Tag: episode-1215

GAFFNEY: CONTRARIAN BOND INVESTING TRANSCRIPT

October 2, 2015

CONSUELO MACK: This week on WEALTHTRACK, a contrarian forecast from Eaton Vance bond star Kathleen Gaffney who sees a brighter outlook in China, the U.S. and much of the world and is finding unusual bargains in battered areas like energy and commodities. That’s next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. The Federal Reserve’s decision not to raise interest rates in September confounded most of the investment world. After nine years of its unprecedented zero interest rate policy, or ZIRP, as Wall Streeters’ call it, the consensus was it was time to get interest rates out of emergency mode and back to some sort of normalcy.

It turns out Federal Reserve Chairwoman Janet Yellen agrees with the consensus. In a stunning speech the week after the Fed’s decision, Ms. Yellen made a lengthy case for a rate hike this year, saying: “…it will likely be appropriate to raise the target range of the federal-funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2% objective.”

As veteran Fed watcher, Roberto Perli at Cornerstone Macro noted, after months of not knowing where Chairwoman Yellen stood on rate hikes we now have clarity on her views at least.
This seemingly endless fixation on when and if the Fed will raise interest rates might seem overdone but the signals and actions of the world’s most influential central bank of the world’s reserve currency country has huge implications and can steady or roil global markets.

This week’s guest is among those very concerned about recent Fed policy and its financial impact on markets and investors.

Kathleen Gaffney is Co-Director of Diversified Fixed Income at Eaton Vance Investment Management. She is also Lead Portfolio Manager of the Eaton Vance Bond Fund, which she launched in early 2013. Until 2012 Gaffney was Co-Portfolio manager of the Loomis Sayles Bond Fund with legendary investor Dan Fuss where their team was awarded Morningstar’s Fixed Income Manager of the Year.

I began the interview by asking Gaffney why the Federal Reserve’s decision not to raise interest rates in September was a mistake.

KATHLEEN GAFFNEY: It was really a shock to the markets, and I had been thinking really the timing is irrelevant almost, but they brought another factor into the equation with global volatility, and volatility is here to stay. In fact, that’s part of the return to normal. So it seemed to take a little more flexibility away from them, and the path that they have articulated to the markets and to investors has been one of data dependency, and we’ve gotten lots of good data.

CONSUELO MACK: Good data from the U.S.

KATHLEEN GAFFNEY: Yes, and flexibility, gradual path. Well, I think they lost some of that ability to be gradual, and I think that’s what the market was really reacting to; throwing uncertainty onto an uncertain market.

CONSUELO MACK: So how do you feel about the fact that a week later the Fed Chairman Janet Yellen made a very lengthy and detailed case actually for a reason to raise rates, so does that help how you feel about the Fed’s mistake at all or not?

KATHLEEN GAFFNEY: If I read the markets, it hasn’t helped yet. CONSUELO MACK: It hasn’t.

KATHLEEN GAFFNEY: The tone of the markets has changed since that initial decision, and I think it’s about the uncertainty because they brought in that other factor of volatility. I don’t see that going away, and even though they immediately, a very quick reversal, said we’re going to do this in 2015, but the markets don’t seem to be buying it.

CONSUELO MACK: So was it a game changer or kind of a nuance change?

KATHLEEN GAFFNEY: Probably more of a nuance change in that the fundamentals will always determine where the market is headed, and the fundamentals are positive I think.

CONSUELO MACK: In the U.S. they’re positive.

KATHLEEN GAFFNEY: In the U.S., and I think the global picture is actually far brighter. So that’s important. The fundamentals are positive. The technicals particularly with quantitative easing have really taken hold of the market for the last several years. Everything is about the technicals. It’s hard to just do fundamental investing, and with that additional level of uncertainty, I think it’s made it a little more challenging. You have to fight a little harder to find those opportunities and have the ability to stay the course.

CONSUELO MACK: And when you say technicals, for the layperson what do you mean by technicals?

KATHLEEN GAFFNEY: The supply and demand, investor appetite in the market, that it isn’t reflecting the fundamentals. It’s driven by where rates are and that need to be invested because of cash on the sidelines and the need to put it to work.

CONSUELO MACK: So it makes it harder for bond managers to navigate and also for bond investors, and one of the things that you said after the Fed’s decision in September was that you told clients that income investors need a broader opportunity set in order to navigate a more volatile bond market in the months ahead. So the markets are going to be more volatile you think even more than they have been?

