Thu, 7 Apr 2016
Panelists at the Morningstar Individual Investor Conference discuss how to position for profit amid anemic growth, energy volatility, the threat of inflation, and extraordinary central bank activity.
Jason Stipp: I'm Jason Stipp, site editor for Morningstar.com. It's gloomy here in Chicago, but we've got some bright minds and bright ideas for you today. We have got five sessions and one video special. You won't want to miss any of it.
We're going to start by taking the market's temperature with a panel discussion this morning. I'd like to introduce the panelists we have here today. We will be talking about how the economy might be affecting the markets and how you may want to position your portfolio. We have Charlie Bobrinskoy; he is Vice Chairman and Head of Investments for Ariel Investments. Thanks for joining us, Charlie.
Charlie Bobrinskoy: Thanks for having me.
Stipp: Michael Fredericks is lead portfolio manager on BlackRock Multi Asset Income Fund. Michael, thanks for being here.
Fredericks: Thank you.
Stipp: And Bob Johnson, of course, is our director of economic analysis at Morningstar. Bob, thanks for being here.
Bob Johnson: Thank you.
Stipp: Let's start out at a high level and talk about the economy very broadly. If you look at the economy month to month, if you are looking at retail sales, if you look at manufacturing data, it can seem like we're going through periods of booms and busts. The data is very noisy, but when you dig underneath the month-to-month volatility and noisy data, what does the actual real economy look like to you? Are we strengthening? Are we weakening? Charlie, let's start with you. What's your take on what the economy is really doing?
Bobrinskoy: We have been surprised how pessimistic people are about the economy, which frankly, we think is pretty good. We've had, obviously, a long period of steady gains in jobs, a long period of dropping unemployment. We think that people are excessively afraid of the economy. Obviously, 2008 had a massive effect on people's psyches.
People are looking for that next big recession, which we don't see anywhere. We've got a lot of tailwinds, in our view. We have got a very strong auto market. We've got a better housing market. We have got low interest rates, low energy costs, lower unemployment. We think there is a lot to feel good about, particularly in the U.S.
Stipp: Michael, we haven't had necessarily the kind of growth that you'd normally like to see coming out of a downturn. But we've had a very prolonged period where we haven't had to deal with a recession, since 2008. How would you characterize this sort of slow-growth environment that we're in? Is this something that you think is positive, that it's been so long and ongoing? Or is it not growing fast enough for us?
Fredericks: I think it suggests to us that it's kind of a bifurcated economy. Yes, I totally agree, there are pockets of strength and there are pockets of weaknesses. The housing market and auto sales have been good. Consumer spending has been OK. We've been buying a lot more stuff, but the price of that stuff has, in general, been falling. So real retail sales haven't been so impressive. Manufacturing has been a bit of a different story, particularly over the last year or so.
Consumer looks pretty good; the manufacturing and industrial side of the economy, not so hot. And I think that translates into another year of growth that is just OK: 2%-2.25% GDP growth. When you look to some of the overseas markets, they're not doing so well either. You've got Europe growing in the low 1% range, and Japan is whole other can of worms.
So I think it translates into a continuation of a world where overall growth is not that exciting, but not bad, either. But the level of growth is what is really complicated for investors, because it doesn't take much in terms of a slowdown in data for it to feel like we're hitting stall speed, and people get very anxious that we are going over the edge into recession, and that leads to big sell-offs and real choppiness in markets. Unfortunately that's the environment we think we're in.
Stipp: Bob, you've often referred to the economy as a giant ocean liner that's very hard to turn one way or the other. It's been moving slowly forward and slowly upward. Is there any reason to suggest that we won't see that same sort of slow but generally decent growth going forward?
Johnson: I think that we're looking at probably more of the same and in the same range of 2%-2.5% growth. The one thing that is weighing on this recovery is demographics. We've had a slowing in world population. It's not just here in the U.S. where we have seen the population growth slowdown, but the issue is even a bigger deal overseas.
On top of slower population growth, we're also seeing a situation where that population is aging, and people as they age have entirely different spending habits. That's really affecting a lot of industries very unevenly, but I think that's why we've got the slow growth that we're seeing right now in the economy. It has so much to do with demographics.
I think the idea that the Fed or the ECB or the Bank of Japan can solve all our problems and make us grow faster again is probably not true. I think the bigger issue is demographics, and I think we've got more slow growth to look forward to. That's probably not bad news for consumers, but it's probably not great news for corporations that are used to more unit growth.
Stipp: Charlie, something else that's slowing down is productivity. What does the trajectory of productivity mean for the U.S. economy?
Bobrinskoy: Most importantly, it could have an effect on inflation. Productivity is one of the things that allows you to get more goods and services at lower costs. It used to be that productivity improved how fast you could grow crops, how fast you can make a car, the number of people it used to take to do a spreadsheet can now be done very quickly by a computer.
