Rick Rieder: Nobody Has Ever Seen Anything Like This
The prominent manager of BlackRock Global Allocation Fund addresses the COVID-19 pandemic's macroeconomic impacts and their implications for asset allocation and investing.
Our guest this week is Rick Rieder. Rieder is BlackRock's global chief investment officer of fixed income, and co-head of BlackRock's global fixed-income platform. In addition, Rieder serves as a member of BlackRock's global operating committee and is chairman of the BlackRock firm-wide Investment Council. As part of his responsibilities Rieder manages several prominent BlackRock strategies, including BlackRock Global Allocation, BlackRock Total Return, and BlackRock Strategic Income Opportunities. He's currently a member of the Federal Reserve Bank of New York's Investment Advisory Committee on Financial Markets. Before joining BlackRock in 2009, Rieder was president and CEO of R3 Capital Partners, and prior to that did a stint at Lehman Brothers. Rieder earned his Bachelor's degree in finance from Emory University and his MBA from the Wharton School of Business.
Rick Rieder’s bio
Macro and Outlook
BlackRock’s 2020 Global Outlook
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar, Inc.
Ptak: Our guest this week is Rick Rieder. Rick is BlackRock's global chief investment officer of fixed income and co-head of BlackRock's global fixed income platform. In addition, Rick serves as a member of BlackRock's global operating committee and is chairman of the BlackRock firm-wide investment council. As part of his responsibilities Rick manages several prominent BlackRock strategies, including BlackRock Global Allocation, BlackRock Total Return and BlackRock Strategic Income Opportunities. He's currently a member of the Federal Reserve Bank of New York's investment advisory committee on financial markets. Before joining BlackRock in 2009, Rick was president and CEO of R3 Capital Partners, and prior to that did a stint at Lehman Brothers. Rick earned his bachelor's degree in finance from Emory University and his MBA from the Wharton School of Business.
Rick, welcome to The Long View.
Rick Rieder: Thanks, Jeff. Thanks for having me.
Ptak: So maybe for starters, where do we find you today? And how has the way you work changed amid the coronavirus crisis?
Rieder: I'm actually working from Florida, came down here about a month or so ago with my whole family. We live in New Jersey. And the idea was separate, and work from here. And it's worked out--if anybody ever saw my office and all the screens that I have up, it's like an audio-visual extravaganza in my office--but it's worked really, really well. My communication, I mean, one thing we've come to discover is technology works. And I think more and more companies from our industry to technology to other businesses are going to realize that you can be incredibly productive. I was looking at our data from the trading side, how much we've traded in things like credit. We actually had a couple of days where we broke--not only broke records of how much we traded, some of it was because the new issue market was so heavy -- but it's also the fact that you can transact in this environment. I was going to say not only did we break records, but I think one day was double our prior record. I know it's--technology works, communication works. We just have to do it more regularly. And we have more meetings where we get groups of people on the phone to talk about what's happening in different sectors. But it's been--it feels like a more normal abnormal experience in terms of a transaction point of view and from a business operating point of view.
Ptak: Since you mentioned that, I'm curious from a business operating point of view, and how it is you and your team work. Have you begun to grapple with maybe how you might change the way you work in the future as a team?
Rieder: Yes, and I'd say we haven't really devised what the long-term plan is yet. But it goes without saying--I've been literally watching headlines over the last few minutes of companies determining that a larger portion of their workforce will work from home and/or have remote locations and don't have people as concentrated in one specific area. So, we haven't specifically game-planned around how we're going to do that from here, but there is no question about it: We're going to do more of that.
One of the things that's actually been pretty elegant over the years is having analysts that cover certain sectors like energy being in Houston, or technology to be located in San Francisco, et cetera, and I think you'll see more and more of that, locationally efficient. But also you realize that, whether it's people for quality of life point of view, or quite frankly, just a business operational point of view, that I think you'll see more of that from our industry and from our company, for sure.
Benz: So, before we discuss what looks attractive and what doesn't, many of our listeners allocate capital either for themselves or for their clients. Drawing from your own work, what is a framework that you'd suggest that they use when assessing the fundamental merits of various asset classes, especially when things are as uncertain as they are right now?
Rieder: So, Christine, I have this view that I've had for a really long time. And maybe it's simplistic but having done every asset class from private investments to real estate, to securitized assets, to equities, and I have a really simple framework, but it works for me and that is, I look at three lenses whenever I look at any asset. So, I look at leverage, liquidity, and cash flow. And I do these client calls I do all the time, and I always say--I always try and bring things back to those three lenses. So, why is that? And by the way, why has it been so acutely important today?
If you start with the cash flow: How much cash flow do you think you're getting today, where is it going from here, what's the stability of that cash flow, et cetera? If I can get my arms around knowing cash flow--and by the way, it's not earnings when I look at an equity, although obviously you look at earnings--but I want to know cash flow, I want to know free cash flow. And then, after I know that, then I want to know the leverage. And so, I want to understand how does that cash flow get down to where I am? Am I a senior bondholder? Am I an equityholder? Am I mezzanine? And if I know my cash flow, my leverage, then I've got a pretty good idea where I'm going. The third point being liquidity, and that is something that is obviously becoming hugely important today.
