BND - Pause Profitability And Portfolios

2023-05-20 04:30:00 ET

Summary

• So far, the world of investing in 2023 is proving to be very different from 2022.
• In early May, the Fed raised interest rates above 5% for the first time since 2007.
• Investors are asking questions about whether rates will stop rising and if inflation has reached its peak.

Oscar Pulido: Another month, another Fed meeting, and yet another increase in interest rates. For the first time since 2007, the federal funds rate in the US is above 5%. Where does the Fed go from here? Have we reached a peak in inflation? Here to help answer these questions, I'm pleased to welcome Gargi Chaudhuri, Head of iShares Investment Strategy. Gargi will help us make sense of today's market environment and the investment opportunities that lie ahead.

Gargi, thank you so much for joining us on The Bid.

Gargi Chaudhuri: It's great to be here. Thank you for having me.

Oscar Pulido: Gargi, it's May, the Fed has just raised rates for the 10th straight meeting. We're above 5% on Fed funds rate for the first time since 2007. Inflation is still a problem. The markets are volatile, and we've had the collapse of another bank this time, First Republic ( FRCB ), getting taken over by JPMorgan ( JPM ). So with all of those concerns that, you're hearing, what are clients saying right now and how are you responding to them?

Gargi Chaudhuri: So to your point, we've had the fastest rate rising cycle with 500 basis points of rate hikes in a course of 14 months. It's hard to believe now that in the beginning of last year, rates were still at zero. The big thing that clients are reiterating over and over again to us is the need to be flexible in this time, the need to be nimble in moving around portfolios because the story keeps shifting.

If we look back to the first quarter of 2023, January was actually a pretty good month. Remember, that was when the reopening of China story came about. Then you had February, not such a great month. You had March, nobody saw the bank turmoil coming about, but that happened.

April comparatively was a lower volatile month, but of course you had some idiosyncratic risks and now we're sitting at May with what we think is the final rate hike for this cycle. So I think there's a huge amount of discussion around nimbleness in portfolios. That's one thing. And the second thing that we're talking a lot to clients about is really the return of income.

Clients are so excited that you can actually earn some income, especially in fixed income and where they should do that, how they should do that, and how they can reallocate back to the fixed income market. So that's been very topical for us. And this is across clients in the US, LatAm and Canada, and globally.

Oscar Pulido: As you mentioned, every month has been different in 2023. There's been no consistent pattern. Tell us a little bit about, the three Ps framework that, I know you've been talking to clients about. What are the three Ps?

Gargi Chaudhuri: One of the things that we discuss when we talk about markets is, what are the important things that clients should remember as they're thinking about asset allocation, what will drive markets right now for the next quarter, for the next few months?

And at this juncture, those are number one, the Pause, that's the first P. Number two, Profitability, and the number three, Portfolios. So if we look at each of these individually and why they matter now. The first one is really about the pause, which is that the Fed has raised rates by 500 basis points, over 10 rate rising cycles over 14 months, and now, they pause.

The Pause is not the same as the other P word, which is pivot, which many investors expect. Actually, the market expects the Fed to cut rates. We don't think that's going to happen. And why not another P for you? Prices! Inflation remains pretty high, much above the Fed's target, which is 2%. As of right now, we're sitting in May; when we last looked at inflation numbers, they were closer to 5% than to 2%. So, all of this allows for the Fed to pause, but not pivot, not to cut. So that's the first P.

Also we're talking a lot about profitability, which is actually related to one of the Ps, which is prices in a world where prices are going up, where inflation has been a consistent problem over the last 18 months.

Looking at companies that have the ability to pass on prices, that have the ability to have margin resiliency, to be able to be profitable even in a period of slowing growth is really important. Finding those companies, finding those sectors that have pricing power, that have profitability, which have earnings growth, which have a strong balance sheet, those are really important.

And then we'll move to the third P that we spend a lot of time talking about as I mentioned earlier, which is around portfolios and specifically the role of fixed income in portfolios, how at this juncture with the Fed Funds rate being a little bit over 5% allows for investors to earn a lot of income in very high-quality parts of the market. So, you can sit in Treasuries, which are backed by the faith and credit of the US government and earn 5% in certain parts of the Treasury market. You can earn close to 6% in certain parts of the very high-quality corporate credit market. So again, thinking about the portfolio construction in this environment is really exciting.

Oscar Pulido: You mentioned Pause, and that's your view that the Fed is going to take a chance to kind of just assess what they've done over the last 10 meetings. For the camp that's out there that thinks that they will pivot, that they will cut rates, what's their argument as to why they think that will happen?

Gargi Chaudhuri: Sure. So I'll talk a little bit about why we're in the pause camp, and then talk a little bit about the Pivot camp.

So, the Pause camp is entirely because of inflation. Congress has given the Fed two mandates. The first mandate is to have prices be stable which is defined by the Fed as 2% on PCE. The second mandate is having the job market remain pretty resilient.

