Nick Sargen & John Kim Transcript 2/01/2013 #932

February 1, 2013


#932- 2/1/13


CONSUELO MACK: This week on WEALTHTRACK, how do you build financial security for a lifetime? That’s the job of two chief investment strategists for two top rated insurance companies. New York Life’s John Kim and Western and Southern’s Fort Washington Investment Advisors Nick Sargen show us the building blocks for their portfolios next on Consuelo Mack WEALTHTRACK.


Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. In the news business what makes it into the headlines is generally bad news, not good. Well this week on WEALTHTRACK, we are focusing on some of the positives we and our guests see developing, starting with our homes. The housing market is unmistakably on the rebound. After crashing leading into and during the financial crisis, home prices are now recovering and are expected to continue to do so. A major driver behind the housing recovery is affordability. It is the best on record thanks to a combination of the dramatic multi-year drop in home prices and record low mortgage rates. As a matter of fact, consumer net worth is on track to make a new high thanks to increases in the prices of houses, stock and bonds, as well as declines in mortgage debt.


And speaking of stock prices, the gains are a global phenomenon. The MSCI All World Index has broken out to the upside and we know how well the U.S. markets are doing. Several indices have hit record territory. Finally the most powerful trend of all is the widespread central bank easing that has taken place across the globe- the Bank of Japan is the last major financial player to fall in line. Lower global interest rates have made it cheaper to borrow, more difficult to save and have pressured investors to move funds into riskier assets such as stocks and lower grade bonds to get decent investment returns.


Finding decent returns that will last a life time is the job of this week’s Financial Thought Leader guests. Each is the chief investment officer of one of the oldest and highest rated insurance companies in the country. John Kim is Chief Investment Officer at 167 year old New York Life and President of the New York Life Investments Group. In total he oversees $360 billion in investment assets. New York Life is a sponsor of WEALTHTRACK but John is here on his own merits. He has a 26 year track record of running investment management and retirement businesses at other major insurance firms. Nick Sargen, a WEALTHTRACK regular since the beginning, is Chief Investment Officer of the Western & Southern Financial Group and Fort Washington Investment Advisors, the investment arm of the 125 year old insurance company, where he oversees about $45 billion in assets. I began the interview by asking them how much the world has changed since I last sat down with the two of them in July of 2011.


JOHN KIM: I think the world has changed indeed a great deal. You have to start with the euro zone crisis, and back a year and a half ago we were concerned as most investment professionals that the euro zone was going to break apart. There was a liquidity crisis. There was a capital crisis. There was a growth crisis. Today I don’t believe liquidity is an issue. I think capital has become much more available, especially for the European financial institutions. So the issue in Europe today versus a year and a half ago is one of growth and politics, because we’ve got some important elections coming on in the latter part of this year.

The second is we’re concerned about a slowdown in China and, indeed, China did slow down, but many people were concerned coming in to 2012 that it was going to experience a hard landing, and it appears that it will likely orchestrate a soft landing and perhaps grow in the coming year. And then last but not least, the monetary policy around the world, starting with the U.S., has really gone from one of very easy monetary policy to all chips in- so whether it’s Europe, the United States and now most recently the Bank of Japan, those three regions comprise over half of the economy in the world. The central banks have basically said we’re going to provide as much liquidity as necessary to generate growth and, as a result, it’s actually forced investors to go out on the curve, whether it’s a yield curve for bonds, the spread curve or certainly the risk curve here as related to equities, and that’s why the marketplace has responded so favorably.

CONSUELO MACK: So Nick, I saw you nodding in agreement.

NICK SARGEN: Absolutely.

CONSUELO MACK: So anything to add to the big changes that John just alluded to?

