Though summer has ended, investors felt the heat during September’s mini meltdown. In this episode host, Sammy Azzouz, and Heritage Financial’s CIO, Bob Weisse, discuss what rattled the markets, the glimmers of hope that are beginning to appear, and…
- The Feds olive branch to the markets
- Why overshooting the correction is better than coming up short
- The U.K.’s startling currency crash after the government tried to boost growth
- Why the worst year on record for bonds should start to excite investors
- Opportunities in private credit and how it works
October Market Update: Is the Fed Overshooting?
This automated transcript may contain grammatical errors.
00:00:10 – 00:05:00
Welcome to Wealthy Behavior, talking money and wealth with Heritage Financial. The podcast that digs into topics strategies and behaviors that help busy successful people build and protect their personal wealth. I’m your host, Sammy Azzouz president of Heritage Financial, a Boston based wealth management firm working with business owners, executives and retirees for longer than 25 years. Now, let’s talk about the wealthy behaviors that are key to a rich life.
In this edition of the Wealthy Behavior podcast where I talk to our chief investment officer, Bob Weiss, about what’s going on in the markets and investment universe right now. Bob and I have these conversations at the beginning of every month and we’ll continue to do so, so please look for them wherever you get your podcasts. Bob, how’s it going? Doing well Sammy how are you? Pretty good. Better than the markets maybe a little bit in September, although they’ve turned around, we’re recording today on Tuesday, October 4th, and we’ve had a couple of really strong days to start October after what would have to be described as a pretty horrific September. Yeah, I think that’s fair for September and October. I haven’t seen held lines to put into historical context, but back to back days with stocks up about 3% each day is an amazing start to the quarter. So tough September, but things are looking good right now. So in your opinion, what happened in September? Yeah, we’ve been talking about this for a little while with the theme of inflation slowing. I think at our last podcast, we talked about how energy prices have been coming down. Housing has been slowing. Well, more housing data came out and we saw price declines month over month. So we’ve actually seen housing slowing and then there’s kind of a mess overseas in the UK with tax policy, how they cut rates, cut tax rates from 45 to 40 at the top bracket, and then the market panicked, so they removed that policy. And something I think noteworthy happened on Friday, the fed vice chair Lael Brainard. So she is vice chair, second in command next to Powell, she gave a speech at the Federal Reserve Bank of New York and the title of the speech was global financial stability considerations for monetary policy in a high inflation environment. Sounds like a riveting speech, Bob, by the way. Good title. Just start with the first four words there: global financial stability considerations. So, oh, the fed is taking into consideration global financial stability. This is the fed that we’ve all been so afraid of recently, the guns blazing fed, who is out to crush inflation and nothing’s getting in their way. Well, now they’re actually thinking about global financial stability and this is what the fed does. They do these things. They put governors in places to give talk. and it’s their way I think of blood in the market. No, hey, we are keeping an eye on these things and we’re not going to bust the financial system. That is something we pay attention to. So I think maybe almost call like an olive branch that the fed gave markets that, we’re not here to crush you. That impacted things this week is what you’re saying because that speech was last Friday. So does that mean you do think the Powell Jackson Hole speech late August where he was, and we’ve talked about this, pretty dire and pessimistic and kind of rattling the market in terms of, you know, just letting them know we’re serious. We’re not slowing down here. We do expect pain to come. Do you think that contributed to the September mini-meltdown, I guess I would describe it. Yeah, exactly. The fed’s almost playing games with us as investors when you think about it that way. Powell scares us there will be pain and we are going to crush inflation. So stocks go down and then Brainard goes out and says, well, we are paying attention to stability, so we’re not going to be too too hard and stocks go up. So I think that’s kind of it in a nutshell, but I guess maybe I’m over applying the importance of the speech and that inflation is also slowing. And I think that’s coming out in the data. So it gives the fed an out and that you don’t need to be so hard if inflation is slowing and you are seeing weaknesses in a system. There’s risk to that though, right? I feel like people were somewhat optimistic in July and most of August and it turns out that maybe in hindsight, the market got a little bit ahead of itself in terms of being optimistic about a good inflation number, or a better than expected inflation number, and then we gave that all back plus more in September.