Today the productivity and technology improvements are infotainment, entertainment, and healthcare, which are making people live longer, but don't really making us more productive.
So productivity does not have the kind of positive impact on the economy that it used to, and frankly, it's not going to keep inflation down. So we do think that there is a risk--and we'll come back to this later--of inflation because of the lack of productivity improvements.
Stipp: Charlie mentioned inflation there. When you think of some of the other risks, Michael, to the U.S. economy, what are some of the things that are on your worry list?
Fredericks: It doesn't take much to knock this economy into recession. It goes back to this point of, if you do get a slowdown in growth, we are close enough to stall speed that it can become self-fulfilling.
Some of the real concerns, some of the weakest pockets of the economy, we'd say, continue to be in manufacturing. The more recent data has been mixed just over the last week or so. Manufacturing jobs continued to fall; [companies] are continuing to lay off people in the manufacturing sector. But some of the forward-looking indicators were better. So there continues to be some mixed messages. So, I think the shocks could come from manufacturing. We think the consumer actually looks pretty good. They've really built up their balance sheets. I don't think it is coming from there.
There is … a lot of potential for disruption from China. … [China] is undergoing really important shifts from a manufacturing-driven economy to a consumer-driven economy. There is a lot of pent-up debt that has been built up over the previous cycle, and they are struggling to contain their currency, and manage their currency. A lot of policy response from China could be disruptive to global economies.
Stipp: Obviously, China is still growing faster in absolute terms than the United States, but their trajectory had not been great recently. So if China has not been doing as well, and the U.S., you say, could be shocked relatively easily, given our slower growth, are there any bright spots in the global economy that you think could help if China has some trouble and we see any ripples here?
Fredericks: The consumer in most developed markets looks pretty solid, and so we take that as a positive. This kind of bimodal economy--with a decent consumer and a pretty soft manufacturing sector--suggests for investors is that you really want to think about, to your point earlier, about where are we in the cycle. This has been a long recovery; it's been a shallow recovery, but it is a little long in the tooth. For investors, I think the time where you make a lot of money is earlier in the cycle when valuations on stocks are really low and bond spreads are really wide. That's the time to take a lot of risk. And we think for investors, you really want to be thinking about modulating risk, taking risk down, at this part of the cycle. It's not that we think we're coming to an end, but we think being up in quality in fixed income makes a lot of sense. We think that taking down some of your equity exposure at these higher valuations is prudent, particularly for the income investors that we focus on.
Stipp: Bob, we've mentioned inflation a couple of times, and we haven't seen a lot of inflation throughout the recovery, and certainly commodity prices have kept certain parts and measures of inflation depressed over the last year, year and a half. But you are starting to see some signs that inflation could be creeping into certain parts of the economy. What are you seeing?
Johnson: I am a little worried. I am not quite as benign on inflation. I don't think we're going back to a 1970s style situation, where everything is up double-digits in terms of prices, but I am worried. If you look at what's been holding back prices, it's been the energy sector, which everybody knows about, and knows that's going to go away.
Less recognized is that goods prices, until recently, were also moving down as the expensive dollar began to bring the price of goods down, so that helped keep goods prices down. But we've had services inflation--your haircuts, your health insurance, your auto insurance. That part of the economy has seen inflation of around 3%. That's relatively high compared to past history, and all we need is some kind of dislocation in energy that moves those prices up, or at least they stop going down, and then you've get the goods situation maybe getting a little bit inflationary. Then all of a sudden, you are staring at some pretty bad inflation problems, and we think it could be at 2.5%-3% year-over-year inflation by as early as December. I don't think that's recognized yet. We're not saying it's going to go to 5% or 6%, but enough to slow the economy a bit, and we're already seeing it in the consumer spending [data].
Stipp: Inflation is also on your worry list?
Bobrinskoy: I've mentioned it already, but this would be the risk that we think the market is not getting right. The market understands how soft the economy is, the slow growth of the economy. Everybody gets that, we think. But we don't think it's appropriately valuing the risk of inflation.
The other thing I'd add to what Bob said, all of which I agree with, is the U.S. has now run up $19 trillion in debt. The U.S. government has a real incentive to reduce the value of that debt, which they can do through inflation, and countries around the world have been competing to devalue their currencies.
So, what is inflation? It's the reduction in value of currency. And the U.S. government, [Federal Reserve Chair Janet] Yellen has said it's one of her goals to increase the rate of inflation, and this is one of the things where governments can be very effective when they want to be …
I agree with Bob. I'd even be a little bit more worried about higher numbers. The average inflation rate in the last hundred years is 3.2%. Most people think we're having zero inflation, but the actual number is close to 2% right now, heading north. So, we would be listing this as a very high risk that's not properly understood by the market.
