Stephen Smith Transcript 6/14/2013 #951

June 14, 2013

CONSUELO MACK: This week on WealthTrack, maverick bond investor Stephen Smith studies countries and currencies around the world to find bonds worth investing in. What’s he collecting now for his top performing Brandywine Global Opportunities Bond Fund? A WealthTrack exclusive with Great Investor Stephen Smith is next on Consuelo Mack WealthTrack.

Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. How worried are you about the bonds in your portfolio? If you have been listening to many of our WealthTrack guests, you are probably very concerned. Several of our recent Great Investor guests have called the bond market extremely dangerous and risky. After a thirty plus year bull market in bonds, they see little upside and plenty of downside potential. Of course they are mostly referring to the U.S. bond market, U.S. treasury securities in particular, which have already seen signs of weakness.  

But this week’s guest has a different approach. He runs a top performing global bond fund and he says there are plenty of opportunities in the fixed income world, especially outside of the U.S.

He is Stephen Smith, long time  lead co-portfolio manager of the five star rated Brandywine Global Opportunities Bond Fund, which has delivered stock market like returns over the years as exemplified by its performance over the last three and five year periods and since inception. As Smith points out, the advantages of going global have been and are enormous. If you thought U.S. treasuries have had a good run over the last ten years with their nearly 5% annualized total return, consider Australia’s 12% returns, or Canada’s 9.7%, or Poland’s 9% or Sweden’s nearly 8% performance. It turns out among nearly 20 government or sovereign debt markets, the U.S. was toward the back of the performance pack.

Another benefit of going global? The improving credit quality among developing markets. Twenty years ago, only 2% of emerging market sovereign debt was rated investment grade-  that means with bond ratings of triple-B or higher- from the ratings agencies. The rest were not. Fast forward to now: 60% of emerging market government debt is rated investment grade. Only 40% is not. Bonds of Chile, China, Malaysia and Poland rival those of the U.S. and other developed markets. So where is Stephen Smith finding value in global bond markets now? He says it all begins with the story of the market. I asked him why that is so important for him to understand as an investor.

STEPHEN SMITH: Well, I think it’s really important that you have some kind of a context or framework for your strategy. And in the last number of years, you could have written a book about this year of living dangerously. You could have written it after Lehman Brothers, you could have written it in 2009, ’10, ’11, ’12. And I’m not just saying that tongue in cheek but we’ve had, you know, the Greece, Greece went bankrupt; you have the European malaise. You had a nuclear meltdown in the third largest economy in the world, in Japan. You had to deal with the sequestration. So how do you, actually, as an individual, take all this in and… you know, it would almost be exhausting.


STEPHEN SMITH: And so what we did is, first of all, when you just look at the environment, I didn’t know– probably like most other people– after, which I thought was the worst policy error in 80 years, Lehman Brothers, leaving them go, if we were going to have a depression or not. And so what you needed is a framework to say, okay, we are not. And what happened is the third week in February of 2009, Bernanke had this expression of will, he put a stake in the ground and he said, “I’m going to guarantee all the bank commercial paper, CDs, and any corporation that wants to issue commercial paper, we’ll guarantee it for three years.”

Now, the bears may have taken that and they may still be bearish, but you could say that was a tremendous expression of will, and I just say look in the rearview mirror, the rest is history. And so with that we had a financial crisis. And the financial crisis was twofold. One, we had a misallocation of resources to the real estate sector.

CONSUELO MACK: Right, all those housing loans.

STEPHEN SMITH: And then secondly, we had a misallocation of resources to big government. And so the way you get out of the real estate crisis is you don’t build more houses, and the way you get out of a crisis of big government, is you don’t actually increase taxes. And so when you just go look at that context, one of the issues you had is very simply this: what was the real estate crisis? And this is extremely important. In 2008 the GDP was approximately, you know $12 and three-quarter trillion, and we lost $8.5 trillion in wealth. And the average consumer was wed … had a lot of his wealth wed to real estate.

CONSUELO MACK: Right. These areas, this is… these are paper losses.

STEPHEN SMITH: These are paper losses.


