Archive for March, 2015

SMITH: LEGENDARY MAVERICK TRANSCRIPT

 

Stephen Smith, founding portfolio manager of the Legg Mason Brandywine Global Opportunities Bond fund and finalist for Morningstar’s 2014 Fixed-Income Fund Manager of the Year is known as a contrarian investor. In an exclusive interview on WEALTHTRACK, Smith takes on consensus views about oil prices, interest rates and global growth and shares where he and his team are finding opportunities in bonds and currencies.

Stephen Smith Portfolio Manager Legg Mason Brandywine Global Opportunities Fund

This week on WEALTHTRACK, in an exclusive interview, contrarian bond investor Stephen Smith explains how studying the big moves in oil and the dollar have convinced him that the world will grow faster than others expect. How it is changing his strategy in his Legg Mason Brandywine Global Opportunities fund is next on Consuelo Mack WEALTHTRACK.

CONSUELO MACK: Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack.

We’ve all heard the predictions: low interest rates as far as the eye can see…. European Central Bank President Mario Draghi is sticking to his 1.1 trillion euro easing program, the equivalent of about 1.2 trillion dollars worth of bond buying to keep rates low in the eurozone. His goal: to stimulate economic growth and inflation.

Numerous central banks around the globe continue to cut rates for the same reasons. Sweden, Denmark and Switzerland all have those astounding negative rates on their short term government debt. That means lenders, who are buying their debt have to pay the countries, the borrowers, for the privilege. As Ken Leech, the Chief Investment Officer of major bond firm, Western Asset management wrote recently, quoting Alice in Wonderland, it’s getting “Curiouser and Curiouser!”

Even the Federal Reserve, which is planning to start raising short term rates in June or September – our sources say September is more likely – has cut its interest rate forecast for the year. Instead of anticipating short term rates of over one percent by December, it is now targeting .625%.

Then there is the strength of the dollar… another universal expectation is that the dollar will continue to strengthen against other major currencies. The rationale is that the U.S. economy will continue to grow, while other economies in Europe for instance will struggle. And the interest rates we are offering on our treasuries, even though meager to us, will be much more attractive than those on other top quality government debt.

Not so fast, says this week’s great investor guest. He is Stephen Smith, Co-Lead Portfolio Manager of Global Fixed Income at Brandywine Global Investment Management which he joined in 1991 to build its bond business.

Smith is the Co-Lead Portfolio Manager of the highly regarded Legg Mason Brandywine Global Opportunities fund which he launched in 2006 and has a history of beating the market and its Morningstar World Bond category since inception.

A contrarian investor, Smith and his team invest in global bonds and currencies with an emphasis on government bonds. I began the interview by asking him where he disagreed with market expectations. We started with Europe and Mario Draghi’s decision to have the European central bank finally embark on its massive quantitative easing program, six years after the Fed.

 

STEPHEN SMITH: The irony of this, Consuelo, is that Europe is now finally coming out of the funk, so to speak, and he is now going to start buying bonds. Now, the interesting thing about it, when we were doing QE, remember, we had a deficit of 10 percent of GDP.

CONSUELO MACK: In the U.S., uh-huh.

STEPHEN SMITH: In the U.S. he’s doing it, they have a deficit of, you know, about two- and-a-half percent of GDP, so it’s about 250 billion euros. He’s going to buy twice that amount. So there’s actually the idea there’s a shortage of bonds, and so what ended up happening is, he’s actually propelling a market to levels that are just unprecedented. I mean, interest rates in Italy, a little over one percent in ten years, and German bonds at 19 basis points for ten years, you talk about stimulus. So we really think that he is going to be extraordinarily effective in the quantitative easing European style.

CONSUELO MACK: And therefore, that Europe will grow faster than the market is currently anticipating? Is that what you’re saying?

STEPHEN SMITH: Europe, will do better than the market’s anticipating. And the reason, one of their main reasons, because of the decline in the price of oil; because that’s going to have a very stimulative effect on not just the U.S. consumer, but the European consumers, who have been, you know, their claim to fame I would say is they’re just used to having taxes being raised all the time. So they finally actually have a tax cut, complements of the private market, not the political class.

CONSUELO MACK: Right. And how soon do we actually see the stimulative effect, where we actually see the impact in GDP of the precipitous decline in oil prices that we’ve had?