NICK SARGEN: I think he highlighted the big ones. The way I think about it, Consuelo, in the case of Europe, is we were asking for the first time the existential question. Could the euro zone make it? And the reason was we went from worrying about small countries, Greece, Portugal, Ireland, to the bigger countries, Italy and Spain, and I would say today we’re still worrying about the economies. They’re in recession, but tail risk. What does that mean? The risk that the financial system could collapse, that risk has dissipated, and it’s amazing. Why? Because of one man, the head of the European central bank, Mario Draghi, said, “We’re not going to let the euro zone fail, and I need the authority to go out and buy their bonds.” He hasn’t even had to buy a bond, and yet you’ve had the rally that John talked about.


China, as he indicated, the fear was again property bubble and the like, and I would completely agree with him that the Chinese story and the Asian story in general is improving. Just lastly, though, I think on the U.S. side, what were we worrying about? The debt ceiling debate. In all the years I’ve followed the markets, I never even thought of that, and yet here we have this issue that caused the S&P to downgrade U.S. Treasuries, to lose the triple A status, and we went into the first real downturn in the equity markets since the rally. We lost more than…

CONSUELO MACK: Right, in August of 2011.

NICK SARGEN: That’s right, and so now you look at it, and we went over the fiscal cliff, and investors kind of yawned, and they said, “We’ve seen this act before, and we just don’t take it seriously. We don’t believe the two sides are going to allow that to happen. So that risk of policymakers making a terrible mistake, I think that’s diminished.


CONSUELO MACK: So what’s wrong with in this picture, not with this picture? This picture is a good picture, but what are you worried about, John?

JOHN KIM: I’m worried about the general level of complacency in the marketplace, so not summer of ’11, Consuelo, but coming into 2012, there was a fair bit of pessimism in the marketplace. Seventy percent of investors thought that the euro zone might break apart. We were very concerned about the continuation of the QE programs and the like and, as a result, I believe the markets, corporate earnings, multiple expansion, all sort of surprised us on the positive here.

There’s a remarkable calm in the marketplace today. Many of our cohorts seem to be more optimistic than not, and perhaps it’s the contrarian in me suggests that I’m just concerned that we’re all too optimistic, and we’re too complacent about the year ahead.

CONSUELO MACK: So is there anything that you are doing as far as your investment strategy as a result of that?

JOHN KIM: Yes, we are.


JOHN KIM: We still like risk assets like equities and high-yield bonds and even high-grade bonds that are more on the speculative side here, but we’re just increasing the credit quality of all our risk assets a notch here or so, whether it’s equities. We want to go into higher quality equities. On the fixed income side, again, while we still like high-yield bonds, we might want to move a little bit on the higher end of the high-yield sector.

CONSUELO MACK: Which exactly the opposite of what other professional investors who are complacent and are optimistic would be doing at this point.

JOHN KIM: That’s right. They still have the risk trade on fully as we see it.


CONSUELO MACK: So Nick, what are you worried about?

NICK SARGEN: You know, it’s interesting. As I was listening to John, I can see where he’s coming from, and yet I have a slightly different take. For example, I certainly agree that in some of the risk assets in the bond market, where we ask ourselves today, even investment grade credits, are we being paid for the credit risk we’re taking with the spreads so narrow, the yield spreads so narrow?

CONSUELO MACK: Right, and again, yield spreads, the difference between the short term and the long term.

NICK SARGEN: Exactly, but here’s the difference. So I think the complacency is on the bond side. The stock market has had a phenomenal run, but I think quite frankly many people missed it, and why do I say that? Consuelo, I looked at mutual fund flows. Up until the beginning of this year, a steady pattern of outflows from equity mutual funds ETFs into bond funds.

CONSUELO MACK: Oh, absolutely.

NICK SARGEN: Then you could say, well, what about maybe not so much the institutional investors, but even there I saw something that was really surprising to me recently, is in pension funds their allocations to equities after the financial crisis came down- I think it used to be 55% to 39%- their allocations to bonds went up from 22% to the mid-30s. And so what I’m saying is the difference is, I agree with John on the bond side. I still think that there is more legs to the stock rally, even though we may have a pullback, but I don’t worry that investors are overly positive on the stock prices.


