why has prices been going down was simply, in the early 2000s, we had the China-driven cycle, a rural economy suddenly becoming an industrial powerhouse, urbanizing and being modern. That soaked up a ton of commodities. That was a very famous, so a demand-driven cycle for the supply driven cycle.

Albert Chu: And, in the preceding decades, we got very good at finding it, whether it's hydraulic fracture, unlocking massive reserves in the U.S., or GMO and precision farming just making yields in farmlands, globally, that's just more and more productive, we found more and more. Natural gas is a great example. Every year we consume more. In China, it's grown exponentially, U.S. natural gas have displaced coal, to a certain point, almost entirely. Yet, prices went in a straight line down because we found too much of it.

Albert Chu: But what does a 10-year, 10-plus-year bear cycle do? Well, very little pipelines were built. Very little... Actually, no refineries were built in the U.S. Then, we weren't thinking about offshore wells. Meanwhile, demand kept on, going up. You know, COVID was, I think, a head fake. We thought everybody was going to be in the metaverse. We won't need to eat real food or drive real cars. But, within the course of a year, we found vaccines. The global economy, lives resumed. We went back to the office. We went out again. People started driving. Demand came back, not above trend, after trend. But the problem was, supply didn't.

Albert Chu: Now, in commodities world, what we like to say is, "High prices is the cure for high prices." You let the producer know, "Wow. Right now, you can make a great profit. Please produce." This time, it's unique because we're not letting the pricing [inaudible 00:17:41] be sent. The ESG[HR1] [SR2]  factors are not letting the producers produce, meaning, if you're an oil producer right now, you're under attack daily, from the media, from the government, from your shareholders. "You're big oil. You're bad. In 10, 20 years, we're all going to be driving EVs. We don't need you anymore. You're polluting. You're corrupt. Go away."

Albert Chu: Well, message received loud and clear. If you're a oil company and you look for a offshore oil well, it takes you about 10 years to go from discovery to production, in billions of dollars. For you to build a new refinery, it's probably 10 years, and pipelines, five to 10 years. Right now, what it is, is that the financial world and the media, in popular understanding is that, we can redivert capital and sentiment, at a snap of the finger. We can sell all of our Exxon and buy Amazon immediately. But the physical world, the world of reality, is that we cannot divest that fast. We cannot shift that fast.

Albert Chu: While EVs will penetrate, eventually, my children, they will be driving an EV. They won't drive IC Engines. But, for the next decade, the two decades plus, IC Engines will still have a big part. Just the natural replacement of the auto cycle implies traditional IC Engines are not going away. But, if you're an oil company, when does your capital decision switch, in 15, 20 years, when the inflection points hit 50% market share? When, IC Engines are only 50%? No. The answer is, you start shifting capital weight now. You start developing greener business prospects. You're returning higher cash to shareholders. Every dollar that's diverted away from [CapEx 00:19:24], into the field and into mines, is a capitalist dollar that's taken away from future production.

Albert Chu: The thing is we're consuming more and more. And, for the foreseeable future, we're going to consume even more. So right now, there's a duration mismatch. You know how we think about commodities, and the actual importance of commodities in our lives, there's a misperception there. And that's what's causing both the magnitude and the duration of the cycle to be vastly, vastly under underestimated. So for me to think that, when I look at the supply and demand factors that I referred to earlier, everything is just widening. There's no doubt about it. We are still not incentivizing supply. And we're not incentivizing demand destruction. And substitution effect, meaning, well, "Hey guys, why don't we just buy an EV? Let's not buy an IC Engine." Well, logistic nightmare. Right?

Albert Chu: There's a long wait time. Prices are still high. Is there even going to be enough lithium, or copper, or charging stations? Can we rebuild the grid fast enough to actually support all of this? All of these things will take years, if not decades, to transition through. But, right now, in the financial markets, we're incentivizing companies don't produce it. Either by replenishment, or by staking [inaudible 00:20:35], they're not.

Albert Chu: So, right now, we're looking at probably one of theObviously, in my investing career... And I've only done commodities. This is the tightest market I've ever seen. And this is even before Russia and Ukraine, across the board, in energy, in agriculture, in metals and mining, we're looking at, pretty much, record-low inventories everywhere. And, unless something changes, meaning either prices continue to skyrocket higher or policy really, really, does a 180, we're looking for a widening of supply and demand.

Eric Hundahl: Thanks, Al. You know, if investors want exposure to commodities, you obviously run an active strategy. But there is plenty of passive strategies out there, as well. What's your take on active versus passive, in the current environment?

Albert Chu: I think in all environments, you want an active manager. The way I like to describe it is, if you take the S&P Global Natural Resources Index[HR3] [SR4]  and build bull market, bear market, doesn't really matter. You chop it right in half, the top performers versus bottom performers, the dispersion, if you will, between the first 50th and bottom 50 percentile, it's 40 plus percent, meaning, in commodities, there's always a bull and bear market, somewhere.

Albert Chu: Example, 2020, you do not want to be invested in oil. You want to be invested in gold. You want to be invested in renewables. 2021, you want to be invested in oil. You want to be invested in natural gas. You know, some of the trades that we were having, you did not want to be in iron ore, because you can see the [Evergrande 00:22:11] situation brewing in China. You can see inventories piling up. But you want to be long natural gas, because you can just... The inventories are low. Production's not keeping up. There's a 10-year bear market catching up. So the dispersion, the opportunities for alpha, is always higher in the equities.

Albert Chu: What you can do is you can get the... You catch the commodity beta. Let's just say we all agree. We love oil. We're going to buy oil. The beta's just one-to-one. When it's up one percent, you get one percent. Now, if you captured that commodity beta, then you layer on the equity alpha, the stock-picking part, because the equities, they have financial leverage. They have operating leverage. And, in many cases... For example, one of our biggest equity positions, or oil positions is billion plus company. They did a transformational merger. During the downturn, they looked horrible because they over-levered. But the management team made great strategic decisions, sold off assets, shored up the balance sheets. And, during the upturn, a $50+ Billion company was over a hundred percent, at one point, this year, versus oil, that was only up between 20 and 30 percent.