But if you understand where a company's leverage, is or a company has CLO, a real estate transaction, the liquidity is, How do you get from here to there? How do you get the--that you can survive and are you running enough liquidity in your portfolio? You see companies that are actually, their leverage is moderate, but they haven't managed their liquidity, and vice versa. If you have abundant levels of liquidity, you can run a higher leverage position. So, you need to think about those things in concert. So--at least from my years of coming up on the credit side, but those are the three things that I look at and quite frankly, it works for anything I look at and I think it's part of--I've gotten more and more involved over the years in equities. And it's been incredible and (one man's) opinion. I think when people look at equities, they always look at P/E ratio and earnings. And I just don't think it--unless you understand how that company throws off cash flow, and then how that cash flow gets down to the equityholder, and then how they manage their liquidity around it, then I don't think you get a fulsome read on it. So, anyway, that's been my metric for a number of years. It's simple, but it's incredibly applicable, or sincerely applicable to virtually anything I look at.
Ptak: That's helpful. So, maybe we can do a before and after of sorts. You run BlackRock Global Allocation Fund. Can you walk us through what you're thinking and positioning was pre-COVID and contrast that with your thinking and positioning after, and I suppose amidst the coronavirus? Perhaps you could reference the three facets that you talked about earlier--leverage, liquidity, and cash flow--and perhaps how you've twiddled those knobs as we've transitioned from pre to post.
Rieder: Sure. First of all, I have a core thesis around--particularly in global allocation--and you wouldn't be surprised by how I think about equity allocation. I always try and get our equity allocations to what I call the “fast rivers of cash flow.” I always find, like, if you have--what global allocation allows you to do is look across all different asset classes, debt, equity, et cetera, but you want to hold your equity in what are the fastest rivers of cash flow that are the most convex. So, things like technology, healthcare, some of the consumer spaces, where you have a growth potential and real convexity, and quite frankly, a lot of those companies that we'd look at have been ones that have been putting money into R&D and CAPEX, et cetera, and those are the ones that perform. And so, that gets into the, “How do we get equity?” and that's how certainly pre-COVID and post ones. We'll talk about the tweaking of that since.
Then--so, what do we do on the debt side? I always say like, “Why do people own utility stocks in equity funds?” People say, “Gosh, my utility stocks did well.” Really? You should own interest rates. Because the reason why they did well is interest rates came down. So, we look at things like--I'd rather buy utilities or consumer staples in bonds, A) because they generally borrow at cheaper levels than others. They're consistent. Think about a utility--it's a 12% ROE type of business that is consistent, and why wouldn't I just debt-fund those as opposed to buying their equity because I don't have a lot of convex upside. So, that's how generally we are running it.
So, what's changed? Something really significant has changed from a portfolio evolution point of view--if you think about where we were pre-COVID, the volatility markets were incredibly low. Volatility was super-cheap in the markets, and there were these persistent volatility sellers that were out there. And if you remember where it came at the beginning of the year, the volatility market, the VIX Index, was at 9 or 10. Where you could actually buy call options was--you could buy 2% out of the money calls S&P at 7.5, 8 volatility points.
Think about how that's changed since COVID. Now, volatility has exploded higher. So, one of the things we've done that we've changed quite a bit in global allocation--we were a big buyer of optionality of call options, particularly. It helped us in a big way when the market went up and then when it went down, because our call premium went away. It didn't hurt our portfolio nearly as much as otherwise would have. But now, you can build income in a portfolio.
So some of the things we're doing today, where we think the equity markets have run up. We think there's a need in the world for income. So one of the things we've been doing is with volatility markets so high we've taken some of those companies we like that are in the fast rivers of cash flow-- some of these technology companies, some of these healthcare companies--and you can actually sell call options against your position and build income. With volatility so extremely high and valuations have been moved up, so it's been a big shift in terms of how we're managing the portfolio. And then, the other side of it, because I do like these fast rivers of cash flow, some of the tech companies, healthcare companies, et cetera, I do think they're even more durable on a go-forward basis as we live in a more virtual world from here.
We haven't really changed our concentration. The only thing we've been doing is capping some of the upside by selling some of the calls, but building income in the portfolio recently. So, those are some of the big shifts.
Ptak: If I may interject with a quick question, fast rivers of cash flow. Are there any examples of industries or business models where I guess your perspective and orientation on whether it delivers fast rivers of cash flow has completely flipped since coronavirus burst to the fore? Are there industries that you think have just fundamentally broken and no longer deliver the requisite cash flow?
