SARGEN: FINANCIAL GAME CHANGERS TRANSCRIPT

February 13, 2015

What are the biggest financial game changers of this decade? The unprecedented cycle of global central bank easing and low interest rates? The dramatic decline in oil prices? On this week’s WEALTHTRACK, Fort Washington Advisors’ Nick Sargen discusses the economic and market moving shifts in energy, inflation and central bank policy – and what they mean for investors.

Nicholas Sargen Senior Investment Advisor Fort Washington Investment Advisors

CONSUELO MACK: This week on WEALTHTRACK, financial game changers. They are coming at us fast and furious from plummeting energy prices, to lower interest rates, to deflationary forces. How should you respond? Veteran international economist and strategist Nick Sargen discusses the best investment course next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. If I were to pick the biggest financial game changer of this decade it would be the unprecedented cycle of global central bank easing that we are seeing. Ed Hyman’s top economic group at Evercore ISI has counted more than 500 of easing moves over the past three plus years, with no let up in sight. In recent weeks countries from India, to Egypt, to Peru to Turkey, to Canada to Denmark, to Russia to Australia have cut rates. Other central banks have eased credit in other ways including the European central bank’s intention to buy over a trillion dollars worth of Eurozone government and corporate bonds.

As we have reported numerous times on WEALTHTRACK, for better or for worse these low interest rates have been sending investors to the stock market, in the U.S. in particular, and other asset classes for higher returns. Hyman’s group believes they will continue to do so.

The other big game changer in the shorter term has been the dramatic decline in oil prices which have fallen more than 50% since the middle of last year. The last two times oil prices plummeted in 1986 and from 1997 to 1998, the U.S. economy experienced strong growth. Will that be the case this time?

Falling oil prices are a major contributor to another game changer, low to declining inflation rates. Inflation has slowed in virtually all of the developed countries, the U.S. Europe and Japan and in many developing nations including China, India and Mexico.

This week’s guest is tracking all of these trends and advising clients about them. He is Nicholas Sargen, Chief Economist and Senior Investment Advisor at Fort Washington Investment Advisors, the asset management arm of Western and Southern Financial Group with close to $50 billion in assets under management. A PhD economist, Sargen was the Chief Investment Strategist at Fort Washington until last year and has held many high ranking positions at major Wall Street firms.

I began the interview by asking him why he considers lower oil prices to be such a major game changer.

NICK SARGEN: Consuelo, throughout my career, the last four and a half decades, any major change in oil prices has a tremendous impact. We’ve had four periods of spikes, double or quadruple, four recessions.

CONSUELO MACK: Wow.

NICK SARGEN: We’ve had two periods where oil prices declined comparable to today and in both cases a better than expected growth. So I think just the odds are that this will be a plus for the global economy. I think the other thing I’d stress that’s different is in my career the U.S. has always been dependent on foreign sources of oil, and that’s led us to be vulnerable, and today now because of the shale oil revolution for the first time the U.S. is on the cusp of being energy self-sufficient.

CONSUELO MACK: And what difference is that really going to make in the economy and the markets, Nick, in the U.S.?

NICK SARGEN: Well, I believe again from my perspective the decline in oil prices is the equivalent to a tax cut for the consumer. So all of us when we go to the pump, we see that. That gives us more money to spend on other items. That’s the stimulus part of it, but what I was saying is then there’s the security implications for the United States. So often our economy has been vulnerable to developments in the Middle East, and my argument is if you’re energy self-sufficient there may still be an impact, but you’re not as vulnerable.

CONSUELO MACK: What about the markets?

NICK SARGEN: Well, the markets I think are less certain how to interpret things, and I think it’s human nature. One of the reasons is that the price move is enormous. So the markets, when you read the newspapers, you’re reading about the energy companies that now are suffering from corporate profits. They’re cutting back on capital spending, and so therefore people worry about that. But what I’m saying is, think about it again. My estimate would be that the price decline is going to boost consumer spending by about a full percentage point. So if you say that, then who’s benefiting? Well, there are some companies that it’s obvious, the airlines, the transports, but think of a lot of it goes into consumption. The analyst doesn’t know which firm. So I think, therefore, what happens is you get analysts marking down the companies that are hard hit but not marking up the companies that will benefit because they just don’t know.

CONSUELO MACK: Is there a way that you’re taking advantage of it, for instance, in your personal portfolio? It’s such a huge change and this is not a cyclical thing. It’s not a supply/demand thing. It’s a technological innovation. It’s going to be with us for a long time. Right? This new technology. It is a game changer.

NICK SARGEN: That’s correct. This is structural.