Eric Hundahl: Great points. Well, Suzanne and Al, thank you, so much, for your time, today. I really enjoyed the fascinating comments around how we can use alternatives in portfolios in this new regime. Thank you, again, for your time. Really enjoyed it.

Eric Hundahl: All right. Well, I'm gathered here, as well, to talk about the interesting fixed income market, with [Gautam Khanna 00:24:23], Head of Multi-Sector Fixed Income at Insight Investment, as well as [Brendan Murphy 00:24:28], Head of Global Fixed Income at Insight Investment, as well. Thank you, gentlemen, for joining. Gautam, let me start with you. The Fed is in motion. You, yourself, has called for 50 basis point rate hikes, this year. What's your outlook on U.S. rates? And how should investors be positioning?

Gautam Khanna: Good morning. So the driving force in markets this year has been all about uncertainty, whether it's geopolitics, supply chain issues that continue to linger, China with their zero COVID policies, commodity markets, oil, inflation, and then, finally, and most importantly, for fixed income investors, the direction of interest rates and the Fed, as you point out. The result of all of that has been elevated volatility, whether it's in equity markets, spread markets in credit, or rate markets.

Gautam Khanna: The good news, however, is the market has front-run a lot of what the Fed is likely to do over the next 12 to 18 months. So if you look at where rates are trading, we've already priced in about two and a half percent of Fed fund hikes, incrementally, over what they've already done this year. So we'll end this year at about two and three quarter percent at Fed funds. And that's largely priced in. That's the good news.

Gautam Khanna: Further out the curve, if you look at the 10-year treasury, one year forward, it's already priced for 3.3 plus percent. So a lot of the damage is in the rear-view mirror. So, from our outlook perspective, purely as it relates to interest rates, we think that the lion share of the damage is behind investors. Now, the impact of the rate hikes is yet to be felt. As you know, there is a lag between when the Fed is hiking interest rates and the flow-through and the impact it has on the real economy. So that will be felt over the next 6, 9, 12 months, as some of these hikes start to take effect. And that will have its own set of repercussions. But, from a purely interest rate perspective, which is what I think you were asking me about, we are now suggesting to investors that, if you've been underweight fixed income, kudos to you because it's been a winning trade.

Gautam Khanna: But now, at this stage, there is ballast available in the fixed income markets. And we think that having a position in fixed income, which can mitigate risk[HR5]  on the downside, given all of those elements of uncertainty, that are still playing out varying degrees, is something that makes sense.

Eric Hundahl: But you talk about the ballasts. But, in the last quarter, we saw the stock bond correlation actually increase as both of them sold off. And, against this backdrop higher rates, a lot of people, maybe rightfully so, are questioning bonds as a diversifier to stocks. What's your view on that?

Gautam Khanna: So, certainly, I would concede that, when the 10-year treasury... Take that as an example. When it was sub one percent, frankly, there was no alternative to equities because, at one percent treasury, deeply negative, real yields, there was very little ballast in fixed-income markets. How low can rates go to give you that price performance? But with, now, the 10-year at nearly three percent, there's a lot of ballast. If, over the next nine, 12 months, we were to enter into a precipitous slowdown, equity markets could have a significant downside, and there will eventually be a flight to quality. And why couldn't the 10-year go right back down to one and a half percent, let's say? That's a lot of ballast, that's present in fixed-income markets.

Brendan Murphy: Sorry, Eric, I was just going to jump in there. I totally agree with Gautam, with what he just said. I think, to me, part of the reason the correlation has gone up so much is because it's been this uncertainty around the inflation environment, as well as the uncertainty around monetary policy, which Gautam highlighted, earlier on, that's been driving the volatility, not only in fixed income markets, but equity markets, as well.

Brendan Murphy: So, as more and more of that gets priced in, my personal view is that the narrative will shift, a bit. And the driver will be less about inflation and, likely, more about growth, and how the tighter monetary policy flows through, into the growth picture. So, looking forward, over the next six to 12 months, my suspicion is that you're going to see that become the driving dynamic of the correlation between those markets.

Brendan Murphy: And, certainly, if it's negative, in other words, if the tighter policy has a negative impact on growth, I'd expect to resume a more normal correlation, where fixed income behaves more as a ballast, than what we've seen over the last period.

Gautam Khanna: Yeah. You know, I'll add spot on, there. I would add that the easy money in equity markets, it's been made. And, with monetary policy reversing course, here, and the fact that the fixed-income markets have largely priced in a lot of what the Fed is likely to do, you've basically got a situation, now, that fixed-income arguably has a lot more value in it than, let's say, the equity market, at the moment. So that correlation to Brendan's point absolutely is going to revert back to historical direction.

Eric Hundahl: That makes a lot of sense. And, speaking of narrative shifts, Brendan, one area where many people often overlook, and, maybe the narrative should shift to. is investing in global bonds. And you recently shared that you haven't felt as strongly now being a good entry point for the global fixed income market in the number of years. Can you explain what's going on in the global market, and why now could be a good entry point?

Brendan Murphy: Yeah, well, I think it's a really interesting period, on a couple different fronts, we've touched on some of that just now. Yields are a lot higher. The yield on the global [ag 00:31:26] is about two and a half percent. That's the highest it's been in over a decade. So you're getting, not just hopefully the ballast component of it. But you're actually getting some income, compared to what we've been able to get over the last few years. So, if you think about the allocation out of cash, for example, as Gautam said, if you've been in cash, that's been great. You've done really well being in cash, of late. You might want to consider fixed income as an asset class, because you are getting much better yields. And our expectation is that you'll get the correlation benefits of that, going forward.

Brendan Murphy: The other way to think about it is if you're invested in equities, and you want to allocate out of equities into fixed income, again, that correlation element, as we enter a period of tighter monetary policies is likely to move more in your favor, and you're likely to benefit from the ballast components of it.