STEPHEN SMITH: And 28% of homeowners were underwater on their mortgages. So Bernanke studied the recession, the depression of the 1920s, and this was the framework. Bernanke could not afford to have the banks or the US citizens continue to have deflation.  And so he just set on a path, and his goal was he wanted asset prices up. Now, you can sit and argue about QE1, QE2, QE3, we may have QE6- but at the end of the day, was he successful? And you just look at it from 2006 ‘til today, we’ve had two and three-quarter percent inflation. And if you just go look at the storyline, the stock market, after that enormous hit, is now up over 125%, and now you’ve got real estate prices up, year over year, almost 11%. So we would argue that what he needed to do was establish collateral, because if you can establish the collateral, you then create confidence. So to me, I think Bernanke has been extraordinarily successful.

CONSUELO MACK: So the story, when you look back at the financial crisis on how everyone was really panicking, and even at Brandywine Global, I’m not saying you were panicking, but the Opportunities Fund had a rough year, right, in 2008?


CONSUELO MACK: So… but you didn’t… did you recognize the story then, in fact, that there was a, you know, that Bernanke had put a stake in the ground and that, in fact, that that was an essential part of the turn around and, therefore, we will invest accordingly?

STEPHEN SMITH: What we did with Bernanke, had that expression of will, and you had corporate bonds yielding four or 500 basis points more than treasuries, you had the Australian dollar, a lot of the commodity currencies were down 30%. We felt it was time that the information risk versus a price risk were wrong. And what Bernanke wanted was he wanted asset prices up, and he was going to do whatever it takes.

Now the interesting thing to me is, as this thing moved forward, you then ended up in a crisis in Europe. And so what we’ve been thinking about all along is leadership, that leadership matters. And so he provided the guiding light.

CONSUELO MACK: Right. So what’s the story now, as far as the story of the market? And I know that a key question, and you just mentioned it was, you know, you’re saying your key theme is, was Ben Bernanke successful? What if Ben Bernanke is, in fact, successful?

STEPHEN SMITH: Right. And it’s hard to have just one leader, but luckily Draghi.

CONSUELO MACK: Mario Draghi, right.

STEPHEN SMITH: He graduated ahead of Bernanke, MIT, sort of out of the same cloth, really understands markets, understands what we need. So then we had another leadership position. And then, lo and behold, we actually have a politician showing leadership. This Abe decided to get out of 20 years of deflation.

CONSUELO MACK: Right, Prime Minister of Japan.

STEPHEN SMITH: And you can see, does it make a difference? I would say yes. And so a year ago, we started to ask the question, what happens if Ben Bernanke is successful?

CONSUELO MACK: And being successful means what?

STEPHEN SMITH: Well, being successful means we have a self-sustaining economic advance.

CONSUELO MACK: Okay. Without very much inflation?


CONSUELO MACK: Lower unemployment right.

STEPHEN SMITH: Right. So a self-sustaining economic advance means that the government can withdraw its stimulus, the economy creates enough jobs and the unemployment rate continues to fall, you don’t have much inflation, and people develop a sense of confidence that we’re not going to have a recession because I would argue all along, because of economic policies, that this is about confidence. And so we just keep thinking, well if Bernanke is successful, where is the misallocation of capital? And so when we look at the world, we would say U.S. treasuries, German bonds and gilts, which are supposedly the store value- and for people who don’t know, gilts are British bonds- that those are the bonds which people think are safe havens that we think have the most risk.

CONSUELO MACK:  So that’s a misallocation of capital, for people to be investing in those government bonds in the U.S., the U.K. and Germany. That’s the wrong place to be at this point.


CONSUELO MACK: If Bernanke is successful, if in fact the economy recovers. Okay.

STEPHEN SMITH: Now you have to think about why are people doing it? Well, if you actually, if you experienced 2008, and the market went down, what’s been happening- which I find is absolutely fascinating and I try to talk to financial advisors about this- when I go and you look at the… since the recovery began in June of 2009, you go ask a panel of people who are investment people, and anywhere between 25% and 37% of them say in the next year there’s going to be another tail risk event. And basically what that means is another Lehman Brothers or another depression.