STEPHEN SMITH: The reason that we are optimistic, and you will read a lot of data about this, so they’ll say, well, okay, oil prices decline and it doesn’t have that much of effect. But you can’t look at what oil prices, all the times that oil prices peak like in 2008, and we ended up going into a recession. You have to look at it, how many times did oil prices decline when the economy was growing? You have a different outcome.

So when we’re looking at the world, oil prices lead … by that, I mean with a lag. The price goes down and about 270 days later there is an effect because consumers have an increase in their purchasing power. So what we’re thinking about is big price decline last year. People were now saying, well, you know, in the fourth quarter consumption was only about 25 percent above trend line. Which is just basically the way that it should work. So we’re sort of thinking, as we get into the late spring, not just in the U.S. but globally, this big decline in oil is going to help the billions of dollars of consumers. It’s clearly not going to help Russia, Venezuela, Saudi Arabia, etcetera. So we think it’s going to be very positive.

Now, I’d just like to lead to one last thing. Every $20 decline in oil in a developed world, generally speaking, adds, with a lag, of say of about 270 days, about four tenths of a percent to growth. But in the emerging markets, where oil intensity is a lot, you know, you need more barrels of oil for one dollar of GDP, it has about an 80 basis point effect. So when I keep thinking about the world, we’re actually thinking, as I said, the IMF and the World Bank may have it wrong, because I think going into the late spring this is going to have a profound impact on the global economy.

CONSUELO MACK: The concept and the belief in the market, that oil prices are going to stay low or possibly even go lower, what is your thought about that belief in the market?

STEPHEN SMITH: I think that most people are thinking about the supply and what happened in the U.S. with the fracking. But what you really have to do is put it in context, is that it’s also demand. So when you think about the second and third quarter, Japan, the third largest economy in the world, down six, seven, one-nine. Italy, in a recession; Europe on the brink of a recession. China with the slowest growth in three decades; Brazil in a recession; Russia in a recession. I think the reason oil came down, not just the supply, but the global economy really just slowed. And demand for oil …

CONSUELO MACK: Right, so demand for oil …

STEPHEN SMITH: … went down.

CONSUELO MACK: … declined, and energy in general.

STEPHEN SMITH: So we look at it, to go back to an earlier question, we think that there … because Draghi was dragging his feet, we kept saying, well, let’s watch his feet. And his feet never moved in September, October, November. They’re finally moving now. Is what happens is, what’s going to create the equilibrium? Because monetary policy was too tight. What created the equilibrium was oil went down, and where oil goes down to a level where you think that it’s going to stabilize the markets. So I think that’s one of the great growth stabilizers, or destabilizers. And to me, it’s going to stabilize their market because it’s going to increase consumer incomes globally. It’s a trillion-and-a-half dollar tax cut. It’s really breathtaking.

CONSUELO MACK: When you look around the globe, everyone except for the U.S., just about, is easing their central bank policy; government policies are very accommodative. Baked into the market right now is the belief that that is going to continue, that in fact interest rates are going to remain low in the rest of the world, into the foreseeable future. What’s your theory there?

STEPHEN SMITH: I’m not sure how this is going to ultimately play, and I don’t think anybody knows. But the level of interest rates, I would just say, is breathtakingly low. I mean, they’re really just at this … because we have issues. But to answer your question, Europe is easing but they eased 15 months after they should have. Remember, they shrank their monetary base by a trillion dollars. So that was just a policy error. The Chinese have been very, very slow to easing because they’re doing supply side economics their way. They’re trying to rebalance the economy. And if you look at the five or six or seven years back, you will see the consumption versus investment has changed by about 500 basis points. They’re just slowly moving that boat.

CONSUELO MACK: Right, away from investment and more in to stimulate consumption.

