The Income Challenge

>The Income Challenge

Welcome to Active Intelligence, the podcast from J O Hambro Capital Management, where we discuss debates and consider some of the biggest issues facing investors. I'm your host, Jon Cronin. And for this edition, I'm delighted to be joined on the line by senior fund manager and team head, Giorgio Caputo, and senior fund manager, Lale Topcuoglu, both based in the US for the firm's global income builder strategy. So Giorgio, Lale, welcome.

Giorgio Caputo:

Thank you, John. We're excited to be here.

Lale Topcuoglu:

Thanks, John. It's exciting to be here now.

Jon Cronin:

Now, we're still living in extraordinary times. There's no doubt about that. The global coronavirus pandemic remains very much with us affecting lives and economies across the world. All of this is having a profound effect on government and central bank policies, which of course impacts global markets. In this edition of Active Intelligence, where we're going to explore what this means for investors. And in particular, the challenge posed for income investors. So Giorgio, I'll come to you first. Just how tough is the income challenge we're talking about here?

Giorgio Caputo:

So, Jon, the income challenge is very difficult. You have a remarkable confluence of events in that interest rates are at generationally, low levels, precisely when a large population cluster is entering retirement. So in many ways, it could not be happening at a worse time.

Jon Cronin:

Sounds like a perfect storm there, Giorgio.

Giorgio Caputo:

It's a perfect storm. And if you think about it's frankly, both a financial and somewhat of a moral issue. We've been taught since our earliest days about the value of thrift. Think about tales like ‘The Ant and the Grasshopper’. The likes of Jane Austen, for instance, have also written eloquently about the importance of income in terms of finding a significant other. And so to some extent, we have to question both our financial compasses, and to some extent, our moral compasses. What do we teach our children if we are no longer rewarded for thrift and the way we once were?

Lale Topcuoglu:

In fact, "A large income is the best recipe for happiness I've ever heard of," is a quote from Jane Austen.

Jon Cronin:

Now Lale, talk us through that. What is your take on this? 

Lale Topcuoglu:

Look, it's been really hard. I mean, if you look at the world and what we're going through and the response by the central banks, I mean, they're effectively throwing trillions at the market. It's not millions, it's not billions anymore. It's the land of giants, it's trillions. And just to put it on perspective, the fed was buying more than $1 million in financial assets every second, okay? Every second during this past crisis we had around March. I mean, such a flood of liquidity creates many challenges for investors to seek income without taking undue risk.

Lale Topcuoglu:

And I think that's really the challenge. So the motto in the markets is follow the Fed, buy what the Fed is buying, or buy what the central banks are buying. I think that certainly works, but it's an opportunity that gets exhausted very, very quickly. Therefore, we have been thinking about a wider set of opportunities across capital structures that are perhaps, I would say, a second derivative of the central bank support. So think corporate hybrids, preferreds, short and front end paper that's going to get refinanced shortly. And all of these just rely on the theme of just a monetary support.

Giorgio Caputo:

And so basically what's really happened is that central banks have effectively cut off our ability to earn what we call risk-free income. If you want to actually get a positive nominal return, you have to go out almost 30 years and you're lending to the German government. Now, otherwise one, two, three, even 10 years, you're actually getting a negative return. So you are paying for the privilege to lend money. And so as Lale said, it is important to have a flexible toolkit and look in other areas. Because frankly, what would individuals have relied on for decades now to enjoy the fruits of their hard work and thrift is no longer available. Risk-free income has frankly never been a riskier proposition than it is today.

Jon Cronin:

So that the world very much upside down. And of course, banks are struggling to cope with the central banks doing what they are able to in the midst of a pandemic that's becoming an economic crisis.
Monetary policy clearly is then in favor of borrowers rather than savers at the moment. And that's part of the challenge that we're facing here, isn't it Giorgio?

Giorgio Caputo:

It certainly is. And it is likely to persist with one important caveat. And so we liked that dichotomy between the borrowers and the savers. We work for the savers, obviously. So we continue to fight the fight to try to earn a reasonable yield without undue risk of capital impairment. But there are certainly reasons why governments would want to favor borrowers. The global health crisis that we're living through has led to unprecedented unemployment. And if we don't support industry, it could lead to a depression, the likes of which we've seen in the 1930s.

Giorgio Caputo:

The pandemic has been described by many as a war against a sort of a faceless adversary. And so we do find that the lessons from monetary policy in and around World War II are quite relevant. Then as now the central banks, the Federal Reserve, did intervene to keep yields low, but that only lasted so long. And in the years after the world war, you actually had some quite pronounced bouts of inflation. And so even though it's something that is out of mind right now, it is something that we have to keep in mind when we think across the risk of various scenarios. And so yes, certainly lower for longer, until somehow we open Pandora's Box and inflation effectively gets unleashed.

Jon Cronin:

Just to pick up on that, Giorgio, it seems almost too difficult to imagine inflation at the moment rising at those rates, especially with near zero interest rates that we're currently experiencing. But you're saying that this is a risk. We've seen it in the past. We've seen it just after the Second World War and it could be coming our way after what we've been through now.

