Gaffney Signals End of Era; Provides Alternative Strategies for Fixed Income Investors

During a frigid Chicago lunch-hour in late February, Kathleen Gaffney, CFA, spoke to a room of CFA Chicago Society members and their guests at the Willis Tower’s Metropolitan Club about the prospects of fixed income investing and potential income generating strategies during the eventual rise in interest rates. Her overriding message was one of reassurance; “We’ve been here before.”

Gaffney, the lead portfolio manager for Eaton Vance’s multi-sector bond strategies, began her presentation by discussing today’s current ultra-low interest rate environment and the risks associated with a Fed decision to increase short-term rates in 2015, which she expects in June, lest the Fed risk being behind the curve. However, she was quick to give the Fed credit for current policies and actions, which Gaffney labeled “bridge-financing” until the private sector can provide the momentum to move the economy forward. As the U.S. leads the world into economic recovery, while other world economies toddle, Gaffney is not concerned about inflation or rising long-term rates. Her forecast for the yield on the 10-year Treasury bond is 4% by the end of 2015, although she admits her forecasts for the 10-year have been incorrect in the recent past.

Besides the obvious risks to bond values in a rising rate environment, Gaffney also noted that nearly none of the fixed income practitioners operating today have experienced the magnitude of the long-term rise in interest rates that preceded the cycle’s peak in 1984. Additionally, regulatory changes have reduced Wall Street’s ability to put their own capital to work, resulting in decreased valuation support, reduced liquidity and very swift corrections in high yield, emerging and equity markets.   The end of the era will require careful asset allocation and alternative strategies that seek to mimic fixed income returns, while minimizing interest rate risk.

Gaffney encouraged the audience of investors and advisors to enhance portfolio flexibility by thinking broadly about the various “levers” that can be pulled to generate investment returns, i.e. credit, country and currency. She likened taking interest rate risk in today’s rate environment to driving down a dead-end road at 80 mph.  Rather, with her expectation of a secular bull market in equities, fixed income investors may consider “high-quality” equities with good dividend yields that will provide additional return on positive market movements, according to Gaffney. She also suggested that investors consider equity sensitive convertible bonds to mimic the returns of high yield bonds, while minimizing interest rate risks. Floating rate bonds were also offered as a reasonable alternative. However, Gaffney noted that floating rate notes introduce an additional element of repayment risk if rates rise too high or too fast, which she does not expect. The current strong dollar also provides opportunities to benefit from the potential growth from product importers to the U.S. Additionally, Gaffney proffered an idea that countries working to implement long-term positive structural reforms, including Brazil and India, have the potential for enhancing portfolio returns. However, she cautioned investors regarding new issuances encouraging investors to increase due diligence levels for new market entrants.

Gaffney finished the luncheon session with a question and answer session that included audience inquiries regarding duration assignments, the potential for negative deposits rates and, among other things, the performance of the her managed portfolios if the 10-year yield does reach 4% in 2015.

Distinguished Speaker Series: Kathleen Gaffney, CFA, Co-Director of Diversified Fixed Income, Eaton Vance

The Distinguished Speaker Series featured Kathleen Gaffney, CFA, and Co-Director at Eaton Vance who focuses on fixed income. Eaton Vance is one of the oldest and most distinguished investment management firms in the United States.  Gaffney warned that the “end of the era” of low interest rates is at hand and that more volatility will be the result.

The increase in volatility is due to more than just the expected rise in interest rates.  Gaffney warns that the broker/dealer community has been hard hit by new capital rules that prevent them from holding large inventories of bonds.  Due to the global financial crisis of 2008-2009, this “shock absorber” has been taken away.  Gaffney stressed that moving capital will be difficult, leaving the market vulnerable to sharp corrections.

Gaffney stated that she is convinced that the credit markets are ripe for correction.  The FED’s actions will most likely impact short and intermediate term bonds the most.  If the FED does not begin to tighten in June, it will be accused of being behind the curve. She believes that the fundamentals in the United States are good and that once rate hikes begin; the resulting yield curve will resemble a “bear flattener” as short rates will rise faster than longer term rates.  Inflation will result when economies outside the US continue their economic recovery.

