Fuss & Bernstein Transcript 7/12/2013 #1003

July 12, 2013

CONSUELO MACK:This week on WealthTrack, as the 30 plus year era of ever lower interest rates winds down, how can investors stay on track? Loomis Sayles legendary bond manager, Dan Fuss and top ranked strategist and portfolio manager Richard Bernstein share their investment itineraries, next on Consuelo Mack WealthTrack.


Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. The investment climate has changed. After falling for decades, interest rates are rising. And as in everything else in this global, electronically connected universe, the shift has been dramatic and rapid. Credit or blame Federal Reserve Chairman Ben Bernanke’s testimony to Congress weeks ago, which Wall Street is still parsing. When will the Fed “taper” its stimulative bond purchasing program? Who knows! Even Bernanke says it’s data dependent, but the markets have been responding ever since with increased volatility.

If you didn’t refinance your mortgage during the past year, you will notice a big difference now. Mortgage rates have soared since hitting record lows last year, which will make owning or buying a home more expensive. That will eventually have consequences for the housing recovery and the economy at large. The reaction of investors has been instantaneous. According to TrimTabs Investment Research, after investors poured a record $1.2 trillion dollars into bond mutual funds and ETFs in the four years from 2009 through 2012, they are now fleeing them. Bond funds experienced record outflows of $60 billion plus in June. Meanwhile, after years of outflows since the financial crisis, stock mutual funds are starting to see substantial inflows this year. According to TrimTabs, both bond and stock mutual fund investors, however, are notoriously bad at market timing and any extreme behavior on their part, such as we have been seeing recently is a contrary indicator!


What is the view of this week’s WealthTrack guests? Let’s find out!


Dan Fuss is Vice Chairman of Loomis Sayles and has been portfolio manager of the firm’s flagship Loomis Sayles Bond Fund since its inception in 1991. The Bond Fund has an outstanding long term track record and Fuss has won just about every award given in the bond world including twice being named Morningstar’s Fixed Income Fund Manager of the Year. Loomis Sayles is a WealthTrack sponsor, but Dan is clearly here on his own merits.


Richard Bernstein is the CEO and Chief Investment Officer of Richard Bernstein Advisors, a money management firm he founded in 2009, which now manages assets of more than $1.3 billion. The firm subadvises several mutual funds, unit investment trusts, and separate accounts, but its flagship fund is the Eaton Vance Richard Bernstein Equity Strategy Fund. According to Barron’s, equity strategy has ranked in the top ten of its Lipper Global Flexible Fund category since its October 2010 inception. Bernstein, formerly the Chief Investment Strategist at Merrill Lynch, was named to Institutional Investor’s “All-America Research Team” 18 times and its top “First Team” spot 10 times. I began the interview by asking Fuss if we are finally seeing the long awaited rise in interest rates.


DAN FUSS: Yes is the short answer. I’ve been saying for some time we’re in the foothills. And it’s been a long time in the foothills. I think the first foothill, or the one we’re in now, has been a real substantial foothill. And I think it does mark the end of the very, very, very low… to use the ten year treasury as a reference point, we were back…oh, what… in early May, end of April, we had the ten year at about a two-ten, two-fifteen yield, somewhere in there. Now we up into the two-sixties, and now drifting down from there. So…


CONSUELO MACK: But that’s a huge move in a short period of time, right?


DAN FUSS: It is. And considering that last July, July of 2012, you had a ten year treasury yield of around one-sixty, spiking down to 146. You say, well, okay. That isn’t big. Yeah, that is big. That’s a substantial move. We’re into the rise. But it’s very early on, and probably being interrupted now, as we speak.


CONSUELO MACK: So is it justified? I mean, the kind of rise that we’ve seen in interest rates, and we’ve had false starts like this before.




CONSUELO MACK: Right. So what is it that tells you that this is real, that in fact that we’re going to be going to higher levels as opposed to going back down to lower levels, which is what has happened in the past?