Rieder: Yeah, I mean, on the negative side--it's easier on the negative side. I mean, some of the transportation and leisure sectors and air are going to be hard for a long time. I mean, as the economy reopens--you think about some of the manufacturing businesses that will come back faster, witnessing some of the technology companies or asset-light companies that can work remotely. Those businesses are certainly going to be more consistent and continue to create that high level of cash flow. By the way, it's also a regional dynamic. One of the things that I think that you're seeing play out globally is those areas that have invested in R&D and CAPEX and are at the innovative forefront, tend to be located in the U.S., tend to be located in China or parts of Asia, whereas you don't see it in Europe, you don't see it as much in the emerging markets.
So, a lot of what this has done, when we think about fast rivers of cash flow--the way I think about those fast rivers is, I try and cut it two ways, regionally and sector-wise. And what we try and do is, we say it's like a grid. If we can position ourselves in the portions of the grid that are in the fastest rivers regionally and the fastest rivers by a sector breakdown, then we got a better chance that we're going to win more persistently. So, today, we don't think monetary policy helps Europe grow as fast or really works at all from where we are today. But we do think that there's a vibrance to what the U.S. is doing, what Asia is doing, parts of China are doing. And then sector-wise, we'd like to stay in these companies that are in the technology, healthcare--quite frankly, it's a big screen for us. And it's been amazingly intense in terms of how it's worked, is who is invested in R&D and who is invested in CAPEX? And when you run revenue and EBITDA with a lag from who is invested in R&D and CAPEX, then it becomes really clear who is going to drive cash flow on a forward basis. And so, we've had nothing else. We've increased our rigor and our attention to that.
Benz: So, the Fed has essentially proclaimed itself the buyer of last resort in certain areas like corporate bonds, like municipal bonds, and that appears to have stabilized these markets. But do you think that there are underlying imbalances on balance sheets or in market structure that have gone unresolved and could threaten stability in the future?
Rieder: Yeah, that's a great question. I think early on--I think, right, as the Fed was starting to execute this program, one of the things we said is, following the Fed is a durable strategy. But I think it's become much more nuanced. When it was “follow the Fed” around interest rates, particularly front-end interest rates or the short end of the yield curve, the Fed can control that directly. And they have a pretty good way through quantitative easing to control the back end of yield curve, so Treasuries for sure. And then mortgages, particularly agency mortgages--it's a place where following the Fed made a ton of sense because the Fed--that is part of what has been their remit, and has done a tremendous amount of buying in that space and wants to keep home prices elevated, wants to keep mortgage rates down.
But then I think there are other places--I don't think following the Fed in credit, which I think a lot of people have said “We'll just follow the Fed,” because they're entering the investment-grade credit market, and now they're entering the high-yield market, so I'll just follow the Fed there. I don't think that's a good strategy. I think what the Fed cares about in credit is making sure the markets are open, making sure they're liquid, making sure there's no emergency liquidations and you still have to do your credit work, particularly in high-yield because they've entered the top part, the highest quality end of the CLO market that doesn't tell me for sure, gosh, I'm just okay buying any CLOs. In fact, you've seen a bifurcation in that space.
The other place where the Fed has to do more is state and locals and in the municipal market, where there is still pressure. And by the way, it's a place where there's got to be fiscal initiative as well. But the municipal market is still a difficult place to be, particularly given where yields are today in that space. So, still there is more to go. I think the Fed will probably do more there. And then I think there's some interesting ways that the Fed will progress from here around some of the lending and where they've been supportive around small business. We've seen stories recently about things like university funding, et cetera. And that's the next evolution of where I think it's going to be fascinating in terms of where the Fed goes.
And listen, I think they've been historic. I think they've been amazingly thoughtful about how they've addressed these markets, and being thoughtful and innovative about how they do it. But I don't believe in the thesis away from Treasuries and mortgages that you just follow the Fed willy-nilly, because the Fed is not trying to move prices in a certain area, certainly not in credit.
Ptak: And so, do you see evidence that there are other investors out there who perhaps are disagreeing with you in effect, and they are following the Fed? And perhaps they've pushed prices of things like corporate bonds back up beyond what are sustainable levels, given market conditions and some of the credit risks that still lurk?
Rieder: Yes, I think so. And in fact, I hear it all the time, where people say, “You know, I'm buying (for example) investment-grade credit”--which by the way, we're buying as well but in a slightly different way. But people say, “Gosh, if the Fed is in that, they are going to make sure that market holds up well.” I'm not sure I really believe that. What the Fed is trying to do--the Fed has been buying in the one- to five-year part of the marketplace from a maturity point of view, and they're trying to make sure that liquidity is in good shape for companies. Then they want--and part of why they're keeping real rates down or nominal rates down in the longer part of the Treasury market, is they want companies to fund themselves in the private markets. And so I think you've got to be really thoughtful about the companies you're buying, where on the yield curve you're buying. I mean, quite frankly, now because of what the Fed has done, because there is such a view that, gosh, if the Fed is going to buy one- to five-year investment grade corporates, I should just do the same. To fund companies at 1.5%, 2%, low-2%s in what is one of the greatest shocks to the economic system we've ever seen, to fund that at 1.5% to 2%, I'd much rather buy companies in equity form and/or buy them out the yield curve, further on the yield curve where I'm getting paid for that yield. But I wouldn't… I think there is too much overzealousness that, gosh, I'm going to be okay as long as the Fed is there without doing the credit work. I hear it all the time.