KATHLEEN GAFFNEY: Even more than they have.

CONSUELO MACK: They are.

KATHLEEN GAFFNEY: I think volatility has been held down because of quantitative easing. It was simply we’re here providing liquidity. Go find your investments. Take some risk because the Fed is here being accommodative. Well, that’s ending which is a good thing because it means the economy can stand on its own two feet, but to get back to normal, capital’s going to move. It’s going to go from where it has been for many years into areas of new return opportunities. A lot of value has been taken out of the market.

CONSUELO MACK: And when you say a lot of money has been taken out, the U.S. bond market. Right?

KATHLEEN GAFFNEY: Yes.

CONSUELO MACK: We’ve had a 30-year bull market run basically in U.S. bonds. So this is going to be a big change.

KATHLEEN GAFFNEY: This is a big change. It’s a transition. There are so many transitions going on in the current market. You’ve got U.S. interest rates. You have the U.S. economy. Technology is a bigger part of the economy and what we do. The innovation is just tremendous, and energy is certainly in the crosshairs of the market, but it’s a great opportunity right now.

CONSUELO MACK: So let me stop you there because I do want to talk about the opportunities, but let me just ask you one last question about the U.S. bond market for instance, because I looked at some figures. Investors since 2009 have moved over a trillion dollars out of money market funds, for instance, and largely into bond funds and many of them in traditional U.S.-based bond funds. So how vulnerable is that money now do you think?

KATHLEEN GAFFNEY: That’s one of those really important transitions. We’re at the end of this bull market, and everyone has come to think of fixed income bonds as a safe haven, a great place to earn return in a secular decline in interest rates. There’s a lot of fear and uncertainty about rising rates because shouldn’t rising rates be bad for bonds, but what I think is so interesting about the transition is that bonds are more than just interest rates. They are capital. It’s capital that you’re lending, and so you want to earn a fixed return for it, but there are opportunities to use credit risk, so lending to a company instead of the U.S. government or another government and country and currency risk, lending to companies outside of the U.S. or countries. Those different levers will help offset interest rate risk which, as interest rates go up, just bond math, bond prices will go down, but there are some levers that will provide upside, and so you need fixed income. You need bonds, but it’s a new environment in a new secular rise in interest rates, and I think that is very exciting as a fixed income manager and really important for investors to think about and not run from the changing role of fixed income in their portfolios.

CONSUELO MACK: So, which brings me to the Eaton Vance Bond Fund because it’s described as having an opportunistic multi-sector bond strategy. So explain what multi-sector strategy means.

KATHLEEN GAFFNEY: It is a bond fund. That doesn’t mean it’s a traditional fund. It’s really not your average bond fund. It’s opportunistic, meaning it’s got broad flexibility to pull various levers, and we’re managing it for total return which means best ideas and a fair amount of return for the amount of risk, pulling those different levers of credit risk, investing in investment grade corporates or high yield, investing in emerging markets, corporate and sovereign. It’s additional level of risk but it’s a great way to earn additional return.

CONSUELO MACK: Now you also can invest in stocks. KATHLEEN GAFFNEY: Yes, very true.

CONSUELO MACK: And why? You launched the fund in 2013. Why was that part of the mix that you wanted to give yourself?

KATHLEEN GAFFNEY: Well, it really ties into a changing environment, and that is rising rates. What I spend a lot of time thinking about is fundamentals, company fundamentals, country fundamentals, interest rates, but if they’re going up one thing that investors do count on from fixed income is that stability of income. Fixed income isn’t the only source of income. Equities pay dividends. Now it’s not momentum. It’s not growth equity. It really is much more in keeping with the strategy which is a value-orientation, looking for opportunities where the securities have a good valuation with that stability of income.

CONSUELO MACK: One of the things that you describe yourself as is a contrarian investor. So let’s describe some of your most contrarian views right now, one of them. The IMF recently reduced its forecast for world growth but you, Kathleen Gaffney, basically think that world growth is going to be stronger than expected. Why and where are you seeing stronger growth?

KATHLEEN GAFFNEY: I do. I think that in Europe which weighed heavily on the markets for a good portion of 2015, we’re seeing PMI, Purchasing Manager Indices …

CONSUELO MACK: Index.