DAN FUSS: Well, two things. I’ve been surprised all my life in this business, so you never know. And nobody knows the future. But the way it seems to me right now, what’ll keep us from going back down to where we were in July of 2012 is the pressures on the market. Now, on the fixed income market. The outflows from the mutual funds have gotten off to a real strong start. In fact, you know, tapering off now, but they… really out, and so we’ve broken a habit there. The whole world is not market timers. A lot of people say gee, that’s it. I want out of fixed income. Or I want to at least watch it for a while. I don’t want to be there. And it’s easier to do these days.


CONSUELO MACK: Because of ETFs and mutual funds and…


DAN FUSS: Well, ETFs are a special problem actually, and that’s surfacing now for the first time. So, and then out of the mutual funds, on the institutional side of the business, essentially retirement plans and defined benefit plans, and other types of institutional investors, there’s been a pickup of money coming in, but not as dramatic as the outflows from the mutual fund. But I think the recognition of where we might be going in the future is more broadly held and the push-push-push for yield is felt a little bit less strongly right now. It’s not the end of the world for the bond market by any means. But the market reaction to the Fed’s statement in the chairman’s discussion was really quite something.


CONSUELO MACK: So what’s your view? I mean, is the long-awaited turn in interest rates, has it begun?


RICHARD BERNSTEIN: Well, Consuelo, I think if you’re as bullish as we are on the U.S. economy longer term, you have to figure the longer term interest rates are going to go up as the economy improves. I mean, that’s just normal, and that should happen. Whether we’ve seen the secular low in interest rates or not I think is a much more difficult question because that’s going to depend on inflation expectations and the health of the rest of the world. And I think one of the places where we’re very different from a lot of other managers is, we’re quite skeptical about the growth opportunities outside the United States, especially in the emerging markets.


If we’re right on that and people have underestimated the risks in the emerging markets, it’s likely we will see a repatriation of funds back to the United States, which would support the dollar and might argue for lower interest rates as well at the longer end of the curves, people run for safe havens. That’s unlikely to happen in a matter of weeks, but as we look out and we go out quarters or maybe a couple of years, that may be a countervailing pressure on downward pressure on rates, where as the economy strengthening would normally be an upward pressure on rates.


CONSUELO MACK: So you did take a very contrarian stance a couple of years ago when you started actually managing money at your own firm, and that was to be overweighting the U.S. and saying that the U.S. was going to outperform emerging markets and just about every other market, and equities, specifically. So do you still hold that view? I mean, it was a correct view, turns out, great call.


RICHARD BERNSTEIN: Right. Knock on wood. Right.


CONSUELO MACK: Still hold that view?


RICHARD BERNSTEIN: Yes, we do. One thing that we found is that the expectations for growth in the emerging markets, despite all the problems that are beginning to crop up, whether it’s India, Brazil, China, Turkey, you look at all these different markets, what you find is a lot of the problems that people have been so scared about here in the United States, out of control money growth, higher inflation, things like that, they’re not happening in the United States, but they are beginning to happen in some of the emerging markets. If you look at where the highest rates of money growth and the highest rates of inflation are in the world right now, you’re going to find them all in the emerging markets.


So we think that peoples’ expectations for growth are much too optimistic. And you see this every quarter as the proportion of companies in emerging markets reporting negative earnings surprises, has been habitually between about 55 and 60%. Analysts refuse to mark down their estimates as growth begins to slow. And what we’d want to see to become more interested in the emerging markets is some kind of realization that these markets are not the growth markets that people thing they are. In fact, right now, the projected earnings growth rate on U.S. small cap companies is almost double the projected earnings growth rate for the emerging markets. The U.S. is now a better growth story than the emerging markets, which people can’t fathom that notion that that could possibly be the case.


CONSUELO MACK: So Dan, what’s your big picture view as far as, you know, at Loomis Sayles as far as what the growth outlook is, the outlook for the U.S. economy…


DAN FUSS: On the economics of it as opposed to the markets?




DAN FUSS: The economics, actually, I think it was just very well said. I don’t want to worry you.


RICHARD BERNSTEIN: No, that’s okay.