Ptak: Maybe shifting gears to talk a little bit more macro. Putting aside matters of public safety--and I realize that we can't do that so easily, so I don't want to sound flippant there--but if we were to put that aside for a moment, we're seeing a gradual reopening of some states. And so, what do you and your team think are the economic implications of this?
Rieder: It is hard, frankly. I think it's the hardest thing to assess today in investing and it's the hardest thing to assess. We do an extraordinary amount of data analysis and data mining, trying to understand economic conditions, not just where they are today but where is the puck going, as it were. And it's really hard to understand the reopening of businesses, and specifically by asset class. We're encouraged that you're seeing some reopening in terms of the economy, and quite frankly, there is an exponential cost for not opening some businesses over periods of time. When you look at restaurants and some of the leisure areas, et cetera, the longer it goes on, you create an exponential risk, particularly to small businesses that don't have the resources to make it through. So, we're at such an incredibly important inflection point around where that goes, and so I am sympathetic to opening businesses.
It's hard to map it out, quite frankly, with any really good data because it's regionally diverse and then it's by-industry diverse. So, the way we've done it from an investment point of view is, you know, the places--if you think about in commercial real estate, or you think about in residential real estate or some of the asset-backed markets, there are some industries that it's very hard to get your arms around. When talking about airlines, when talking about hotel, even office property. It's hard to understand how does urbanization evolve from here. It's very hard to think about, are people going to come back to the big cities in the ways they did, or start to be more dispersed across the country, or across the world?
So the way we've done it is said, gosh, in those areas where it's harder to analyze, we want to own the higher quality and then we're willing to take the risk where we think it is more clear that you're going to have a more normal operating environment. We’re talking about tech and equities, et cetera. But those are places--we think about cable. You feel pretty confident in terms of how that's going to play out. Some of the media parts of the market you feel pretty good about. It can create a sense of normalcy sooner. But we decided to stay high-quality in the areas that it's just so hard to map and to model, and that we're going to be much slower in terms of taking risk in those spaces.
Benz: So, does it strike you that the market seems somewhat blasé about the possibility of further fallout, especially if COVID resurges in the fall or winter as it's widely expected to do?
Rieder: Yes, but there's something that is--it's a long long discussion and I've taken too much of everybody's time--the amount of stimulus that's going in is immense. And we do a bunch of analysis, just to throw some numbers out at you… In the monetary policy side, if you go back to QE1, QE2, QE3, et cetera, you're talking about roughly, roughly depending on point in time, about $3 billion a day that was going in. We're talking about $26 billion a day that's coming in through monetary policy. And then, we've mapped the numbers that are coming in around the fiscal stimulus. And we've shown some work, and I put it in the media and otherwise, that the sheer size of over $2 trillion of stimulus is so big and more is coming, that you actually, if you just map it out, the income level, if you assume it all gets into the right places, and you assume that the savings rate doesn't move up dramatically, there's actually more stimulus and more income effect positive than negative. So you think about what that means, that the sheer stimulus can lift asset prices more than the economy necessarily benefits. And by the way, when the Fed moves Treasuries to zero, you create this dynamic that gosh, I can't buy Treasuries or I can't buy some of the lower-yielding assets, mortgages, et cetera. So, gosh, I got to buy equities. So, the market is de facto becoming blasé, because they got to put money to work in different places. That is a little bit daunting. It's part of why we've talked about we've been reducing some of our equity exposure, which by the way, I think over the medium to long term equities are actually fine, but near-term I think the markets have become a bit comfortable.
It's interesting--not to get too technical--when you look at some of the volatility markets, the longer-dated volatility is still higher than it normally is. And I think that's a reflection that the markets are being pretty thoughtful and pretty precise about, gosh, you could have a second wave in the fall. And I think that's why you're seeing some of those longer-dated volatility markets, some of which we've been, as I said, been selling some of that volatility, again, some of our current positions. But I think what--you know, people regarded as the markets are somebody's disposition, but what ends up happening is when you create this much stimulus and this much liquidity, the money goes somewhere. And when you make certain assets unattractive, then it lifts some of the assets that have some upside, i.e., equities or some of the yielding markets.
Ptak: Maybe to focus on the labor market for a moment. Granted, there's been a monumental amount of stimulus that's been pumped into the system and the economy, as you point out. It still seems there's a risk of things breaking in the labor market. I think that you've mentioned previously the importance of employees staying connected to their employers during the crisis. And so, can you explain what you mean by that, and why it's structurally important to the labor market for this connection to be maintained?