Now they are doing very well on the job market front, unemployment rates as of right now are sitting at close to 50-year lows. We haven't seen a labor market this strong in a very long time. But on the inflation side of the mandate, they are actually not getting to that 2% level that is their target. So, they don't necessarily need to raise rates higher at this juncture. 5% is a pretty high and a pretty restrictive level of interest rates. At the same time, they don't really need to cut rates either because they're so far away from their inflation target, and the labor market remains strong.

The question is why then is there so much discussion and debate around whether the Fed should cut rates? There have been some financial cracks that have emerged more recently, as you pointed out earlier, was in the banking sectors where, especially for the small and medium sized banks, they have begun to come under a meaningful amount of pressure and the fear that pressure continuing would mean that credit will continue to tighten.

Small and medium sized banks are a big resort for small businesses for loans. If you're a small business in this country, you are responsible for a majority of the jobs of this country. So, if small and medium sized businesses are unable to get the credit that they need from the small banks, that becomes a problem for the entire economy in the US. So, investors and the market actually, that is now pricing in that Pivot narrative, that is pricing in rate cuts by the end of 2023 is actually foreseeing this credit tightening becoming a larger issue as time goes on and the Fed needing to cut rates to stimulate growth as a result.

I'll also say that certain interest rate sensitive parts of the economy have already begun to show some slowing. You've seen that in the housing data, you've seen that in the auto sector. So there have been certain manufacturing components that have begun to slow down. There is the Senior Loan Officer Survey we were talking about earlier, Oscar, the SLOOS that's become a very common or very hip data point to look at these days because the Fed has popularized it and talked about it quite a bit.

All of that is showing a little bit of credit tightening in the economy as well. So those investors that are thinking about rate cuts for the remainder of this year are thinking about that because of the slowdown that is already emanating and expectations of more slowdown because of the impact on small and medium sized banks and the ramification that would have on the small businesses.

Oscar Pulido: So, can we go back then to profitability? You talked about quality companies and what does that mean? Are there particular sectors or industries that when we talk about quality, that tend to come to mind more than others?

Gargi Chaudhuri: So, when we say quality companies, what we really mean is a group of companies or certain sectors that have really strong fundamentals. And what do we mean by those strong fundamentals? We talked a little bit about the ability to be profitable. It's really important for them to have low debt, especially in a world where interest rates are higher, where debt servicing costs can be going up, having that low leverage ratio can be important, and having free cash flow, that ability to weather slowing economic periods and having the cash flow that allows them to do so. And all of that can be manifested in companies that are higher-quality companies, so they have stronger balance sheets.

Now, in a world if interest rates were back to being zero, let's say we were back in 2020 and it rates were at zero, I think in those environments that resiliency of balance sheet isn't as important because rates are at zero and companies are not paying as much for the financing of their debt. Real rates were actually negative instead of the very positive amounts they're at now.

A lot more could be done in a zero real rate environment if you were a company that wasn't as profitable because you didn't have that debt burden or that debt financing burden. Right now though, we are in the camp of higher for longer. We've reached that higher part. We've gotten to above 5%, we haven't reached that longer part.

So, the longer is going to happen for the remainder of the year, and in that environment of staying higher for longer, we think that quality characteristic really comes to head in both the equity as well as the bond markets. Looking at sectors like energy, technology, a lot of free cash flow, strong balance sheets, and frankly those are the parts of the market, that have done very well. People have gravitated towards those very strong companies with strong balance sheets that have cash flow and are profitable and have earnings growth power.

Oscar Pulido: And then maybe to go to Portfolios, you touched on there's income in the market now with interest rates having gone up, the investments in one's portfolio are generating more cash flow. You look a lot at flows, where are people-- what are they buying, what are they selling. What are you seeing? Are investors allocating away from stocks into bonds because of that income that they can generate? Or are they moving out of cash or a little bit of all the above?

Gargi Chaudhuri: So first of all, last year, as we all know and experienced, 2022 was just a rough one for investors. Whether or not you were in the safest parts of the market, which tends to be bonds or if you were in the equity market, which tends to have a little bit higher volatility, you had a pretty rough, investment period for at least 2022. Many investors, had they chosen to be in cash, would have actually had a safer outcome.

This year though, what has happened is quite the reverse. Both equity markets and bond markets have done well, but many investors because they had this negative experience last year have chosen to remain in cash.

So, one of the things we are seeing investors do is actually step out of cash. For the first quarter of this year, we saw them step out of cash to the front end of the fixed income market, so to Treasuries and investment grade credit in the front end, so you could earn a lot of income, but not take a lot of interest rate.

And more recently, in April and May, we're actually seeing investors taking a little bit more interest rate risk in the fixed income markets, but still remaining high quality. Still looking at companies or sectors that are most highly rated within the fixed income market, so whether that be Treasury bonds, or whether it's very strong companies like investment grade credit rated companies. So, we are seeing those flows gravitate towards the fixed income markets.

The other thing that I would say that has been more of a recent phenomenon is actually investors moving away more from the value like stories. And when we think about the different types of investments there are, there's value and growth. Value of course tends to do well in the part of the business cycle where the growth is beginning to take off. And now when there's some fear or expectation of a slowdown, growth is where people are allocating capital to. Our research shows that growth does make sense, but allocating to those areas of the growth companies that are still fairly priced, so growth at a reasonable price. And again, energy sector and certain areas of tech sectors could be things that investors could consider.

