MCLENNAN: CRISIS INVESTING TRANSCRIPT

CONSUELO MACK: This week on WEALTHTRACK, First Eagle Fund’s Great Investor Matthew McLennan is predicting increasing economic, financial and geopolitical turbulence ahead. What has he put in his all-weather portfolio to ride out the storms? That’s next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack.
Founding father Benjamin Franklin famously wrote “In this world nothing can be said to be certain, except death and taxes.” To that I would add another certainty: “change” and the world is changing rapidly.

As recent guest Michael Hartnett of Bank of America Merrill Lynch recently pointed out, for the first time in human history senior citizens are on track to outnumber children by the year 2050. Global interest rates are at 5,000 year lows. The developed world is currently experiencing one of the slowest and longest deflationary recoveries ever and central banks around the world are engaged in an unprecedented wave of monetary easing to reverse that deflation.

As top research firm Evercore ISI reported to clients the balance sheets of the Bank of Japan and European Central Bank are expected to expand an incredible 30%+ this year and China has announced more than 70 fiscal stimulus actions so far this year.

Inflation in just about every country is MIA. The two notable exceptions are Brazil and Russia. Both are in recession and are grappling with high inflation. How this will all end is anyone’s guess, but this week’s guest is not taking any chances. He predicts we are entering an era of episodic crises and he is building what he calls an all-weather portfolio to survive it.

He is Matthew McLennan, Head of the Global Value Team at First Eagle Investment Management and Co-Portfolio Manager of several funds including the flagship First Eagle Global Fund which he has run since 2008. The Global Fund is in the top decile of its world allocation category over the last 5 and ten year periods and is known for its superior risk-adjusted returns. In other words it performs better in market downturns than its peers and benchmark index.

I began the interview by asking McLennan about one of First Eagle’s enduring investment approaches: focusing more on what can go wrong, than what can go right.

MATTHEW MCLENNAN:There’s a very simple reason for it. We think that in investing the first thing that you have to do is preserve the capital that you’re managing in real terms and then think about growing it in real terms. I think we live in a world where people have somewhat confused objectives when it comes to investing. They’re focused on short-term alphas and betas, tracking error statistics, et cetera, but I think if you start out with a watchful eye as to what can go wrong, it makes you a more prudent investor long term. It helps you seek a margin of safety in your individual investments, and it’s that margin of safety that not only helps you preserve capital, but it has you asking for lower valuation points which in turn provide for higher returns long term.

CONSUELO MACK: Is there more out there today that can go wrong than there has been in a while?

MATTHEW MCLENNAN:When you look at the commentary in the media, I think there’s a sense that things have returned to normal and that returning to normal is a good thing, but if you have imbalances in the world, returning to normal may not always be a good thing, and so when we look out at the world today there are a range of different variables that are quite detached from their normal histories, and if we return to normal on those variables it could be quite challenging for markets at some indeterminate point in the future.

CONSUELO MACK: So what is really detached from historical norms right now that you’re tracking?

MATTHEW MCLENNAN:I think one of the things that has become detached from historical norms is just the aggregate level of debt in the world today. If you add up household debt plus corporate debt plus sovereign debt and you compare that to GDP globally, we’re actually at higher levels today than we were before the crisis in 2007, and that’s not just in the western world. That’s in the emerging market as well, and so we’ve been through a large leveraging cycle around the world which has lifted asset prices, which has produced nominal growth, but if you return to historical norms that could produce somewhat of a deflationary dynamic.

CONSUELO MACK: Explain that, though, because after the financial crisis there was a tremendous amount of deleveraging that was going on.

MATTHEW MCLENNAN:The deleveraging in my opinion was an illusory deleveraging because what you saw was household debt going down in the wake of the financial crisis as there were mortgage write-offs and people saved more for a period of time, but that was more than offset by growth in government debt. So imagine debt being like a beanbag. If you sit on one side of the beanbag, it squeezes out the other side. If we had let the household sector and the corporate sector deleverage, it would have been very deflationary as the stock of money supply shrunk, but policymakers had no appetite for deflation. In fact, democracy and deflation are like oil and water, and so instead of letting that deflation play out, policymakers reduced interest rates to zero, embarked upon quantitative easing and had extremely loose fiscal policy. So we essentially moved the excess of debt from the private sector to the public sector, and so we didn’t get rid of the debt. We just moved it.