DAN FUSS: No, we do agree with that. There are pockets of difference outside of the U.S., obviously. But in the major areas, including emerging markets as a bundle in certain areas, in general, we do agree with that. The funds flows may come back a bit towards the US dollar. There, we probably wouldn’t agree quite as much because watching the reserves of the various countries, the central bank reserves, the reallocation now by trade patterns is what it’s called, and anecdotally, just noticing that the direct bid for U.S. treasuries has dropped to a nominal number, would indicate that people that used to buy the dollar, or dollar based, are shifting.


CONSUELO MACK: So these are foreign central banks that used to buy treasuries and the dollar, therefore.


DAN FUSS: Right. Well, one in particular, but…






CONSUELO MACK: People’s Bank of China, right.


DAN FUSS: But it’s all assumption. I mean, they don’t call us up and tell us. But if we had really hard data, I suppose you’d run out and buy everything that’s loose in New Zealand, for example, if you’re going to shift your reserves strictly according to trade patterns. And so you have that type of setting. Domestically the problem, because we are in the camp of saying that, okay, the secular rise has started. Now again, the qualifier…


CONSUELO MACK: But the secular rise in the interest rates has started, right.


DAN FUSS: Right, that. We’re coming off this particular low and we’re into the first cycle, which doesn’t look to be all that bad, quite frankly, because of the weakness in other parts of the world, and the demographic slowdown around the world. That’s a major factor.


CONSUELO MACK: You mean people getting older around the world and therefore will consume less.


DAN FUSS: There’s nothing wrong with getting older. You need the young people there to support the old people, and that’s where the shortfall is. Now that I’m an old people I’m very sensitive to that. And so you have that. That slows things. And there are demographic reasons to argue that if in fact this is a secular rise with cycles in between, it won’t have the length of the last one. No.


CONSUELO MACK: Which was, the last one, the secular decline in interest rates lasted like 30 plus years.


DAN FUSS: Thirty plus. But the last rise essentially, I think, went from World War II on out to late September of 1981 with bumps along the way. We don’t think at this point, and don’t see any sort of strong evidence that would lead you to believe that it would have any sort of crescendo like you had in the second half of the seventies, so this is a more moderate secular rise with cycles in between, and it’s all guess work, but the guess is, okay, from peak to peak you have maybe 100 basis points, a one percent difference.


CONSUELO MACK: What I’m hearing from both of you is, number one- that this could be, you know, the rise in interest rates, as you said, we’re going to have kind of peaks and valleys. So it’s not going to necessarily be straight up. So in the meantime, so who are the biggest winners, from a gradual rise in the interest rates if it’s going to kind of go up and down a little bit, and who are the biggest losers, Rich, from your perspective?


RICHARD BERNSTEIN: Well, the winners, first of all, we have to assume that interest rates are going up because the economy is getting stronger, right? There is a faction that believes that interest rates will go up because the United States will be treated like Greece, and everybody’s going to punt the dollar, and punt our bonds, and we’re going to be mired in this horrible situation. I think the probability of that happening is extraordinarily low. So let’s assume for a second interest rates are going up because the economy’s getting stronger.


CONSUELO MACK: Right, which is a good thing if the economy’s getting stronger.


RICHARD BERNSTEIN: It is good. That’s exactly right. And I think the Fed Chairman has tried to point that out, that we all want interest rates to go up because that would mean that the economy’s getting stronger, employment’s getting stronger and everything else. So what wins in that environment? Well, it would be cyclical stocks. But you have to be a little careful because there’s different types of cyclicals. What you really want to play at this point of the cycle, or what generally are called mid-cycle cyclical stocks, in other words, they’re not the late cycle things like commodities or energy, or something like that. Commodities and energy are big inflation plays. Inflation’s a late cycle event. That comes later in the cycle.


This point in the cycle, you probably want to play traditional industrials, manufacturing, little bit of technology, even consumer cyclicals do reasonably well in this environment. And of course, if the yield curve continues to steepen, meaning long term interest rates go up relative to the short term interest rates, financial stocks do very well, too, because the margins on their lending get more beneficial to the company. In other words, short term rates, deposit rates are still low, but the lending rates are going up. They make more money for every loan. So it’s a cyclical bias that you want to have in a portfolio. I think you want to stay away from bond proxies, things like utilities, consumer staples, you know, very defensive stocks.