Gaffney is convinced that duration risk is the greatest risk facing the US bond market.  It is her position that US interest rates are too low and that the 10-year treasury yield will approach 4% by year-end.  She also believes that high-yield and investment grade corporate bonds are currently expensive. In this environment, as part of a multi-sector strategy, Gaffney utilizes dividend paying equity substitutes in her fixed income portfolio.

Gaffney purchases equities that yield between 1.5% and 3.0% at prices that are more reasonable than current bond prices.  These equities have yields that currently compare favorably to the 10-year treasury.  The equities market at this time also offers more liquidity than fixed income markets, and she is able to use up to 20% of her portfolio for equities.

In the brief question and answer period that followed Gaffney stated that she is an optimist and that strong GDP numbers which she expects in the near future will be a catalyst for rising interest rates.  She assigns a 0 duration to the equity positions she holds in her portfolio. It was interesting to hear how a multi-sector strategy allows her to include equities in the search for yield.

Distinguished Speaker Series : James Bullard

James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, spoke to a packed room at the Standard Club on Jan. 16 about Federal Open Market Committee macroeconomic forecasts. His presentation was also transmitted via a live webcast.

The first problem is that all forecasts are required to be based on “appropriate monetary policy assumptions.” But what assumptions are appropriate, asked President Bullard? One could assume that no policy changes occur. Another forecaster could instead include the monetary policy changes that she prefers—and maybe have overly rosy scenarios to show that those policies would work very well. To the contrary, another forecaster could try to incorporate his expectations of the FOMC decisions—and predicting a dire economic situation if he does not agree with the FOMC consensus.

Clearly, there is no perfect way. But this is not an academic endeavor, the speaker emphasized, because these forecasts are necessary to inform monetary policy decisions.

Bullard went over the FOMC forecasts on GDP, inflation, and unemployment for the last few years. There are 12 Fed Presidents and up to seven Governors, providing 19 forecasts. Looking at averages, the FOMC for the last two years got GDP about right, while its forecasts for unemployment were pessimistic and those for inflation too high. The speaker joked that erring on the same side for two years in a row is pretty bad.

The implications for monetary policy, given low inflation and shrinking unemployment, are that there is no change expected to the FOMC rate-raising path because inflation and unemployment balance each other.

Bullard allowed plenty of time for questions. Here is a summary:

  • The FOMC would prefer to arrive at the next recession with a non-zero Fed Funds rate, but if this does not happen they can do another QE. He would prefer to be able to cut rates so he’d rather increase rates in 2015 and if the economy slows down they can always cut.
  • Wages are a lagging indicator because unemployment must move a lot before wages move. Moreover, corporations do not cut wages in recession and therefore are slow in raising wages in expansions.
  • The fall in participation rate is largely explained by demographics. Participation peaked around 2000 and is expected to not increase by a lot.
  • Headline inflation is a better measure than core inflation because food and energy are what people buy every day. If we are concerned about volatility we should use trimmed measures such as the Dallas Fed’s and not exclude stuff that people buy regularly.

Distinguished Speakers Series: Barry Sternlicht

Distinguished Speakers Series: Barry Sternlicht

Distinguished Speakers Series: Barry Sternlicht

Barry Sternlicht was the featured guest at the Distinguished Speakers Series held on Nov. 21 at the Standard Club.  Sternlicht is the Chairman & Chief Executive Officer of Starwood Capital Group, a private investment firm he formed in 1991 focusing on global real estate, hotel management, oil and gas, energy infrastructure, and securities trading.

Using an inordinate number of slides Sternlicht gave a sweeping account of just about everything that related to the global economy.  His remarks covered a range of investment topics including; the domestic housing market, New York City property prices, currencies, quantitative easing, oil prices, global real estate valuations, and the 2015 outlook for the U.S. and global markets.