CONSUELO MACK: Why is that a problem?

MATTHEW MCLENNAN:Because the debt still exists today, and so what you see around the world in the developed world at least is that sovereign balance sheets are the worst that they’ve been in a generation. We have the highest levels of debt to GDP that we’ve had in a generation, and that’s a hard imbalance to rectify. It’s different from a crisis that you would typically see in the consumer or corporate credit markets. When we have consumer and corporate credit crisis, you usually see spreads blow out. You see bank restructurings and the like. When there’s excessive sovereign debt, you get the opposite. Sovereigns have the incentive to repress interest rates to keep interest rates below the level of nominal GDP growth so that they can shrink the stock of debt over time. And so we see monetary policy that gets detached from economic reality, and that’s the problem with excessive sovereign debt.

CONSUELO MACK: What will normal be, and how much of a threat is that going to be to the financial markets to our stability?

MATTHEW MCLENNAN:This is a core question. With record levels of debt around the world, can we handle the real price of money? It’s not just interest rates. It’s exchange rates, and so wherever you look in the world, you see imbalances in the price of money. So regions such as Japan, China and Europe that have current account surpluses, you’d expect them to have strong currencies, but they’ve had weak currencies because they’re using a weak currency to stimulate their domestic growth, to promote exports, to help adjust their excessive debt levels. In economies like the Anglo-Saxon economies that have current account deficits.

CONSUELO MACK: U.S., right.

MATTHEW MCLENNAN:U.S., the United Kingdom, Australia, you’re seeing very low levels of interest rates to offset that deflationary force. So it’s as if certain regions of the world are trying to export their deflation and other regions of the world are having to counter that with very low levels of interest rates. If we moved interest rates back to their more normal four or five percent levels, budget deficits would look a lot worse. Consumer floor of funds data would look a lot worse. The debt service ratios would be worse. High-yield interest rates would be a lot higher so all of that high-yield debt that had been issued would no longer be covered as effectively. If Europe or Japan had exchange rates that were ten or twenty percent stronger, closer to equilibrium levels or China, then you’d see pretty strong deflationary forces in those economies, and that’s the problem. If the balance sheet of the world is too big and you then go and impose a real cost of money on that balance sheet, it’s deflationary.

CONSUELO MACK: Is it possible just to extend this cycle out kind of ad infinitum or what are the kind of risks that are building up?

MATTHEW MCLENNAN:Well, I think if you look at the behavior of policymakers around the world, they would opt for the “extend out to ad infinitum.” They would like to amortize the problem across time, and you see that in all sorts of behavior around the world. Look at the way the Chinese have responded to their stock market collapse. They’ve sort of tried to plug the dyke.

CONSUELO MACK: Right. Prop it up.

MATTHEW MCLENNAN:They bought equities even though equities were at high valuations. They spent over $100 billion defending their currency even though their currency finally had sort of gotten into fair value territory for the first time in a decade. In the U.S. you see the Fed deferring raising interest rates several years into an economic recovery, and so the core of the matter is that in economies that have had an investment boom such as China, they don’t want to see that investment fall. They’re trying to keep it stabilized. In economies that have excessive debt such as the West, they don’t want to see that debt level shrink. They’re just trying to keep it stabilized, and so what we risk here is instead of seeing a severe deflation adjustment, more of a nominal ice age as we try and amortize that problem across time.

CONSUELO MACK: What do you mean by a nominal ice age?

MATTHEW MCLENNAN:A period where nominal growth feels disappointingly low, where you have a combination of low inflation and low real GDP growth. Think about it this way. From the early 1970s, the world economy has grown around six or seven percent a year, but that was a period that included dramatic balance sheet expansion. The trend rate of growth is probably less than that, and if we have to correct for that imbalance, it’s probably less again. So we all grew up in a world of seven percent nominal growth, three to four percent GDP growth, three to four percent inflation globally. Prospectively, given the imbalances that we see, we might see more like three or four percent growth, and if the emerging world is growing quicker than that, that could mean the developed world is growing nominally less two or three percent. In fact, that’s what the sovereign bond markets of the world are telling you. If you look at the interest rates outside the United States – Europe, Japan – all are anchored below one percent going out a decade, and the commodity markets are telling you that nominal growth in the emerging markets complex will be sluggish as well.