CONSUELO MACK: Right, that have done so well, right.


RICHARD BERNSTEIN: They have done well.


CONSUELO MACK: Since the financial crisis, right. But what’s so interesting about your point of view, number one, as a money manager now, you don’t choose individual stocks. It’s an asset allocation that…




CONSUELO MACK: … in different types of sectors. And just quickly, the reason for that is…?


RICHARD BERNSTEIN: I was a former strategist. And as a strategist, I was the type of strategist who focused on things like asset allocation or size, and style, and geography, sector in industry, and that sort of thing. And I think one has to realize what one’s good at and what one’s not good at. And I’m not very good at picking company stories. So at one extreme you may have somebody like a Warren Buffett, right, an equity portfolio with a very few number of companies, very high concentration. At the other extreme you would have a firm like ours. You would have our portfolio, which right now has over 300 stocks in it, and each stock, very tiny weight so that no one stock can influence the portfolio. But what we can do is, we can tilt the portfolio to try and get U.S. versus non-U.S., large cap versus small cap, or industries and sectors and things like that.


CONSUELO MACK: Who are the biggest winners, and who are the biggest losers in the bond world, in this current environment where we’re going to see interest rates go up, for whatever the reason… gradually?


DAN FUSS: Well, everybody loses if they borrow money in the future at higher rates than today. So if they have to refinance, that hurts. It hurts more if rates really get going. Then you have to be very, very careful on the credit side. Because credits that were perfectly fine in this environment where they could bring down, as they refinance, bring down their financial cost, their cost of carrying the debt, then they were benefitting from that, in.


CONSUELO MACK: So high quality companies now are really… you’re going to notice a big difference, right?




CONSUELO MACK: Financially strong companies are going to do well. The weaker companies are not going to do well because of the borrowing costs are going to go up.


DAN FUSS: In general.


CONSUELO MACK: Yeah, okay, in general.


DAN FUSS: In general. Now, on the other side of Rich’s very good approach, we’re in the item picker camp. On the stock side, we’re stock pickers. On the bond side, we’re bond pickers. And the coming environment- if it happens, if this happens- means that the credit risk side of bond picking is going up. So you have to use a longer time frame in looking at what might happen. You always try to look out. But you know that if the… let’s say somebody’s a number four market share in a growing market, uh-oh, better be careful, if that’s their principle business, because one, two and three are likely to have lower incremental cost. The area’s growing. You need to add plant and equipment. Your incremental cost is going to be higher. I mean, that’s… it becomes market growth, market share, market growth, market share. And that benefits the larger market shares. Now, it’s a global market, and other things interfere. Like national tendencies. But that’s part one.


Part two, the good news is, you worry a little less about reinvestment risk as rates go up. And something that we didn’t have until recently in the bond world are discount bonds. All of a sudden we have some discount bonds. The deeper the discount, the less you worry about call risk. And call risk also includes other things that could cause a company to retire their debt at par. When the bonds were selling at 108, that’s a real risk. When they’re selling at 80, that’s a much lesser risk.


CONSUELO MACK: So there are more opportunities now than in certain sectors of the market. I know that in the high yield bonds, which had just jumped in price at one point, you were telling me the other day that actually there are some opportunities in high yield bonds now.


DAN FUSS: Yes, that’s true. That’s true. With the proviso… with a proviso, and the proviso overrides short term views in the market. The proviso is- you have to be extra sure of the credit under an environment of rising interest rates.


CONSUELO MACK: Quality, quality, quality.


DAN FUSS: So, however, having said all of the above, you get enough shake outs of the market, like was present in early June, you get a real good shake like that, high yield perhaps being one of the two great examples; emerging market debt being a tremendous …


CONSUELO MACK: In the other.


DAN FUSS: …you then, all of a sudden, things that aren’t just steady movers in the market, so-called on the run bonds, you get away from that, and there’s a lack of bids for the bonds. And yet, you have outflows, particularly from a mutual fund and also, notably, from the ETFs.


CONSUELO MACK: Right, lack of… right, bids being buyers, to buy the bonds, and you’ve got all these bonds that are being sold by the mutual funds and the ETFs, right.