00:05:00 – 00:10:01
So maybe too much optimism in an environment like this could be a double-edged sword. Absolutely. These things can take time to settle through. Maybe one example in real estate is month over month we saw a price decline, but in CPI, when they look at rents, rents frequently reset year over year and if someone’s rent is through October 1st, year over year, it could still be going up. So it can take a little while for these things to go through in the numbers and the fed may be waiting to see that. Don’t go running, backing up the truck now and saying we’re out of the woods, but there are good signs. Yeah, and so also on the flip side of that, don’t be in a rush. Which you should never should be, really, unless your situation’s changed, don’t be in a rush to get out of equities or stocks just because you don’t like the volatility levels that you’re seeing. One thing that’s jumped out to me is some high profile media savvy investors, the types of folks you always see on CNBC and are not shy in speaking their opinion. The Jeffrey Gundlach and Jeremy Siegel’s of the world have kind of come out crying a little bit about what the fed’s been doing. Pretty aggressively whining I would say that the fed is overdoing it. The numbers are already good, they’re improving, they’re really going to crush things, what’s the point of all this? Jeremy Siegel’s clip on CNBC, which I shared through one of my Wednesday reading lists was quite strong, you know, the fed chair owes us an apology. This is kind of a train wreck monetary policy, the inflation numbers that we were seeing when commodity prices were high that they told us not to worry about are now lower and they’re telling us we need to worry about them. He was going at them pretty strong. Are they right? Is the fed kind of overdoing it? Or are they overshooting it? Or is this just jittery investors who have a microphone and they don’t like what they’re seeing? I lean more towards their right, specifically with Siegel. And it’s so easy to Monday morning quarterback the hindsight 2020. But when you go back to 2021, the fed was not concerned about inflation at all. And you’ll look at lumber as an example. Lumber prior to COVID was around call it $400. It’s $400 for a thousand feet of two by fours, like it’s something like that, but if you use the number $400, it went up to about $1700. And they’re sitting there saying no inflation is not a concern. We’re going to keep rates low. We’re going to keep buying bonds, keep our foot on the gas. And inflation was there. And now lumber’s back down to $400. So that flipped up to 1700. $1000 stayed in that highly elevated range. And now it’s back down. And now is the okay, now inflation starts. Well, it was here last year. It’s kind of gone. So I definitely relate to what he’s saying. And I think it’s especially fair to be critical of them in 2021. Inflation was here. And it’s not just they didn’t acknowledge it, they were stimulating the economy, they were there with the gasoline can out which was a mistake. But I think they recognize it and they’re not going to make a mistake again. Or they may make a different mistake, right? What these guys are talking about is overshooting on the correction side. And I’ve heard this analogy before, but the fed is not some nimble ballet dancer, it’s an elephant trying to stick the landing. And they’re not likely to stick the landing in moments like this, but eventually they get going in the right direction. So to me, for investors who can be critical about the fed and, you know, there are reasons to be critical about them for my entire career, right? I mean, Alan Greenspan overstimulated and in hindsight went from the maestro to kind of apologizing for missing certain things. I still hold Bernanke in pretty high regard. I feel like he was the only game in town in terms of getting us through the financial crisis. But some members of his fed committee were worried about inflation well into 2008, which just seems asinine in hindsight. You talk about Powell, maybe ignoring inflationary signs. That’s fine, and they do deserve criticism, but eventually they get going in the right direction. So if you’re an investor and you’re listening to this, I would say you don’t have to be terrified of the consequences of the fed overshooting because they can definitely pivot and start correcting things in the other direction. Yeah, I think that’s fair. You and I have talked about this before with the VIX in particular as a fear gauge and I would imagine it’s more subdued this month, but where did it get in September?
