Listen to Eddy’s recent interview on the “Money Life with Chuck Jaffe” podcast to hear his thoughts on the inverted yield curve and the likelihood of a recession.

Transcript

Chuck Jaffe: It's Big Interview time on today's show and I'm very pleased to welcome to the show for the first time, Eddy Vataru, Portfolio Manager for the Osterweis Total Return Fund, ticker symbol O-S-T-R-X. And if you are not familiar with the Osterweis funds, really good fund family. What goes into a good fund family? Well for most people it goes into returns and it's all about returns. But what I really like about Osterweis is really great commentary, really thoughtful managers where if you're looking at their statements, you read the research that they do, things along those lines, you come away going, "Yeah, I feel really comfortable that these guys take a really savvy approach." They don't talk to the media a whole lot, but if you want to learn more about them and you want to go check out some of the things that I was talking about, like their manager statements and more, go to osterweis.com. But right now they are talking to the media. Eddy Vataru, thanks for joining me on Money Life.

Eddy Vataru: Thanks for having me.

Chuck Jaffe: We are living in those proverbial interesting times. We've got an economy that seems to be changing tracks, but a lot of countervailing winds that are affecting it. I mean, you've got the economy where manufacturing growth is slowing and in fact around the world it's mostly considered recessionary, but you've got a market that has been able to hold record highs. You've got a fed that has gone from raising rates to cutting rates, and has a lot of pressure to cut them further. For you, does all of this have to sort out before we get any sort of direction or is the direction coming and none of this is going to change what that direction is going to be?

Eddy Vataru: That's a complicated question. There are a lot of factors influencing markets right now, some of them are more sentiment driven, some of them are fundamentals. As you pointed out, we are seeing a significant slowdown in manufacturing globally, but we're also seeing a strong consumer domestically, we're seeing strong earnings domestically in terms of wages, and we're seeing a tight labor market as you see with the unemployment levels where they are.

So domestically we're in a little bit of an island relative to the globe in terms of the strength of our economy, but we are impacted by what's going on globally, obviously with the trade dispute with China, with the slowdown in ECB action in Europe. So, there are a lot of factors that, and I'm not envious of, but that Jay Powell needs to navigate in terms of kind of dictating where rates go and what the FOMC decides to do. It's not entirely based on fundamentals. A lot of it is based on news and external forces that we don't control.

Chuck Jaffe: What is your expectation? I mean obviously the market tends to bake certain things into where it's headed, but for you, what are you baking into your portfolio moves right now?

Eddy Vataru: Well, I'm very defensive on interest rates. I mean, we're at lows in rates that we haven't seen and I mean we kind of touched some of these levels in 2016 but really since QE began, we haven't been at rate levels this low, which is a pretty stunning outcome given we're 10-11 years on from the inception of these programs. I believe that the interest rate market right now globally, and in the US, is pricing in pretty high probability of recession. In Europe, it's pretty full blown. I think that's just a little bit too aggressive given the relative strength I'm seeing from the economic data in the US, manufacturing data not withstanding. That's the lone kind of weak patch that I'm seeing. But a lot of that can be explained by the uncertainty around trade with China.

Chuck Jaffe: But the data that you're seeing also includes an inverted yield curve.

Eddy Vataru: Right.

Chuck Jaffe: Historically, that has been a sign that a recession is coming. Not that a recession's happening immediately, mind you, but that a recession is coming.

Eddy Vataru: Right.

Chuck Jaffe: So if you're saying that the interest rate market is pricing in a high probability of recession, but you think that's too aggressive based on the data you're seeing, does that mean you don't think that the yield curve is going to have that impact this time?

Eddy Vataru: It's interesting you point that out. The yield curve has been a very popular topic over the last few months, given its flatness and inversion in recent weeks. The one thing that I think is important to remember is not just the shape of the curve, but the level of the curve, and historically every time that we've seen the yield curve invert, it's typically because we've been through a prolonged period of tightening, we've been trying to slow down an overheating or strong economy, and typically you will see the curve inverted at rate levels where the tenure might be at 4 or 5, 6%, not 1% or with a one handle.

This is a different animal and that's why level of rate is important because the real issue is how accommodative is policy? Fed funds is two and a quarter. It's not five and a quarter, it's not well north of that which we used to see back in the previous century. So to compare this period to those purely on the shape of the yield curve, doesn't really capture the whole story. I think current level of rates is actually relatively accommodative compared to our history, and I think the shape of the curve needs to be looked at in conjunction with that.

If you're a company and you're borrowing at 2 or 3% and you can't make it, that's a problem with your company. But historically, when we would enter into these periods, you would have rates at 5, 6, 7% for companies borrowing. And that's a different constraint for them. So I would really take the two into account together. Not only the shape of the curve, but the level, and accept that these are pretty accommodative rates that we're seeing in general and I think they're still very stimulative and supportive of growth in the economy.

Chuck Jaffe: And of course that's great if you're running a company. But if I'm an investor, which I am, and I'm looking at interest rates, I not only have the inverted yield curve here, I have those low levels of interest rates that you're talking about, and I have negative yields if I'm looking at certain international markets. So what am I supposed to do as an investor? I get the difference, and that it might not be so bad if I'm running a business, but if I'm an investor, what do I do in this market?

Eddy Vataru: Well, the first thing I would tell you is never to never to buy a bond with a negative interest rate. It really makes no sense.

Chuck Jaffe: Yeah. I have to say, they're not very appealing even to people that don't know very much.