Rieder: We've done an immense amount of work on labor trends and demographics. There's some things that are really, really important around the demographic evolution, the aging of the economy, and particularly when you look at parts of the world, look at places like Japan and Europe, and why the aging is so much more prolific and where it's so much harder for growth to be anything other than mediocre because of the aging demographic. But you still have that in places like the U.S. and it's still important. I mean, the reason why we were going to, the unemployment rate pre-COVID was 3.5%, going lower, was because--because of the demographic. You don't have as many workers, particularly in that 30- to 45-year-old age bracket that tends to be the most vibrant in any economy.
So, anyway, that's one part of it, one reason why I think that it's really important to follow these labor trends and what happens and how it impacts consumption. But I think there's something else that people don't really talk about, and part of what we talk about the connection around labor, et cetera. There's a number of reasons why people go to work. I've studied this, and I've learned this from people in the technology space quite a bit. People go to work, A) obviously to earn her living, but they also go to work because it's their meaning, it's sort of their purpose. And that's really important and it's part of why people working whether it's virtually or otherwise, they have that.
People go to work also for community. I think people underestimate how important community is in terms of, gosh, there's a group of people I associate with, and it's sort of fulfilling in terms of their lives. And then, the last thing is, people go to work because of growth, whether that's intellectual growth, or the ability to progress in terms of where they are in life. And I think employment goes well beyond people go to work to get paid. And I think there is an incredible sociological as well as economic set of ramifications for employment. And that's why we talk about it quite a bit. We talk about connection and employment quite a bit.
Benz: You work for a large, influential firm and that gives you access to management at the firms whose issues you invest in. What were you hearing from them, from management, a month ago, and how has the tenor of those conversations changed as time has gone on and we've kind of gone further into this crisis?
Rieder: Yeah, that's a great question. So, first thing, that might hit you on a superficial level is more and more companies are pulling their guidance on future revenues and future earnings. And obviously, reflective of the fact that the uncertainty on how the economy opens and globally has caused them to pull their guidance overall. And we're hearing that from a lot of companies. And it's not necessarily people tend to view that as a negative, and I don't necessarily view it as a negative. I just think it is appropriate uncertainty given where we are today. That has been the biggest shift.
The second part that we obviously talked to a lot of companies, as you said, we look at a lot of surveys that are done. The other thing that companies are doing is more and more looking at technology, R&D, how to make your business more efficient, how do you operate your business, obviously more virtually, and it's pretty impressive in terms of that rate of growth there. The other side of it is, I have to say that--and it's hard to say this on a broad basis or generalize it--but we've been pretty impressed with particularly in parts of the manufacturing area, in the homebuilding area, and otherwise, that there's some optimism that this is not going to be a V-shaped recovery, but it's also not going to be an L. Business will come back and they're seeing green shoots in a bunch of their businesses. Places like China have been a very good illustration of--and we talked to a lot of companies there, that economy has really closer to a V-shaped than I think others would have imagined. And you see the companies that are selling into Asia or interacting with places in Asia and China specifically. We've been pretty impressed with how that's come back.
Now it's different. Europe is still really tough. The emerging markets generally are still tough. But I've been pretty impressed with particularly in some industries the enthusiasm of some comeback in terms of their businesses--again, if it's travel or leisure or transportation, tougher--but other places, you know, better than I would have thought.
Ptak: We're going to turn to investing and allocation more specifically in a moment, but since we were talking policy earlier, you had characterized it. But I'm curious, what hasn't been checked off the list? Areas that have gone unaddressed, or that maybe represent a vulnerability where you think further policy action would be welcome?
Rieder: So, the big one is state and local. I mean, that is a place that--I mean, the amount of funding that's come through state and local has just been immense, and the burdens on state and local from whether it's revenues from the tax side, whether it's the derivative impact of rental payments that aren't being made, and whether it's--and then, you know, specifically related to state and local and then otherwise, is healthcare reimbursement. I mean, that is the place where there’s still more funding has to go. And then, to go specifically on that area, healthcare reimbursement is hugely important and not yet sufficiently addressed. And my sense is more is to come there.
And I would say lastly, there are some businesses that we talked about, whether it's restaurant, travel, leisure--there was some real, you know, I wouldn't say permanent structural damage, but at least intermediate-term stress in those industries. And there is moral hazard issues with how you address those, whether it's in the monetary policy side or on the fiscal policy side. It's really hard to think through how that's going to work out, because no matter what, the virus is not going away tomorrow. Hopefully, there's a vaccine and I'm pretty enthusiastic about the innovation that's happened. And then, the vaccine development and testing becomes more aggressive. But the virus and the concern about a second wave or quite frankly, iterative outgrowths of the virus effects, mean it's not going away in 2020. So, some of those areas where people are still going to be overly cautious are going to require more assistance. And how that plays out is tricky. Part of why from an investment point of view we just want to be more conservative there, at least for the next few weeks.
Ptak: It seems like one tool that you're not eager to see the Fed use is negative interest rates, which is a topic I think you've written about recently. Can you talk about why you think it would be counterproductive for the Fed to try to engineer or maintain negative interest rates?
