Major Investment Themes for the Second Half of 2019
The Investment Conversation
Major Investment Themes for the Second Half of 2019
A Roundtable Discussion
ID: Joseph Graham, CFA
Joseph Graham: Welcome to the 2019 Midyear Outlook. My name is Joe Graham. I'm an investment strategist at Lord Abbett. Today, I'm joined by a number of our leading investment professionals. We'll be talking about markets, what's happened over the last two quarters, where the opportunities are today. So now I'll turn it over to these individuals to introduce themselves.
ID: Leah Traub, Ph.D.
Partner & Portfolio Manager
Leah Traub: Hi, I'm Leah Traub, partner and portfolio manager in taxable fixed income.
ID: Kewjin Yuoh
Partner & Portfolio Manager
Kewjin Yuoh: Hi, this is Kewjin Yuoh, partner and portfolio manager of taxable fixed income.
ID: Dan Solender, CFA
Partner & Director of Tax-Free Fixed income
Daniel Solender: Hello, I'm Dan Solender, partner and director of the tax-free fixed income group.
ID: Thomas O’Halloran, J.D., CFA
Partner & Portfolio Manager
Tom O’Halloran: This is Tom O'Halloran. I'm a partner of Lord Abbett and a portfolio manager of the growth strategies.
ID: Giulio Martini
Partner, Director of Strategic Asset Allocation
Giulio Martini: I'm Giulio Martini, partner and director of strategic asset allocation.
1. Municipal Bond Opportunities
Graham: Are there still opportunities in the municipal market, Dan?
Solender: From my perspective, looking at it from municipal bonds, I'm more concerned about the bottom line of this, rather than all the details a lot of other people focus on, because in the municipal bond market, about two-thirds of the investors are retail individual investors and they invest based on sentiment.
They don't have inflation expectations. They don't look at the growth numbers, say, 3.2% versus 2.5% [economic growth]. They're more sentiment-focused. And from that perspective, there's a lot of opportunity right now, because the economy's doing well.
People are working. People are making money. Tax receipts are coming in very well. So from that perspective, individuals are very comfortable, when you compare where we are now in the beginning of 2019 to where we were in 2018. The whole impact, for me, the Fed, whether the Fed raises a quarter, lowers a quarter--what's more important is that the move is not going to be very big. That makes investors comfortable that rates aren't going to move much.
So since they're comfortable with the rate environment—last year they weren't, this year they are— from that perspective, that carries over, and in the municipal bond market we have very, very strong demand, because people are comfortable that their rates are not going to be too volatile.
We have an environment where we just came from a U.S. tax bill from 2017 that's dramatically changed people's sense of wealth, where in any state that's a high-tax state, people got through tax season and found out they didn't get a tax cut. They're paying a lot of money, and that's made them want to search for municipal bond tax exemptions. So we have very strong demand based on the tax bill, based on the comfortable rate environment. And then on the supply side, the tax bill took away about a quarter of our supply [from the elimination of advanced refunding bonds], so our supply is down, so we have high demand/low supply.
So that's leading our market to outperform some other markets, so the ratios are getting lower. But in this environment, people are comfortable. We're seeing in the first four months of 2019 that about $30 billion has flowed into municipal bond funds. That's the record. They've been counting since 1992; it's never been close to that.
You know, all the important details everyone was talking [earlier] about are very important. The underlying sentiment for individuals is things are calm, rates are calm, they're comfortable where they are. Their taxes are going up. They're going to have to pay taxes. Supply is down, and they just keep trying to find ways to cut their tax bills where they can.
Graham: How about credit? Are you getting paid for taking more credit risk within munis?
Solender: We are. You know, lower quality has been outperforming. We've been going through several years now, where everyone keeps saying, "The spreads are too tight. It's not a good time to take credit risk," yet credit risk keeps outperforming, every year.
And we're in an environment where it keeps doing well. But then there is still a lot of value in that part of the market. And the biggest flows of investor money are going into a high-yield part of our market—that's where we're all seeing the strongest flows.
So there's good value. Credit's holding up well. And certain parts of the market—obviously with all the strong performance, certain parts are overvalued, but there are a lot of different parts of the market [where] things still look good.