Giorgio Caputo:

So what we're seeing right now in practice is very similar to what has been described as modern monetary theory or MMT, which is something that certainly has been prominent as a means for potentially financing a Green New Deal that could potentially lead to greater decarbonisation of the economy. You have something that is quite expensive and conventional ways of financing, this transformation seems daunting. Now, today we have something very similar. We have the governments around the world spending trillions of dollars to stimulate their economies, even as they ask citizens to stay at home because of the health crisis.

Giorgio Caputo:

And at the same time, you have the central banks buying up the debt that is required to make those expenditures. So it is effectively a form of MMT (Modern Monetary Theory) where we are spending for fiscal goals. I'm not suggesting they aren't justifiable goals, but that's what's happening, and we are monetizing the debt. And the quantum of liquidity that is being injected is so substantial that it has to be part of one's planning horizon, that there is the possibility that you could see an inflationary surge as the crisis abates. It's not necessarily a base case, but when you manage a portfolio, when you manage assets, when one does have to look across a variety of different scenarios.

Jon Cronin:

Lale, how are you positioning your investment strategies in light of all of this? What kind of opportunities are there out there?

Lale Topcuoglu:

Well, it's not easy. It requires a lot of diligence and looking globally and across all asset classes, not just single asset class. And to highlight on Giorgio's points, if you look actually into US, for instance, where the government spending has been substantial to provide benefits to the population, the Fed has bought nearly 60% of the $3.2 trillion funding need that the government needed this year so far. And through its lending facilities, they're also crushing credit spreads. So the reality of the world, which is an unemployment rate, at least in the US, that's fairly high, it's around 13%, worse is what you see from the equity market or the bonds. They're just entirely disconnected.

Lale Topcuoglu:

So for an investor, that's looking for an income it really creates a lot of challenges. So what you look for is yes, you buy the things that the fed and the central banks are buying. But look for other assets that will get that halo effect, that will benefit from the flush of liquidity that's in the system. So for us, that's corporate hybrids, it's preferreds, it's front end paper that we think the companies are going to practically refinance, as well as Giorgio pointed out, some of the dividend paying equities.

Jon Cronin:

And what's the broader outlook, do you think, then Lale, for fixed income securities bonds and the like, in the midst of all of this? You're looking for alternative opportunities, but fixed income. What's your view?

Lale Topcuoglu:

As long as the central banks are here to support the, the fixed income world will be fine. The challenge is whether you're going to earn an income on it with in Europe, sovereign bond yields are negative. It's a flat yield curve in the US. It's not negative in terms of treasury yields yet, but it's getting close to it. And the yield curve again, is it's fairly flattish. So what actually it creates from a fixed income perspective, and again, Giorgio highlighted this a little bit earlier, normally in a portfolio construction, fixed income instruments offer two solutions. One is income, which we just addressed, it's consistently getting chipped away. The other piece is the downside protection.

Lale Topcuoglu:

So if you're commingling equities and fixed income in a portfolio, especially your sovereign bonds are there to sort of absorb a volatility shock. Well with negative yields or close to zero yields and a flat yield curve, I think some of the downside protection of this fixed income is increasingly going to get called into question. And again, it creates a portfolio construction issue as well. And to reiterate, we're addressing that by sinking about second derivative products that are still fixed income instruments, but can still offer an income and perhaps absorb some of the shock.

Jon Cronin:

And you've highlighted one or two of those, Lale, corporate hybrids, and the like. Just go into a little bit more detail about how effective you think they are and can potentially they be.

Lale Topcuoglu:

Basically some from a security point of view, I simplistically think of them, they're somewhere between a corporate bond and then equities. And one of the things that we've done, because we're an integrated team, one of the debates we have is, "Well, are we better off being in the equity? Are we better off maybe perhaps being in the preferred part of the capital structure?" And in some cases, you can earn a similar income from the preferred security, similar to the dividend yield, but not take that equity volatility. And again, as depending on what sector it is and et cetera, there's massive valuation differences in the market. There are the haves and the have nots. So our goal is to find the best risk opportunity for our investors without taking undue risk. And that's how we're thinking about portfolio construction and the broader opportunity side.

Jon Cronin:

Giorgio, what would you add to that?

Giorgio Caputo:

I think Lale mentioned something important because it does create portfolio construction issues for traditional portfolios. Portfolios that would rely on government debt to offer both income and return as well as diversification. And that's just a critical point with interest rates near, below, around the zero bound. In many ways, modern monetary theory has killed modern portfolio theory, if you will. It's a bit of a battle of these so-called modern theories. And so when we think about construction, we look elsewhere for antifragile assets.

Giorgio Caputo:

We've talked about the risk of inflation. We do hold some hedge assets in the form of some gold-related securities, some dividend paying gold miners that could appreciate substantially. If you were to see either inflation or some severe stress, gold did relatively well earlier this year during many phases of the crisis. We also look for resilience income and inflation protection through some of our equity investments, where we can invest in some businesses that are high quality, that distribute income, that have a very durable business models and strong customer captivity.