Stipp: Charlie, I want to stay with you for moment. We have a question from a reader, Randy. This is related also to the point Michael made about investors and how they position their portfolios, given where we are in the current cycle. Randy asked, when economic growth is projected at 2% to 2.5%, how can my portfolio do better than that? What do you do when the economy is in a slow-growth mode? Where are you seeing opportunities to do better than a slow-growth portfolio?
Bobrinskoy: The good news is there is leverage in the world. So, if your revenues are growing at 2%, you often can get profit growing more than that, and you do have fixed costs coming down. You have energy as an important cost for a lot of companies, and that's coming down. If anybody is making wallboards, or making pharmaceuticals or fertilizers, the natural gas price under $2 is being very helpful.
We do think you can grow profits and have grown profits faster than the 2% GDP growth. Obviously, very low interest rates mean that people are buying back their stock and having their earnings per share grow a lot faster than the overall economy.
Earnings have been disappointing, only up about 1%-2% for the S&P over the last two years. We think that's going to get better, and we're going to get more like 6%-7% over the next couple of years.
Stipp: Michael, when you are thinking about positioning a portfolio in a slow-growth world, how do you think about doing better than slow growth for your investments?
Fredericks: We've increasingly over the last year or so transitioned our portfolio to try to generate our returns on the basis of cash flow. We have a yield of about 5% on our fund, and we're trying to take very little volatility risk and get to our total return by just clipping coupons, largely from fixed income. At the moment, we've had the lowest weight in equities that we've ever had. It's not that we really dislike stocks--we don't think we're about to fall into a bear market--but we look at, say, BB high-yield bonds where you're getting coupons of about 6% in a favorable economic backdrop with a lot less volatility than stocks. We think that looks pretty interesting. Or bank loans, where you can get yields of 5.25% or 5.50% with fairly low volatility, particularly compared to equities. Preferred stock. So we've been diversifying our fixed-income exposure into non-agencies and CMBS, and these other pockets, other diversifying sectors within the fixed-income universe. We're not trying to hit a home run at this point, but just trying to hit predictable monthly total returns with as little volatility as possible.
Stipp: Charlie, you are an equity shop at Ariel, but you're not seeing really any opportunity in fixed income. In fact, you are pretty bearish on fixed income?
Bobrinskoy: That's right. We're going to have our first disagreement of the day. We think the area that is the most expensive is people stretching for yield. There is this unpleasant joke about more people have died stretching for yield than through any other cause. We think that right now people are doing that. There is a safety overvaluation right now that people think they're getting in bonds, and the problem with that is, with a 1.8% 10-year Treasury, all of the instruments that we're talking about here are priced off of those Treasuries, which, in our opinion, are way overpriced. I'll make a blanket statement, we're seeing no good opportunities in long-dated fixed income, and no good opportunities in stocks priced like bonds: utilities, MLPs are all in our judgment overpriced.
Stipp: We've also seen a lot of more the more fixed-income-like stocks run up in the first quarter as well …
Bobrinskoy: Utilities did extremely well. Absolutely, these high-dividend paying stocks are much higher priced than their brethren with a lower yield, and we think that will reverse when we get more inflation and higher interest rates.
Fredericks: Let me take a stab at that one. I would agree that there is no value in Treasuries, particularly at 180 [basis points] on the 10-year. On the other hand, when you look at some of the global forces that are keeping rates low, when you look at German 10-year bond yields that are close to zero, or you look at Swiss 10-year bond yields, which are negative and so on. There is a lot of international money that will look at, say, 1.8% on the 10-year, and they think that's pretty interesting. We see this a lot from our overseas clients where the difference in policy response from the European Central Bank and the Bank of Japan--they are going to continue with these policies and keep those rates really low.
So we don't see in the short run--certainly in the intermediate run there is a different story--but in the short run, we don't see a big risk to rising interest rates. But we're looking more at the spread sectors within fixed income, whether it's high yield or preferreds, and those are much more geared to the economy. And we think that combination of spread on top of albeit fairly low Treasury rates, if you can get to a total return of around 5.5% or 6% in this environment, that's a good place to be.
Stipp: You mentioned global central bank policy. I'd like to talk about our domestic central bank policy. The Fed has obviously been trying to get out of the extraordinary stimulus measures that we've undertaken over the last several years, really since the financial crisis.
The market has been obsessed with the Fed over the last year or so. Bob, … I'd like to get your insights about the way that the Fed is going about normalizing policy. If you're going to give a report card to the Fed, how they are doing, how do you think it's going so far, being very slow and taking a wait-and-see approach, and then we'll raise rates if we can?
Johnson: I think they've been dealt a relatively poor hand, and I think that they've done a decent job of adjusting. They've certainly had a hard time trying to communicate where they are. As we sat here last year, we were talking about what words were left in and out of different policy documents, and we're still kind of sitting there at that level.