Brendan Murphy: Then, the other way to think about it is just, with your fixed income allocation, I'd argue the Fed's been pretty hawkish. Inflation certainly has been very high in the U.S. Inflation's high everywhere, but to varying degrees. And we're seeing varying responses out of central banks. And, while interest rates have risen across most of the developed markets, there are some pockets, mostly in Asia, currently, where inflationary pressures are less evident, where central banks are not necessarily hiking rates. In some cases, they're actually looking to ease policy. So the diversification benefits you get by not being tied to just one central bank, I think, are particularly attractive in the current environment. In fact, global, as an asset class at the index level, has done quite well, relative to the U.S. Negative returns, similar to what we've seen in the U.S., but outperforming the U.S. on the margin.

Brendan Murphy: So those are all reasons why I think the asset class, itself, is attractive. I think we've done pretty well, in terms of navigating what's been a difficult environment. And I expect there to be a lot of opportunities, going forward, to continue to add alpha on top of the beta, from the asset class

Eric Hundahl: Yeah. Brendan, carrying on that conversation, anytime an investor invests in global, or outside the U.S., they need to think about the currency component of it. And with the Fed raising rates, there's been a lot of concern around the direction of the dollar, and should we hedge or unhedge our non-U.S. positions there. Can you explain your thoughts on how investors should go about hedging currency risk, particularly in a fixed income portfolio?

Brendan Murphy: Yeah. Well, it's a super important question. So if you think about the volatility in currency markets is quite high. So, if you look at different fixed income funds and vehicles that are offered out there, you'll see a wide range, some that hedge most, if not all, the currency risk, some that don't. So it's really up to the investor in terms of what type of exposure they want. It's been better, certainly, to be in hedged vehicles because the U.S. dollar has been quite strong and, whether to be in a hedged or an unhedged vehicle, going forward, it's going to depend on what level of volatility you want, and also on your view on the U.S. dollar. Do you think the U.S. dollar will continue to rise? You probably want to be in a hedge vehicle. You think the dollar will fall, you probably want to be in an unhedged vehicle.

Brendan Murphy: So I won't make any necessary statements on which one is the best. It really depends on individuals' choice, and how the funds fit in their overall portfolio mix. But I would say, what's interesting now is, if you look at the rise we've seen in terms of U.S. rates, you actually get paid when you hedge a lot of these lower-yielding fixed income markets, like Japan or Europe, whatever it might be, back into the U.S. dollar, you pick up yield to hedge. So it's sort of a... It's a unique circumstance where you're actually reducing volatility in your portfolio by hedging the currency risk, by taking it out. But you're actually also enhancing the yield of that portfolio through that transaction. So-

Eric Hundahl: So, normally, where we think of hedging as a cost, in this instance, maybe the opposite is true?

Brendan Murphy: So it really depends what market you're looking at. So think of the hedging transaction as being the exact opposite of what the nominal yields show. So, if you were to buy an emerging market, like a Brazil or South Africa, where yields are quite high, you would have to pay. It would cost you to hedge that, because those interest rates are a lot higher than they are in the U.S.

Brendan Murphy: But, when you hedge lower-yielding markets back into the U.S. dollar, you're actually enhancing yield, or picking up yield. in particular, the vast majority of the exposure is in developed markets. There's a small allocation to emerging markets. But most of it is in developed markets. So, if you can own some of the... Japan has actually been a very strong performer in a relative sense, even though the nominal yields are quite small, because there hasn't been the same price volatility in Japan, and because, when you hedge Japan back into the U.S., you pick up most of that yield differential.

Eric Hundahl: That's fantastic, something I've never thought about before. Gautam, turning back to you, a lot of conversation has been around the yield curve inversion, and in its ability to foreshadow recessions. What's your take on the yield curve, and what's it's telling us?

Gautam Khanna: Yeah, look, I think there's been... There is some signaling attributes there, but there's been a lot of cross currents, global relative value being an example. So Brendan just talked about Japan. The Central Bank, there, is wanting to buy unlimited amount of 10-year notes to maintain yields at a quarter percent. So, from a Japanese investor point of view, they want to own U.S. assets. So that has an element of distortion that comes into play. Pension funds, we have a lot of business ourselves, on our desk, that is defined benefit plans that are really well-funded, that are looking to immunize their asset and the liability, the liability being the pension. And both are naturally hedged on rates. So they're a little bit agnostic. And there's a lot of demand there, as they lock in some of the gains from equity markets and hedge their liabilities on the fixed income side. Butch Lewis, another example of money coming into fixed income, where they are a forced buyer of high-quality fixed income instruments.

Gautam Khanna: So there are a lot of other elements, and forces at play, further out the curve, that might be contributing to some of flattening, and perhaps even inversion, at points in time. So having said that, to the extent that there is still demand for longer-dated points on the curve, in the face of inflation, and in the face of the Fed raising interest rates, what it suggests is that the market is skeptical, that the Fed will continue to raise rates, and ultimately we'll probably have to reverse course.

Gautam Khanna: So, what is the terminal rate likely to be? And that's why, with the 10-year already at, call it, 330, one year out, it's suggestive of, at some point, you're going to reach a terminal rate. Then it starts to go back down, thus reducing the likelihood of a significant steepening.

Eric Hundahl: The, that skepticism that the Fed can successfully navigate this, the somewhat narrow path, what's your view on that? Will they be able Will they be able to achieve their objective and get out in front of inflation and achieve a soft landing?

Gautam Khanna: Well, that's the goal. They're never going to admit that they're going to implement monetary policy and not achieve their goals of price stability and full employment without putting the economy into a recession. Having said that, when there's so many moving parts, and we are a levered economy, and rates are going up rapidly, there is a concern that this could lead to a recession. Now, I'm not saying that, that is our central case. But it is a risk case, for sure.