JOHN KIM: On the equity side, the only concern I have about the equity side is that last year’s 16% performance of the S&P500 was really generated by a pretty material multiple expansion. Now, it was off of a fairly low P/E multiple, so I calibrate something called the trend P/E ratio, and that ended the year at 17 times earnings multiple. That’s a historic average, so the equity market is only cheap vis-à-vis the bond market. Versus historical averages, it’s about fairly valued. So I am a little bit more cautious than Nick is that the equity market, while it might have some more room to improve, that there might be limitations to that. That’s why I don’t think it’s going to realize the total return growth that we experienced in 2012.

CONSUELO MACK: So what do you think is going to drive stock prices higher, Nick, and do you think they’re going to go substantially higher, or… ?

NICK SARGEN: You know, the answer is…

CONSUELO MACK: And I don’t know what substantially means. You tell me.

NICK SARGEN: Well, can we test the all-time high for the S&P, say, 1570, 1575. I think it’s possible.


NICK SARGEN: Yeah, we’re not that far away.

CONSUELO MACK: No, we’re not far away at all.

NICK SARGEN: And so I think that the basic story that I feel, Consuelo, is… the key question I ask myself is, is the U.S. economy gaining traction in the private sector? In other words, if you looked at the headline number for the economy, it doesn’t look all that exciting. Two percent growth. If you say, what are people forecasting? Two percent growth. But what makes me more optimistic is that I break out of that the private sector component, the consumer spending, the business investment, the housing sector, which I think is really coming back as well as the export sector, and I take out the government sector. So the basic story is when the economy was beginning recovery, you needed that government sector to give the economy the boost. Now we’ve gone from stimulus or push to a drag, and the private sector is still expanding at a healthy clip.


So my call would be that we’re going cumulate getting stronger growth, better jobs growth, and then that’s going to help buoy confidence. So what I think will happen then is, all these flows into the bond funds start to migrate back into stock funds. That would be the basis for it, but I agree with John. It was a great run last year. I’m not promising or we can’t promise. But do you get 16%return? No. I don’t think here.


CONSUELO MACK: Is the bond market in a bubble now, John, number one? And number two, when are interest rates going to go up? And what should investors do in advance of that or to plan for that?

JOHN KIM: A bubble implies that it’s going to burst soon, and by that definition, Consuelo, I would say that we’re not in a bubble. I actually believe that there is a reasonable chance that interest rates could stay low for a longer period of time, but I believe it’s not when. Well, the issue is when but not if here, so when you have a 1.8 percent sub 2 percent 10-year Treasury rate, I just don’t see over a 10-year horizon how that could be an attractive investment. So while I might not call it a bubble, this is really not a time for active investors over the long term to be investing in the long end of the bond market as their core investment vehicle.

CONSUELO MACK: So do you think that there’s going to be a change in the bond market and, if so, when? Where rates start going higher and, therefore, your underlying principal is going to decline in value.

JOHN KIM: Yes, I think there’s a decent chance that there could be a rise in interest rates here this year, especially if you adhere to Nick’s sort of economic forecast which I think is reasonably accurate.

CONSUELO MACK: So a little bit more growth than consensus.

JOHN KIM: Exactly and, again, to underscore the point made earlier, if you look at the mutual fund flow data, it’s really been a trillion dollars over the last four years that have moved out of the equity market into the fixed income market, and so the big question is, what’s going to begin the shift back to equities? Will it be a 50 basis point rise or 100 basis point rise? Somewhere in that range, there’s going to be a shift, and I would agree that when that shift occurs, it’s going to occur fairly quickly.

CONSUELO MACK: And are you talking about a rise in the 10-year note?

JOHN KIM: I am, exactly, so which is, again, slightly below two percent today.


CONSUELO MACK: Right, and Nick, you told me earlier that you’re actually strategizing at Fort Washington Investment Advisors, and you might be, too, at New York Life as to, you know, kind of when and not if interest rates start to rise. You know, what do we do? So what do you do? And when do we do it?