The one thing that's bothered me a bit about the Fed is that that they've talked about watching the labor market and watching inflation; that's our charter, and that's what we're watching. We've got the labor market relatively strong right now, and it's met their parameters. This is not an abnormal situation anymore. And we've certainly got, in our minds, inflation is back up again. They've gotten a little help from energy prices lately, but other than that, I think that they've got inflation where it needs to be.
You'd be thinking they'd want to raise rates and normalize things more than they have, and instead they've said, now we're worried about international and now we're worried about something else. They've added a lot of caveats to what was a pretty straightforward message a year ago: We're watching these two things. Now everybody is a little uncertain of what they're watching, and that uncertainty, as we mentioned, isn't a good thing, because when you're on this cusp of growth, uncertainty is the last thing you want. Now, we're kind of wondering, what's going to be their excuse next month?
Stipp: It also seems that if inflation is the risk, as we've talked about, that could be heating up faster than expected. This sort of wait-and-see method that the Fed is undertaking, they might not be able to, right? If we start to see inflation creep in, they won't have a lot of time to wait-and-see anymore, right?
Johnson: Right, and this is what always happens. The Fed is always behind the curve. If you look back over the last 50 years. They want to err on the side of caution. They don't want to take away the punch bowl too soon. There are seldom examples of where they pulled it away too soon, and I think in this case they are waiting to the very end. I think they were on the right track, and then the swoon in energy in February really threw them off track. I think they will regret not having started to raise rates again in 2016.
Stipp: Charlie, we've had the 10-year Treasury yield at 1.9%. I think it even went lower than that recently. Where do you think normal 10-year interest rates--if we know what normal 10-year interest rates--should be? How far away are we from a normal environment?
Bobrinskoy: Well, this is where we think you can look at history. People have been issuing 10-year Treasuries for 100 years, and the average number is closer to 4%--a 3% inflation rate and a 1% real return on top of that. We have never been this low, except for the day after Pearl Harbor. We'd never been below 1.75%. We've now been bouncing around this level for three or four years, but other than that period, we were never below 2% except for the day after Pearl Harbor. So, this is very unusual low interest rates, and we think we're going to go back more to the traditional 4%.
Stipp: When we're thinking about a rising interest rate environment, and you're thinking about trying to position a portfolio that has lots of different kinds of assets, some of which will be much more rate sensitive, how do you position for an environment where maybe we don't know exactly when it's going to happen, but it's going to happen at some point? What do you do to prepare for that?
Fredericks: I think it may happen. But if you just look at what the bond market is pricing in, the bond market believes that 10 years from now, if we're sitting here … on the very same set, the 10-year Treasury yield will be about 3%. So, we're talking about looking out 20 years in the bond market. Now this may be a very pessimistic view and that says something about how much pessimism there is in the bond market. But the markets believe that rates are going to be low for the next 20 years.
Bobrinskoy: And that's the danger. That's what we're arguing with. I agree with that, but that's the danger.
Fredericks: That's what's priced in. We think that's probably excessively pessimistic, but it's also suggesting that the markets believe that growth is going to be much lower than historical averages, and we think there's something to that.
It's important to differentiate where you're taking interest rate risk. If inflation does tick up, I think probably the most vulnerable part of the yield curve is going to be at the front end, and that's where I think if you look for any mispricing, and if you think that inflation is going to surprise, you have to assume that the Fed is going to become more diligent. And right now when you look at what's priced into rate expectations, it's a very benign, slow move higher in short-term interest rates, and that's what we've hedged out of our portfolio. We're concerned that the bond market has been mispricing the trajectory of Fed rate hikes, and so we've hedged out that risk using interest rate futures from our portfolios. We're more comfortable, again, from a short-term tactical perspective, owning longer duration assets, because we think those are being driven by more of these global dynamics, namely really low if not outright negative interest rates from overseas markets.
Stipp: I want to talk about negative interest rates quickly, because we've been hearing about them. Janet Yellen mentioned that negative interest rates are off the table for the United States. But what is this idea of negative interest rates? How does it work and why are some of the central banks undertaking that policy? What do they hope to get from it? Can you explain that?
Fredericks: It started with the idea of lower interest rates will stimulate the economy, and particularly we've seen in Europe and in Japan, rates went to zero and they still weren't able to jumpstart life into the economy. So they pushed them negative, so as investors you actually have to pay to deposit your money, which is a really bizarre notion, but that's where we are. It's also pushed down interest rates across the yield curve. In Germany, you have negative interest rates out to seven or eight years. It's hard to believe, but it's the case. And in Switzerland it's even more severe.