00:10:02 – 00:15:05
How volatile was the market, how nervous were investors? Yeah, it touched around 35 was the level in September, which about matched where it peaked this year. I think back in March, it also hit around 35. To put that in context, 70 is the number that we saw in March of 2020 and then November of 2008. So 70 is the number like the absolute peak of the great financial crisis in 2020. The absolute pick or trial for everyone to think about March of 2020. That’s almost the ceiling. We haven’t seen worse than 70. That’s when people were calling us and asking if they should pull their money out of their bank account and if the Dow could go to zero, basically. That’s when the Dow can go to zero conversations are happening 70. So if you put those aside and say, okay, well, how’s 35? But if you take 2020 out of the dataset and then you take this year out, you have to go back to 2011 to see 35 again. So with the financial crisis, 2008, 2009 and then you saw 35 again in 2011, but then through 2012 through 2020, you didn’t see a 35. In 2011, that was when the international markets were not doing well, we had the S&P debt downgrade on the U.S.. Exactly. Markets kind of got near bear market territory. Okay, just some context. So that’s still, I think your base case, right? I mean, we’ve talked about this before. That you do think we’re going to have a recession. It’s not going to be a “soft landing”, but the worst case scenarios of 2008 are just not on the table. The system is healthier and people don’t have to anchor to that 57% decline and the length of that recession in terms of trying to understand this market. That’s right. And what makes you say that, Bob, what is better off this time around? Looking back at 2008, I remember one of the discussions was, you know, well, I think Muhammad Al-Arian said this might have been either in the book I read or the podcast here is something I did with Mary Childs, about having his wife go and get money from the ATM. That was in the book, yeah. It was in the book. I mean, those types of conversations, that’s scary stuff when the banks might all close, the whole system will collapse, go get money while you still can. Like that type of fear, I don’t see it now, COVID, March 2020. I mean, there is no vaccine anywhere in sight and the mortality rate was high from that. It was spreading like wildfire. I mean, that’s scary stuff. You know, the price of a cheeseburger going up, year over year, it can hit the pocket, but it’s not like a pandemic that’s going to wipe us all out or the financial system melting down. People losing their homes in a way being when they are finance and getting 100% financing on homes. You’re not seeing that these days. So I just think consumers are in better shape and just what we’re dealing with is not as bad as those two instances. And that book again is The Bond King by Mary Childs about Bill Gross and his rise and fall through the investment industry. It’s a great book that we’d recommend. We also did a recent podcast episode on it. So then Bob, I agree with all of that. I mean, I’m generally an optimist if I have a blind spot when it comes to market as I do tend to think, you know, it’s all going to work out in the end. One thing that we’re seeing this year that you and I have never seen and I don’t think any investor has, correct me if I’m wrong, the bond market is on track for its worst year ever. Since that index that we all use to bar cap ag to track U.S. investment grade bonds first started, we’re looking at a year unlike any that we’ve really ever had. Yeah, that’s right. The Bloomberg U.S. aggregate bond index is down about 14% year to date, which is the worst year on record. So it’s been tough for bond investors as markets have adjusted. The good news to this, and people pause what’s good about bonds going down 14%. It actually is pretty real and good news. You could think of it two ways. Let’s say you enter the year and bonds are yielding 2%. You could keep yields at 2% and bond investors clip away your 2% coupon for the rest of your investment horizon in 20-30 years or whatever it is. And that’s great, 2%. Or yields can adjust and go up to 4.5 to 5%, probably 5. And they spike up to 5%. Now you’re clipping away at 5% for the next 20 or 30 years. The rest of your investment horizon. That’s pretty awesome, if you ask me, you’re getting a 3% extra yield for the rest of your investment horizon in exchange for that there’s an immediate adjustment in price.
00:15:05 – 00:20:10
Which works out to about a 13, 14% decline, but now you have a higher yield. And that higher yield is there to stay. That yield can go higher, the price goes down more, or that yield can go lower, and you’ll get some price appreciation. So unfortunate, short term, but one of our bond managers said bonds are back. Like with a big smile like bonds actually can help you hit your goals and objectives now. You can get 5% in a fairly conservative bond fund these days. And a lot of financial plans don’t need much more than 5, 6, 7% return, and when it conservative bond fund can get you 5, you’re starting to have a pretty good setup. So you don’t think this is the start of some long-term bear market in bonds. No, no, definitely not. But why are yields up this year, Bob? It’s inflation and the fed raising rates combined with just the risk off environment. There is a lot to it, but so bond investors do, all investors, look at the real return, the return of inflation. So when inflation is low, a top line nominal lower return is acceptable and inflation is high. We have enough some people would say, yeah, but 5% return on bonds that’s not great when inflation is running at 8% and I’d say you’re right except for we’re not expecting it to be at 8% annualized for the next 5 years. So elevated inflation and the fed raising rates. So short rates are in the threes now. Even 4’s from them pushing up rates. So they’re moving the market. So have bond investors or have people been selling institutions been selling bonds in an environment like this? It’s more just the adjustment in that when the fed raises rates, like raises the fed funds rate to 3% – 3.5%. The market adjusts – who’s going to buy a ten year treasury at 2%, no one. So just the price just immediately pops up to what’s an inverted yield curve right now. So even a little below, like a 6 month or a two year treasury. So what’s the risk to investors or for us, and I guess in terms of being wrong about the bond market, you know, starting to become more attractive and that this isn’t the beginning of a prolonged, ugly stretch for fixed income. Is it that rates continue to go up and inflation really doesn’t