Giorgio Caputo:

And what that means is that in an inflationary environment, they are able to increase their prices. And so in some ways they can be considered somewhat of a real bond, a bond-like stream that that does offer you inflation protection. So high quality consumer staples, businesses, some software and technology businesses where there's just strong customer captivity. And so we are looking for those, as long as they Lale points out, risk-reward trade-offs that have some asymmetry where frankly in a downside scenario, you can preserve your value, but you can also participate if the world does improve, which frankly, we believe it may.

Jon Cronin:

So final thought from you both, crystal ball time. I know it's an old cliché, but I'm going to throw it at you. What do you think investors should be preparing for over the next six months? You speak to them, you think about them, you work for them. Six months from now, who knows where we'll be? But it's your job to think about that. So what would you say investors should be thinking about themselves and preparing for? Lale, I'll come to you first.

Lale Topcuoglu:

So for me is pay attention to the pace of the recovery. Markets can look through the weak economic data in the short term, they can be long-term oriented, but in the long run, companies and people need to have an income to pay their bills and their debt. And I think that's going to be critical for the sustainability of the initial recovery we've seen. The second piece that finally, and we talked briefly about this the first time we did the podcast almost a year ago now, that looked at the curious world of the credit markets.

Jon Cronin:

How time flies, Lale. It soon whizzes by.

Lale Topcuoglu:

... If you remember, it talked a lot about plumbing. It was a lot about plumbing. And there's a saying that says "A chain is as strong as its weakest link." And I think everybody gets scared of leveraged loans and collateralized loan obligations, CLOs, or just triple B's, the corporate debt, and et cetera. And how that was going to cause a massive issue in the market. Guess what? The crisis was caused by a liquidity squeeze in the treasury market that was coupled by corporations getting concerned about the health crisis that we're in, withdrawing money from money market funds, coupled with the banks' inability to intermediate, which we talked about, this was the plumbing and the house comment, due to district regulations.

Lale Topcuoglu:

It was none of these fancy schmancy products that people have been talking about that sort of brought the system to its knees. So I think this is a theme that investors really has to pay attention to. The market structure has changed, and when the system is strained, it will cause volatility. So being flexible so that you can take advantage of opportunities and not reaching for risk when you don't think you're getting compensated for it, I think are critical for long-term success.

Jon Cronin:

So I think you're telling us, Lale, to expect the unexpected.

Lale Topcuoglu:

Exactly.

Jon Cronin:

Giorgio, I'll give the final word to you.

Giorgio Caputo:

Jon, I would really echo what Lale said. We pay a great deal of attention to the plumbing and market structure, and it's changed frankly, in fixed income markets. It's changed in equity markets. Market liquidity tends to evaporate quite quickly. And so yes, we continue to see volatility and uncertainty ahead. There's somewhat of a very bifurcated position right now where a lot of capital has flowed into businesses and securities that will benefit from kind of the work from home environment. And to some extent, investors have been shunning kind of the more traditional businesses that would revert back to the old normal.

Giorgio Caputo:

And it makes sense, many people see the world as very binary. So binary world, bifurcated markets. When we hear terms like binary and bifurcation, we think of balance. The world isn't zeros and ones, black and white, it's shades of gray. And frankly, so we try and build a portfolio that will do reasonably well in a variety of scenarios. So a strong base of defenses that can weather the storm, but also some investments that will participate if the world normalizes faster than we expect. There is a chance that it might, that technology could come to the rescue.

Giorgio Caputo:

Even as we see kind of grim economic data, we see very promising potential developments on the vaccine and the health care. We want to stay open to that, even as Lale suggests, the economic data is critical to follow. And so, I guess in closing, I would say, don't put your eggs in one basket to go back to another oldie but goodie. Look for mispriced risk, which is what you hear from us when you hear about some of these securities, hybrids, preferreds, things that slipped through the cracks that traditional investors pay less attention to. And then, critically, be prepared to take advantage of that market volatility and air pockets when they do emerge. Those are often the best risk-reward opportunities that you can find.

Jon Cronin:

Okay. Giorgio Caputo, Lale Topcuoglu, thank you both very much, indeed. And thank you for listening to Active Intelligence, the podcast from J O Hambro Capital Management. To find out more about Giorgio and Lale's thoughts and investment strategies, and other investment opportunities at J O Hambro Capital Management, please go to www.johcm.com.

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Podcast

  • The Income Challenge

    1 July 2020 | 23 mins

  • Giorgio Caputo

    Senior Fund Manager & Head of Multi-Asset Value

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  • Lale Topcuoglu

    Senior Fund Manager & Head of Credit

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This podcast is for professional investors only. The information contained within this podcast including any expression of opinion is for information purposes only and is given on the understanding that it is not a recommendation. Views as of date of recording, 01 July 2020, and are subject to change. Past performance is no guarantee of future performance. The value of investments and the income from them may go down as well as up and you may not get back your original investment.

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