Investing Insights: Morningstar Investment Conference

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Sarah Bush: Hello. My name is Sarah Bush. I'm a director of fixed-income manager research at Morningstar. Today I'm at the 2019 Morningstar Investment Conference. We had the opportunity to talk with three topnotch bond managers about where they're finding value in the fixed-income markets and also what risks are out there for investors to be aware of. Here's what they had to say.

Sonali Pier: You know, this is an environment where we don't want to rely heavily on a corporate credit overweight because betas have compressed. We're looking for flexibility and resiliency in our portfolio construction, such that we can step in to provide liquidity in a sell-off. We see financials as presenting some attractive opportunity, given the strong capital ratios and increased issuance to meet regulatory needs. Today, they trade wide to similarly rated nonfinancials, and there's virtually no M&A risk.

Additionally, at PIMCO we've seen nonagency mortgages as a high-conviction area. Our positive view on housing, which calls for 6% housing-price appreciation cumulatively for the next two years, as well as the fact that they are relatively insulated from some of the global risks effecting markets. Then we've seen improvement even in the underlying borrower quality from fewer defaults, fewer delinquencies, improved credit quality as reflected in their FICOs, and increased home equity.

Laird Landmann: Given the credit cycle is very, very old at this point, and I think we saw in December the strains of the credit cycle, and the credit cycles are very typical--you build up debt throughout the cycle. It's been 10 years of debt buildup, mainly in corporates and high yield and leveraged loans in the cycle. Then interest rates rise, and the debt becomes harder to sustain. Eventually, earnings turn down, and that's really the teeth of a credit contraction. We're sitting right on it today, in our opinion, and you'll want to be extremely careful. 

Bonds have two main features associated with them. One, they are bounded and mean-reverting. By that I mean when values get high, they're not like equities, they can't go to the moon. And so what you'll find is that the next move tends to be lower and you need to watch out for that at the end of credit cycles. 

The second feature is bonds that are good and money good tend to pull towards par over time. If you could find segments of the market that are pulling towards par, have shorter durations--whether they be short, high-quality corporates at this moment-juncture, stay low in your durations, or it be the legacy nonagency assets from the last cycle that are all pulling the par and deleveraging over time--those are going to be the safe places in this credit cycle.

Mike Collins: With regards to the credit cycle, there's actually mixed signals. The consensus narrative seems to be that we're late in the cycle. It's been a nine-year expansion. There's been a lot of relevering of corporate American, for sure, but there are actually a lot of good signs, a lot of more early, or midcycle signs out there, particularly with regards to, say, the big money center banks in the U.S., which haven't levered up at all. In fact, they've de-levered dramatically since the financial crisis. Consumers, on average, really haven't started relevering. Maybe just now they're just getting off the mat and starting to borrow a little more money.

Small businesses generally are in pretty good shape. All that bodes, I think, well for the longevity of the cycle. Our base case is that we're sitting here in two or three years from now and still probably not seeing a recession. All that being said, there are risks. It's really not coming from the sectors that blew us up in '08: housing, banks, structured credit, and derivatives. They've all been heavily regulated, and now they're essentially much safer. But it's the other areas.

It's really the private debt markets. It's the investment-grade corporate market where we're seeing a ton of issuance, a lot of M&A activity, a lot more highly levered companies. You've heard a lot about the BBB space. There's a lot of leverage, a lot of very indebted company in that space. Obviously, if you do get an economic slowdown, there is a chance for some fallen angel activity. That could reprice risk assets pretty significantly.

Pier: The risks we see in the credit markets today stem from: First, starting valuations are not cheap. Then, when we look at globally, the concerns that are out there--trade disputes, less accommodative central banks, peripheral Europe--there's reasons to be concerned here. Within credit, we're selective in certain segments. Given the robust capital markets we've seen, we've seen weaker lending standards. As a result, in bank loans, for example, we have a lot of loan-only issuance with no subordination below you, asset-light sectors that are coming to that market as well as covenant-light issuance, which could challenge recoveries in the next cycle.