come under control for a while? Yeah, I mean, the risk you are getting down a scary path. It’s a death spiral. The main issue with higher rates is we’re talking about the US Treasury market. And the treasury has, I think it’s around $30 trillion in debt outstanding. And you start plugging through that at a 4% rate, which is around where yields are now. That’s $1.2 trillion in debt service. And $1.2 trillion in debt service. I think personal income tax receipts so you take all personal incumbents, it’s either it’s $2 or $3 trillion. So you take all the taxes, everyone pays on the country and if it’s two or three and 1.2 of it goes to debt service, if you start playing that, where treasury yields go up even more, that math gets ugly quickly. So you’re saying the risk isn’t necessarily that rates keep rising unchecked. It’s that higher rates could lead to defaults, basically. Yeah. Yeah. I mean, that’s financial stability risk. And the fed is inducing these higher rates and they do not want to bankrupt the country. You don’t think that’s going to happen, but I did ask you what’s the risk in terms of the bond thesis not playing out. Correct. Yeah, gotcha. Okay. And you touched on this at the beginning with what’s going on in England, which I did want you to explain a little bit more. It seems somewhat mind boggling and a headline that kind of crossed out of the blue in terms of their currency crashing and them reversing course on some tax policies, what does it mean for investors or is it just noise? It’s mainly just noise, also just a sign that markets are a little finicky right now, like something that shouldn’t be a huge deal you wouldn’t think, cutting tax rates on the top bracket by 5% from 45 to 40 the market panicked. Is that because it’s an inflationary move in a country that’s already dealing with high inflation? Yes, that and also it’s the bond market that reacted. So the bond market, as a bond investor you’re asking yourself, am I going to get paid back? And you just, by reducing taxes, you just cut your income as a country, your inflows are lower.
00:20:11 – 00:25:06
So I am concerned that I’m not going to get paid back as a guilt investor. Therefore, I require a higher yield to lend you money, so that’s what happens. And also, I don’t like this currency as much. The currency went down. So global investors just kind of puked on a guilt and the pound when tax rates went down they said we don’t like this, we don’t think you can afford it. And they had to backtrack. It did rattle markets for a little bit, but you are seeming to think it’s more in the noise category and a sign of the times that we’re in versus a long-term portfolio adjustment that people would need to make. Definitely. It could be fair to say that it was poor policy and the market sniffed that out and kind of reported that back. But in more ordinary times, I don’t think you would have seen such a strong reaction. What else is on your plate or on your minds these days, Bob, as if, you know, a prolonged bear market isn’t enough to get some gray hairs going. Nothing we haven’t talked about. I guess the one other thing I touched on it a little bit with lumber prices. Something we’ve talked internally about, I think it really is a good case study for inflation because you think about the case when it went up so much. Powell was in his defense saying it was transitory. You had the sawmills shutting down, so the people who go in and cut the trees to make your two by fours weren’t showing up to work, they had COVID, so you had a backlog. So you had a supply shortage of lumber and meanwhile, houses are being built, people are doing the home improvement projects, putting on new decks. And it seems like that’s kind of flushed through the system. Now that the price is back to where it was at the beginning. So maybe it was transitory. And that’s gone. So just seeing that as a case study has kind of resolved itself that’s positive in my opinion. So it’s a small thing. It’s one commodity, but it did get a lot of headlines and just seeing the spike up and the crash down. And now it seems like we’re back to a normal level, which is a healthy thing for the economy. And what do you think of the deflation versus disinflation concern? And just setting that up for people who may not have listened to us chat about it in the past. Deflation is a decline in prices, disinflation is a slowdown in the increase. People would like to see disinflation deflation would not be great. We did get, I think, at least one number, a real estate number that showed a slight decline in prices month to month in a 20-city index. But where are you in terms of deflation versus disinflation and are you concerned that we could get a deflationary environment and despite what we already talked about that’s not 2008 that could be a little bit of a steeper or deeper recession? Yeah, probably not deflationary for the most part. Though an exception, I would say is housing. Housing did get a little frothy and to see, you know, even housing give up 6 months of gains is deflation. And so I could see housing prices pull back and that’s deflationary, but overall just seeing disinflation. So the rate of increase slowing, I think, is a good base case. There’s been some bright spots in the market this year and in portfolios, specifically in areas that we’ve touched on before, one of which is real assets, which we did a podcast on a few episodes ago. And I think covered that well, and I’d encourage people to go listen to that. That’s real estate, farmland, Timberland, and infrastructure. But there’s also another segment of the market in our portfolios that we haven’t highlighted as much that has managed to be a bright spot in 2022. Yeah, we haven’t talked about private credit much. And we have private credit investments through limited partnerships for some qualified purchaser investors, and then also through interval funds with a manager called Cliff Water and the two Cliff Water funds we own are up through today one is up, 8.5% year to date and the other one is up 4.4% year to date. So both really healthy gains. They’re lending funds so they’re making loans at high rates. So they’re clipping the coupons. One thing that’s nice with those funds is the way the loans are structured as they’re floating rate. So they have a base rate and as the base rate, like the fed funds rate or libor, as that goes up in lockstep their yield goes up. So they actually do better when rates increase by benefiting from a higher yield and they do make high quality loans that are different ways to invest in private credit and we’ve stayed with what we think are the funds that make higher quality loans.