CONSUELO MACK: Right, and this is supposed to happen once every 80 years, but they’re saying now in the next year– and these are professionals, right?

STEPHEN SMITH: These are professionals. So people are all worried about risk. And so they have the, you know, rich people say, “I don’t want to lose my money.” They see the state pension funds have 42% of their money in bonds because they’re just worried about risk. And so the question really on the table is that if you’ve been spending the last five years worrying about risk, what happens if Bernanke is successful? And so you just have to think, in other words, it’s not like reading the headlines today.

CONSUELO MACK: So what are the headlines going to be in six to nine months?

STEPHEN SMITH: Well, I think what’s going to happen is unemployment rate is going to continue to fall, housing prices are going to continue to go up, the equity market is going to be okay, and just like in the last year, there has been, U.S. treasuries, last summer, had a double, in my opinion, a double top in prices, yields fell one basis point below where they were on December 18th, 2008, and interest rates are up in the treasury market by over 50 basis points. I would ask you this: does the world come to an end? No. Is the equity market up? Yes. Are real estate prices up? Yes. And actually, even the question, is the consumer actually going into debt and borrowing? He’s still not doing that.

And so things are getting better. What’s happening in the corporate sector may change its mind, individuals may change their mind for risk appetite. And then that would just mean that Bernanke is going to have less and less of, you know, he’s going to have less and less conviction about buying $85 billion worth of treasuries or agency paper, you know, every month.

CONSUELO MACK: So the story really is fundamentally changing, so we’ve gone from a risk averse market to a, to one that is basically rewarding risk taking, and you think that’s going to continue. So, therefore, how do you invest in an environment like that as a bond investor?

STEPHEN SMITH: Okay. Well, as a bond investor, a couple of years ago, one of the reasons we’ve been very fortunate is we had a lot of like long bonds, duration was, you know, over eighty years. In other words we had a bond portfolio with, you know, 20 year average maturity or more. And now we’ve cut that duration in half. And the reason we’ve done it is because of this worry about success. To me it’s like the natural order of things. If Bernanke is successful, would anybody in the listening audience be surprised if T bills went from zero to one percent? I don’t think so. Not if the employment rate is coming down, the housing market is doing well and, you know, you are actually creating jobs. Now, the reason we have a better shot at this is if you think about, when I mentioned about a politician Abe, he finally said enough is enough, it’s the third largest economy in the world, they want to have growth.


STEPHEN SMITH: And so at the margin that’s going to make a difference. You think about Europe. Europe has been in a recession. And even somebody in kindergarten would have known why did they go into recession? When you think about 2011, Trichet was Chairman of the Central Bank, and what was he doing?

CONSUELO MACK: Tightening.

STEPHEN SMITH: Tightening. Raising interest rates. What’s that do? Slow the economy down. Secondarily, when Berlusconi was in office, out of office, and they finally threw him out, they brought a technocrat in. Now, we have studied this historically, it’s just that the press, and most people don’t believe this, but if you cut government spending– we did the re-sorts on Canada in ’95, Sweden in ’93, Spain in ’77, there was nine instances of this after World War II- there’s no corrective method, but generally speaking it should be $9 in government spending cuts to $1 in tax increases. So not only did they raise rates, but what Italy did is they did $8 in tax increases to $2 in spending cuts.

CONSUELO MACK: So, therefore, you knew, in fact, that Europe would be in a recession and it would for a fairly long time?

STEPHEN SMITH: What would you expect? Absolutely. And the fascinating thing– and that’s why this business is an art– is that when you raise interest rates they lead with a lag, which basically means that when you raise interest rates it’s going to affect the economy with a long lag. And so what happened is Draghi had to put up with the after effects of his poor policy. But now we’re at the point where, as an investor, you can say Europe is– last summer was very, very, very bad. And now it might just be very bad. And maybe a couple of weeks, months from now, it might just be bad. But when you move from very bad to bad, less bad is actually good, and that’s why the equity markets have been going up, that’s why interest rates have been coming down. And when you just think of the word trust, it’s really important. Draghi hasn’t even done anything except he did the same thing that Bernanke is. Last summer he had an expression of will and he put a stake in the ground, he said the euro is here to stay.