A subset of Sternlicht’s presentation comments included:

  • The top 1% are getting richer in all markets. This subgroup of the investing population is no longer willing to solely invest in domestic or global markets.  Instead, these investors are now buying up real assets in prime locations – South Americans investing in Miami, Asians investing in New York, Russians investing in London, etc.  These global buyers are pushing higher purchase prices in these ‘world class’ cities.  As a result, buyers looking for reasonably priced real estate will have to look to ‘second tier’ cities.
  • The U.S. government deficit will continue to grow despite the spending bill passed at the start of 2014. Entitlements – Medicare, Medicaid, and Social Security will increase the deficit dramatically over the next decade.  To combat this the retirement age will be raised, and benefits will be reduced.
  • The movement of populations from high tax states to low tax states will accelerate as more baby boomers retire. This will drive real estate growth in those low tax states and provide for slow or even negative growth in high tax states.
  • Growth in retail rents is and will continue to be bifurcated. Luxury retail malls will continue to outperform in terms of high occupancy rates, and growth in rents.  Properties that are not at the A level will likely exhibit slow or flat growth in rents.
  • The Euro zone and Japan will institute their own form of quantitative easing. This will cause the dollar to rise against the Euro and Yen.  The U.S. has promoted a weaker currency over the past several years with lower interest rates and growth in the money supply.  The stagnating economies in Europe and Japan will push policy makers to weaken their own currencies in an attempt to reflate their respective economies with increased exports.  Even so, a greater currency war will be fought over the next several years with many nations fighting to have a weaker currency.
  • The Federal Reserve will keep interest rates lower for a longer period due to a lack of any inflation on the horizon and lower energy prices. In addition U.S. yields are higher than in Europe and Japan, which will cause flows into the U.S. market, keeping the long end of the curve depressed.

Sternlicht ended his presentation by taking questions from the audience and sharing details of his latest hotel and apartment project – the ultra-luxury Baccarat Hotels and Resorts development in midtown Manhattan.  This development underscored several of the points Sternlicht made earlier – premium properties commanding outsized rents, and investing in world-class cities for outsized returns.

Distinguished Speaker Series: Jeremy Siegel

Distinguished Speaker Series: Jeremy Siegel

Distinguished Speaker Series: Jeremy Siegel

Are stocks overvalued?  Not according to Chicago native Jeremy Siegel.  The Wharton professor and author often described as a “perma-bull” took a sanguine view towards the equity markets in his CFA Chicago presentation, saying that while stocks are the most volatile asset in the short run, they have proven to be most stable asset in the long run, producing an average real return of 6.7% since 1802.

When Dr. Siegel delivered his keynote address to the CFA Chicago Society’s annual dinner in 2011, he described stocks as “undervalued”.  Since then, the S&P 500 has returned nearly 63%.  Slightly less prescient was his prognostication regarding bonds, which he believed to be overvalued at the time.  In his booming, enthusiastic style, Siegel spoke highly of stocks, saying that “In every country in the world, stocks have slaughtered fixed income over the long run”.

One of the most interesting anecdotes Siegel told was around his tenuous media relationship with fallen bond titan Bill Gross.  In Gross’s August 2012 Investment Outlook piece, the former PIMCO portfolio manager wrote that “the cult of equity is dying” and identified Dr. Siegel as the leader of that cult.  “I’ve had my differences with Bill Gross over the years,” Siegel lamented to chuckles in the audience, noting that Gross’s ill-timed call preceded a massive run-up in equity prices.

Turning his attention towards the subject of valuation, Dr. Siegel used the price to earnings multiple over a long time horizon to show that the current market valuation isn’t very far from the norm.  Taking the analysis a step further, Siegel stated that removing high interest rate periods from the PE calculation would indicate an even higher average multiple, suggesting that the market could potentially be undervalued even after nearly doubling from the March 2009 low.  Dr. Siegel then issued a rebuttal to his friend Robert Shiller’s popular Cyclically Adjusted Price to Earnings (CAPE) ratio, stating that in 392 months out of 396 months from 1981 to 2013, the actual 10 year real market returns have exceeded CAPE forecasts.  The CAPE ratio even characterized the S&P 500 as overvalued in May of 2009 when the Dow was at roughly half of its current value.  FASB accounting rulings also affect firm earnings (and thus PE ratios) by requiring firms to write down, but never “write up” investments.  This phenomenon was observed in 2002 due to the acquisition of AOL by Time Warner where the subsequent $99 billion write down produced the largest loss in corporate history, further distorting reported S&P 500 earnings.