Rieder: It's really hard, and I would take up too much of your listeners' time because I--I mean, I think negative interest rates--I don't think they work at all. And I think the whole dynamic and I think what the ECB will ultimately realize is that in an aging demographic particularly, the debilitating impacts of negative interest rates are so pernicious and so much more significant than when you drop interest rates to the zero bound--you know, traditional economics would suggest that there is a real symmetry to interest rates, meaning if you drop rates from 6% to 4% and then from 4% to 2%, and then kept going that the effect would be similar. It's not true. Particularly in an aging demographic where people need income, you create adverse impact when you go to negative because you are hurting pension funds, insurance companies. And you think about what it does to the banking system--talk about why there's no velocity, and why the banking system can't grow of any significance when your net interest margins are coming under pressure. And you can't take credit risk because you can't build return on equity fast enough. It just shows this dramatic negative effect from negative interest rates.
And then the other thing that I think people don't recognize is why does savings rates go up when you go into negative interest rates, because people are concerned about their savings. So, it doesn't create in theory when you lower interest rates, it incents people to invest and I actually think once you breach the zero bound, it actually goes the other way. That gets away from all those shocks and all those negative influences. Then you get into what are quite frankly the logistically challenged parts of negative interest rates, where you think about banking systems and deposits and how rates work in the government market and other markets. And part of what the Fed has rightly said and will continue to say--asset purchases, flexibility around capital ratios for the banks, there's so many tools at their disposal, that my hope is and the way the Fed has been pretty clear about this, that going down the negative interest rate route would be the wrong reason. I think Europe and Japan will show long term that the better way to do it is you have to do fiscal and you have to create incentives for companies to grow and innovate. And the reason why I think Europe is so challenged today is you're not getting enough investment in technology and new business and R&D. And just by dropping interest rates you're not going to create a demand for credit. You need innovation; you need innovative capital. And it's part of why I've argued that the ECB would be better off buying equities than it would be continuing to drop interest rates because at least it helps companies with their book capital, and their market rate of equity, and allows them to do M&A and change their business model, and allows them to invest in their businesses because they can issue equity at better prices.
Whenever I go down that path, I get too passionate about it--but I don't think it works. And I think history will chronicle that negative interest rates is not a good innovation.
Benz: So, deficits aren't on the front burner right now, probably for obvious reasons. But what will be the future repercussions do you think of running such massive deficits and further increasing the national debt?
Rieder: First of all, I mean, I think today, one of the reasons why we like owning inflation in our portfolios is, nobody's talking about inflation today. In fact, there's a near-term deflationary shock from COVID that gets in where companies have to reduce inventory, obviously, dropping the rates people charge for airfare, et cetera. So, there's a near-term deflationary effect. The longer-term effect, though, is inflationary. And I think part of why we like longer-term inflation is the more and more we put debt on the economy, then the more you run the risk of having to monetize the debt. And we go back to Europe and Japan and think about, you have an aging demographic, you don't have enough revenue, you don't have enough income to offset the debt burden. So, ultimately, it's only one road you go down; you have to rip up the debt. That creates a pressure on your currency and that creates a problem in terms of inflation. And one of the risks in the U.S. is that that inflation gets imported into this country from other parts of the world.
And so, I don't believe in this thesis, so we just keep issuing more debt and that there is no limit to the amount of debt we issue. I will say the United States though is benefiting from one thing that is really powerful, and that is, well, A) the demographic because we can, because more people need income, and more people are looking to functionally lend. But the other benefit that is significant is there are four parts to how an economy borrows and lends. There is the government side, there's a corporate side, there's a household side, and the financial side. And so, people don't look at--they were saying about government debt unilaterally, but you think about what happened in Europe over the years in places like Spain or Ireland, it was actually the financial debt that really hurt.
But you think about what's happened today, individuals, households have delevered, for the most part have brought their leverage down. Financials, generally, the banking system has delevered. Corporates have brought their leverage up. It's not as large of magnitude as people chronicle, but they brought their debt up. But the point being that because the other parts of it are not highly levered, like if you go back to pre the financial crisis, households were levered, financials were levered, corporates were levering, and the government was levering. That is a recipe for disaster. Today, you've got--you don't have nearly that much gearing going on in the economy. So, the government can borrow more, and because of the aging demographic, you can support it. But the one thing that--you know, everybody looks at static state and says, well, 10-year Treasuries at 67 basis points, so we can keep borrowing. When you stress the economy at a higher interest rate paradigm--so, if we go back to this point, if we got more inflation--when you start to lift interest rates 100 basis points, 200 basis points, those deficits and the debt burden becomes incredibly pernicious.