The last thing that we are looking at or that we have found interesting in flows is gravitation towards gold, which is interesting. You have the trifecta of real rates that are moving lower, remaining constant, you have a little bit of a flight to quality, if you will. And you also have, investors that are worried about a growth slowdown. And all of that has pointed to investors moving towards gold. So that's something, it's a pretty recent phenomenon, not something we often talk about, but certainly gold has begun to shine again, to use a very overused expression, but certainly seeing some flows there.

Oscar Pulido: As you point out, last year was such a difficult year that investors are saying, if I had been in cash, I would have been fine. And so maybe I should do that again in 2023. But you've highlighted a number of different investment opportunities that have presented themselves this year and that you think are still very worthwhile going forward.

Gargi Chaudhuri: Look, if you need the cash for liquidity reasons, of course holding cash, especially depending on how you're holding it can be something that is absolutely needed in your portfolio for liquidity reasons, and that makes sense.

But if you're holding it for fear reasons, if you're holding it because you expect an exact repeat of 2022, what I would say is the valuations have changed meaningfully, especially in the fixed income market. And this is where earning some yield in the fixed income markets and having that ability to make some total return in the fixed income markets, that opportunity has now risen because the Fed had not raised by 500 basis points this time last year.

Oscar Pulido: I'm just curious, you speak to a lot of clients and investors around the world, whether it's in the US and Latin America, Europe, you name it. And so, is there a common question or concern that you hear from them?

Gargi Chaudhuri: There’s a couple. One that comes up a lot is around the fears of a global recession. Interestingly, that was something that was coming up a lot towards the end of last year. There was a huge fear of a stagflation, so an environment where growth is slowing down, but inflation's remaining high. That slowed down pretty meaningfully in January, and perhaps some of that was because in Europe the winter wasn't as bad, China had the reopening. There was some sense of optimism, so that slowed down.

But more recently, I would say over the last three or four weeks, the questions around a recession have come back. They're not around a stagflation this time around, they're much more around a recession, if that's going to happen in the US, if we expect that in Europe, so that's something that's definitely top of mind. And what should investors do in a recessionary environment? Where should they turn to in a recessionary environment? Especially because last year fixed income wasn't that appropriate allocation.

So having that conversation around where in fixed income and why this time is different, because of course we talked about the US, but globally, many other central banks like the Bank of Canada, for example, done with their hiking cycle. If you look at Bank of England, they're closer to being done than not. And ECB probably still has some more rate hikes to go, but again, many of them have moved a lot further on that hiking process.

And then the second thing for the first time in a long time, US investors are asking about emerging markets as an option. So, I think that's interesting because I hear from, for example, investors in the LatAm or investors in Europe who have historically been allocated to the emerging markets, especially in the equity space, but in the US this is the first time that we are seeing US investors ask about emerging market debt, local currency emerging market debt, and single countries within emerging markets. So not viewing emerging markets as a monolith, but a view around should we be allocating to India because they've heard about India now being larger in population than China, or thinking about China because of the reopening or thinking about Mexico because of friend-shoring.

So, the view of US investors thinking about different emerging market countries has been really exciting and something that's new and hopefully will continue for some time.

Oscar Pulido: I'm listening to the comments that you're making and the phrase that comes into my mind is 'it's a marathon, not a sprint.' When you think about the discipline that you need to exhibit with long-term investing, and speaking of marathons, one thing I learned about you recently is that you've run 25 of them in your life. So talk to us a little bit about the parallel between the marathons that you've run and what it is that your day-to-day looks like working in iShares Investment Strategy.

Gargi Chaudhuri: Thank you. Love this question. I want to write a book about this one day. So a couple of things immediately come to mind. When you train for a marathon, you have to put in the work, you have to go for your long training runs, and I think the work that we're doing with our clients and helping them understand the markets, and invest accordingly.

The other one I would say is, and I often don't do this, but I should, and after 25 marathons, I've learned the lesson is start slow and then get comfortable because it is a long run.

And similarly, to running, I would say the same for investing. Start slow. If all you can do is take a small amount and put that away in a diversified fashion, and that's all you can do, and you don't have to get too crazy, you don't have to listen to every earnings call of every company, you don't have to do that. Later, once you've gotten used to the investing lifestyle, once you've gotten used to looking at data or earnings or any kind of economic indicators, you can become a more sophisticated investor.

But start slow. The last thing, I guess I would say, and I use this for markets, but also for people's careers, run your own race. When you're running a race, you might be on mile 20 dying and someone might pass you by running seven-minute miles. They are having another race. You are not running their race.

Similarly in investments, if you have a friend that's invested in something very cool and something very esoteric, that might be amazing for them. But think about your own portfolio and what it needs. So run your own race in the markets, in your career, but certainly in the investing landscape.

Oscar Pulido: It's great insight and we wish you luck on your 26th marathon whenever that takes place. Gargi, thank you so much for joining us on The Bid.

Gargi Chaudhuri: Thank you.

Oscar Pulido: Thanks for listening to this episode of The Bid.

This post originally appeared on BlackRock.

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