One other risk I would highlight is more of a style bias, as investors try to time the beta. We looked at Morningstar data, which examined high-yield bank loans and EM. We looked at when investors were invested across these asset classes over a one-, three-, five-, and 10-year period and found that they give up roughly 1%-2% trying to time that beta. Earlier, I mentioned flexibility and liquidity, as these two factors in an active mandate can make quite an impact on alpha-generation when betas are compressed.

Landmann: The risks at the end of the credit cycle are very manifold. They start with the fact that you have high valuations. In a bounded market, as I commented earlier, that means they go down. That's the next move for high-risk assets out there. You don't have unlimited upside, like equities, and that's where you should take your risk. If you don't agree it's the end of the credit cycle--by all means, buy equities, don't buy fixed-income. 

But the risks you have to watch out for now are really ... The big risks are liquidity, and we saw that again in December. Liquidity just dried up. The risks are that we have a lot of ETF type of vehicles that haven't been tested at the end of a credit cycle. Really, it's psychological. Right now, companies, like ride-sharing companies, can get huge valuations in issue stock because everyone's optimistic. Everyone believes the world is changing for the better, and when that psychology changes, it's very hard to remember what people felt like in 2008, in 2002, in 1998. When that psychology comes back, valuations are going to change in a profound way. So, this is not the time to stick your neck out.

Collins: Interestingly, there are a lot of attractive opportunities in the global fixed-income market today. Again, the sectors that were more regulated after the great financial crisis are much safer, and they're actually, arguably, undervalued right now. We like the big global money center banks. Again, their leverage is really low. Their liquidity is really high. They trade a pretty attractive spread relative to government debt. One area we've been really adding to are a variety of very high-quality senior tranches of structured products, asset-backed securities, things like AAA rated collateralized loan obligations, commercial mortgage-backed securities, securitized nonagency mortgages, or consumer loans, where you have a tremendous amount of credit enhancement. These things are trading at really wide spreads relative to the underlying credit risk.

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Christine Benz: Hi. I'm Christine Benz from Morningstar, here at the Morningstar conference, and I'm thrilled to be joined by Anne Lester. She's a portfolio manager and head of retirement solutions for J.P. Morgan Asset Management.

Anne, thank you so much for being here.

Lester: Thanks for having me.

Benz: Anne, you took part in a really interesting session today about retirement decumulation. One topic that came up during the course of the conversation was this idea of sequence risk. Let's talk about what that is, and whether that's a particular concern for people who are just embarking on retirement today, given that we're 10 years into a quite strong equity market rally.

Lester: I think one of the things that people really struggle with is, on the one hand, I'm going to live another 30, 35 years that need to be invested, and, on the other hand, what if the market goes down? Sequence of return really is, in our view, the largest risk for the youngest retirees. When your balance is the largest, you've got the most time in front of you. If you have a material 20%, 30%, 40% reduction in your balance, which would mean a really large equity correction, you're risking your ability to generate income in the future if you sell.

A couple of things that I always talk about is being right-risked. Are you at a level of risk where you can tolerate a drawdown in your portfolio and not sell, or only sell little bit to live on? Because, if you don't sell, you're not locking those losses in, and you can recover.

Benz: So the key is to take a look at your asset allocation. How do people sort of right-size their asset allocation just as they're embarking on retirement?

Lester: We actually think that the point in time that you should be the most conservatively invested is actually at that moment of retirement when your balance is the largest. Because that's when your ability to generate returns on that total balance will really, if you have, again, a big drawdown, that's going to really impact your future cash flows. So we really think that sort of on average something sort of between 30% and 40% equity, maybe a little more, is probably appropriate.

Then, oddly, and it's a little counterintuitive for people, as you move through retirement, as you know more about 10 years in, 15 years in, 20 years in, it's sort of counterintuitively a little bit easier to take a little more risk because your balance is smaller. So if there's a drawdown, it's not going to eat away so many years of future income.

Benz: So it's sort of that reverse glide-path idea.

Lester: Right, right.

Benz: The question is, behaviorally, do you have concerns? If someone's managing their glide path on their own, and they've encountered a big equity market shock, and maybe didn't have a very equity-heavy portfolio, so they're OK from a portfolio sustainability standpoint, do you think they'll have the--I guess it depends on the individual--but the mental fortitude to ramp up equity risk at that point?