We've seen this in CBO estimates. So, when you look at debt to GDP, it's reasonably sustainable as long as interest rates stay down. But when interest rates start to move up, and if there's an exogenous shock that sends interest rates up, that debt burden becomes devastating to our economy and creates a crowding-out effect, where it crowds out companies, it crowds out households, it crowds out financials, because the government has put so much debt on their balance sheet. So, the longer-term effects, people should not discount. I think today the government has to spend and has to borrow because this is a one-time shock to the system from COVID. But my hope is that longer-term you have to bring this debt down and hopefully create enough nominal GDP you can delever the economy, because I just think this idea where you just keep putting debt on is incredibly irresponsible.
Ptak: So, that is very bedeviling, isn't it, the fact that we would applaud on the one hand some of the measures that they're taking to stabilize markets and in certain cases stimulate demand, but then also reckoning with the consequences? And so, when it comes to yield-curve positioning, duration posture of the fixed-income strategies and sleeves your team manages, how do you reconcile those two things and how does that translate into the position that we would see in those strategies?
Rieder: When we think about interest rates, when you take interest rates, we were running a longer interest-rate exposure, longer duration exposure in our portfolios for much of this year. And particularly, we loved owning the front end of the yield curve, the two-year point, three-year point, five-year point, with a view that if the economy slowed not having any wisdom or foresight around COVID, but that the Fed would take interest rates to zero. But that happened. And now, when you look at interest-rate positioning and the five-year Treasury, the two-year inside 20 basis points of yield, that interest-rate exposure doesn't do anything for you in positioning.
So, what we'd like to do is hold more of our interest-rate exposure further out the yield curve, for a variety of reasons. One, there's actually real yield out in the back end of the curve. Two, if we ever get into an economic--a period of economic duress today, one of the tools that the Fed does have--not negative interest rates--one that they have is to do like they've done in the past Operation Twist or bring long end interest rates down. So, we like owning some of our duration, less interest-rate exposure than we had before, more in the long end of the yield curve, more in--it's something we talked about inflation protection alongside of that, where we think inflation could move up over time. But quite frankly, without owning--you know, we can hold more cash in our portfolios. Owning the two-year note at 16 basis points is functionally the same thing as owning cash. So, one of the ways we've been managing risk is, take some income risk in the portfolio. We've been taking down a bit of the equity risk, because it's run so much, but run some equities depending on which portfolio. Have some income, so buy some quality, I'd call it, some of the middle-quality income places, parts of the credit markets, parts of the mortgage market, even parts of the high-yield market in the right sectors and right industries, and then hold more cash. And you can carry pretty well in your portfolio and you have enough upside because of the beta that comes through the equity market or some of these income-producing asset classes. But there's no reason to own a lot of short-end Treasuries anymore. And quite frankly, in Europe, with significant negative interest rates in places like Germany and France, et cetera, it's not worth taking a lot of interest-rate risks that you have a better chance or at least equal chance of losing money as making money on them today.
Benz: So, with respect to equity, we've had these long-running trends where value has underperformed growth, smaller stocks have underperformed large, U.S. stocks have beaten foreign stocks. So, I guess the question is, Why doesn't the equity sleeve of BlackRock Global Allocation lean more in those directions, toward value, towards small and mid, toward foreign stocks and away from U.S.? Why is that?
Rieder: I really believe in this thesis that it's all about innovation and R&D and CAPEX spend, and I think a lot of what is traditional value is not growth. And I think a lot of technology's changing much faster than people give credit to, let alone what COVID did for taking technology to the next level. But I think people grossly underestimate the convexity of upside around technology. Look at places like software development, or artificial intelligence, or energy, and how things are changing in extraordinarily fast ways. Your upside convexity of owning technology, the demographic benefit from owning healthcare, and then the consumer being in good shape, better shape than it's been historically certainly with the stimulus et cetera, is I just don't understand the thesis today of could a traditional value orientation work for a month? It could. Could it work for a quarter? Maybe. And by the way, there are parts of what I would argue that are cyclical companies in some of the railroads, some of the industrial places that we like, holding some risk today.
But I have to say, I mean, I'd much rather own in equity. You know, it's different when you think about are you a bondholder or an equityholder. If I'm in equity, I want to protect the upside convexity of my portfolio and I want to get as much upside into it, and this goes back to that discussion we had early on. When you think about it, it's the same thing when we do real estate or we do--whether it's a CLO or any financing. If I'm in equity, I want to own the place that I've got the upside and I want to own convex upside. But if I'm taking, what we call the top part of the capital stack, senior debt, I just want safety and I want collateral and I want safety. So, in value, I just think there are times that it gets too cheap, and there was a time at the end of last year where energy got too cheap, recently energy has gotten too cheap. And so, we view value as something you do more tactical. By the way, a lot of the companies that are "value" have also put on a lot of leverage. The way they've kept their revenues higher or their net income, is they've kept their leverage high. That is a really tough dynamic today, particularly with some uncertainty around the economy.
So, I'd much rather stay in the areas where--now, you've got to balance that with do those stocks run up too high and that's part of what we're talking about, gosh, now you can sell call options against them because people are paying huge volatility for some of that upside. But I'd much rather be in equity. I think over time people are going to realize that equities are no different than when you look at real estate or any other transaction. If I want equity, I want upside and I want convex upside and return for that and that tends to be in those areas that have a better chance to have free cash flow growth generation. So, that's where our orientation will continue to be.
