With: Scott Minerd, Guggenheim Partners Global CIO, Portfolio Manager, Litman Gregory Masters High Income Alternatives Fund
Date: November 14, 2019
Jack: I think a real and current-day example of this process in action is the recession.
Scott Minerd: Right.
Jack: We know that internally there are lot sort of debates on the recession. You've defined it as a coin-flip probability very recently. Maybe we could get into that.
Scott Minerd: Sure.
When we developed this, which was – God, Jack – you probably have looked at this for the last two years.
When the Fed (Federal Reserve) began to embark on raising rates, we'd done a lot of work to determine what we thought the terminal rate of interest was going to be. We did it back in 2013 when Bernanke began to talk about the ending of quantitative easing.
The question we asked ourselves was, "What will the terminal rate be?"
One of the people that worked with me – Maria Gerardo – did the work. I'm going to go to Slide 12 for one second to just look at Maria's work.
She determined that the correlation between the level of interest rates and the amount of debt in the economy limited the amount of how much we could raise rates.
When we got this result from basically just a spline regression, we asked ourselves, "Okay. Why? Why is this?"
We did additional work and Maria determined that once you get rates to this 3.25% neighborhood on corporate debt, that you'd have sopped up enough free cashflow in Corporate America that would be equivalent to where we've seen companies begin to stop hiring and lay off in the past. Because of strains on financial issues.
This gave us a really good roadmap to look at. So we decided to take that– go back to Slide 5, please – and then say, once the Fed's started to embark on its interest rate hikes, "Okay. Great. When will they arrive at 3.25%?" That's February of 2020, if they had stayed the course.
Of course now, we developed these metrics which are historically extremely good indictors of recession. The blue line is just the historical average for recessions. Then the grey band around it is the dispersion of those observations.
We could pretty much time when we thought recession would arrive.
But of course the Fed pivoted. You can see than we were tracking right on-track to have a recession sometime in the first or second quarter of next year. Then all of a sudden we diverged.
If you read the commentaries that we put out, I began to talk about a period of what I call, "Indian Summer." Just like if you grew up in the Northeast, you're familiar with the fact that sometime in September or October you get a real cold snap. It's like, "Oh, Winter's coming!" Then all of a sudden it'll get warm again for a few weeks. Then everybody thinks, "Oh! Summer! It's just like Summer!" Right?
Indian Summer is something that comes late in the year. It also is relatively short-lived.
We really faced a dilemma at this point in what we should do. Recognizing the strains this was putting on credit, as the Fed was raising rates. Credit spreads blew out.
As I like to tell people, in the fourth quarter of last year, we were geniuses. This year we've been dogs.
One of the reasons is, we had a lively debate internally, which is, "Since we really don't fundamentally believe that this is a huge extension of the expansion, but at best is going to be a mid-cycle slowdown like 1998 or 1987," where they managed to push the recession out by maybe 2 or 3 years – then –
Should we be adjusting the portfolios to put credit-risk back into the portfolios when – in reality – this is a tactical move? It's not really fundamental.
This is where we were guided by Danny. Danny's observation is that investors trade their portfolios way too much. They think they can catch all these short-term tactical moves. Then in essence, even if they're correct and they get the tactical move correct, all of a sudden, they're faced with the dilemma of, "When do I pull out?"
We basically opted to stick to our strategy. As history would show us in 1998 or in 1987, the initial response to risk-assets is for risk-assets to quickly recover, as the Fed reduces interest rates.
Subsequent to that, credit spreads begin to widen again. It's different than the experience of 2007/2008 or the experiences of other recessions that we've had. That is that when we go into these mid-cycle slowdowns and the Fed eases.
Shortly after the end of the time when the Fed is finished easing, credit spreads begin to widen again. If you look at the experience of 1998 to 2000/2001, actually most of the credit-widening occurred before we got to the recession.
If you waited for the recession to come to adjust your credit-risk in the portfolio, then you'd already missed the opportunity. That is what's been guiding us.
There are two things that I'd say here, if I want to speak about Danny. Danny talks about the idea that the incremental value and utility of a dollar in terms of a gain is lower than the regret of a dollar that is lost. We really work hard at bringing in the highest-possible absolute-returns with the minimum downside volatility.
You'll see it if you look at any of the stats around our performance. That sort of stuff.
I also sometimes just refer to the great investor Baron von Rothchild, who once – when asked when asked what was the secret of his great wealth –
He said, "I sold early."
By the way, if you want to know when asked what he thought when one should invest, he said, "When there's blood in the streets."
When the recession hits, and we can talk a lot about corporate debt and where we think this is going – we see a huge opportunity in the migration of investment-grade debt to below-investment-grade debt