Gautam Khanna: And then, the other thing to consider, for fixed income investors, is that, if you do have a recession, the lion share the damage occurs to the first loss piece, as in the equity crunch of the issuers you invest in. Further up the capital structure, you're only going to incur material damage, if we have a really, really hard recession, and a prolonged recession. I don't think anybody is really calling for that.

Gautam Khanna: Could you see a couple of quarters of negative GDP, and therefore, a little bit of a contraction? Yeah, absolutely. But does it change the fortunes of many of the issuers we invest in? Probably not, not in terms of their ability to service their debt, generate enough cash flow to meet their debt service requirements.

Gautam Khanna: And just one other point I'd like to make, which is on the leverage finance side. So that would be another area that, arguably, would be more impacted by a slowdown. But when we look at the relative health of the high-yield cohort of companies that we invested, again, upper tier components of high yield.

Gautam Khanna: Balance sheets are relatively stable. Companies are generating free cashflow. There's positive retained earnings. So there's a little bit of a cushion. So cashflow could actually go down without burning cash on the balance sheet. So we're not ready to throw in the towel completely. We still want to find ways of earning income on behalf of investors. And that's one of the areas where we do find value, front end, shorter-dated theta to capture that income, where we have good visibility. So that's just some of the points that I thought might be relevant to your question.

Brendan Murphy: The next six to 12 months are critical to this question about whether or not these central banks can engineer a soft landing. It's all in their hands. And the challenge is super difficult, not just for the Fed in the U.S., but for the ECB in Europe, the Bank of England, the RBA. All these major central banks are facing an inflation problem. They're tightening policy. And the ability for them to pick the right level, how hard to push on that, to get the inflation down without cratering the growth outlook is a huge challenge. And I don't think we have the information yet, because we don't know how far they're going to push.

Brendan Murphy: Our suspicion is that we're likely, hopefully, to be near the peak, in terms of inflation in the near term. So, as inflation, month-over-month, starts to come down a little bit, that should hopefully ease the pressure that they need to put upward, in terms of tightening policy. But there's big risks around that on both sides. So the next six to 12 months, I think, are going to be super interesting and super exciting for fixed income.

Eric Hundahl: I couldn't agree with you more, an exciting time in an asset class that we rely on for stability. But, gentlemen, I really thank you for your expertise and your time today, and your insightful comments. Thank you once again.

Gautam Khanna: Thank you.

Brendan Murphy: Thank you.

Eric Hundahl: So joining me today to talk about the municipal bond market is [Dan Rabasco 00:44:30], Head of Municipal Bonds at Insight Investments. Dan, thanks for joining us today. The muni bond market hasn't been immune from the troubles, this year, in the rates market. Yet, this is an asset class that investors favor for its stability. Are muni bonds a bargain right now, given valuations? Or should investors really expect more uncertainty in the muni market? What's your take?

Dan Rabasco: Our take is that the muni bond market represents some excellent value, right now. Sure, we're following the quarter you mentioned, which was historic weakness. It's probably the most weak quarter in at least 40 years. And that weakness continued into April. So, yes, the market is experiencing dislocation. However, we think again, it's a great opportunity, and for the following reasons. Valuations are extremely attractive. Also supportive seasonal factors, which occur in the muni market, are coming up midyear. What that means is we're out of tax time, when people sell munis to pay for their tax bills. Additionally, we're heading into midyear where there's a lot of coupon reinvestment potential. And, actually, with all the maturities that'll be happening, May June, July, there's going to be more bonds leaving the marketplace than will be coming into the marketplace, through new issuance.

Dan Rabasco: So we think that's very supportive too. This net negative supply concept that we see repeatedly in our market midyear. But getting back to valuations, muni AAA rates are up 150 to 200 basis points from the beginning of the year. That is a huge move. And, additionally, the muni-yield to treasury-yield ratio started the year for a 10-year muni at 68%, meaning, a muni yield represented 68% of the treasury yield. And these are tax-exempt munis, by the way. Also, a 30-year muni yield started the year at around 78%, 80% of the 30-year treasury. Again, tax-exempt yield. Right now, these yield ratios are at 95% and 104%, respectively. So muni debt, on a tax-exempt basis, is yielding almost as much as treasuries in 10 years and more than treasuries in 30 years. And, if you think of the taxable equivalent standpoint, you're really able to shelter a lot of income from taxes at these muni yields.

Dan Rabasco: The other thing I would mention would be this. Spreads have widened out, for double A bonds, single A bonds, triple B bonds, bonds. And what we encountered last year, just to give a little bit of a backdrop, incredible demand for muni product, rates driven lower, spreads driven tighter, and those ratios I mentioned, that we started the year with, very rich. And now, across rates, ratios, and spreads, munis represent value. But you know, the question in everyone's minds, these days, is the Fed. And our view is, the Fed move is pretty much, factored in, into the dislocation. We've seen, in treasuries, and munis accompanying that, when the market's grappling with the accelerated timeline, or in terms of these moves that are going to happen, our view is, "You know what? The Fed moves are, pretty much, factored in." So you take all these factors into account. We think we're going to head into a period of some relative stability for munis.

Dan Rabasco: The last thing I'll say, I'd be remiss not to mention fundamentals. Muni fundamentals are incredibly strong. They're the strongest I think I've seen in recent history. And we had the fiscal stimulus over a trillion dollars, direct, indirect fiscal stimulus, benefiting munis that occurred. The economic recovery has been strong. And what's this translated into, in terms of fundamentals, strong revenues from municipalities, building up reserves, increasing pension fund liability funding, which is always something that we've always talked about, as the unfunded pension liabilities, that has improved to the tune of around 85% at the beginning of the year, up front 70%. So we've got a lot of strong, positive fundamentals going on. And one last point. The housing market is... And for local governments, property taxes, that's the basis of how they pay for things. That segment of municipal credit is awfully strong.