Lastly, Dr. Siegel addressed the way the Standard and Poor’s aggregates S&P 500 earnings, saying that the earnings number they report can be wildly distorted due to the firm not cap-weighting each company’s share of profits and losses.  Instead, Dr. Siegel offered National Income and Product Accounts (NIPA) as an alternative earnings measure.  When NIPA earnings are used in the Shiller CAPE ratio, the market shows no overvaluation at all.  Attendees were left with plenty of food for thought around markets and valuation, and Dr. Siegel again delivered an excellent talk.

Distinguished Speaker Series: Mario Gabelli, CFA , Chairman and CEO, GAMCO Investors

Nicknamed “Super Mario” by financial media pundits, Mario Gabelli, CFA , Chairman and Chief Executive Officer of GAMCO Investors, Inc., presented his ideas on shareholder activism to a sold out crowd at the University Club on Aug. 12, 2014.

The idea that activists are catalysts was center to this Charterholder’s presentation. Teeing up that idea, he gave us insight into the philosophy and investment thesis that GAMCO follows with several quotes: “If you drink it, we follow it, and if you watch it anywhere, we follow the content”.  What and who have influenced him?  He noted Graham and Dodd and Security Analysis as being the definition of value investing and Roger Murray, his professor at Columbia Business School as having a large influence on his decision to go into investment management.  Gabelli’s unique sense of humor bubbled through as he compared Mount Rushmore to the four professors who created value investing.

Given these influences, his investment process is very similar to what Graham and Dodd taught in the 1930s.  So, what twist does Gabelli put on value investing?   He looks at private market value – intrinsic value plus a control premium with a catalyst.  Catalysts bring underlying value to the surface and include regulatory changes, industry consolidations, death of a founder, share repurchases, division sales, management succession and finally, shareholder activism.

Activist hedge funds net asset inflows were 5.3 billion in 2013 with 59% of activist objectives achieved in 2013.  Gabelli walked us through various models of shareholder activism touching on big names and big results such as Carl Ichahn, Jeff Ubben, George Hall and David Einhorn.  He pointed out that Carl Ichahn’s model works because there is demand for it.  When discussing shareholder rights and the “poison pill”, Gabelli advocated that GAMCO votes against it per their Magna Carta of shareholder rights. After all, it is all about the shareholders who own the company.

The presentation wrapped up with a discussion of companies in our own Chicagoland backyard who have either split and created value or have the potential to create value with a split.  As a final nugget of wisdom before the Q&A, Gabelli recommended The Graduate as an important movie because as you watch a young Dustin Hoffman receiving advice on what he should do with his career, you realize this is defined the attitude of people in the ‘60s or ‘70s.  What movie will define the times we are living now?

Distinguished Speaker Series: Rick Rieder, Managing Director, BlackRock

The Distinguished Speaker Series hosted Rick Rieder whose other duties include Chief Investment Officer of Fundamental Fixed Income for BlackRock and Chairman of the BlackRock Investment Council. BlackRock is the largest asset management firm, now managing over $4.3 trillion for clients worldwide.  In 2013 Mr. Rieder was inducted into the Fixed Income Analyst Society Hall of Fame.  He was introduced by James Franke, Co-Chair of CFA Chicago Distinguished Speaker Series Advisory Group.

Rieder’s presentation was entitled “The New Economic and Investment Regime”.  His thesis is that economic forecasting and investing is now dependent on the following four critical factors; 1. Demographics, 2. Leverage, 3 Technology, and 4 Monetary Policy. He went on to demonstrate how each of these factors works to influence the economy and therefore interest rates. His thesis is that growth will be slow and the yield curve will continue to flatten.

Rather than simply alluding to an aging population, Rieder pointed out the employment problem and the financial burden of high student debt on the younger population. The demographics lead him to conclude that current consumption and spending trends will remain low. The implications of leverage in developed and emerging markets point to the continued availability of cheap financing. Rates in the US and UK could grind higher in the context of a flat yield curve. Rieder concluded that technology has created the biggest headwind against inflation and will continue to suppress levels of employment.   With respect to monetary policy, Rieder points out that an important by-product has been that long-dated Treasuries have become scarce due to less supply needing to be issued, continued strong foreign buying and demand for long-dated assets from pension funds and insurance companies.