I think you're starting to hit tipping points on the benefits of lower interest rates. It's meant to stimulate the economy. It hasn't really worked very well yet, but cracks are starting to emerge in this policy experiment, namely in terms of the profitability of some of the big European banks, which had very difficult earnings in the fourth quarter and you've seen their share prices fall dramatically. They cited negative interest rates, and with negative rates, it's really hard for banks to turn a profit. And if you start to undermine the stability of the financial system, that has really negative implications for the broader economy. So, I think the ECB heard that message loud and clear. They're still going to continue with stimulus, but they're going to use different tools rather than pushing rates lower and lower.
Stipp: Bob, Michael mentioned that lower interest rates haven't necessarily stimulated the economy as much as they could have. Do you think that we've reached the end of low interest rates? Why haven't low interest rates worked as well as we'd like? Why aren't they having the impact that we'd want?
Johnson: I think a lot of it is related to some of the demographics issues. The demand for money is not as good as it once was. Certainly here in the U.S., we've seen that's true. I'd say less so overseas. But here as our population growth has slowed, you don't need a new factory to produce more milk when you've got no population growth. You just make the old stuff work more efficiently. That's all you've got to do.
We haven't got this big demand for money from new capital equipment, and a lot of the developments that we've seen in technology now relate to social media and that type of thing, where you don't need capital investment. We've seen business spending has been one of the things that's been holding back the recovery, this year at least. It's unusual. We've all talked about how the consumer is a key driver, but behind that message is that business spending is going nowhere, even with interest rates that are practically money for free. So I think a lot of demographic issues are weighing on this. Companies don't need the money as much as they once did and certainly there's a lack of confidence in where the economy is going, which is probably also holding them back.
Again, consider a slow growth world that's more focused on technology and social media, you just don't need capital in the way you did when GM was a key driver of the economy.
Stipp: I'd like to jump over to a reader question. This is related to inflation, but also the cost that companies are bearing now. Gerald is asking if you have any thoughts on the push to $15 minimum wage and the effect that that could have on inflation.
Bobrinskoy: I didn't plant that question, but I'm glad that that person asked, because part of inflation is cost-push inflation; the costs that come through the system contribute to inflation. There are lots of different things that cause inflation. Monetary policy and more money in the system cause it, demand causes it. But costs cause it, and we are going to have increasing labor rates in the country. Minimum wage rates are going up.
This is not well understood, but the actual population moves … there have been more people go back to Mexico than come this way. The available labor force has actually gotten a little bit smaller, and that's going to push rates up. Healthcare benefits, the increasing benefits that people have to pay when they hire workers, is going to push inflation up.
All of these factors, the price you pay for a hamburger at McDonald's, is influenced by what they have to pay for the person that grills that hamburger. And that number is going up. We've had a lot of things that have driven inflation down--we've had low food costs, we've had low energy costs, we've had low labor rates. But all of those things, including a strong dollar, are in our opinion about to head the other direction.
Stipp: Michael, we had another reader question specifically on inflation. There are lot of different ways you can track inflation. John is asking, what are some of the ways that you might want to look at inflation, because you have the core and then you have other measures and then there are measures for folks in retirement as well. And some people might be feeling a lot of inflation and other people might may not be feeling as much. So, how do you get a handle on the inflation measures and how fast some of them are moving up?
Fredericks: It's a tough question. Inflation is tough to measure, because there are some many different influences. I'll speak for myself: My experience is that inflation is running hotter than the government statistics. I certainly feel like my cost base is definitely going up faster than is being measured by the government.
If you look at headline inflation, which includes food and energy, that's the most volatile part of it. I think we're at levels where falling oil prices, which have dampened the headline inflation, are about to roll off and become less important. So, to some of the points made earlier, I think you are going to start to see the official number pick up. But if you strip out food and energy and you look at core inflation, it's been drifting higher.
This does raise a really important point around corporate margins. Some of these cost pressures that have been building up… We have seen peak margins. They were extremely high, and it was really impressive, the profit margins that corporate America was able to generate over the last several years. But those have started to roll over on the back of some of these cost pressures that are starting to build. Just in the latest fourth-quarter GDP release, we saw the corporate profit share of GDP fall double-digits, which is--I shouldn't say unprecedented--but it's very unusual.
This is where we struggle a little bit with the upside case for equities, because you look at falling margins and you look at earnings growth, which has not been terribly exciting, and you compare that to the S&P with a multiple of 17 times, that's a big number. We think that number is pretty bullish. That would suggest that investors are pretty bullish on markets.
When we compare that to pockets of fixed income, particularly up in quality and some pockets in high yield, or we look at preferreds and so on … those spreads, particularly if you went back six weeks ago, are absolutely at recession levels. There is a lot more bad news priced into the bond market than the stock market, and it's this disconnect that has us talking down our equity weights and pushing more into fixed income.
Stipp: You mentioned commodities there and the impact that lower commodity prices can have on companies, but we've also seen commodities have ideally a beneficial impact for consumers. They would have a little bit more money to spend. But I do want to turn the conversation to commodities. We've had a lot of questions on what is the effect of low oil prices on the economy and on companies.