STEPHEN SMITH: More into consumption. So the Chinese are really now, in my mind, behind the 8-ball. The actually do need to ease. But just to back up a bit, if you remember when i was in here the last time, it was when Bernanke did the “temper tantrum”, and everybody became worried about the emerging markets. So what ended up happening, the emerging markets started raising interest rates. And you now have the biggest disparity between emerging markets interest rates and U.S. interest rates, just about, on record. And we actually thought that they would start lowering rates in the fourth quarter. Instead, Russia raised rates. Brazil raised rates, and Indonesia, raised rates. So now, with what the ECB’s doing, and with this global slowdown, and inflation falling, we now think this is going to be another simulative impulse this year as we think Indonesia, India, Russia, all these countries are going to start lowering interest rates because they are now having, from raising interest rates. Their money supply slowed, inflation’s slowing, and they’re going to now be another catalyst that’s going to help to create GDP growth as we move into the summer.

CONSUELO MACK: As a global investor, in both sovereign debt mostly, in government bonds, and in currencies, where are you seeing the opportunities that are being created?

STEPHEN SMITH: Okay. So your lead question was … I always think like lower for longer. The trend’s going to continue.

CONSUELO MACK: Right.

STEPHEN SMITH: Lower for longer implies, Consuelo, that global growth struggles. So the way we look at it, and what we’re thinking about, is that there’s three growth either stabilizes or destabilizers. I already went through oil. Oil has come down quite a bit. So that’s going to create growth later in the spring. The other thing is, is interest rates have coming down. Interest rates also lead with a lag, not 270 days, but a year to a year and a half. Well, they’ve been coming down for 15 months. I would just say, maybe they don’t have the impact they had in the past, but I’d rather get a 3 3⁄4 percent mortgage than 4 3⁄4 percent mortgage. And then lastly, things that probably very few people think about other than geeks like me is, currencies. All these currencies have come down. You’ve been reading it in the newspaper. It is the strongest bull market in the dollar in the last 18 … eight months on record. But all these currencies are down.

CONSUELO MACK: All the other currencies, right.

STEPHEN SMITH: All these other currencies are down, and so if your currency goes down, you have to think about it, then your export prices go down. And you’re able to compete better on the global markets. So when we add all these three things up, the reason we don’t come to a negative conclusion is, these are great … or three either … are growth stabilizers that, because China and Europe was late to the party, we think they’re all going to be kicking in the late spring. And what’s going to happen is, the global economy is going to be better, and it’s not going to be lower for longer, but global GDP is going to pick up. And if global GDP picks up, maybe the surprise will be that the emerging markets may not do as bad as a lot of people think; because Europe won’t be in a recession. Japan won’t be in a recession. And U.S., instead of growing at 1.8, maybe it’s going to grow at 2.8.

CONSUELO MACK: What happens when the Fed finally does raise interest rates, and it could be in June, it could be in the fall. What do you think?

STEPHEN SMITH: Well, think when they finally raise rates, I don’t think any central bank could sit around and honestly look anybody in the eye and say they like what they’re doing. It’s zero interest rates. And to me, I go back to, it’s just the natural order of things.

CONSUELO MACK: That rates have to go up from zero?

STEPHEN SMITH: Yes. So even if they take them to up 50 basis points, I mean, I just look at it, is the world going to end if we have 50 basis point T-bills? I don’t think so. I think they’re doing so much discussion about it that people want to just get over it. Greenspan was raising rates for 16 straight months, and the economy continued to grow.

CONSUELO MACK: Let’s talk about you as an investor at Brandywine Global Funds. Where are you seeing the best opportunities as far as government debt is concerned, or just bonds in general?

STEPHEN SMITH: From a risk adjusted standpoint, in Brazil, which is having a crisis because the lady that got re-elected …

CONSUELO MACK: Rousseff.

STEPHEN SMITH: Yeah, Dilma, I mean, I was thinking she basically was a populist, redistribution of wealth. She wasn’t a ‘70s style socialist, but maybe a ‘90s style socialist. And the under-class reelected her, and they reelected somebody who believed in redistribution of wealth, but she can’t do it anymore because the policies that got her reelected actually was what’s hurting the country.

CONSUELO MACK: Right, the economy is a mess. Where is the opportunity in Brazil?

STEPHEN SMITH: Well, the opportunity in Brazil is, Brazil’s going into a recession. And, going into a recession, they’ve been raising interest rates because they’re now deregulating. The pumps, at the price, they’re going to go up. Utility bills are going to go up. All this deregulation, you’re getting a surge of inflation. But it’s going to be a one-off, and they’re doing it because Brazil doesn’t to be downgraded to junk. So even though she’s a socialist, she knows that it was such a hard won fight, the low inflation, and the fact that they had an investment-grade rating that she’s now going to take the tough medicine. So if they go into a recession, and eventually at the end of the year inflation starts to fall, I could easily see a 13 percent bond yielding ten percent. And so to me, it’s an attractive …

CONSUELO MACK: So Brazilian government bonds are attractive.