STEPHEN SMITH: And the rest, again, is history. And I would argue the bears have been fighting it. I could sit here and give you a great bearish story, but I just look at it. We have now come to the point, is that central banks, they’re big, they’re powerful and they can move markets

CONSUELO MACK: So if the story of the markets now is that risk is going to pay, that economies are coming back, that things are improving, what do you do as a bond investor? And bring the global, your… the aspect of your global investor into this as well, how important being able to invest globally is too?

STEPHEN SMITH: Well this is extraordinarily important. But you have to understand I have a bias because I’ve been doing this most of my life. And the reason global is so important is that every country is in a different point in the business cycle; like the U.S. has been struggling to grow, whereas you do have some countries like Turkey, Russia, Mexico, and even the last year, this country, some of them been growing four, four and a half, five percent. And so they are at a different point in their business cycle relative to where the U.S. is. And the reason this is important is that if you just look at a country like you would a corporation.

CONSUELO MACK: So your largest weightings, basically, are in Mexico?

STEPHEN SMITH: Mexico is our largest weight.

CONSUELO MACK: And so why is that? Why Mexico?

STEPHEN SMITH: Well if you think back, say six months ago, I could have the choice of buying a bond here with a two percent handle for 30 years, or I could buy a bond in Mexico with seven percent. And you think, well, is that a risky investment? Their inflation rate and our inflation rate are exactly the same. Their debt as a percent of GDP is around 41%. Ours is 82… a little over 80% and the president doesn’t feel that we have a spending problem. Not only that we have a big trade deficit. They’re basically running a very, very marginal trade surplus. And their economy the last two years has been growing between three and a half and four and a half percent. They had a change in the political party there and so, there’s again, leadership matters. They’re doing a lot of supply side things that I think are going to invigorate the economy. So I would just ask somebody, why would you not want to own a Mexican bond with yields two and a half more times than a U.S. treasury?

CONSUELO MACK: Because of the political risk. Because of, you know, what you… they’re still an impoverished company, because of the drug cartels and the drug wars. All of those things, they matter too, so how do you figure that into the equation?

STEPHEN SMITH: There is no question under the Calderon administration there was 58,000 people, you know, killed in the drug cartel.

CONSUELO MACK: Yes, right.

STEPHEN SMITH: And it’s in a very, you know, they’re in areas that are away from where the manufacturing sector are.

CONSUELO MACK: So the economy was not affected?

STEPHEN SMITH:  So the economy is not being affected by it. And so you just go look at it from the standpoint of their wages are about $3.50; wages like, there like here, haven’t gone up for almost a decade. They’re now competitive with China. Ten percent of all the cars in the world are actually built in Mexico, so they moved up the chain. And what’s more important, Consuelo, is that their short-term interest rates are three and three quarters percent. They actually have a yield curve. They, they don’t, they have not had to manipulate the… they have not had to manipulate interest rates to zero to sustain their economy. And so as a global bond investor I could look at Brazil, where short rates are seven percent. I can go into Australia where short rates are two and three quarters; Poland three and a half percent. So around the world there are a lot of countries that haven’t had the real estate crisis, haven’t had what we had.

CONSUELO MACK: So what do we do for our one investment for a long-term diverse fund portfolio? What is it, the one thing with this new story of growth, what’s the one thing we should be investing in?

STEPHEN SMITH:  Well, having done this for, I hate to say, over four decades, I had actually thought, about a year or so ago, that the natural order of things, is all of our portfolios are long only, and not that there’s anything wrong with that. But what we’ve been doing is we’ve been becoming more and more defensive. In other words, we’ve been selling- almost all our corporate bonds are sold, almost all of the treasuries are sold in what I would consider the store value markets. And we have been reducing risk, you know, raising cash in the anticipation that the markets are going to go up.