Lester: Well, even if they don't, it's probably OK. Again, I think one of the interesting things about investing as you're taking money out is that volatility is really not your friend. So sort of the risk of being too conservative, I would argue, is much smaller than it is when you're young, when you can ride through a lot. Because you're systematically assumedly selling, you never have the ability for those assets to go back in.

We talk about dollar-cost ravaging on the way out, instead of dollar-cost averaging on the way in, so it really is a different calculus. Again, if you were going to err on one side or the other, if you are withdrawing, I think it's better to err on the side of being slightly being too conservative rather than slightly too aggressive because your ability to recover is so much more limited.

Benz: I know another thing that you think belongs in the tool kit of retirees is the ability to adjust withdrawals. So rather than just using that 4% with inflation adjustments, static withdrawal amount, you think that taking a look at your withdrawal rate annually and making course corrections is really valuable.

Lester: Absolutely, and from our perspective, it's what people do anyway. I mean, obviously, if your income goes down, if your investments return poorly, you don't take the fancy vacation. Maybe you drive somewhere instead of flying somewhere. Maybe you do a one-week trip instead of a two-week trip. Those are kind of, I think, pretty easy adjustments that, again, if you're reasonably affluent you can make those adjustments. Course correcting to me involves both thinking about how much you're taking, but also, again, that course correction on your risk side. Again, assuming you've got the courage to do it. The market's down, cut what you're taking out a little bit, but also put a little more risk in your portfolio.

Interestingly, we are able to look at data from the J.P. Morgan Chase retail banking network. We get all this data that's fully anonymized, and we do think we have a handle on how America is spending money as they age. We found a couple of really interesting things. The first thing that fascinated us is that spending drops as people age. That's very surprising to some people who think, “Well, surely, healthcare costs will go up, and everything else stays the same, so my total spending will increase.”

What we saw at all wealth levels is that spending drops consistently, really accelerating in people's 80s. If you think about it, you're not going out as much. You're not traveling as much. Your consumption patterns change. So, yes, you're consuming more healthcare, but you're spending less money on everything else.

Benz: So accelerating later in life for healthcare expenditures?

Lester: Absolutely, but never as much as everything else's dropping. Now, surely, some households are different, but, I mean, this is on average.

The second thing that surprised us was sort of, in and around retirement, spending was really volatile. There was a real ramp up, a spending surge as people approached retirement. We think that's people fixing up their houses and fixing up themselves, so maybe getting the knee replaced, maybe doing the operation that they'd been putting off before they retire. Then that spending sort of surge persisted about 18 to 24 months into retirement when spending seemed to stabilize at a slightly lower level. But the spending volatility persisted for a number of years sort of through retirement. To us that really sort of highlighted the need for some flexibility in course correction as well.

Benz: Anne, really interesting research, great to get your perspective. Thank you so much for being here.

Lester: Thank you.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.

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Jason Kephart: Hi, I'm Jason Kephart, senior analyst on Morningstar's Multi-Asset and Alternatives Research Team, and I'm joined today by David Giroux, portfolio manager of T. Rowe Price Capital Appreciation, a fund that's been on a Joe DiMaggio-like streak over the last decade. It hasn't finished worse than 29th in the category over any single year over the last 10 years. 

David, thank you for joining us.

David Giroux: Thank you. Thank you for the kind introduction as well.

Kephart: David, let's start with just a quick recap of 2018. It was a very difficult year for asset allocators with bonds kind of struggling in the first half of the year, and the fourth-quarter stocks jumped off a cliff, but your fund was able to hold up and actually make a little bit of money when most funds were down around 5%. So, what worked?

Giroux: Well, there's probably a couple of things that worked. One, obviously, we came into the year in 2018 being more conservatively positioned, so we're between 500- to 1,000-basis-points equities, and that actually helped the performance quite a bit. And then I see in Q4 when the market fell off, as you mentioned, Jason, we were able to go overweight equities, actually on Christmas Eve, and get the portfolio positioned well for the upturn we had in '19 so far. You think about what really went right, though, is early in Q1 last year, we made a big call on utilities. Utilities were really out of favor. Everybody thought the 10-year was going to go straight to 4%. We made a 600 basis-point overweight in utilities in Q1. We took that to 1,000 basis points by the end of Q3, and so, while the market from Q1 to Q4 was obviously down a lot, utilities were up a lot. It was that big utility bet was a big contributor to our alpha generation last year.