CONSUELO MACK: Therefore as a game changer…

NICK SARGEN: I agree with you 100 percent that this is what makes it so critical. At the same time then, I believe though that the market is still trying to figure out what’s the right price for oil, and you tend to get over actions on the way up and on the way down, and my call would be that near term we may settle where we are now.

CONSUELO MACK: In the 40s somewhere.

NICK SARGEN: Yes, 40s, 50, but I do believe over time oil prices will gravitate to what will it take to get that next barrel of oil, and what most experts would say, it’s probably closer to being in the $70 area. So for people such as myself, I didn’t have a lot of energy in my own personal portfolio. I’m saying, is this a good long-term opportunity? We can come back to that later.

CONSUELO MACK: All right. Other game changer is the fact that except for the U.S. we are seeing a global movement of central banks to lower interest rates. Interest rates in many countries are at historic lows. In some countries they’re negative. What is the significance of this as a game changer? First of all, what’s causing it?

NICK SARGEN: I would say that certainly outside the United States, and I’m thinking particularly of Europe because that’s been the focus of late. Here we are seven years since the financial crisis, and the European economies looked for a while like they were beginning to lift out of a recession, and then last year they slipped back in to recession. And so when you go through a prolonged period of weakness then suddenly price pressures, instead of rising, start to come down, and I observed this in Japan after their bubble burst in the early ‘90s. People talked about deflation in Japan. Deflation really didn’t surface initially. It took about five or six years, but eventually then a deflation mindset set in where people… In other words, it’s not just that prices are falling. It’s people say, “Well, if prices are falling it’s going to be cheaper to buy tomorrow than today, so I’ll hold off my spending.”

CONSUELO MACK: Therefore, the consumer stalls. I mean, not the consumer. The economy stalls.

NICK SARGEN: That’s right.

CONSUELO MACK: Is that what happens?

NICK SARGEN: That’s correct. Both the consumer stalls and even businesses say, “Well, why should we invest in plant and equipment if there isn’t going to be the demand there, or if we can undertake those investments cheaper tomorrow?” So that’s the deflation mindset.

CONSUELO MACK: Right, and are we there yet in Europe?

NICK SARGEN: I don’t think we’re there, but I think that the risk was that we aren’t too far away. So for example, even before the oil prices came down very dramatically in the second half of last year, I was monitoring inflation throughout Europe and seeing that the inflation measured by the consumer price index or even if you took out food and energy was coming down. And that’s when the central bank Governor Draghi started to talk for the first time about buying government bonds, the quantitative easing program, but they didn’t do anything, and then I believe when he saw the steep decline in oil prices at the end of the year, he realized now Europe for a good part of this year will have negative inflation readings, and I think what he’s basically trying to do is say we’re here to act to make sure that this doesn’t get entrenched, and that’s the reason for their decision to embark on large-scale bond purchases.

CONSUELO MACK: Is there any evidence that it’s going to work to stimulate the economies and also to stimulate inflation?

NICK SARGEN: Yes. I would say, Consuelo, yes and no. Let me do the no first. How did these purchases help the U.S. economy? And I think the thing is that you have to realize in the United States we have a large capital market. If you’re a company, you go out and you borrow through bonds, and so what really happened was when the Fed went in and purchased government bonds but basically bond yields for corporations came down massively, and that gave them the wherewithal to refinance and that was stimulative to the economy. So the difference in Europe is their capital market or bond market for corporations is relatively small. The primary channel then they finance themselves is through the banks, and that’s been the problem. The banks have excess reserves, and for whatever reasons we’re not seeing credit grow through that channel. So that’s why I don’t think it will be as successful as U.S. the one thing …

CONSUELO MACK: Because the banks aren’t lending.

NICK SARGEN: That’s correct. The one thing that does work, though, is it has contributed, this program, to a significant weakening of the euro and currency depreciation there. What does that do? It does two things. If their currencies are cheaper, it means that their businesses find it’s easier to export. They’re more competitive. At the same time, when the countries go to import, their prices go up, their import prices, and that’s how they’re trying to counter the falling prices by seeing higher import prices.

CONSUELO MACK: Let me ask you about a phenomenon also that’s new to me and this is negative interest rates. So as a lender, I am basically paying for the privilege of buying government bonds in Switzerland or Japan, Germany, France, whatever. I don’t understand negative interest rates. Why would anyone buy bonds where you’re getting negative interest rates?

NICK SARGEN: That’s a good question. The way I think about it is that it comes back to your question of what’s causing it, and what I see say in Europe where we’re seeing these negative interest rates, think about some of the geopolitical developments. I mentioned you have Greece has a new left wing government, and we’re already reading reports about people taking their money out of their bank deposits.

CONSUELO MACK: Right. There’s been a run on the banks in Greece.

NICK SARGEN: Where does that money go? Possibly Switzerland. Take all …

CONSUELO MACK: Even with negative rates because they figure that the Swiss Franc is going to be strong. Right? Or safe.