2. IPOs, Growth Stocks, and the Tech Revolution
Graham: So retail investors are feeling very confident. Another place you might see that is in the IPO market, which has been pretty hot lately. Do you think the market's getting ahead of itself there? Or can it handle the recent IPO supply?
O’Halloran: I think it can more than handle the supply. These are great companies coming out. I've been very busy with “debutante balls” this month, and the reason is that we had a market correction in the fourth quarter, so no companies came public, and then the government shutdown lingered into the first quarter.
So it was really six months where the IPO window was shut. And now these companies are coming out, having been bottled up for a long time. But they're great companies. They're very disruptive. One company is disrupting video conferencing. Another company is taking what Amazon has done [in its key markets] to Africa.
There are great software companies, social network companies. So these companies are growing 50 to 100% a year, and they're very promising. And as a growth investor, I'm looking for these opportunities in “the revolution of the brain,” which is what I call the tech revolution.
And when we look at things like search and hosted software and social networks and ecommerce, these are extraordinarily powerful trends. And they provide some type of gale winds to the economy. Joseph Schumpeter the economist, talked about the constant of capitalism being creative destruction, as the perennial gale of capitalism. And it's happening in a much more powerful way today than it ever did. And I think most people underappreciate what that is doing for growth investing and how much it's hurting value.
And I'll use the example of Polaroid. Polaroid had 110,000 employees in 1998 and it had a $24 billion market cap. In 2012, it had 11,000 employees and it was bankrupt. The next year, the company that slayed it got sold for a billion dollars, and it had 13 employees— Instagram.
So the pace of technological change has accelerated because what's really going on is the tech revolution continues to grow in processing power at an exponential rate, and our mind doesn't comprehend what that means. If you take 30 linear steps, you're 30 times higher. If you take 30 exponential steps, you're a billion times higher. So this tremendous processing power is proceeding, and we're doing a very good job of converting it to real-world opportunities. And one of the big areas is mobility.
You don't have to go to the mall. You don't have to take your car there. You're-- it's safer to do it from your house. You're probably going to get everything cheaper. So mobility has been one of the big areas of the tech revolution, and we have a couple of new companies that are doing their debutante balls, that are transforming the way we're transported—and not just the way we're transported, but the way we're going to get our food, the way autonomous vehicles are going to move around.
So this is all really good stuff. Now I don't know whether these IPOs that have just doubled or tripled can sustain their prices. Probably that's debatable, but they're very fine companies, and it's not a case where there's too much froth in the equity markets. And I'm very bullish on the equity market. I think we're going to break out to new highs soon. And one of the main reasons is what we've been talking about, that our economy continues to expand and inflation is very much under control.
3. Leveraged Loans and Credit Standards
Graham: You know, I read a lot about corporate debt increasing and the serviceability of that corporate debt. Especially in the leveraged loan area, seems to be something that people talk about, where standards have weakened somewhat over the last few years. Is that an area that concerns anybody here?
Yuoh: There are numerous numbers that we could put out there, but when it comes to a structured product, the most important thing is that there is credit enhancement and then someone owns the equity, right, which is the first loss piece, first loss exposure.
And so in a CLO, the double-B-rated tranche has 5% of credit enhancements. During the financial crisis, cumulative losses did not exceed 2.5%, so double-Bs were “money-good,” right? It was the equity tranche or the equity holder that really lost out. So again, the CLO market is underwritten in such a way and structured in such a way that it doesn't pose the risk that the subprime non-agency market did.
Martini: There are two other points that I think are worth making, is that in many ways, CLOs are substitutes for high-yield issuance. Issuers who would've normally issued high-yield securities are instead issuing leveraged loans that then get packaged into CLOs. So in a sense, when you put those two markets together, you know, investors are safer, because the covenants in leverage loans at least exist, whereas in high-yield loans, they're absent, right?
So to the extent that it's a substitution, it's actually giving investors more credit protection than they would have in high-yield. The second thing is that leveraged loans are typically not held as much by depository institutions as they used to be.