Ptak: Maybe a couple of closing questions. One more specific, which is on agency residential mortgage-backed securities, which I believe has been a pretty big focus of the fixed-income strategies that you manage one of which is BlackRock Total Return. Can you explain in layman's terms what you think the market is mispricing and why those securities aren't inviting risk/reward trade-off?
Rieder: Yeah. Once nuance to that is that because since the Fed started buying them, we've sold a lot. And you know, the Fed has made those as really rich in those assets and so we've reduced a lot of the exposure there. Generally, why we like those assets is they tend to be--by the way, at the beginning of this year they were fantastic because at the beginning of this year the credit markets were much too rich, and everybody was buying income and the view was we're going to be stable forever and the credit markets were too rich. But the beauty of mortgages is, A) they were cheaper in yield than the credit market, they were cheaper on a relative value basis and they were very liquid. And the beautiful thing about mortgages is they trade in huge size and very liquid fashion. And so, we use them quite a bit. There's also fantastic financing trades we do in mortgages. There's fantastic opportunities in TBAs versus pools or different coupons, Fannie 4s versus 2.5s. The opportunity set around investing and managing risk around it, financing trades around it, it's an area that we think, given our research and analytics and our scale is a place--historically, including this year, it's been tremendous around--is a place that we think there's huge opportunity and they are liquid.
Near-term, we've reduced a lot because the Fed has made them unattractive. While they’re still liquid, there are places that we're doing more in the agency mortgage space, recently around some of the high-coupon areas because prepayment speeds have picked and those assets have become a little bit cheaper. But we love agency mortgages. We think it's one of the places that a platform like ours can generate persistent return and they’re liquid, so you could do relative value trades actively within mortgages and across asset classes.
Ptak: Last question. We obviously have experienced a fairly violent sell-off and investors certainly reacted to that in some very resounding ways. They were liquidating their investments and going to cash. So, I wonder, as someone who's been running money for a long time what lessons did that experience that you went through in running money for clients over the last few months impart about your own risk and liquidity management systems. For instance, did it reveal any gaps or areas that you think need to be fortified in the spirit of continuous improvement?
Rieder: It's a great question. I have to say, I mean, I've been doing this 33 years. The reason why I found the business as fun as I did 33 years ago is, you're always learning. It's the most dynamic industry in the world. I mean, every day there's a new menu of news to react to, there's new environmental criteria that you're trying to think through. This one was that--I mean, we've never seen--nobody has ever seen anything like this. It'd come on so quickly and the uncertainty on the back side of it is so profound. So, I would say, generally, our risk systems held up really well and what we were able to do in terms of managing our risk, building--we've built a lot of cash and you had to because the uncertainty was so profound. And so, we held, and we always hold a lot of liquid assets in our portfolios, and the idea being you never know what's going to happen.
One of the things--by the way, that happened during that period was quality assets came under a lot of pressure and it's because you've sold what you could sell. And we thankfully, did not have some of the outflows that were out there in some of these areas. But we were able to sell some quality assets. We were able to sell a lot of these--talking about the front end of the yield curve and two-year notes, and you realize that when you want liquidity, part of your question about mortgages, mortgages are beautiful in times like this because they generally--they were under some stress but you could trade them. So, I just think it reinforced the idea of liquidity and make sure you're thoughtful about liquidity.
And if I could say one last thing is, part of this discussion--and I think you guys--I mean, some of these questions I thought were superb around that I've been talking about or thought about for a long time. You know, when you think about portfolio allocation, you think about the structure of your portfolio and part of why I talk about equity--you know, what does equity do for you, what does fixed-income do for you. What analytics and data have allowed us to do and we're continuing to build and learn about this is to say, okay, what is that asset doing for you, and to run it and do stress testing, scenario analysis, and to think about what every asset means in your portfolio. Part of what equity does for you should be different than what credit does for you. The high-yield market came completely unglued during that period. And so, part of why I think about if I’m going to own beta in my portfolio, I want convex beta at the right times, and it worked out really well. And you know, some of--like having optionality in the portfolio, some of the things that I think we did and I think we continue to build on, it's like when you use optionality, like call options were incredible for us because the market was in great shape and it was running and it gave us upside. But then, all of a sudden, all you lose is call premium on the downside and you don't lose your corpus on your positions. So, some of those things proved really valuable. And I think we're in a new era where you could use data and stress testing and scenario analysis, and we're really passionate about keeping our volatility down relative to what the markets provide, and there are so many tools at your disposal, and what data and analytics allowed us to do is just take that to the next level.
Ptak: Well Rick, this has been very insightful. Thanks so much for sharing your time and perspectives with our audience. We really appreciate it.
Rieder: Thank you very much. I appreciate it.
Benz: Thank you, Rick.
Rieder: Thanks, Christine.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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