NICK SARGEN: They’re saying if I keep my money in a Greek bank, I could lose it all because if Greece is forced out of the Eurozone they face a huge currency loss on those deposits, and similarly if you’re in Russia or the Ukraine and you have all this uncertainty where they’re actually experiencing high inflation as their currency has tumbled, so people are looking for a safe haven store of value and so you’re right. They’re in effect going to Switzerland and saying, “Listen, for the privilege of holding money in your currency which we think is a sound currency, we’ll pay you a modest amount for the safety.”

CONSUELO MACK: Well, how long can this last?

NICK SARGEN: Good question. I think that again I wouldn’t be so concerned if it was one country but, as you say, when you start to see negative interest rates, I believe in Europe at the moment there’s more than a handful. Maybe there’s nine or ten countries that have these negative interest rates. That is concerning to me because the central bank has to figure out some way to normalize the situation, and so that’s why I say their tactic now is this bond-buying program to jumpstart the economy. I think that the currency depreciation is an effective way, but I’m just not sure. So we’re living in a whole new world and the big question is, how long does it go on? And the other big question is, how does it impact us in the United States?

CONSUELO MACK: Yes, well, also the other big question is, how does it impact me as an investor? Is there any way as an investor to take advantage of this situation, number one, and is there any way I can protect myself from getting negative returns on my bond portfolios?

NICK SARGEN: Well, again I think that my argument would be in the United States, as you’re saying, nobody is going to want to invest in those vehicles because we can buy our own bonds and at least we earn a modest yield. So I think that again part of the reason… The anomaly for me this past year was I think this U.S. economy has gained traction, and throughout my career if somebody said to me at the beginning of the year, “Nick, the U.S. economy is going to grow by four percent annual rate in the last three quarters of the year, and we’re going to create three million new jobs,” then you’d say, “Oh, of course, interest rates would go higher on a strong …” So last year they fall 100 basis points.

CONSUELO MACK: Right, a full percentage point. Yes.

NICK SARGEN: Yes, and so my explanation is because we are a global market, and overseas investors see our yields as looking attractive, and so as their yields fall they pull down our yields. We haven’t seen this very often in the past.

CONSUELO MACK: You have written a book that will be soon to be published, Ten Shocks that Shaped the International Financial System, and in that book you say… and you’ve had a long history at Wall Street … That the last 25 years or so that the number of financial crises has increased actually and that we are kind of in a new era of more financial crises. Why is that the case?

NICK SARGEN: First, so what am I alluding to? I think back to the first being the bursting of Japan’s bubble, the Asia financial crisis, the tech bubble.

CONSUELO MACK: Russian financial crisis.

NICK SARGEN: Yes, all of those.

CONSUELO MACK: Tech.

NICK SARGEN: And so what I think caught investors in the markets off guard was this was occurring in a low inflation period. It wasn’t the high inflation of the ‘70s and ‘80s, and everybody thought low inflation went hand in hand with financial stability.

CONSUELO MACK: Stability.

NICK SARGEN: And so actually researchers at the bank of international settlements in Switzerland, the central banks’ central bank, they’ve done a lot of research on this and said, well, that’s part of the problem is we haven’t experienced goods market inflation, but in this low-inflation environment central banks are injecting liquidity and creating credit. People go out and buy assets, real estate, stocks and the like. As those values go up, they get to unsustainably high levels. So the argument is that really two things happened in the last 25 years I’d say. Number one, the financial markets became deregulated, and then the second thing was globally there was the decline in capital controls around the world. So now money is free to move anywhere in the world.

CONSUELO MACK: And quickly.

NICK SARGEN: Yes. So the argument is I think on one hand that goes hand in hand with more efficient allocation of capital, but at times it can be associated with financial instability as too much money runs in, assets appreciate too much and then, once people realize that, the money goes out the door, and that creates the financial volatility.

CONSUELO MACK: If you ask any investor, one of the things that they’re most worried about is market volatility. It sounds, therefore, if we’re going to see more financial crises and more instability that we’re going to see more volatility. What do we do as investors?

NICK SARGEN: What I would simply tell you as a professional investor, what we try to do is say, okay, let’s look at some indicators to give us early warning signals about when markets may be getting frothy, and again the research at the Bank of International Settlements would say look for countries where there’s been very rapid expansion in credit, and property values are actually more risky than stock markets because the financial sector is more leveraged to those markets. So that’s kind of been an early warning signal, and I’m thinking today that’s why a lot of people focus on China. Could that be the next bubble? So whether it is or isn’t, I think just going in with your eyes wide open is helpful, but then the second thing I argue is because you don’t always capture them, but once a bubble bursts what’s the single most important decision an investor has to make, and to me it’s – do you believe that the policymakers understand what the cause of the problem is, and do they have the wherewithal to deal with it? So I’ll give you two examples. The Fed Treasury after the ’08 financial crisis. My call was they make mistakes before, but I think they realized what was called for to stabilize the financial system. So what we did at our firm was gradually work our way back into taking risk, first with investment grade corporate bonds, then with high-yield bonds, then with equities.