And the way that the [2008–09] financial crisis developed was because banks held a lot of risky securities that then created huge losses and stopped intermediation in the financial system, as banks started to recover. Leveraged loans and CLOs are held much more widely by institutional investors, by mutual fund investors, and by investors overseas, rather than by U.S. depository institutions.
So even if a problem develops, the potential for that problem to then spiral out of the financial system into the economy as a whole is much less with those instruments than it was with, some of the securities that really took the system down in the financial crisis. So Kew's right; it's too small, but also the way it's owned and the holistic financial system perspective just suggests it's not a systemic threat.
Solender: I guess my question on that is how does it affect corporate profits if you can't borrow in the loan market, you have to go borrow in the high-yield market? Longer-term bonds that have higher yields with more speculative companies selling and higher borrowing costs, does that hit the stock market? Because the companies in that part of the market, they're more smaller cap [companies] with higher borrowing costs.
O’Halloran: Well, we'll see it in the stock prices if that's happening. Right now, we're not seeing it. But it's out there as a risk, for sure.
4. A Final Word: Valuations
Martini: you know, as we're sitting here, the U.S. stock market has gone to a new high-- and just exceeded, you know, the September level. But if we look at valuation, valuation has not returned to those high levels, so at the peak in late September, U.S. stocks were selling at 18.5 times forward earnings. Right now, they're selling at 17 times-- you know, having come back from about 14.5 [times]. So we've made new highs in prices. We have not made new highs in valuation.
And the same with high-yield spreads. You know, with high-yield spreads are 350 to 360, we touched 304 at the tightest before, and so more or less across the board, even though there's been a rally in markets and investors have gotten the money back that they lost-- in the fourth quarter of last year, valuations have not recovered to those peak levels that they were at, at the end of the third quarter.
Graham: Let-- let's end on that optimistic note. Thank you all for your time and thank you all for joining.
Collateralized loan obligations (CLOs) are structured finance securities collateralized predominantly by a pool of below investment grade, first lien, senior secured, syndicated bank loans, with smaller allocations to other types of investments such as middle market loans and second lien loans. CLO debt issued to investors consists of several tranches, or layers, with different payment priorities and, in turn, differing credit quality and credit ratings.
Fed refers to the U.S. Federal Reserve.
Forward Price-to-Earnings Ratio: Stock analysts calculate a forward price-to-earnings (P/E) ratio by dividing a stock's current price by estimated future earnings per share. Some forward P/Es are calculated based on estimated earnings for the next four quarters, while others use actual earnings from the past two quarters with estimated earnings for the next two. A forward P/E may help you evaluate the current price of a stock in relation to what you can reasonably expect to happen in the near future. In contrast, a trailing P/E is based exclusively on past performance.
IPO refers to an initial public offering of a company’s stock.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond’s market price. Spread is the difference in yield between two different investments.
No investing strategy can overcome all market volatility or guarantee future results. Statements concerning financial market trends are based on current market conditions, which will fluctuate. All investments carry a certain degree of risk, including the possible loss of principal, and there are specific risks that apply to each investment strategy.
The credit quality of the securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO) such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities. High yielding, non-investment-grade bonds involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.
Investing involves risk, including the loss of principal. The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. The municipal market can be affected by adverse tax, legislative, or political changes, and by the financial condition of the issuers of municipal securities. Investments in foreign or emerging market securities, which may be adversely affected by economic, political, or regulatory factors and subject to currency volatility and greater liquidity risk. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.
No investing strategy can overcome all market volatility or guarantee future results.
Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
The views and opinions expressed by the Lord Abbett speaker are those of the speaker as of the date of the broadcast, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. This material is not intended to be relied upon as a forecast, research or investment advice. It is not a recommendation, offer or solicitation to buy or sell any securities, or to adopt any investment strategy. Neither Lord Abbett nor the Lord Abbett speaker can be responsible for any direct or incidental loss incurred by applying any of the information offered.
The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.
This broadcast is the copyright © 2019 of Lord, Abbett & Co. LLC. All Rights Reserved. This recording may not be reproduced in whole or in part or any form without the permission of Lord Abbett.