NICK SARGEN: Yeah, well, let’s do the when first. What should you focus on? It’s pretty simple, I think. The Fed has said what they’re focusing on is the decline in the unemployment rate to six and a half percent.

CONSUELO MACK: Right. That’s what they’ve said is their target.

NICK SARGEN: From 7.8, so we’re a long way from that. So the Fed…  it’s not that the Fed will be in raising interest rates, but then market says, “I’m going to watch what the Fed’s watching.” So again my story would be, Consuelo… of late job growth on a monthly basis has been about 150,000 new jobs a month. That’s not going to move the needle. That’s priced in, but if we start printing 200, 225,000 jobs, I think the bond yields that John’s talking about, they’re going to rise ahead of that. So that’s our cue.  So now, what do you do in the meantime? We’re developing contingency plans, because like John, and I’m sure, if we compared notes… let’s say we’re invested in corporate bonds. Guess what? The average value of our bond portfolio- and I’m sure it’s for John’s- is probably $115 for a par value of 100. So if you did nothing, that would go back to 100.

CONSUELO MACK: That’s a big loss.

NICK SARGEN: That’s right. So what we’re saying is that…

CONSUELO MACK: From where you are today.

NICK SARGEN:  … but you have to back your products, so you keep those bonds, but do you do certain types of hedging strategies to protect yourself in the event that you think there could be a rise in bond yields. So you can do that. The other thing I think, and it’s too early to do this just yet, but if you said to me, “How will things change?” floating rate notes will become a lot more popular when we do get to a rising rate environment, because they’re not going to be subject to capital losses that fixed rate instruments are, and I think it’s very interesting here. The Treasury is doing two things. It wants to extend its maturities. Why not? Lock in very low interest rates, but they are developing a program, I believe, of also eventually issuing floating rate notes for those investors worried about rising rates.


CONSUELO MACK: Do you also have a contingency plan, and again, that we could apply to individual investors as well?

JOHN KIM: Absolutely, Consuelo. So in addition to what Nick said about floating rate instruments that, by definition, have low or no duration here, the sector that we actually do like would be equity real estate, because they offer current income but also inflation protection which is sort of embedded in higher interest rates. There should some higher inflation, and for institutional investors you could basically invest in commercial real estate properties, and that’s a very attractive category that we have been investing in, but for individuals, you know, REIT stocks or REIT bonds.

CONSUELO MACK: The real estate investment trust.

JOHN KIM: Exactly, are good places to generate some current income but also provide you with some upside protection here if rates do rise.


CONSUELO MACK:  The last time that you were on, we were talking about that you at New York Life planned for these kind of contingencies, and I remember one of the things that we were watching very closely, where the Spanish 10-year note was trading, and what the interest… and that turned out to be a perfect barometer to figure out whether the markets were going to go up or down. So is there another similar thing that you’re looking at now?

JOHN KIM: There is. Inflation at some point is going to be problematic here, and again, this is yet another example of when, not if, and within the broad inflation statistics, we would look at payroll inflation at the core.


JOHN KIM: Yes, wage inflation. So if Nick is right that employment growth is going to be more robust this year and beyond, that should translate into some wage inflation, and if you see that, that’s a more permanent form of inflation, and we would be concerned that that might create a catalyst for larger inflation going forward which would obviously increase interest rates, and you would have a lot of mark-to-market loss in fixed income securities.


CONSUELO MACK: Right. So where do you go for income? Which I know that you two are searching the world for income, because of the obligations you have to meet as insurance companies.

NICK SARGEN: Absolutely. Well, you know, it’s interesting when John talked about the real estate investment trusts. Our favorite play has been dividend-paying stocks, high dividend-paying stocks for the reason that, as I say, we look today and we go, if we had to buy a high-quality corporate bond, we can’t put it on our books for four percent yield, yet we are able to find in the stock market same companies maybe issuing stocks that have dividend yields above four percent. So for us, it’s a no-brainer in two respects, that we’re getting comparable yield, but at the same time we do believe over the long run the stock market will outperform the bond market, so I’d rather hitch my horse to a market that can go up in value rather than hitch my horse to an asset that I think will decline in value.