Dan Rabasco: So, based on fundamentals, based on the technical picture, meaning supply demand, as we see it, based on where valuations are, and also the overarching view on the Fed, we feel munis represent some real good value, at this time. And then, in particular areas that we think there's value, again, double A, single A, triple B, sub-investment grade paper... We like the airport sector, and the toll road sector, because there's a lot of pent-up demand. You're seeing passenger use of air travel, up. I think March 31, it was about 90% of what it was in 2019, and certainly up a lot from '20 and '21. Same thing for toll roads. We think there's a lot of pent-up demand there. And those credits are solid.

Dan Rabasco: Now, New York paper represents some value here, along with the essential service type issuers, water and sewer electric issuers, and AMT bonds, bonds that are subject to the [inaudible 00:50:21] tax. With tax reform that we had happen, several years, there's not many people who have followed to the AMT category. Most bonds are giving you 40 to 45 basis points more in yield, compared to a non-AMT bond. So these are some of the pockets of opportunity we're seeing, right now. And, overall, I think the market... It's time to put some resources to work.

Eric Hundahl: Yeah, Dan, you touched on some of the technical supply/demand issues and also the pandemic spending. And what we saw last quarter was that bond issuance by states and local governments actually dropped, compared to a year earlier. And a lot of public officials are talking about spending down a lot of that cash received during the pandemic. What's your take on the issuance going forward?

Dan Rabasco: Yeah, we think issuance will be lower than it was last year. I mean last year was a very heavy supply year. And I think the year before that, 2020, was very heavy supply too. You know, we think supply is going to be lower this year. And you know what? The point that you make about these municipalities are flush with cash. Yeah, sure. They're putting that money to work for social services, pension funding, and also, to a degree CapX. So, therefore, they don't have to issue as much. But we think there's also other factors that we should consider, about the supply picture. You're in a high-rate environment, right now.

Dan Rabasco: So the economics of issuing debt... Issuers might be a little bit cautious in that regard. And you know, I mentioned last year. A low-rate environment, a lot of issuance happening. I think issuance was somewhere in the range of 475 billion, in thereabouts, of that portion. Over 140 billion were taxable muni bonds. And we saw a lot of issuance, last year, in taxable muni bonds because rates, overall, were low and tax reform, that I mentioned earlier, took away the ability to advance refund tax-exempt debt with tax-exempt issues.

Dan Rabasco: So a lot of taxable debt came last year to refund tax-exempt bonds on an advanced basis. With rates being up, taxable issuance is down. Muni issuance, both tax-exempt and taxables, down about eight or nine percent, eight to nine percent year-to-date. Taxable muni issuance is down almost 40%. So I think that gives you an idea that, that vehicle isn't working because rates are high and a lot of refunding was done last year. So you've got more limited issuance for those reasons. Again, issuers pull back when rates go up. So we expect issuance to be less because of that.

Dan Rabasco: And, also, we had the infrastructure bill that got passed, 550 billion. And I think municipality is a way to see how that's going to be dispersed. But issuers could also be a bit on the sidelines, waiting to see what money comes through that they don't have to issue debt for infrastructure purposes. See about the Federal money coming through. Now the 550 billion sounds impressive. But, you know what? It's somewhat of a drop in the bucket, if you consider the fact that, I think, the MSRB said, over the last decade, about $2 Trillion worth of municipal debt was issued for infrastructure purposes. It just shows you how much municipal debt finances our nation's infrastructure. And I think it's to the tune of 75% of the infrastructure that's been financed has been through municipal debt. So the 550's good. And it will probably cause a little bit of less issuance, and some folks to see what type of money they're going to get from that. But, for all those reasons, we think issuance is going to be less.

Dan Rabasco: Now, TheStreet estimates... They've got the investment banking resources. They've got the underwriting. ... estimates the range of new issue supply for 2022 to be from 420 billion to a little over 500 billion, I believe. So, that's quite a wide range. I'd say this. We're more in the direction of the lower end of that range. Now someone could ask, why is someone thinking there's 500 billion in issuance, in view of everything that we've just laid out? And most folks, who think the issuance is going to be more, think that municipalities will actually lever the resources they have, the financial resources they have, and also the Federal infrastructure money, to issue debt on their own, and then bring it up even more. But we're of the opinion, there's going to be less issuance this year, towards the lower end of that range I just mentioned.

Eric Hundahl: Fantastic, Dan. As always, thank you, so much, for your insights and your discussion on the opportunity in the muni market. Really appreciate your time. Thank you.

Eric Hundahl: All right. To discuss the exciting and rapidly-evolving equity market, I'm pleased to be joined by [Brian Ferguson, Senior Portfolio Manager, U.S. Large Cap Value, at Newton Investment Management, as well as [Roy Leckie Executive Director of Investment & Client Service, at Walter Scott. Thank you, gentlemen. And thanks for joining.

Eric Hundahl: Brian, let me start with you. Inflation, Fed policy, Ukraine, commodity prices... The lot of risks are top of mind for investors. Risk seems constant. But this seems like an exceptionally difficult environment to navigate. What are your thoughts on how investors should approach equities?

Brian Ferguson: Yeah. So, I'll tell you. It was well said by you. You listed off a lot of the bricks in the wall of worry. And there are more, as well. I would add China shutting down, with just a few COVID cases, major cities, while they continue to raise a zero COVID tolerance policy. So, clearly, there's a lot to be concerned about. And then, of course, there's always the fire is never where the hose is pointed. So what didn't we mention, that we're going to be mentioning three months from now?

Brian Ferguson: But, that's always the case. So, when it comes to equities, the word that comes up, when we talk about that, is investing. So that's what we're coming in to do every day. And it requires being able to filter through the noise, but understanding and embracing the opportunities that that noise creates. And we're looking, longer-term, at opportunities where we can find companies where the price-per-share is much lower than the value-per-share and, in turn, understanding and having an investment case that allows for a pathway to close that gap between the price-per-share and the value-per-share.

Brian Ferguson: So, a lot going on in this current environment, perhaps more than an average day, if you will. But we've been through many of these periods before, in the market. This is another one that creates opportunities for us, as we come in and construct our portfolios, every day.