And so a lot of people would say, well, Steve, that’s not going to make me a lot of money. But sometimes it pays to play defense rather than just offense because it might just pay to be patient and tap your toe. And so I’ve been telling people that, you know, as a global bond manager, maybe the thing you might want to consider is going with a strategy where you can short bond markets or, if you feel really vitriolic about a currency, go short circuit currencies. And you know, as a way to, you know, make money in a world of low interest rates and, particularly, if Bernanke is successful and you basically, the world gets lifted and interest rates gradually move higher.

CONSUELO MACK: And so looking around the globe as you do, are there any countries that stand out, for instance, that are going in the opposite direction, that actually are… where interest rates are going to go lower? Or is this pretty much a global phenomenon where interest rates are going to start rending higher?

STEPHEN SMITH:  No. As, as inflation falls there are countries, as you say, I mean you can get seven percent rates in the front end of the Russian T-bills. You can get seven percent rates in Turkey. You can get seven percent interest rates in, in Brazil.

CONSUELO MACK: And these are countries that you’ve invested in government bonds of those successfully.

STEPHEN SMITH:  And you can get seven percent interest rates in India. So, as you, say, reduce your risk in the U.S., the question would be, well, gee, are these really risky investments? And I would just pose the opposite side of that. If I buy a one-year T bill at seven and a half percent in each of these four countries, if nothing happens I get seven and a half percent. If I do it in the U.S. I get ten basis points. So I could even be slightly wrong in the currencies by one or two percent and still get a better return than a, than a ten-year or 20-year or 30-year treasury. And so it’s all trying to look at what are the risk adjusted returns. And you can actually end up having a fair amount of cash, 25, 30% of your portfolio, actually earning a handsome rate of return over and above, you know, what the inflation rate is here in the U.S.

CONSUELO MACK: So that would lead me to ask you for one investment for a long-term diversified portfolio is, maybe I should be investing in some of the government bonds of the countries that you mentioned, that have, that… short term, their short term interest rates that have much higher yields.

STEPHEN SMITH:  Right, because they’re in a different … trying to get the point is, they have, they’re at a different point in their business cycle than the U.S. is, and so by holistically looking around the world you can capture that. I mean so what we do is the world is our oyster and so you’re just looking at, if I have a dollar to invest, do I want to put two or three pennies in India? Do I want to put two or three pennies in Russia? Do I want to put 15 pennies down in, you know, in Mexico? Do I want to take all my money out of long treasuries, which we’ve done a long time ago, because we don’t think that they have value?  And so this is just the way you manage money. And, you know, just like I said, started this about the year of living dangerously, I mean I don’t know what’s going to happen in the next six months. I know there’s going to be a couple of crises and they will probably create opportunities if you actually have, you know, cash on the sidelines waiting to take advantage of that. And so that’s, that’s basically what we do for a living. And over a long period of time, it has been a very, very successful investment strategy.

CONSUELO MACK: That it has.  So Stephen Smith, thank you so much for joining us, from Brandywine Global Opportunities Fund, it is a treat to have you on Wealth Track.

STEPHEN SMITH:  Thank you, Consuelo.

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: think globally in your bond portfolio. We just heard Steve Smith at Brandywine explain how his ability to invest in the government bonds of foreign countries with improving finances, economies and currencies has enabled him to outperform the markets and competitors over the years. We should certainly be taking advantage of those fundamentals too.

Among Morningstar’s other favorites in the world bond category are funds run by WealthTrack guests, including Michael Hasenstab’s Templeton Global Bond Fund and David Rolley’s Loomis Sayles Global Bond Fund. Given the dominant position that heavily indebted countries have in traditional global bond indexes, this is one area I would recommend investing in an actively managed bond mutual fund.

And speaking of the same, next week we are going to argue the active versus passive debate with two pros who are very familiar with both strategies: Vanguard’s Daniel Wallick will present the active side and Gerstein Fisher’s Gregg Fisher will weigh in on passive strategies. If you would like to watch this program again, please go to our website Premium subscribers can see future programs 24 hours in advance, and additional interviews with WealthTrack guests are available in our WealthTrack Extra feature. And that concludes this edition of WealthTrack. Thank you so much for watching and make the week ahead a profitable and a productive one.

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