KATHLEEN GAFFNEY: … showing green shoots that a lot of the austerity that Europe has gone through over the last several years is paying dividends. We’re starting to see countries like Spain really make good progress. Even Greece which really weighed on the markets is on the right side, staying in the union and potentially will have some growth down the road, and Portugal is saying, “Look how far we’ve come. We’re not going to go the road that Greece took, and we’re benefiting from it today.” So the periphery and much of Europe is finding their way through own version of quantitative easing, and I think we’re going to see growth there. It doesn’t have to be robust, but I think you get large economies, the U.S., Europe moving in the right direction, and then the big question …

CONSUELO MACK: China. KATHLEEN GAFFNEY: … is China.

CONSUELO MACK: And that’s another contrarian view that you have is that you think that the really severe market reaction to China and to the fact that they seem to be throwing everything but the kitchen sink to prop up the stock market and didn’t do too well doing that, and also they surprisingly devalued the yuan or the renminbi, whatever you want to call it. That had huge shocks in the markets, but you think that China’s policy has been misinterpreted by the market. So how so?

KATHLEEN GAFFNEY: I do. They are not westerners. They’re always going to have a different policy and a different strategy. Your best research is to really understand not necessarily your enemies, but others, to understand what the motivation is, and that’s where I see the misinterpretation. Now I’m a long-term investor. Long term to me is a market cycle, three to five years, maybe a little longer. I think it takes a long time to recognize value. The Chinese policymakers make me like a short-term investor.

CONSUELO MACK: Oh absolutely. They’re thinking in, I don’t know, 50 years, 100 years, 1,000 years…they really are.

KATHLEEN GAFFNEY: They are. So their mission is to restore China to the world stage.

CONSUELO MACK: Are you in the soft landing camp for the Chinese economy or the hard landing or … ?

KATHLEEN GAFFNEY: I’m in the stability camp. I think what they’re doing will achieve stability, and that’s where I get the better global growth picture. U.S., Europe, stability in China. That is a much brighter picture than what the market’s painting today. When you look at oil prices, other commodity prices, they’re trading at levels that reflect where we were in 2008. We’ve come a long way since then. It’s that fear and uncertainty of how we’re going to handle the transition to rates, the transition within our own economy and the emerging markets world, particularly China, their own transition. So there’s a lot going on, and there’s a lot of uncertainty. It’s not a surprise to see higher volatility as the market sorts out what the next phase of the cycle, who the winners are going to be.

CONSUELO MACK: That was another area that’s a contrarian area that you’re investing in, is in energy, and you just explained why, and emerging market debt and currencies are other areas again that have been creamed in the market recently, but you’re investing in emerging market debt and some currencies.

KATHLEEN GAFFNEY: Yes.

CONSUELO MACK: And why is that? You think that we’re going to see some normalization, and things are not as bad as the market is pricing. Is that essentially what your interpretation is?

KATHLEEN GAFFNEY: That’s true. Whenever I see the market leaning very hard in one direction which was the U.S. dollar can only go up, it reminded me a little bit of U.S. house prices can only go up.

CONSUELO MACK: Only go up.

KATHLEEN GAFFNEY: So I started to think. What’s the argument for the dollar not to go up? That would be better growth around the globe, that it wouldn’t be just the U.S. growing and the U.S. raising rates, but that with better growth you have less support for flows to continue to go into the dollar. We’ve seen some significant depreciation in currencies like the Brazilian real, the Mexican peso.

CONSUELO MACK: Emerging market currencies overall are down 20 percent in the last year versus the dollar I think. It might be more than that.

KATHLEEN GAFFNEY: Yes. For some it is more, but that’s the type of depreciation that will become a positive because there are goods that they can export, and if global growth is stable and continuing to improve, it gives them a tailwind. So currencies should find a floor, and in fact with better growth and opening up their markets. The Reserve Bank of India cut rates, but more importantly they’re opening up their markets to foreign investors. Those are the types of signals that we’re seeing in emerging markets that differentiate emerging markets. It’s not just a sector. It’s about identifying the countries that have the ability to reform, have good fundamentals. It’s getting back to the roots of fundamental investing and finding where those stories are and recognizing that capital will flow into those positive fundamental stories.

CONSUELO MACK: So as a contrarian investor and this opportunistic approach, what are a couple of the major positions that you’ve got in the Eaton Vance Bond Fund right now?

KATHLEEN GAFFNEY: So our currency position is about 20 percent right now, and two thirds of that is emerging market. Brazil is one of the positions that is pretty contrarian these days. The real is down a lot. President Rousseff is in the headlines quite a bit. You’ve had corporations, Petrobras, also in the headlines with the carwash scandal. A lot of negative news, a lot of down side has already been priced into the market. What are the positives? The real is down a lot. The debt burden is primarily in local currency. What we worry about with emerging markets when they go through a downturn is that if they have borrowed, if they have to pay it back in dollars …

CONSUELO MACK: In dollars.