I would like to start first by just talking about the fact that U.S. markets and even global markets and commodities have been so tightly coupled. Every day it's crude has gone up, because they are going to make a deal and stop production and the markets go up. Or now maybe Iraq is not going to participate, so then crude comes back down, and then the markets come back down. Why are they so closely coupled recently?
Bobrinskoy: This is disappointing to us. We did believe the drop in oil prices would be good for the U.S. economy. It's certainly good for the consumer. I think it is two things. It's correlation, it's the perception of weakness in China causes oil prices to drop, and weakness in China has other effects, which cause manufacturing companies to make less money. So, they are correlated as opposed to causal. But it is causal to the degree the banks have made a lot of loans to oil companies, and if a lot of these [companies] go under, banks are going to have a lousy time. The state of Texas and the state of North Dakota have made a lot of investments in the energy business, and that's going to get tough.
We do think that in the short term oil prices dropping is going to be disruptive to the high-yield market, where at one point it was close to 15% of the high-yield market; it's less than that now. But now with oil back closer to $40, we do think we're at the point where the stock market and the oil market won't be quite as close as they had been.
Stipp: Bob, when you look at the consumer data, have consumers been spending some of that extra money they have been saving at the fuel pump or not?
Johnson: There are two things going on. I think some of the numbers would indicate consumption hasn't really benefited all that much from the lower prices. But then you start pulling it apart, and yes, it has. Some consumer categories are doing unbelievably well. Restaurant spending is up something like 8% year-over-year. That's almost unheard of. And travel is another area--overseas travel was up in double-digits. Spending on sporting goods, spending in many categories that might be considered luxury or discretionary items are doing very well, and not just the high-priced ones--the mid-size SUVs or hunting equipment. All of those semi-discretionary items are really doing quite well.
Stipp: Does that suggest consumer sentiment is pretty good? I know that you are not a huge fan of consumer sentiment, but if people are spending at restaurants and they are spending on sporting goods and they are taking trips… I know Carnival's earnings recently showed that more people are booking cruises and they are booking them further into the future. The consumer is feeling better, then?
Johnson: Absolutely, and some of the statistics we saw on Friday--again, I'm not one to look at the big statistics on consumer sentiment because I can get real-time data faster than those surveys are compiled, so I'm not a big believer in those.
But nevertheless, the consumer is spending. This idea that he's not spending… you think about gasoline. It could go to nothing, but I am still not going to drive any more. My thrill isn't driving my car around. There are a lot of categories in there [that may not show growth]. Food is another one, especially with the diet craze and people being more careful about what they are eating, and they are eating out more. Food spending isn't going up.
So, there are a lot of categories that are a pretty big percentage of consumer spending that aren't going up--not because they don't want to, but it is just kind of… we're satiated, if you will. So, I think that's confused a lot of the numbers. Consumers have been spending more of their money than people think.
And then there is one negative side to that, too. A lot of people are now spending more of their money on rent and more money on healthcare than they used to, and there is this perception that they aren't spending as much, but they are spending a lot on those items, which weighs on the data as well. And conventional retail sales haven't looked so great. Well, maybe they are spending more on healthcare, they are spending more on trips, they are spending more on restaurants. They are not spending the way they used to. And that flows back to some of the demographic trends that we have seen, that older people tend to spend on healthcare and travel, and less on more clothes and more furnishings.
Stipp: Michael, Charlie mentioned some of the knock-on effects of lower oil prices in the financial services sector because banks might have exposure to some of these exploration companies that may be overstretched. When you think of some of the negative knock-on effects of the low commodity prices, are there any concerns? Particularly in the high-yield market--the market of companies that don't have great credit, but they have a lot of exposure to energy. Is there risk there for the economy?
Fredericks: I don't know if there is a lot of risk for the economy, because if you look at the overall portion, the energy-related exposure in the high-yield market as a percentage of the total bond market is about 0.5%. So, I think the potential for contagion is pretty low. Can it roil and has it roiled the high-yield market? Absolutely. We have been really cautious on the entire extraction market--energy, metals and mining--for a long time. It felt like we were very well positioned in our portfolio for all the turmoil that hit starting in the last year or so, when the yield stretchers really got hurt, particularly anyone that had exposure to MLPs as well as energy-related high yield.
Those prices have actually bounced a lot in the last six weeks or so. We are still not believers, and we are still really wary, about some of these fundamentals. I don't know where the clearing price is on energy, but I think we will find an equilibrium more quickly in the energy-related markets than we will in, say, the mining sectors where we think that there is chronic overcapacity, and the demand that was so driven by China is not coming back. It's a lot easier for supply and demand to meet in the energy sector, but the longer we stay at these low prices, the more a challenge it is to the viability of a lot of these MLPs and a lot of these very levered energy and E&P companies.