Eric Hundahl: Roy, Brian mentioned China the hallmark and Newton has really been the ability to be resilient in terms of equity distress. But investing outside of the U.S. has been particularly difficult. How is your thesis playing out?

Eric Hundahl: Walter Scott's...

Roy Leckie: Look, I have to agree with much of what was said, there. I've been saying to clients, the last few weeks, it just seems that the range of possible outcomes, here, are as wide as they've been for a very long time. And that's in terms of economies, and companies, and markets. There are just so many different challenges. But, as Brian said, we've lived through lots of challenging periods before. There is no real reason to give up on equities, as the best asset class for capturing the general propensity of economies to grow and living standards to rise and new technologies and new ideas to come to the fore. So, medium long-term, I think you have to remain very optimistic. And, in terms of the current challenges, the way we would address all the various risks, is just to try and ensure we're invested in the very best companies we can find, so companies with certain qualitative and constant characteristics, market leaders, price setters, companies operating a long way from break-even levels, companies with technologies or businesses that are really difficult to replicate.

Roy Leckie: These are the companies that won't be unaffected by the various challenges but are likely to come through in a much better relative position. Then, of course, you have to consider your valuation risk, as well. But that is what our focus is on. It's trying to scour the universe, the best businesses. And that strategy has served us well, or served clients well, through previous periods of intense volatility. And I think that would be the case again.

Eric Hundahl: Yeah, Roy, we've talked about challenges, but are there opportunities outside the U.S. that may be not as prevalent here as they are abroad?

Roy Leckie: I mean, that's certainly the case. I think there's plentiful, what we like to call, growth vectors that those U.S. investors who choose to maintain a strong home bias are what we'll miss out on. One that we've been investing in for a very long time is the savings and insurance dynamic, in Asia. So we know that the number of consumers going through that magic $10,000 per annum income level, whereby you start to think about protecting, and saving, and insuring, for the first time, not numbers just exploding upwards. We've got some interesting businesses exposed to that really exciting dynamic.

Roy Leckie: Another one might be... Well, so luxury goods, for example, which is lots of demand globally for luxury products. But it is just a fact that the Italians and the French are the best in the world at producing that, when it comes to very, very high-quality aspirational luxury products. So we, again, got some interesting exposures there, through our stock picking.

Roy Leckie: Then, Japanese have lost their comparative advantage in certain areas. But, when it comes to the factory automation and robotics, and such like, if anything, they've enhanced their leadership. So, again, these are a few, as I say, what we call, growth factors that have been really quite fertile areas for us, when it comes to our bottom-up stock picking.

Eric Hundahl: Brian, he talked about growth vectors, but you're a value manager. And we saw recent relative out performance of value, lately, which is a little bit surprising, because value is cyclical. What do you think is driving that out performance? How sustainable is value, relative to growth? What are your thoughts on that?

Brian Ferguson: Wow, there's a lot there. And I'm thinking about the comments that Roy made. A lot of his comments are spot on. And we all talk about, and the media talks about, the stock market. But the reality is it's a market of stocks. So, whether it's within the U.S. or outside of the U.S., there's always going to be opportunities in individual companies, and individual stocks, that are compelling. And, even though we're a value manager, we are still focused on identifying companies that have catalyst-driven business improvement. And it might be something that is very company specific. Maybe there's a product cycle, or a restructuring, or a management change. But it also might be something that is a little more thematic, as Roy mentioned, that might be impacting a broader group of stocks, whether it's an industry or a sector.

Brian Ferguson: So we're keenly focused on identifying those best opportunities, while ensuring that we're paying an appropriate price for that given company. So what we're finding, in terms of opportunities in the market today, falls within energy, where we have an overweight. And we've seen dramatic changes in terms of how management teams are incentive. So incentives drive behavior in any business, your business, our business, but also energy companies. And the punchline here is that, for much of the last couple decades, they were incentive to grow. So all cashflow went back into the ground. And, clearly, that has a negative impact on returns on and off capita. But it also causes supply and demand imbalances with greater frequency, for the overall energy complex. That's changed dramatically, where, now, companies are incented to focus on returns on, and of, capital. Many of them embraced variable dividends.

Brian Ferguson: So that is improving returns on, and of, capital. But it's also causing supply to be less than it would've, otherwise, which now, if you think about the industry and the sector level, you have a much better supply and demand situation. So one of the things that I'm struck at, and energy is a great example, but there are others, is, in the almost 30 years that I've been doing this, I've never seen as many examples as what we're seeing today, as it relates to abnormal behavior on both supply and demand to given prices. So, if you think about energy, we have a hundred-dollar crude, roughly, give or take a little bit today, WTI and Brent. In the past, whenever you got to that level, you'd see a massive supply response. We're not seeing it.

Brian Ferguson: And, conversely, we're not seeing the demand response. And it's, perhaps, coming out of the pandemic with tremendous savings and a lot of pent-up demand that people are ready to get out and return to normal. So there was a cruise line the other week that said they had their best weekly booking in their history. So, even though we have concerns over recession, slow down, for some of the reasons that you mentioned, the consumer is still clamoring to return to what their old normal behavior was. So we're not seeing the kind of demand response to higher... Whether it's cruise prices, whether it's airline, or whether it's gas at the pump, individuals feel like they owe it to themselves, and to their families, after two years of being locked in. So it's very abnormal in terms of the kind of price elasticity for both supply and demand we're seeing. And I think energy is one of the best examples of that opportunity not lost on us, hence a large overweight to energy in our portfolio.

Eric Hundahl: Yeah. You talked about energy, Brian, and price appreciation, or inflation. What other firms or other sectors do you think are well-positioned to potentially pass on those higher prices to consumers and, maybe ultimately, benefit from better margins, solid earnings momentum moving forward?

