November Thoughts from the Research Desk
Heading into 2020, one of the firm’s goals is to increase content for our clients so they can always know what is on our minds. This is part of that initiative – a monthly piece in addition to the monthly market update that we already send out. As always, we welcome any feedback and questions that you may have.
November 27, 2019 | Simon A. Tryzna
In our client review meetings, one of the bigger talking points that I've been making is that our managers (and managers that I've had a chance to meet or read their writing) in the fixed income space are worried about the state of the U.S. credit market. At a recent event that Paul, Stanley, and I attended, Scott Minerd, the CIO of Guggenheim Investments, and Jeffrey Gundlach, the CEO of DoubleLine, presented their thoughts on the space. Tying in the state of the economy as well as the fixed income space, both speakers presented a bearish outlook heading into 2020, which has been reflected in their fund's existing allocation.
Throughout 2019, Guggenheim has built up and held a large cash position, with a big reason being is that they simply don't see the opportunity in the marketplace. In their eyes, credit risk is too high and there will be an increased opportunity set once there is a dislocation in the space. The big concern is rising corporate debt, where more than half of the outstanding debt is rated at BBB, the lowest “investment-grade” rating. If there are a series of downgrades, there will be a big dislocation in the high-yield (HY) market as well - if 15% of BBB rated companies get downgraded to junk, the HY market will double in size. This dislocation in the markets is where Guggenheim expects opportunity to arise.
When talking about the overall state of the U.S. economy, Scott, who is on the Federal Reserve Bank of New York's Investor Advisory Committee on Financial Markets, mentioned that during the last committee meeting, a post-meeting poll of members resulted in almost a unanimous consensus that we are indeed a recession is very likely (albeit no time frame was given). Minerd commented that the Fed is going to do everything they can to avoid one, but it’s not a guarantee that it will prevent one. He likened this period of rate cuts to those of 1987 and 1998 - where the Fed pushed out the recession by a few years. Fortunately, in an election year, the current administration will look to pull all the levers available to them to prevent an economic downturn prior to November. They can be done by easing tariffs; the positive sentiment around the conclusion of the Trade Wars has been a big driver of equity returns during the fourth quarter.
In his presentation, Gundlach echoed some of the same concerns that Minerd had. His team at DoubleLine pegged a probability of 40% for a 2020 recession. They believe that we may skate by without a recession in 2020 due to the election. Like Guggenheim, DoubleLine has been avoiding corporate credit wherever possible, saying that even IG bonds are misrated and that a third of the bonds should be considered junk if the rating agencies used leverage ratios in their rating process. He also believes that in a recession, there will be a massive dislocation in the fixed income markets, and like Guggeheim, this is where DoubleLine envisions opportunity.
How does this view impact our overall thoughts on the fixed income space and the overall markets? These are just two influential speakers whose opinion we value a lot. Many of their comments have been echoed to me by other portfolio managers and strategists that I've sat down with over the last 7-8 weeks. But as long term investors, we're not looking to make a bet on whether we'll see a 2020 recession - rather we are looking to design portfolios that meet our client's long term needs and that in case of a recession, would protect on the downside and in case of a market rally, would participate in the upside. We've been focusing on the quality factor in equity investments, allocating to flexible-mandated bond strategies, and adding new asset classes for diversity. Earlier this year, we moved away from our high yield manager and rotated into Emerging Market Debt. In our taxable accounts, we've maintained a significant allocation to muni's due to both the opportunity set of the asset class and the tax benefit. Lastly, we've also been increasing our communication with teams that we have significant allocations to in order to stay on top of what they are thinking and will look to relay those thoughts to our clients.