DAN FUSS: Right. And anybody else that chooses to sell, they’re not getting great bids, particularly in the off the run area. So you can be socially a good person and bring a bid to an ill-liquid market. You know, it’s a good thing to do. It’s a good thing to do. Not that many years ago, the dealers would just grab them up and package them. Okay, get a nice round lot, put them on the market. Right now, they’re constrained by their known constraints. So…


CONSUELO MACK: Right. The market’s changed.


DAN FUSS: … people like us, we’re not the only ones, are out there becoming collectors at a price that is certainly good enough to be happy with at the first peak, the first cyclical peak in interest rates, and then some. So, eureka. This is the start… the start… of a good time to be in… a bond picker, quite frankly.


CONSUELO MACK: So this leads me to the final question that we always ask our guests, and that is, the One Investment for long term diversified portfolio, Rich, what should we all own some of?


RICHARD BERNSTEIN: Well, Consuelo, we are huge fans of what we’ve called the American industrial renaissance. It’s not just a term for us, but I think a lot of people have used it. But the American industrial renaissance, these are small and mid-cap U.S. domestically focused industrial and manufacturing companies. It is not the big manufacturing companies, because they’ve all been trying to grow through the emerging markets. And as I said before, we think there’s more risk there than people think. But these small and mid-cap manufacturing industrial companies are actually gaining market share. The data show it very clearly It’s not something you have to wait for. It’s happening right now. And Jeff Immelt, who everybody knows, the CEO and chairman of General Electric…




RICHARD BERNSTEIN: … was quoted in the December issue of the Atlantic Monthly as saying that outsourcing may now be an obsolete business model. And manufacturing’s coming back to the …


CONSUELO MACK: Isn’t that great news for us?


RICHARD BERNSTEIN: It is. Manufacturing is coming back here. And whereas if you think of the consensus, has been you have to have multinational companies growing through the emerging markets. We’ve taken 180 degrees, opposite stance, and said, we want domestically focused manufacturing companies.


CONSUELO MACK: So Dan, what would you have us all own some of in a long term diversified portfolio?


DAN FUSS: Well, I’d look for a mutual fund. Now, I’m prohibited from saying, being the Sayles Bond Fund…


CONSUELO MACK: Right, exactly, yes, you are.


DAN FUSS: If I wasn’t, I would.


CONSUELO MACK: That’s where you’re invested and your family’s invested, I know that, but …


DAN FUSS: No, but Rich is on to something here, and this is actually a credit event. And some of this, the manufacturers will be opening into an area that used to be dominated and is not now. So that’s more like a small tech stock in a sense. The area I really like as an area, on the fixed side it’s a little hard to play, but there are a couple things you can do, is the medical, medical tech area, really. Now, some of the big drug stocks you can argue either way on, but I’m talking about really on the newer technology in the area. And again, that’s a general statement. I’d love to give you a name. Legal has prohibited me from doing that. I hope they’re listening. And that …


CONSUELO MACK: But medical technology companies…


DAN FUSS: Right.


CONSUELO MACK: So thank you so much, Dan Fuss from Loomis Sayles, always wonderful to have you one WealthTrack.


DAN FUSS: Thank you.


CONSUELO MACK: And Rich Bernstein, as well, from your own firm, Richard Bernstein Advisors.




CONSUELO MACK: So thank you so much for joining us on WealthTrack.


At the conclusion of every WealthTrack we try to leave you with one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: stay the course and if you must make portfolio changes take incremental steps. The markets might be choppy, others might be panicking, fleeing bonds for instance or piling into stocks, whatever they are doing en masse, don’t follow. Pros like Dan Fuss and Rich Bernstein have learned over time that going against the herd and taking incremental steps is the best portfolio adjustment strategy.


I hope you can join us next week. We will sit down with Wintergreen Fund’s Great Investor, David Winters, who will share new insights on global wealth and how to participate in it. If you have missed any of our past Great Investor or Financial Thought Leader guests you can find them on our newly revamped website wealthtrack.com, as well as additional interviews in our WealthTrack Extra Feature. In the meantime, have a great weekend and make the week ahead a profitable and a productive one.



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