Brian Ferguson: Yeah. So listen. That's key. Here we are, in a period of inflation. We haven't had too many of those in the last several decades. It's been a series of lower lows and lower highs of interest rates and inflation. And the last time that we, as a society, have really had to deal with this was, quite frankly, going back into the '70s. An interesting fact is that the average age of a portfolio manager is 43. So the reality is that the majority of, and certainly based on the average... By the way, I'm a little north of the average, as you can probably tell, despite best efforts. But, even though I'm above average, I was not doing this back in the '70s.

Brian Ferguson: So no one's really had to deal with it. And one of the things that I'd like to mention... And it was something that Roy referred to, in the case where equity isn't taking the long view, is that equities are a great inflation hedge. And bonds aren't. So I think, to the extent that we're in an inflationary period, which we've definitely started, we happen to think that it'll last longer. It won't be linear. But it'll last longer than a year or so. And, clearly, temporary has been dropped from the vocabulary of the Federal Reserve, and many others, for good reason. They're finally, after getting the email and the memo, every day, they finally had to realize we need to drop that word, appropriately so.

Brian Ferguson: So, with that, it's very important to understand who has pricing power. So company-by-company, industry-by-industry, my team, our analysts, are keenly focused on which companies, which industries can contend with a more inflationary environment. So, for us, clearly, we're finding it in certain companies and materials, obviously in energy. Now you can argue they're part of the problem, this inflation problem that we're talking about. But I would add, within healthcare and financials, in particular, are well-suited to contend with it.

Brian Ferguson: And the last thing I'll say on financials is, as we've broken out of this interest rate environment of lower lows and lower highs, that's been a headwind for financials, if you think about banks in the U.S., but also globally. And it becomes a tailwind. And it really helps drive their net interest income, as interest rates go up, point one, point two, is... For companies like banks, with low-cost deposits or insurance companies with low-cost float, that hasn't mattered when money was free to everybody in the world.

Brian Ferguson: Now that money is becoming a little less free... And I think we've just started. ...we potentially could see a dramatic reevaluation of companies that have access to low-cost or no-cost funding. You know, there's a big company out there that's going to have their analyst day tomorrow, which I think the world will probably be watching, out in Omaha. And there's a reason why that company has built up cash to over 150 billion, over the last many years. And their relative advantage was negated by the fact that everybody in the world had access to free capital. It's changing as we speak. I think it's a big deal. And I think it could be very material for companies like that, or like a bank with very low-cost funding, as we look forward over the next five years.

Eric Hundahl: Great. Roy, turn it back to you. You know, Walter Scott is known for its deep research and close communication with the management teams that you invest in. What are you hearing from those firms, in terms of inflation, and supply chain issues, and the cost of capital, that Brian referenced?

Roy Leckie: Yeah, the inflation challenge and the supply chain disruption has been a really, really important part of our research effort for a while now, actually, really since COVID kicked off. And we've been doing a lot of engaging with investee company management and, indeed, just a wider research platform. So it became obvious, quite early on, that COVID was creating some quite severe blockages in supply chains. And that situation's obviously been very considerably exacerbated by the Russia/Ukraine situation, by the zero COVID policy approach that the Chinese authorities are pursuing, as mentioned by, by Brier, there.

Roy Leckie: What companies are saying... And I think there's obviously a very broad range of approaches and opinions, here. But I think the best companies... Clearly, there's been a shift away from this just-in-time inventory management situation, much to a kind of, just-in-case. So a lot of companies have actually built in some redundancy, some excess into how they manage their working capital, how they manage their inventories. And we've seen that, in actual fact, I think that it's being tested, as we speak. I think that redundancy has probably been worked through. My opinion is that the blockage, or the shutting down of Shanghai, and the port, [inaudible 01:14:09] it's the biggest port in the world, is being underappreciated in markets, actually. And you know, this is something we've been exploring with our companies.

Roy Leckie: If you recall, not that long ago, there was the Evergreen, that ship that got stuck in the sewers. And that caused a fair amount of disruption. We're talking about the world's biggest port, hundreds of ships sitting idle, at the moment. So, we are trying to stress that support folio. What is the impact for our companies? And, of course, there are some unknown unknowns here, because it's not just our company supply chain. But it's their suppliers' suppliers, and their suppliers' suppliers' suppliers. And it's really challenging.

Roy Leckie: So my view is, again, there are some things being underestimated, here. And, actually, I think it's reasonably likely that, in the next few months... And, of course, you have to remember Beijing could get shut down. Guangzhou talking about [inaudible 01:15:17]. And Shanghai might open tomorrow. Right? That would be great. But I do think we're likely to feel the reverberations of this for quite a while. And we shouldn't be surprised if we start seeing a few more empty shelves around the place, because supply chains and manufacturing processes are being increasingly challenged. And, of course, that always likely feeds into just higher prices for stuff.

Eric Hundahl: Yeah. Not only is China, Roy, important to supply chains. But a lot of multinational businesses, actually pre-pandemic, wanted to do more business with China. What are your businesses saying about just doing business with one of the world's largest nations?

Roy Leckie: Yeah, look, again, I think kind of medium long-term companies would absolutely remain of the view that China really, represents huge opportunity, both, as a potential marketplace, but also as a manufacturing center. Clearly, in the short term, though, coping with this zero COVID policy is a massive challenge. Shanghai, 24 million people shut down world's biggest port. It's just going to be, I think, very, very disruptive.

Roy Leckie: So, again, it just speaks to the fact that you probably want to be in those companies that have got greater experience in China. They've got management structures, governance structures, that have experience of dealing with this sort of challenge, before. They're business with really robust foundations, both from a market position, but also of financing, and balance share, and liquidity perspective.

Roy Leckie: So, I hope I'm not sounding too negative about things. But I do think we are coming up for some challenges. And, if there's ever a time you want to be in these companies with these stronger fundamentals, I think now is it. So, what you quite often find, in fact, more often than not, find is that, as we come through these challenging periods, actually, those stronger businesses are in a much better relative position than when they went in. So it's the weaker businesses that will really, really struggle, as opposed to the stronger franchises that we think we're in.