And, I'd also say the other thing is we added to Treasuries last year. We added Treasuries opportunistically, and obviously Treasuries having a positive return actually aided our bond portfolio last year as well.

Kephart: And so with the market rebounding so strongly this year, present or current weakness kind of aside, is it time to say, "Thank you, next" to utilities or do you still see value in that sector?

Giroux: We see a lot of value in utilities on a long-term basis. Now, they're not nearly as cheap as they were in that February-March time frame because the geopolitical economic environment is clearly changed, so they've been revalued up from 15 or 16 times to 20 times, but I still think utilities, especially relative to consumer staples, are a compelling long-term investment. What you're seeing in utilities is a really powerful flywheel developing where you're closing down a coal plant and you're replacing with a wind plant, and that is a positive benefit for customers. It's a positive benefit for weight-based growth, earnings growth. So you're seeing utilities that used to grow earnings consistently like 2% to 3% a year, now growing earnings 6%, 7% per year--almost in line with the market on a long-term basis with almost none of the downside risk.

So I would say, paying 20 times for utility when the market is 17 or 18 times earnings, 10% premium to the market, basically, it's almost the same EPS algorithm plus the dividend yield, and you have almost none of the downside. You have no FX risk, you have no secular risk, you have no FX risk. I still think utilities on a long-term basis are very good. We still have a 600-basis-point overweight, but nowhere near the overweight we had going into Q4 last year.

Kephart: Are there any other areas of equities that are more attractive on a valuation basis?

Giroux: You know, it's a good question, and I usually would have a good answer. Unfortunately, there's not really one any sector that looks compellingly attractive today. So, our largest overweights today are healthcare, utilities, and industrials. But if you look at industrials, it's not like we're making a call on industrials. It's a situation where we have a big bet in GE. We're really betting on the turnaround that Larry Culp's going to deliver there, we believe. We also own S&P Global, which is not really an industrial--It's an industrial business services company. So if you take those two companies out of industrials, you're really not overweight in industrials.

Healthcare. We like healthcare. We've liked healthcare. It's been a huge source of alpha-generation over this 10-year period that you talked about earlier. I'd say valuations are attractive there, but outside of maybe Becton Dickinson, I don't think there's anything incredibly attractive right now in healthcare. But still, it's a good relative place--a place you want to be on a long-term basis.

Kephart: And on the bond side, with the yield curve kind of flat and kind of flirting with inversions, what does that impact for the corporate credit market, and how's that affect the bond side of the portfolio?

Giroux: That's a great question. I'd say two things. Now that the yield curve is relatively flat, to your point, what we have done is we've taken all those longer-duration Treasuries we'd bought that have appreciated quite a bit. We actually shortened the duration of the portfolio. And another thing, again, at the end of last year, high-yield spreads were above normalized levels. I think they reached almost 600 basis points at one point. Even IG credits were trading more like in the midpoint of their long-term cycle. So, we added aggressively in Q4, not only to equities but high-yield, leveraged loans, and IG bonds at the same time.

Now what's transpired between December and kind of the first quarter of the year is spreads have come in a lot. So we've seen a lot of those investments actually have appreciated quite a bit on the IG and the high-yield side as spreads have converted. So the playbook we do is if spreads come in, you want to lower the duration. So your risk is actually a lot lower. Obviously, you have a 10-year instrument versus a three-year instrument. If spreads go up 10 bps, three years maybe gets hit a lot less hard than a 10-year instrument. So we've really lowered the duration of the bond portfolio. The portfolio duration was more than five years going into Q4 of last year. And I think right now we're like three and a half years and probably going lower.

Kephart: And for the rest of the year, your outlook--do you see more volatility, or do you want to stay more on the conservative side overall at the portfolio level?