STEPHEN SMITH: Are attractive. Now, people would look at it, when you read it, there’s a lot of risk because of the payola in Petrobras, which is a whole other story.

CONSUELO MACK: Right. And as far as the real is concerned, so as far as a currency investment, is the Brazilian real also a good currency to invest in, or not?

STEPHEN SMITH: Well, this is this idea of regression. Right now, if you read the newspaper you would say no.

CONSUELO MACK: No.

STEPHEN SMITH: But you have to also ask the question is, what’s going to happen six months or nine months from now? And I actually do believe with the Brazilian real where it is, and if we get global GDP growth, and if she does take the medicine that Levy has proposed, that …

CONSUELO MACK: The finance minister, right.

STEPHEN SMITH: The finance minister, thank you. That you will have … I think it’s going to end up being an attractive investment. We also think, you know, investing in India where they’ve actually made the transition, they have a finance minister with the same credentials as Bernanke, since people know him. You know, Modi got reelected. The Gandhi party’s out. He’s taken control. You just have to understand, India’s a democracy. And as Karl Marx once quipped, the problem with democracy and why he thinks it will fail, is it’s going to make so many rules and regulations to protect the minority that the system just doesn’t work. And that’s India. But he’s actually taken about a dozen agencies that are all under him, 15 percent of …

CONSUELO MACK: The finance minister has.

STEPHEN SMITH: Yeah. And 15 percent of GDP has been tied up in contracts that have been let, but they won’t let them do it because of how, you know, the parliament won’t pass them. And it’s a big, big number. But they are going to get passed, and they’re going to start doing … building roads, building utility plants and the things …

 

CONSUELO MACK: So therefore, Indian government bonds are a good investment, you think?

STEPHEN SMITH: Either … they are tough to buy but I think the currency, which yields about a seven percent …

CONSUELO MACK: Right. The rupee.

STEPHEN SMITH: … the Indian rupee is actually a good investment. I think Indonesia is the same thing. There was a new election. It’s a little bit tougher story, but 7 1⁄2 to 8 percent bonds in Indonesia, I also think are attractive with the currency at 13,000. So I think the lower for longer story is …

CONSUELO MACK: Right, lower for longer … interest rates.

STEPHEN SMITH: With lower interest rates, and currencies, is that I think that the move in the dollar now has taken these currencies to levels where I actually believe they’re really attractive on a long term basis.

CONSUELO MACK: Couple more countries I want to ask about. Mexico. 2013 when you were here last, you thought Mexico was very attractive to invest in. Number one, has it been over the last couple of years? And number two, what are your views now?

STEPHEN SMITH: It was actually one of the best places to be invested in. The last six months it has not been. Not so much at the time, bonds were yielding eight percent. They came all the way down to six percent, so there was a lot of money in the bond market. But because of this bull market in the dollar, I view Mexico as a country that they … you know the saying, they threw the baby out with the bath water. The dollar’s just in a bull market. The Mexican peso at 15.50 pesos to the dollar is really cheap. The central bank is now intervening for the first time. They normally don’t do that because Mexico has not had that much inflation in the last couple of years. And they’re worried about, your currency gets weak, you start importing inflation. It’s the opposite story with the U.S., we’re importing deflation. I actually think Mexico and its bonds, to me, have the best risk adjusted returns because it’s a very stable situation; and they are doing the supply side economics. In other words, the oil companies now … it’s not going to be just Mexico, Inc. They’re putting contracts out for the bid. Carlos Slim, who had a monopoly in all the telecommunications industry, prices have fallen rather dramatically there with the deregulation. People forget. People always think about Mexico in oil. But in South America, the dollar value of exports … Mexico is the lowest. It’s 31 percent. Mexico has the highest dollar value of exports in cars and things like that. It’s almost 70 percent of GDP.

CONSUELO MACK: Oh.

STEPHEN SMITH: So they produce about 10 percent of the cars in the world. I mean, it’s a great, great story down in Mexico.