CONSUELO MACK: So what’s wrong with sluggish growth? Isn’t it possible that, number one, you can extend the life for instance of a recovery if it’s kind of slow, steady but slow growth?

MATTHEW MCLENNAN:If a range of variables are below trend, that sort of long, slow recovery that you talk about can be a positive. So if P/E multiples are depressed or earnings margins or profit margins are depressed or confidence is depressed and all those things are sort of slowly reverting back to their average levels…

CONSUELO MACK: Improving.

MATTHEW MCLENNAN:… then you’ve got that positive drift in equity markets because valuations go up. Margins go up. Earnings recover and the like, but if you look at where we are today, debt levels are high and so reversion is a headwind not a tailwind. Margins are high, so going back to historical norms is a headwind not a tailwind. If we look at multiples, price to trailing peak earnings in the equity market are above the historical norms not below the historical norms. Savings rates are below the historical averages not above the historical averages, and so there are a lot of things that could be headwind going forward, and at First Eagle we don’t try and predict with precision what GDP growth will be in any one year or another or where the market will go one year or another, but what we’ve recognized is that there are things that can go wrong going forward, and so one has to invest conservatively for that environment.

CONSUELO MACK: So what’s different now as far as building a portfolio? You called it an all-weather portfolio. Do we have to be more cautious now than we’ve been in the last six or seven years? What’s your stance?

MATTHEW MCLENNAN:Well, prices will tell you how cautious you need to be. If you think about every investment, it’s a tradeoff between price and prospects. Prospects are subjective. Price is objective, and so if you look at the history of how we’ve been invested, in times of low prices such as the end of 2008 or early 2009, we didn’t look like conservative investors. We looked like a fully invested equity fund because we like to own good businesses at good prices. But if you look to where we got at the beginning of this year, we probably had cash levels – if you add our cash and sovereign bond investments – of around 20 percent, plus we had around 10 percent in gold. So we looked more like a balanced portfolio in a time of low risk perception. Today we’ve seen a little bit more opportunity in the month of August. In fact, what we’ve seen this year is what I would refer to as a narrowing market dynamic and a little bit reminiscent of the late 1990s in so far as what has been going up hasn’t had a lot of value. Think of the Amazons or the Facebooks of the world.

CONSUELO MACK: I was going to say the technology, biotech.

MATTHEW MCLENNAN:What has value has suffered in terms of its stock price performance, and so we’ve seen some opportunities come to the table, and so our cash levels – if you add our cash and sovereign bond levels – they’ve sort of drifted down into the mid teens from around 20 percent.

CONSUELO MACK: And that’s just because of the correction that happened in the summer.

MATTHEW MCLENNAN:The combination of the correction in the summer and the narrowing of the market. It’s those two things.

CONSUELO MACK: Those two things.

MATTHEW MCLENNAN:The market itself did not correct to what we would think of as a cheap level, but within the market there were certain sectors that were out of favor.

CONSUELO MACK: So for instance which sectors did you take advantage of?

MATTHEW MCLENNAN:I think in a world where by and large valuations are still high and margins are still high, you have to look for one of two kinds of opportunities. Either businesses that are resilient, defensive and stable but have gone through their own idiosyncratic challenges. To give you an example of something like that, Group Danone. It’s not exactly the most …

CONSUELO MACK: Dannon Yogurt to Americans.

MATTHEW MCLENNAN:Exactly. Dannon Yogurt, bottled water, so Evian for example which most people know, infant nutrition. These are food categories that as a whole are doing pretty well, but for several reasons Danone had suffered the last few years. They had the competition in the Greek yogurt market in the United States. They had seen supply chain issues in China. They’d suffered in Spain where they have a dominant market position because of the softness of that economy. All of those things took margins from the mid-teens down to around 13 percent. This is a business that’s stable, though, and so in a world where margins are high overall, here’s a company where margins are depressed and have the potential to recover going forward. So that’s one example of where you’d find an investment. The other example of where you might find an investment in this market is in sectors that are more cyclical, but they’re already in the heart of their down cycle, and the energy-related area.