Giroux: Yeah, we really have. We were at 63% equity exposure on Christmas Eve, and as the markets rally all the way back almost to all-time highs, we've basically taken that down from 63% to about 57%. But having added a lot of high-yield and IG in the meantime as well on the short duration side.

So when we look at the market today, we say the market is 16 times earnings on 2020 earnings, very, very late cycle, not that attractive. And again, I think one of the things people get wrong about valuation is you have to look at valuation in context to where you are in the cycle. So, 16 times 20 doesn't sound that bad, right? But the market, when it peaked in 2007, was at 15.5 times forward numbers, and the market fell almost 60% peak to trough. The market was at 20 times earnings in 2000-2003, but it was on 20 times trough earnings and the earning in the market doubled over the next four or five years.

So, 16 times late in the cycle is not necessarily a good sign. It's actually probably a negative sign, if you will. I think the combination of the benefits in tax cuts starting to wane a little bit, the fiscal stimulus starting to wane a little bit, and maybe a little bit more political uncertainty as we go into 2020 as well, and, obviously, the European economy seems to be on the verge of a recession as well--it's just not a great backdrop for risk assets in general. So that's why we have a more conservative position. Again two of the sectors we're most overweight are more-defensive sectors. I'd also say that again, we've taken the duration of IG and high-yield down in the portfolio to really minimize risk if you will.

Kephart: Great. Thank you very much for your time.

Giroux: My pleasure, thank you.

Kephart: For Morningstar, I'm Jason Kephart.

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Karin Anderson: Hi. I'm Karin Anderson. I'm a director on the manager research team at Morningstar. I'm here with Sonal Desai, who is CIO of fixed income at Franklin Templeton. 

Sonal, thank you so much for being here today.

Sonal Desai: Thank you, Karin.

Anderson: Sonal gave a wonderful keynote speech today and spoke a lot about the bright spots in the U.S. economy and the fact that you're not really seeing any of the typical recession signs that people might think are a problem. What are some of those signs, and why do you think they aren't appearing right now?

Desai: More than even signs, I think about them as recession triggers. Different factors which could trigger a recession. One of those factors certainly would be an overaggressive Fed. We don't have that. We don't have an overaggressive Fed. I think we can put that one to rest. Even though the Fed raised rates, we have a massive Fed balance sheet out there, and we have great pools of liquidity in the economy. We don't have overtight monetary policy. Then if I think about other things which could trigger a recession, on occasion, it's been oil-price shocks. Oil-price shocks ever since we've started producing shale and, globally, advanced economies have become much more energy-efficient. That seems to be less of a potential source for a recession if you will.

Another item which could potentially trigger a recession is overinvestment. Now, that would mean that firms--you know, it's traditional: Firms invest, overinvest, eventually inventories build up. We aren't seeing that. Investment during the cycle started quite late, and we still have runway room over there to get to the stage of overinvestment.

The last trigger, if you will, for a recession, and indeed the trigger in both the early 2000s and '07, '08, was the bursting of financial asset price bubble. Now, I think, without a doubt, easy monetary policy is contributing to distortions amongst different asset prices. I'm not yet seeing those bubbles, which are on the verge of bursting, but definitely an area to keep a very close eye on.

Anderson: This is very topical given what's going on this week, but you've done a lot of research on trade wars, or trade skirmishes, I think you like to call them. Why are fears of trade wars overblown?

Desai: Two main reasons. One is trade wars, like you said, we haven't had wars. We haven't. We've had tensions, at times elevated, at times less elevated. I think about trade as the dog that didn't bark after that famous Sherlock Holmes story. We keep waiting for the other shoe to drop. We went back and looked at some numbers. Now if I look at earlier periods, so if I look at the period between '92 and the mid-2000s, around that period of time, you will see that we had trade growth at the rate of something like 7% per annum. And you had global GDP growth around 3.7 or so. If I look at a similar period from 2011 to 2018 or so, so I look at a period post-GFC, trade growth was only 2.8%. It dropped by more than half. But global GDP is still kind of chugging along at broadly similar levels.