Stipp: Michael said he wasn't sure exactly where that clearing price is. Do you have a sense of what you think long term? And I am not asking to you to predict what's going to happen in the next six months. But what's a normalized price of oil, given that we have some secular changes, like lower demand from China, for instance. What is the normal price of oil? What can we expect it to converge to?
Johnson: I don't think any of us know for sure, but we talk about with our energy folks about the cost of taking that oil out of the ground and what is the marginal cost? You've already got the sunk cost; your well is in place. What's that extra cost of pumping another gallon out?
It's very different by market. In Saudi Arabia, it's pretty darn low; for shale guys, it's relatively high. As supply and demand comes, usually it comes down to the last players in the market: what's their marginal cost? I think that number was probably in the $50 range or so, but again who knows? We've all been wrong on energy forecasts in the past. I don't think we're going back to sky-high prices again. Marginal cost analysis, which is kind of the logical way (but markets don't always operate logically) suggests a price probably right around the $50 range. But I think we could go higher than that, and we can go lower than that, because energy is something that you can store for a long time and it takes a long time to ship it and you can buy futures on it. So that's why some of the data get so confused.
Supply and demand aren't really all that far off right now. This is really a supply problem, not a demand problem. Energy demand overall in 2015 grew at a higher-than-average rate than it has over the last 20 years …
Stipp: Are you talking about global energy demand or U.S.?
Johnson: Global energy demand.
Stipp: So what made up the difference? The conventional wisdom is China is not buying energy anymore or not as much…
Johnson: Well, certainly at lower prices, we've bought more here. We've mentioned buying cars that are less energy efficient has been the trend. Our energy use here is clearly up. Our miles driven here in the U.S. after years of being down was up over 3% last year in terms of number of miles each car is driven. And there are other areas where energy demand has gone up.
By the way, the demand from China is still there. Actually, their demand for oil was up last year. It just wasn't up as much as everybody had thought it was going to be. This is not a demand issue. This is not China's demand going away. This is unbridled supply.
Fredericks: By the way, I think Bob's point on the motivations for some of these shale producers … they may not necessarily be rational at face value, because they will continue to pump even if they are not turning a profit because they need the cash flow. They can't not pump. They need to make their next debt payment. Because so much of this was financed in the high-yield market, and they used a lot of leverage, they have to keep going, even if it's not profitable right now. They need to keep the game going. That has been an important dynamic in why you haven't seen the supply fall off as sharply as some might have thought.
Stipp: Exacerbating the supply issue, effectively.
Stipp: I'd like to turn to corporate earnings and also valuations in some of the different areas of the market, and tie this discussion back to actual investments. Charlie, I'll start with you because you have some interesting ideas about recent performance that we've seen, but also where are you seeing opportunity in the market, and it's somewhat contrarian, perhaps, not surprisingly coming from Ariel. Can you talk about, given what we've seen, where you are now seeing some opportunity in the market.
Bobrinskoy: We are seeing that there is this risk premium that companies that are perceived to be economically insensitive, low beta if you will, are in our view being overpriced. And companies that have cyclicality are very cheap on a relative basis.
When we rank all the companies in our portfolio, from most expensive to cheapest based on our calculation of intrinsic value, all of the most expensive stocks are the very low beta, low cyclicality stocks and all the cheapest stocks are the names that have economic exposure.
Stipp: Does that include energy names?
Bobrinskoy: It does. It does. You've got to be careful in energy, because they've got to get to the other side of the trough. Energy supply companies, for example--we have a company called Bristow, which flies helicopters that service deepwater drilling rigs, and that company is right now selling for about 40% of the value of its helicopter fleet. There is a very liquid market for helicopters, and there's a very depressed stock price, way below liquidation value. Ben Graham would love this company if he was still alive.
U.S. Silica, which provides the sand that's used in drilling, is trading at an extremely low price. And the same thing is true for financials, banks. Morgan Stanley is trading at 70% of book value. They have a portfolio of some stocks and bonds, and you can get that portfolio today for 70 cents on the dollar, and get Morgan Stanley's M&A business and their advisory business for free. And the reason is because they are tied to the economy. If the market goes down, Morgan Stanley is going to go down more; there is no doubt about it. But in the long run, right now, we think there is an excessive premium being paid for stability, for non-exposure to the market, and you're not going to earn a good return, in our judgment, investing in those "safe stocks" today.
Stipp: So this is consumer defensive names or utilities names...
Stipp: So, look elsewhere. But you have to have some stomach, right, to do that?
Bobrinskoy: Absolutely, and that's one of the lessons that we think history has taught us is the people who do poorest are the people who look at their portfolio every day, because of all the behavioral finance teaches us, we all overreact to losses and underweight gains relative to losses. So if you look at your statement every day, you're going to put too much money in safe investments. And so it's much better to take a longer horizon, particularly right now, when you are, in our judgment, being paid to take that cyclical risk.