CONSUELO MACK: Energy.

MATTHEW MCLENNAN:… is interesting in that respect. You might be surprised, though. We haven’t necessarily been buying the upstream energy producers because they’re not priced for 45-dollar oil. They’re priced for 60 or 70-dollar oil.

CONSUELO MACK: Those are the E&P companies. MATTHEW MCLENNAN:Exactly.
CONSUELO MACK: Exploration and production, the producers.

MATTHEW MCLENNAN:But what we’ve done instead is we’ve focused on businesses that have been out of favor because they have energy end markets, and a good example of that is a company like Flowserve which is a leading industrial company, pumps, valves and seals. It’s actually a pretty stable business because of the large after market. Pumps, valves and seals wear out, but the stock had sold off because 40 percent of their end market is energy, but what the market is, I think, under appreciating is that much of that energy exposure is to refining, not exploration and production, and they benefit from the after market.

CONSUELO MACK: And we are constantly refining because we use oil and gas. So therefore that business wouldn’t be affected.

MATTHEW MCLENNAN:As much. CONSUELO MACK: As much.

MATTHEW MCLENNAN:So for us if the world top down is not priced for attractive returns, if bonds have low single-digit returns, and if equity markets top down seem to be priced for four to six percent returns, the way to preserve value and to create value long term is to kind of curate your portfolio bottom up and security by security. So it’s either stable businesses that have been out of favor for one reason or another or more cyclical businesses that are already in the down part of the cycle so we get a margin of safety in price. That’s really the way we’ve been focused, and if we buy those businesses and we own them for five to ten years, we typically do okay.

CONSUELO MACK: But what you’ve just described to me, though, you’ve always been bottom up investors, and you’ve always looked for individual securities that are mispriced. What’s different?

MATTHEW MCLENNAN:The way we’re investing is the way we always have invested. CONSUELO MACK: Always have. Right.

MATTHEW MCLENNAN:In a sense, it’s time tested and we believe that this approach works in any number of market environments. It produces a very different portfolio because the margin of safety will migrate geographically by sector. Sometimes there will be environments where stocks aren’t cheap and where you have more cash in gold. Sometimes stocks will be cheap or high-yield bonds will be cheap, and we’ll look more fully invested, but the process remains unchanged. I think one other area that sort of bears watching at this point as well is when we look at this global picture, we’ve been in a window of what I’d refer to as U.S. exceptionalism. People have felt that the U.S. has been stronger. It’s returning to normal, and the dollar’s been very strong, and that’s been a headwind for many multinational companies.

CONSUELO MACK: The U.S. has been actually a very good place to invest.

MATTHEW MCLENNAN:It has been a good place to invest, but I think that when you take a step back from that, there may be opportunities going forward outside the United States, not necessarily even in equity markets. They could be foreign sovereign opportunities in currencies that are undervalued versus the dollar. Of course, gold which is a potential hedge for us in our portfolios has suffered by virtue of the dollar strength, but there’s now value in that potential hedge because of the dollar strength.

CONSUELO MACK: At one point I remember you telling me over the years is that basically you limit your position in gold to about ten percent, and that includes gold stocks as well. Have you changed that at all?

MATTHEW MCLENNAN:I mean we view gold as being a stable source of ballast for us in our portfolio. Gold tends to do best when the world is doing worst, and it tends to do worst when the world seems to be recovering to normal. So perhaps unsurprisingly gold has been weak the last few years as the world seemed to be getting back to normal, but we’ve made money on our equities, and so what we’ve done with gold is, as you suggest, we’ve kept it close to around that ten percent level which means while we might have been a net seller back in 2011 when the price of gold was a lot higher, we’ve been a net buyer of gold this year not because we’re speculating on the direction of gold, but we value that potential hedge and it’s cheaper today. If we hadn’t been a buyer, it would have shrunk as a position size in our portfolio to six or seven percent. Just like we have a countercyclical approach to deploying liquidity in the purchase of equities, we do the same in gold, and it’s part of the long-term cycle time of our business.