00:25:06 – 00:29:29
So while we’re seeing some economic stress and some companies struggle by being senior loans backed by good equity, they’re not seeing an increase in default risk. So getting up 4.5% and 8.5% return year to date, it’s been awesome for our clients. So you don’t worry about defaults in a recession or an economic slowdown because of how these loans are structured and how the pools are run. Yeah, maybe that’s a default risk probably has increased, but it’s not to the point of severity where you’re seeing big markdowns. Got it. Yeah, I mean, to get into the weeds a little bit, what they do is they make what are called sponsor backed loans. So if I’m making a loan to a private company, there are two types of companies. There’s sponsor backed and non-sponsor backed. Sponsor backed company is a company owned by private equity firm. So then a non-sponsor backed is owned by employees, or not PE. When you make a loan to a sponsor backed company, so company that say owned by Bain Capital or Blackstone for you to lose your money on the loan, they have to write off the equity entirely. Because equity has to go to zero before bonds go to zero, before the debt goes to zero. Then a manage like Bain Capital is not going to want to write down their equity to zero. That’ll bust a fund if they have really one or two companies go to zero. So by being the senior in the debt, in a company backed by a good private equity manager, gives you a pretty good backstop for valuations. You can handle good amount of volatility in the economy. So good to see bright spots in a year like this. This is obviously bear markets are never fun. They’re challenging, I think, for investors and investment teams. And we’ve talked a lot about maybe some technical things bouncing around to certain asset classes. Bob, what’s your advice for investors today? I hate to sound like a broken record, but you have a plan and stick to it. If you’re an accumulator, you better be putting money to work right now. You have extra cash flow don’t sit and wait for things to get better, put that to work. And if you are living off your portfolio, you should be diversified, and you should have assets that are holding up and doing well. And you should be able to sleep at night because of that positioning. If you’re not doing any of those things, you need to talk to Sammy. Yeah, well I don’t know about that, but nothing like a broken record if the record’s playing the right tune so don’t worry about that. I think my advice is much more simplistic, but also the same kind of risk of repeating myself. Just don’t watch if the market downturn, the red arrows, the negative portfolio values have got you stressed out. Just turn off the TV, close the app, do something else. The markets will recover your portfolio will recover well within your time horizon and you don’t really need to be watching it in the meantime. It’s just not productive and it’s not, it’s not something that you’re going to enjoy doing. So change the channel, basically. Good advice. Thank you for this conversation as I always say when we wrap up, I’m sure it’s really helpful to our listeners to hear what a chief investment officer managing over $2 billion is thinking day to day, but particularly in an investment climate like this, we’d love to hear from you at email@example.com.
Thank you for listening to Wealthy Behavior. If you found the conversation useful, please consider leaving us a review wherever you listen to your podcast and sharing this episode so those around you can live a rich life too. For more insights, subscribe to our weekly blog at heritagefinancial.net and follow heritage financial on Facebook, Twitter, and LinkedIn. Check out my personal finance blog at thebostonadvisor.com. Wealthy behavior is produced by Kristin Castner and Michele Caccamise. This educational podcast is brought to you by Heritage Financial Services, LLC located in the greater Boston area. The views and opinions expressed in this podcast are that of the speaker, are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment or strategy discussed will be successful or will achieve any particular level of results. Investing involves risks including the potential loss of principle. *This automated transcript may contain grammatical errors.
About Wealthy Behavior: Heritage Financial Services
Wealthy Behavior digs into the topics, strategies, and behaviors that are key to building and protecting personal wealth and living a rich life. We’re Boston Massachusetts-based wealth managers who have been helping busy, successful people pursue their financial goals for more than 25 years. Hosted by Sammy Azzouz, President of Heritage Financial, Wealthy Behavior digs into the topics, strategies, and behaviors that are key to building and protecting personal wealth and living a rich life.