Stipp: Michael, I'd like to turn to you, because I think you've cast some defensive notes generally, in how you're thinking about the markets. But what does that translate to with your investment plan? And given that the market has been volatile, but is essentially sideways for the first quarter, and we've also seen several years of good performance, are valuations looking attractive? How do should investors be thinking about their investments given everything that's happening right now with valuations and the economy?
Fredericks: We manage the multi-asset income fund to deliver a pretty high level of yield, around 5%, with low volatility. To meet those ends, we've been positioning, in general, away from stocks. So I would agree that I think the cyclical parts of the market are more attractively valued than particularly areas like utilities. I think probably the most expensive part of the market are the very highest-yielding stocks, which I think I would agree are really unattractive.
But on the cyclical stocks we've got in the portfolio, we've got about 13%-14%, but we've overwritten them with call options to generate more income. And because these cyclical stocks are more volatile, you actually get paid a lot of money to sell 5% or 7% out-of-the money options on these types of companies. I think the market will go up, will drift higher, but we think the likelihood of, say, double-digit returns for the foreseeable future on equities is pretty low, which is why we think that selling these call options is an interesting idea to supplement yield for income investors.
Then the other three quarters of our portfolio are invested in a variety of different fixed-income markets. I mentioned earlier, we're wary of the potential for a big move higher in short-term rates, and so we've hedged out that risks, but we try to look across different markets, whether it's high-yield and bank loans and non-agency mortgages. Commercial real estate, we think, is a really healthy market. You can own really low-quality, very volatile commercial mortgage-backed securities, or you can own higher-quality and sacrifice some yield, which generate very low volatility--that's our preference. Across our portfolio, we're positioning for later-cycle, up in quality, not taking a lot of risk, and we've got a volatility of about 5%.
Stipp: Bob, we're heading into first-quarter earnings season shortly here. You mentioned before about how corporations are spending their money, but also we've talked earlier about profit margins, and there might not be necessarily a whole lot more to eke out of that. What should investors expect from the corporate sector as far as earnings growth, margins, contribution to the economy?
Johnson: I think we're at an interesting dynamic in the economy right now. I think the demographics would argue that labor is about to get a bigger piece of the pie. We've actually seen a number of labor market shortages, drywallers, pilots, airline controllers, chefs. Every day the list gets longer, and companies are saying, I could do better if I just could hire more people. So I really think that we've got this issue of labor shortages weighing greatly on what we're doing here. And I think that's one of the key dynamics that's going on.
Stipp: Do you think the business is then spending more on labor, but not investing back in the business? Do they not need to invest as much back in the business? What about business spending?
Johnson: I am relatively negative on business spending overall, because in general, you don't need the green-plant operations that you used to. With the economy going slower, you don't need the working capital that you used to. But I do think there are a couple of areas of corporate spending that may be interesting. Certainly, with labor shortages, anything that makes people more efficient is going to do well, and I think that could be a case for some select areas in technology, which could begin to look a little bit better as labor-saving devices. I think that's an interesting area to look at. I think there are other areas like that, like travel, which may be of interest because of the demographics that are out there, and people may spend more in some of those categories.
There are a lot of interesting things going on because of demographics in terms of business spending. But I think, in general, labor in most business is at least a third of your costs, and with these labor shortages ongoing, I think that's going to put a lot of pressure on corporate earnings.
I think higher interest rates, whether it's a little or lot, are going to put some pressure on corporate earnings. We've got this generally low level of growth and, of course, the whole story about getting costs down is about getting a little bit more revenue to flow to the bottom line--this high marginal profitability syndrome. And now with more limited growth, higher interest rates, higher labor costs, in general I think corporate profits are a lot to worry about here. I'm very concerned.
It's actually good for the consumer and the individual that more of the pie is going to flow over to them. It's not so great for corporate earnings. But again, the selectivity that Charlie has talked about, there are some people that have very low labor costs and serve the middle class with their products that could do exceptionally well. So this idea that the broad markets are going to do one thing or another are of interest generally, but I think this maybe an area where individual stock consideration and what are the key demographic trends driving their businesses will be the key determinant of who is successful.
Fredericks: The same thing would apply to individual bonds, I would point out. Those benefits also translate over to the fixed-income side of the ledger, too.
Stipp: I think we'll have to end it there. It's been a great conversation. We've covered a lot on the economy, but also how investors should think about their portfolios in these very interesting times. Charlie, Michael, Bob, I'd like to thank you for joining the panel today and for your insights.
Johnson: Thank you.
Bobrinskoy: Thanks for having us.
Stipp: Everyone stay tuned. At the top of the hour, we're going to have our second session. Be sure to not go too far away from your computer screen. We'll be right back. I'm Stipp for Morningstar, and thanks for watching.