Eric Hundahl: Fantastic. Hey, Brian, one thing that we haven't talked about is just interest rates, and the sensitivity that value, as a value manager, that value is sensitive to interest rates. How do you think that these rising interest rate environment will affect value stocks?

Brian Ferguson: Yeah, so, so far, it's been positive, rightly so. And I think, if you just think about basic finance of discounting cash flows back to the present, the further your cash flows are in the future... And then, in turn, having to discount those back at a higher rate, you get a smaller value. So not all, but growth is characterized by cash flows in the future at ever-growing amounts. Whereas, value tends to be characterized by more of your cash flows in the present. So, if you're not discounting it back 20 years at a higher rate, all those being equal, that favors value over growth. So more cash flows earlier in time versus cash flows later in the time should bode well. And it has been, for value. I think it's something that can continue here. We've just started. And don't forget that point one values had a very tough time for over a decade, really, post the great financial crisis, which is very unusual.

Brian Ferguson: Value typically outperforms two out of every three years. And that was the case for a hundred years before the great financial crisis, but very different after. And it was largely because we entered an environment of deleveraging post the great financial crisis. Deflation came with that, and lower highs and lower lows on interest rates, and inflation, quite frankly. And, post-pandemic, for now, those trends have been arrested and have started to reverse.

Brian Ferguson: Listen, my best macro reviews are informed by the micros. So I'm not an economist. But, based on what we're seeing, and how companies are behaving, we think that there's quite a bit more to go, here. And we're always looking at changes at the margin, whether it's a company level or a broader level.

Brian Ferguson: And the two other things that I would mention, that are likely to perpetuate a different inflationary environment in the future, relative to the environment that we experienced over the last many, many years, would be as follows.

Brian Ferguson: One, we're now entering a period. There's no doubt about it. And we can talk about the different reasons, one of which would be national security, but a period of deglobalization. Globalization was a very deflationary force. That has changed. So we're going to have more semiconductors, more pharmaceuticals. We're going to have an Eastern and a Western supply chain, very different than what we've been doing over the last couple decades.

Brian Ferguson: The second, which is a little bit more controversial, is ESG or environmental, social, and governance. And I can certainly appreciate the benefits of this pursuit and the long-term benefits, for society as a whole, of getting rid of carbon. But you do need a bridge. You got to be careful what you wish for. And Europe's finding that out now, in terms of being, and having been, in hindsight, way too aggressive, shutting down all fossil fuel and then, in turn, becoming more reliant on Russia, and finding out that they don't quite have the reliability of their electric grid, when things get stressed.

Brian Ferguson: And, in the U.S., we've had that same experience in California. And, in Texas, when we had some weather that was a little extreme, we also found out that, "Geez. It's great to build alternative and green energy. But maybe we shouldn't have shut down all that we... Gas or coal as quickly as we did, because we need to ensure the reliability of the network."

Brian Ferguson: And, another aspect, too, is that this rush to shut carbine... I mentioned earlier, when we talked about energy and the change of behaviors. Well, that wasn't the energy company saying, "This would be a great thing for us to do." The market demanded it because, as they were viewed as enemies of the pursuit of ESG, it directly impacted their availability and cost to capital. And that was something that they responded for, which, 40 years from now, that might be a great thing. But the problem is we haven't weaned ourself, as an economy, off of energy. We still need it. And it's my belief that these changes have really caused us to be in this situation, unfortunately, where, before we run out of the demand for oil, which may happen in 40 years, we're running into the perception of the reality that we're running out of the supply for oil.

Brian Ferguson: It's very negative. It's a very regressive tax that, unfortunately, a lot of people have to bear that higher cost. So, we're also looking at solutions. Nuclear, I think, is important. We're going to see the perception change on that, as another way to help bridge the gap.

Brian Ferguson: So inflation's here. It's probably going to be a lot stickier than what people think. And that's going to correlate to a rate environment that won't be characterized by lower lows and lower highs, the way that it has over the last two decades.

Eric Hundahl: Thanks Brian. Roy, Brian mentioned that the value's been benefiting from rising rates. I'd like to hear your comments, as someone that invests in high quality growth companies. Is growth disadvantaged from rising rates? That's seemingly what the market told us, earlier in the year.

Roy Leckie: So look. We... Maybe you're asking the wrong person. We've never believed that growth and value are independent investment concepts. You know, growth doesn't work for you if you pay too much. And value doesn't end up being a great strategy if you just, again, zero intrinsic value growth. So I think you also need to kind of differentiate between companies and stocks. So we think high quality growth businesses is where you need to be invested, if you want to be a long-term, buy-and-hold compound growth investor. You need quality because, as we've been talking about, there is so much that changes, so much that could go wrong, so much that's unpredictable, whether it's interest rates, or inflation, or geopolitics, or commodity prices, or whatever. Quality companies tend to do best through challenging periods.

Roy Leckie: And then, you need growth. I think you actually need growth, particularly at the moment, because I suspect... And I'm not the economist either. But I think the kind of macro growth outlook is quite challenged for a period. So I think we do want to find those companies that can deliver some growth, against a more benign backdrop. So we think quality growth is the right approach for the long term, at the company level. But, at the stock level, of course, as I said, if you pay too much for these high-quality growth companies, you ain't going to generate much of a return.

Roy Leckie: So you have to be very cognizant, or we have to be very cognizant of valuation risk. So it's kind of marrying those two concepts, the growth and value concepts, that we think will generate above-average returns over the long term. For each unit of PE that we're paying, with a stock, how much growth, how much profitability, what strength of balance sheet, what standards of ESG are we getting? That's the crucial dynamic for us, rather than just growth companies, per se.

Eric Hundahl: That's a great point, Roy. And, gentlemen, we'll leave it at that. I thank you, so much, for your time in helping us dissect this fantastically interesting equities market, not only domestically in the U.S., but abroad, growth versus value. Your insights are immensely helpful. Thank you for your time.

Brian Ferguson: Thank you very much.

Eric Hundahl: Thanks, Brian. Cheerio.


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