Rieder concluded by suggesting which asset classes have the best potential for appreciation.  He strongly recommended long-dated municipal bonds as there is very little issuance.  Short dated ABS and CLO’s are also attractive in this environment. Rieder is bullish on the equity market given the cheap financing presently available to corporations, he predicts this will persist.

There was a brief question and answer period following the presentation. On the question of what affect exiting QE might have on the capital markets, Rieder stated that although history says differently, he did not think a big equity sell-off would occur. In response to another question, he thought that high-yield was fundamentally sound and although there would be a pause, it would not suffer big outflows.

Distinguished Speakers Series: Rob Arnott, Chairman & CEO, Research Affiliates

A provocative presentation entitled Conventional Wisdom and Pseudo-Science: Are we Blinded by Theory? took place in front of a sold out audience of 176 on June 19 at the Metropolitan Club. Rob Arnott, Chairman & CEO, Research Affiliates was the speaker who generously shared his unconventional thoughts in debunking several core theories of finance.

His objective was to take us on a whirlwind tour of areas where conventional wisdom can often lead one astray. The premise of Arnott’s talk is that much in the world of finance masquerades as science, but is not. When theory and data conflict the standard reflex is to dismiss the data.

In assuming that theory is correct, one must tacitly assume that all assumptions are correct. Unfortunately, assumptions are oftentimes incorrect, and is the cause of the fissures between theory and reality.

Almost every popular theory of finance can be debunked in some way based on a flaw in the assumptions required to make the theory work.

Efficient Markets, Miller-Modigliani, Modern Portfolio Theory, CAPM, Black Scholes, Cox-Ingersoll-Ross, Behavioral Finance, etc.  –- they all can be taken down in an imperfect world where reality does not cooperate with the assumptions.

An easy example to refute the efficient market theory in the equity markets considers empirical data involving the Top Dog in a sector.

The Top Dog is ranked #1 by market capitalization in a sector, a market, a country, or the world.

To get to Top Dog status requires outperformance. Over the preceding 5 year period, the Top Dog in the US outperforms the broad market by 20%. A global Top Dog outperforms the average stock in the world market by an even more impressive 40% in the 5 years leading up to becoming the Top Dog.

Going forward one might expect equal performance by the Top Dog according to the Efficient Market theory. However, reality suggests underperformance. And not just a modest level of underperformance, data suggests the Top Dog underperforms the market vastly in the ensuing 5 year period. In fact, the entire gain that got them to Top Dog status is often given up as the Top Dogs generally deliver less than bonds and cash. Is this a peculiarity? Or simply evidence that markets are not as efficient as theory suggests?.

Arnott suggested that history could taken a different course. What if, instead of advancing efficient markets in 60’s, there was a promotion of deranged markets. The market is always missing and trying to mean revert?  It would explain anomalies.   What if a DAPM (disorderly asset pricing model) involving mean reversion was advanced? The Nobel Prize might have never been granted to William Sharpe for CAPM and his extension of Markowitz’s portfolio theory.

Refuting CAPM was an easy target as the theory assumes everyone on the planet can borrow or lend at the risk free rate while ignoring taxes and a host of other real factors.  If all of the CAPM assumptions rang true, the theory proves you cannot beat a cap weighted market. Because the assumptions are not true, the conclusion of CAPM theory must be taken as only an approximation of fact.

Working backwards, the assumptions allow for the mathematics to work out. Do not make the mistake of believing the theory proves that is how the world ought to work. Rather, the theory is totally expected given the assumptions. When empirical gaps exist between data and theory, do not automatically assume the data is wrong or bend it in order to justify the theory. Just as important as knowing the theory is to perform a judicious search for gaps in the assumptions.

In summary, Arnott left the audience with a prudent message. Theories are wonderful, and it is not necessary to disregard theory. However, please do not confuse theory with fact. It is not.