So, what has happened? One is, potentially, causality is not as strong today as it was then. China's been fully integrated. The second issue I think is that a lot of supply chains have changed. There's been a lot of evolution. Essentially we're seeing different patterns emerge in global trade. It's not telling us as much about global growth. Separately, there's the actual question about what is going on with tariffs. We hear a lot about tariffs, about imposing tariffs. And indeed when we did our research, I was fully convinced that what we were going to find is that tariffs create a massive burden. They're very inefficient. I still believe that, by the way. However, what the data will show you, if you look at WTO data, you will find that, in fact, we've never really had free trade. What we're looking at is the U.S., which has the lowest tariffs.

This isn't to argue that the U.S. should raise tariff, but certainly it's a strong argument for other countries to lower their tariffs. Average tariffs in the U.S., 3.4%. Average tariffs in Korea--by any stretch of the imagination, not your average emerging market; this is a developed country in everything but name--tariffs are 13.8%, which is the same level that you see in some countries in sub-Saharan Africa. There's a huge degree to which Korea can make concessions and lower its tariff barriers. What I find fascinating about trade and the current round of trade tensions is ironically it might ultimately lead to lower tariffs rather than higher tariffs, freer trade because other countries lower their tariffs as opposed to the U.S. raising its.

Anderson: It's fascinating. Since I have you, I also want to talk to you about your view on the U.S. dollar. The U.S. dollar had, I think, its first good quarter against both the euro and the yen in Q1. Where do you see things going for the rest of this year?

Desai: I would say that with respect to the euro, I do see interest-rate differentials playing a kind of traditional role. And it's not just interest-rate differentials. It's growth differentials. The euro area--growth is slowing. I'm not one of those who is panicked about growth in the euro area. But undoubtedly we have more resilience and more likelihood of upside surprises from the U.S. than the euro area.

Now my view with respect to the Japanese yen: similarly, interest-rate differentials are going to carry the day. But I have to also be aware that the yen has a traditional role to play as a safe haven during periods of risk aversion. And that's just something to keep in the back of your mind if you are running a strategy which is not able to take that type of volatility because, unlike the euro, you can predict that, in periods when markets panic or volatility occurs, the yen is likely to strengthen. And I don't think that relationship is going away. Fundamentally, the dollar should probably strengthen against both, keeping in mind that I anticipate greater volatility in the periods ahead. I'm a little bit more cautious on the yen than the euro.

Anderson: Great. Sonal, thanks so much for being with us today.

Desai: Thank you so much, Karin. It was a pleasure. Thanks.

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Ben Johnson: Hi, I'm Ben Johnson, director of global ETF research with Morningstar. I'm coming to you from the sidelines of the 2019 Morningstar Investment Conference, where I had the opportunity to speak with Holly Framsted, who's the head of factor ETFs for BlackRock iShares.

Holly and I had the opportunity to discuss the value factor, specifically what's been troubling it in recent history and what investors can expect for the future of this factor.

Holly Framsted: I think it makes sense to first talk about when value strategies should work best. Value strategies tend to work best coming out of an economic trough. So as the economy expands, these companies with greater operating leverage tend to capture that upswing in the economy far more effectively. As the economy heads toward more stable and steady prolonged growth, then value tends to take a backstage to momentum. And as we head toward a slowdown and a contraction, more-defensive strategies like quality and minimum volatility tend to shine.

So we've been in a prolonged period of economic growth, particularly a time which tends to favor momentum. And that economic growth has been sustained and even extended in many ways through quantitative easing. We believe that we're in now a period of slowdown which should by normal cyclical standards head toward a contraction at some point. And so while value has not been favored in the most recent regime, we do believe it will come back as the economy rebounds off the low.

I think it's really important to understand the economic intuition behind why you are investing in a strategy in the first place. Value companies tend to have a lot of operating leverage, and that cyclicality that we just talked about in their performance is a risk that not all investors are willing to bear. So unless you expect that all investors will suddenly be able to bear a prolonged drawdown--which arguably they can't, that's why we're talking about it--then you would expect that value premium to persist moving forward. Because not all companies will all of a sudden become flexible enough to be worth a premium over time.

I also think it's important not to throw the baby out with the bath water. Value has been underperforming, but all factors are cyclical. And so a portfolio that balances across factor exposures including value but also including quality and momentum as examples can help deliver more consistent performance throughout the course of the cycle.