KATHLEEN GAFFNEY: … that can create chaos for their economies. CONSUELO MACK: And Brazil doesn’t. Then it’s mostly in local currency?

KATHLEEN GAFFNEY: It’s mostly in local currency. So that is a positive. The politics are challenging to say the least.

CONSUELO MACK: They definitely are.

KATHLEEN GAFFNEY: But when Rousseff was elected, she put Levy in as finance minister, similar to Rajan in India that you have western policymakers, U.S.-educated that are putting through some very positive reforms. Still the politicians are not agreeing on what the right path is, but the real recently broke through four which is a level not seen in a very long time. They head of the central bank came out and said, “We have plenty of reserves.” They do have a lot of reserves. That’s different from previous crises.

CONSUELO MACK: U.S. high yield, energy bonds specifically. Is that another area that you’re investing in in the Eaton Vance Bond Fund?

KATHLEEN GAFFNEY: I like energy, but you do have to tread very carefully because those were the borrowers. It wasn’t so long ago that energy was the hot dot for the economy and that all changed last November.

CONSUELO MACK: The energy revolution. Exactly, and so that’s imploded just because the price of oil has gone down so far.

KATHLEEN GAFFNEY: And the companies that were able to take advantage of that were primarily high-yield companies. They’re trading at distressed levels right now, and there are many of them that won’t make it. We’re seeing some consolidation at the higher quality end which is a positive, but in the high-yield area I think you have to focus very specifically and look at companies that aren’t necessarily directly levered to the price of oil. So the oil service sector is one of those areas, and Pacific Drilling is a company where they’re at the bottom of the food chain which means they’re going to be one of the last to recover, but they’ve got liquidity. They have very little in terms of capital spending. Their rigs are essentially brand new which are the ones that will be in demand when the market comes back. That’s the type of high-yield energy bond that will make it through the cycle. So energy is attractive but tread carefully and pick your spots.

CONSUELO MACK: So two more questions. One is your contrarian positions, some of which you just described, have definitely hurt your performance this year in the last year. So how do you … you’re early. Contrarians frequently are early. How are you dealing with that? What are you telling clients?

KATHLEEN GAFFNEY: We tell them exactly why we’re there and that you often need to be there when the bonds are for sale which happens early, and then you have to do your credit work, your fundamental research. It’s more important to know what you’re buying and be willing to hold it which actually works well in a market where we worry about liquidity and being able to buy or sell, but holding on to those names because when the market changes, when global growth looks better, when oil comes back in balance and it’s a supply/demand issue. In the near term, there’s more supply but demand is growing at the margin. Supply is coming down at the margin. We’ll get back to in balance, and those bonds will move up in price.

CONSUELO MACK: Just give me a cycle is basically what it is. KATHLEEN GAFFNEY: That’s exactly it.

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

KATHLEEN GAFFNEY: This is my favorite question, and I’ve given it a lot of thought because the areas where I see great value are not typical right now. So I’m thinking about emerging market equities. To get exposure there, you really want diversification. So an emerging market equity ETF or mutual fund that is not tied to an index but focuses on country selection. I think that is something that a little bit will go a long way for everyone.

CONSUELO MACK: Great. Kathleen Gaffney, thank you so much for joining us. KATHLEEN GAFFNEY: So great to be here. Thanks, 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 is: Think like a contrarian, in at least a small portion of your portfolio. Gaffney looks for opportunities in multiple sectors, regions and securities that are out of favor for her entire portfolio. That’s her job. It takes a strong stomach to do so. But as individual investors we have the flexibility to do so with small positions in targeted ETFs and index funds. Anything related to energy, emerging markets and gold are hugely unpopular right now. One or all of those areas might be worth investigating. As so many great investors have told us the right entry price is a key component of investment success.
Next week we will sit down with Financial Thought Leader Jason Trennert, Co-Founder and chief investment strategist of Strategas Research Partners, one of the most creative institutional research firms on the street. What are the markets telling him now?

To see more of our interview with Kathleen Gaffney and her views on handling an illiquid bond market go to our website wealthtrack.com and click on our EXTRA feature. And for those of you connecting with us through Twitter and Facebook keep the dialogue going. Thank you for taking the time to join us. Have a great weekend and make the week ahead a profitable and a productive one.

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