CONSUELO MACK: So Matt, there are other things I know that you’re tracking as well and I’m wondering about the turmoil in the Middle East, number one, which is really blowing up as we speak, and the migrant crisis in Europe. What investment impact are either one of those going to have do you think? Are you tracking them to figure them into your investment process?

MATTHEW MCLENNAN:Since the Arab Spring we’ve seen a marked upturn in deaths in conflict in the world. Much of that is in the Middle East.

CONSUELO MACK: In terrorist attacks. I mean I know someone who has been tracking that, have increased as well.

MATTHEW MCLENNAN:I think that in part this reflects the U.S. pivot to Asia, and so there’s been a perceived vacuum.

CONSUELO MACK: Away from the Middle East.

MATTHEW MCLENNAN:From the Middle East which has led to movements like ISIS and the call for a fundamentalist Sunni caliphate, and one shouldn’t underestimate the philosophical resonance of a movement like that to a broad swathe of the world’s population but particularly to that region, and I think if you’re thinking about the investment implications of that, you have to think three to five years down the track. Questions like, what could this mean for Saudi Arabia, leading oil producer?

CONSUELO MACK: It’s a problem.

MATTHEW MCLENNAN:If Saudi Arabia becomes less stable because of leadership transition issues, the rise of fundamentalist Sunni movement, what does that mean for oil markets?

CONSUELO MACK: We end every WealthTrack asking our guest what’s the one investment we should all have for a long-term diversified portfolio. What would your answer to that be?

MATTHEW MCLENNAN:Well, in the past I’ve shared a few things with you. I’ve shared the importance of patience as a precept. I think it’s the one commodity in short supply. We have talked about prudence and having a potential hedge in gold. I think one of the other principles that we have is the power of diversification, and so if you’re going to make an investment today in this window of U.S. exceptionalism, perhaps try making an investment outside the United States. One thing that’s been of interest to me to note is that Japan has seen its currency weaken quite dramatically. It’s gone from the 70s to around 120. People say, “Well, I’m not going to buy Japanese government bonds.”

CONSUELO MACK: The yen to the dollar.

MATTHEW MCLENNAN:Yeah, because it yields 0.3 of a percent, and the Japanese government’s over levered, but you can buy into a business like KDDI, a leading mobile telephone company and broadband provider in Japan, at a seven to eight percent free cash flow yield. Now if you can buy a business like that with a seven percent plus free cash flow yield that’s been growing its pre-tax cash flow at a mid to high single-digit clip, the internal rate of return from that is sound. You’re paying a multiple for that business that’s well below other broadband providers in the world, and you’re buying something that’s unlikely to be correlated with the rest of your portfolio, and so right now we’d be preaching a degree of diversification and a willingness to look outside your shores, and KDDI is the largest investment that we have in our overseas fund today.

CONSUELO MACK: Very interesting idea. Matt McLennan, always a pleasure to have you on WEALTHTRACK. Thank you.

MATTHEW MCLENNAN: Thank you.

At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the longterm. This week’s action point is: Add some liquid protection to your portfolio. Matt McLennan just discussed some of the challenges facing the markets which have already caused a spike in volatility. We have talked many times on WEALTHTRACK about the role U.S. Treasury securities can play in a portfolio. They provide liquidity and a money back guarantee if held to maturity. They also hold up well in market downturns, playing the role of a non-correlated asset by appreciating when just about every other investment category goes down. And you can buy Treasurys of every maturity at auction at no cost at treasurydirect.gov.

Next week we are going to focus on generating income with Brian McMahon, Portfolio Manager of the Thornburg Investment Income Builder fund which he founded in 2002 and is a Morningstar favorite. In the meantime to see more of our interview with Matt McLennan go to our website wealthtrack.com and click on our EXTRA feature where he will discuss why he is devoting so much of his personal time to education. For those of you connecting on social media, please reach out to us on Facebook and Twitter.
Thank you for watching. Have a happy Halloween weekend and make the week ahead a profitable and a productive one.