Eddy Vataru: Well, let's not forget too that ... I make this analogy all the time. When you're buying a stock and you think that that stock might have very lofty valuations but you're looking at forward growth or projections as to how that company might do, you might be able to explain purchasing what looks like a rich stock and it gets richer and ultimately the earnings come in. We're talking about fixed income. If the US does great, however you want to define that, 10 years from now when your 10 year bond matures, you're not going to get a $150 for par. You're going to get par. You don't get the upside to anything when you buy a bond, therefore you shouldn't accept negative yields when you're buying a bond because you're locking in a negative return. There really is no two ways about it.

There are a lot of folks that are looking at foreign bonds and saying, "Well, I can buy foreign bonds and hedge them back to the US and using currency hedges to create a positive return." You can, but the positive return is coming from your currency hedge. It's not coming from the bond. And the thing that I worry about is that some people are doing trades where you look at buying a 10-year European bond at minus 60 basis points, hedging it back to the US at say two and a half percent per year and getting a better return than you would get on owning the 10-year bond domestically. Well that's great, but your hedge only works for six months to a year. You can't hedge it for 10 years. So what's going to happen in a year when you're looking at the markets again?

I'm basically saying that the conditions that are creating this demand for some investors to buy foreign bonds with negative yields has nothing to do with the value of the negative yielding bonds, it has everything to do with currency. And that's something that we need to monitor going forward because it really is kind of a misplaced and a miss-hedged investment in something that ... I mean, we don't do this at all. We don't invest in negative yielding instruments of any flavor and we don't invest in foreign markets in my world. But there's just no value there.

Even in the US when you look at 10-year yields at 170, not a ton of value there for the longterm. I like to keep investments really much shorter in the maturity spectrum. Probably two or three years and in, accepting that we might take a low return for now but we're not going to lose. And I think that's really the key here is you don't want to be in a position where you might lose longer term and some of these longer maturity bonds put you in a position where that's very, very, very possible. [inaudible 00:00:09:30].

Chuck Jaffe: Okay. But what are you finding attractive right now? I mean, you know, are you going after corporate credit? Are you going after tips because you want inflation protection? What is the attractive spot? Because yeah, you're never going to find anything negative attractive, but what are you finding attractive?

Eddy Vataru: So both tips and credit are good. I think it's important to be very judicious about picking the right credits. There are a lot of credits out there, corporates I mean, that are highly levered and have potential risk for downgrade. It's important to pick high quality names, but there is a lot of opportunity. I think the economy is stronger than the market's giving it credit for. I think if we get a resolution to the trade crisis we could certainly see quite a bounce in general on risk assets. And I like tips, I like well-selected corporates in that environment, they're both compelling investments as long as you hedge your duration properly and you keep your maturities on the shorter side that either own longer maturity corporates with duration hedges so you don't have interest rate exposure, or buy shorter maturity corporates where the hedges are really not as important and accepting a somewhat lower return.

Chuck Jaffe: Almost out of time here. But as you said, you think that recession assumptions are pretty well baked in and you don't see them happening necessarily. So, down cycles have not been repealed. If a recession is happening, how far out in your opinion?

Eddy Vataru: How far out will the recession happen?

Chuck Jaffe: Yeah. Is it 2021? Is it 2022?

Eddy Vataru: I would be in the longer camp. I mean, I don't think expansions just grow old and die. They continue until there's a fundamental reason for some kind of reversal, and every time we've had a recession in the last few cycles, there has been some major imbalance that has triggered the recession. And the only thing I can point to here is some faulty positioning I would say in some of these negative yielding bonds I think could contribute to some issues down the road, but overall our economy is strong, yields are low, I think it's safe to take risks, but to do it in a judicious way. Pick the right names and buy some tips because you do want some inflation protection here.

Chuck Jaffe: Eddy, great stuff. This was awesome. This was your first appearance, I certainly hope it won't be your last. I look forward to chatting with you again in the future.

Eddy Vataru: Thanks very much.

Chuck Jaffe: That's Eddy Vataru everybody. He is Portfolio Manager for Osterweis Total Return. The ticker symbol on that fund, O-S-T-R-X. Osterweis.com. Could you see what I mean about why I like the managers at Osterweis? Thoughtful, well-spoken, et cetera. Yeah, check out the website if you want to learn more about the firm, its funds, and you want to find more of their work and why they're well-spoken in print as well. Okay. We just hit the halfway [inaudible 00:12:30] on the Friday the 13th edition of Money Life, but halfway means we're just building up speed. Remember, the market call is a little bit later. Aash Shah from Summit Low Volatility, he's going to be here talking stocks. This is Money Life. Stick around, we'll be right back.

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The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve System. The FOMC is composed of 12 members—the seven members of the Board of Governors and five of the 12 Reserve Bank presidents.

Treasury Inflation-Protected Security (TIPS) is a Treasury bond that is indexed to inflation to protect investors from the negative effects of rising prices.

A basis point is a unit that is equal to 1/100th of 1%.

Duration measures the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with longer durations generally have more volatile prices than securities of comparable quality with shorter durations.

Par is the face value, or value at which a bond will be redeemed at maturity.

Mutual fund investing involves risk. Principal loss is possible.

The Osterweis Total Return Fund may invest in fixed income securities which are subject to credit, default, extension, interest rate and prepayment risks. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in foreign and emerging market securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Leverage may cause the effect of an increase or decrease in the value of the portfolio securities to be magnified and the fund to be more volatile than if leverage was not used. Investments in preferred securities have an inverse relationship with changes in the prevailing interest rate. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in municipal securities which are subject to the risk of default.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [41392]

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