CONSUELO MACK: Now what? Now what do we do? That’s what we all want to know.

NICK SARGEN: So I would say what I’m struggling with today is Europe. On one hand I can say I’m grateful that Mario Draghi, the head of the central bank, has taken a page out of Ben Bernanke’s book, out of what the Japanese have done. It may be a hail Mary, but they needed to do it. So that’s what says to me maybe I should be considering European equities because they’re looking cheap, but the reason I’m not ready to commit is, as I say, I’m still not 100 percent sure that this is going to jumpstart their economies. So that’s an example of I’m not sure of the outcome, and in those situations hold off. Don’t rush in.

CONSUELO MACK: To get down to brass tacks, your portfolio for instance and your personal portfolio, how defensive are you? Do you own any bonds? Are you overweight stocks? Are you overweight U.S. stocks? Again, I’m looking for just some guidelines.

NICK SARGEN: Where I’ve been is overweight stocks and predominantly U.S. stocks.

CONSUELO MACK: U.S. stocks.

NICK SARGEN: And it goes back, Consuelo…

CONSUELO MACK: And still. You still are.

NICK SARGEN: Yes. Yes, and it goes back to when everything bad happened in 2008, ’09. Actually at that time I sold some U.S. stocks and did go into high-grade investment bonds and high- yield bonds, and then as I say as I saw conditions improving, went back, and my motto then was if this portfolio is going down, it’s going down on U.S. soil. And the reason, I can chuckle, but really what I think for our country, the best thing of all our problems… we have many … is we’re very adaptable. We adjust.

CONSUELO MACK: Therefore, now is a good time to be U.S.-centric. Everyone says diversify globally, internationally, everything else, but now…

NICK SARGEN: And what I’m doing, though, at the same time is I’m trying to anticipate in saying our market has outperformed the other international markets. Is there a case to be made to begin to dabble in some of the international markets? The answer is I’m open-minded to that. I haven’t yet done it. The last point I’d make is how global the U.S. stock market is, the S&P 500, and one of the reasons it’s experiencing volatility over the last decade. About 40 percent of the earnings of U.S.- based companies in the S&P come from overseas operations.

CONSUELO MACK: And therefore, if you have an S&P 500 index fund, you’re going to be exposed.

NICK SARGEN: You do have international exposure.

CONSUELO MACK: You are diversified for better or for worse.

NICK SARGEN: That’s correct.

CONSUELO MACK: One investment for a long-term diversified portfolio. What would you have all of us own some of in a long-term diversified portfolio?

NICK SARGEN: When I think about it, I always like to go and say what’s mispriced, and I think that there’s been this huge decline in the price of oil. I think it will stay low for a while, but my estimate would be that in a couple of years time it’s going to begin creeping back not to 100, maybe to 70, something like that. So I want to then have something to take advantage of that. So what we actually like is oil services companies because they’re cheap, and I believe that the downside risk at this point is great but they have better upside potential than I think the integrated. So that would be the one investment theme.

CONSUELO MACK: All right, and I know you don’t recommend individual stocks, so there are some ETFs and one of them that your team looked at is the SPDR Oil & Gas Equipment & Service ETF, XES, that might be a way to participate in that particular sector.

NICK SARGEN: That’s correct. I think that’s for many investors where they’re not sure which company. Play the theme, and that’s a good way. It’s an efficient way to play the theme.

CONSUELO MACK: So Nick Sargen, thank you so much for joining us. As always, it’s great to have you from Fort Washington Investment Advisors.

NICK SARGEN: Thank you, Consuelo.

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: Know what you own, especially in your bond portfolios right now. Record low interest rates around the world mean that many bond portfolios are expensive and in some cases yields are extraordinarily low. For instance many European government bond index funds and ETFs are based on indexes with heavy weightings in French and German government bonds which have low to negative yields right now and are dragging down the yield in the funds themselves. These are extraordinary circumstance requiring extra vigilance. Being locked into a set bond portfolio might not be the best choice in these unsettled times.

Next week we are going to talk to a highly regarded financial advisor about retirement. Jonathan Pond has some simple steps to see us through, no matter what our circumstances.

In the meantime to see this program again and our extra interview with Nick Sargen go to our website, wealthtrack.com. Have a Happy Valentine’s Day weekend and make the week ahead a profitable and productive one.


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