CONSUELO MACK: Right. Two more questions. One is, I’m not hearing recommendations for any developed market bonds.

STEPHEN SMITH: We do have bonds in the U.S., and this gets back to one of the questions I might have sideswiped a little bit. Why are interest rates where they are today?

CONSUELO MACK: In the U.S.?

STEPHEN SMITH: In the U.S., because normally they probably would be higher.

CONSUELO MACK: Yes, given the strength of the economy and labor markets and everything else.

STEPHEN SMITH: Right. Again, it’s not that people sit around thinking about this, but every ten percent move in the dollar is the equivalent to the Fed taking interest rates up one percent.

CONSUELO MACK: So things are getting tighter without the Fed doing anything.

STEPHEN SMITH: And the reason for that, for people listening to this, is that because we’re importing deflation, the rest of the world is taking their deflation because the dollar’s going up, so trade-able good prices are going down. So if wages go up in the U.S., but your employer can’t raise his prices at the end, you’re going to get a profit squeeze. What we’re thinking about is, U.S. treasury bonds at 2 3⁄4 percent …

CONSUELO MACK: Ten year.

STEPHEN SMITH: Well, the ten year, at a little over around two percent, relative to German bonds yielding 20 basis points. We think that there’s an arbitrage. Because when you think about the sovereign wealth funds, Saudi Arabia or the Chinese central bank, every day they wake up and have money to invest. So they can say, well, I can buy German bonds and get 20 basis points. Think about that in two percent… every ten years you get two percent on your money. Or I can buy U.S. treasury at two percent. It’s ten times more income. So this goes back to the Greenspan conundrum, why are interest rates so low? It’s because globally what’s going to happen is people are going to buy our bonds. Quite frankly, if we don’t have much inflation, if core inflation ends up being one percent, maybe a two percent bond isn’t all that bad.

CONSUELO MACK: So a real yield is one percent … that’s ex-inflation. Therefore in the Brandywine Global Gunds, do you own, are you an owner of long treasuries, of the 30-year Treasury bond?

STEPHEN SMITH: Yes, we own 30-year Treasury bonds. In fact, on this back up in interest rates about a month or so ago, or about less than a month ago, we did actually add to our bond position.

CONSUELO MACK: Now, there is a contrarian position if I’ve ever heard one. One investment for long term diversified portfolio, what is it that you would have all of us own some of in a portfolio?

STEPHEN SMITH: I would own long Mexican bonds.

CONSUELO MACK: Ten years?

STEPHEN SMITH: Well, we tend to …

CONSUELO MACK: Longer?

STEPHEN SMITH: Twenty or 30 years. I know people think of it as risk, but we don’t see much inflation globally, and we think the currency is ten percent, a solid ten percent undervalued. The story will play out if the global growth story plays out. See, the markets think that the U.S. is stronger for longer. The U.S. may be stronger, but it may not grow at 3 1⁄2 or 4 percent like people think because of the dollar. It may end up growing at 2 1⁄4 percent or 2 percent. And if Europe all of a sudden starts growing at 1 1⁄2 or 1 3⁄4, or Japan last quarter grew at 4 1⁄2 percent, and all of a sudden, if Chile and all these other countries start growing, then you’re going to have, the papers are going to read differently, and then it’s going to be a different way to invest. So what we’re trying to think about is, what are the papers going to read, and what are the headlines on the fourth of July? We’re thinking the headlines are going to be a heck of a lot better because, as I said before, these three growth stabilizers or destabilizers … oil, interest rates and currencies, all to me, look relatively favorable for grow- able growth. And actually should be good for equities.

CONSUELO MACK: We’ll leave it right there, from a bond man. Stephen Smith from Brandywine Global, thank you so much for joining us.

STEPHEN SMITH: Well, thank you. I appreciate the time and the questions.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point is : plan an overseas vacation to take advantage of the dollar’s strength. The Wall Street Journal did a fun story recently comparing random room rates in deluxe hotels here and in Europe. A room at the Ritz-Carlton in Vienna will cost you $401 a night versus $463 at the Ritz in Dallas, Texas. Interested in London? You can have a room at Le Meridien Picadilly in London for $399 compared to $466 at Le Meridien Delfina in Santa Monica, California. You get the drift.