You know, we have a whole range of initiatives. Some are master limited partnerships that we’ve looked into. We’ve looked into alternative investment vehicles that pay higher yields than what a conventional bond would be. So I would say that in the last couple of years I could easily tick off maybe eight new initiatives we have to offset this very low interest rate environment.

CONSUELO MACK: Right, and where are you looking for income?

JOHN KIM: So equity real estate, the higher quality end of the high-yield segment, recognizing that spreads for the high-yield sector have really come in significantly, one of the reasons why it was one of the best performing sectors last year. I think the international arena still offers value, especially if you have a diversified strategy of both equities and fixed income, developed and developing. You can generate some yields that are quite attractive.

CONSUELO MACK: And as a matter of fact, that was One Investment recommendation. It was international stocks…

JOHN KIM: That’s right.

CONSUELO MACK: …when you were here a year and a half ago which has actually worked out quite well. And the One Investment, so we are at the One Investment for a long-term diversified portfolio, and last year Nick was with you, or in 2011. It was to buy a home when you were in the midst of building a home, and it’s finished. So what’s your One Investment now, Nick Sargen?

NICK SARGEN: You know, it was interesting. I said, now, this is personal, so this is… but I ask myself when we realized marginal tax rates were going up, capital gains tax rates, and I’m sitting on my own personal bond portfolio that I said, “Wow, I have huge capital gains. If I sell it, I’m going to pay Uncle Sam.” So I decided, what’s better than doing that? Why not go get one of these advisory funds where you can make charitable donations? Put the proceeds…

CONSUELO MACK: So these are the donor advised funds.

NICK SARGEN: Donor-advised funds where you make a charitable… you put the proceeds of that bond into that, so I’m not paying Uncle Sam. I’m giving it to charity, and guess what. I get to have a tax deduction at the same time.

CONSUELO MACK: Exactly. All right. Good place to put some bond profits.


CONSUELO MACK: John Kim, what would your One Investment be?

JOHN KIM: High-quality, high-yield bonds.

CONSUELO MACK: High-quality, high-yield bonds, and they’re not mutually exclusive?

JOHN KIM: Indeed, they’re not, so the highest quality high-yield by definition is a double B rated. I would stay in that category. That means that you’re not in the speculative, most speculative, but you’re still enjoying a comfortable yield over Treasuries.

CONSUELO MACK: All right, very important distinctions to make. So I look forward to doing this again in another year, and hopefully the good news will continue, but it’s so great to have you both here. So John Kim, CIO of New York Life, and Nick Sargen, CIO of Fort Washington Investment Advisors, thanks so much for joining us on WEALTHTRACK.

JOHN KIM: Thank you, Consuelo.

NICK SARGEN: Thank you.


CONSUELO MACK: At the conclusion of every WEALTHTRACK, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: consider buying a home sooner rather than later if you are planning to be in the market for one. Up until recently, if you waited to buy a home you could be almost assured that the asking price would go down and the mortgage rate you had to pay would decline. The exact opposite is happening now. Home prices are going up and so are mortgage rates. Barring another financial crisis, it looks like it is becoming a trend. So waiting to buy a home no longer pays and acting sooner rather than later might.


These are also the sentiments of next week’s guest who invested early in home building stocks which paid off big time last year. We will have a TV exclusive with legendary value investor Bill Miller, whose Legg Mason Capital Management Opportunity Trust fund was the number one mutual fund last year, up a rousing 41%. We’ll find out why Bill is back and what strategy he is following now.


If you have missed any of our past Great Investor or Financial Thought Leader guests, you can find them on our website You can also see our new programs 48 hours in advance as a premium subscriber, and see additional and extended interviews in our WEALTHTRACK Extra feature. And that concludes this edition of WEALTHTRACK. Thank you for watching. Have a great Super Bowl weekend and make the week ahead a profitable and a productive one.

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