Money Life with Chuck Jaffe: Interview with Eddy Vataru August 2022

Chuck: Welcome to the big interview on the August 25th edition of Money Life. And I'm joined by somebody where I know from you guys, because you write me, chuck@moneylifeshow.com, to let me know what you think of the show. Well, I know that I'm joined by somebody who you like. Eddy Vataru is Chief Investment Officer at Osterweis Capital Management and the lead Portfolio Manager at the Osterweis Total Return Fund.

If you want to learn more about him and the firm, and I will tell you, they do great commentary, worth taking a look at their insights, you can do that all at osterweis.com. Eddy Vataru, it's great to have you back on Money Life.

Eddy Vataru: Thanks for having me, Chuck.

Chuck: Eddy is here on the Gainbridge hotline. Annuities don't have to be complex. With the Gainbridge platform, you make a commitment of time for money by choosing an investment period that works for you and locking in a guaranteed fixed rate. Simple. Learn more at gainbridge.life.

Eddy, this is a market where we're seeing what appears to be a rally, but in a lot of cases people say it's a bear market rally. We have seen an unusual start to the year, in that we had both stocks and bonds down and now they're both up. Are we closer to the end of the bear market or the start of the new bull market? I mean, where are we in terms of what you expect to happen next?

Eddy Vataru: Well, I think the markets are in a little bit of a confused place. I look at it more from the perspective of a fixed income investor, which is what I primarily focus on, and I've noticed the exuberance, I would say, that we've seen in equities over the last couple months. And I think there's a little bit of cheerleading for kind of the soft landing scenario. So basically the Fed, which is front and center, and I think you've noticed with equities that on days where, like you said, fixed income does well, equities do well as well. It feels like equities are more attuned to what the terminal level of the fed funds rate is, rather than the fundamentals of the underlying companies that might be within the indices that equity investors are looking at.

And of course, there's other volatility within equities, that again, is outside of my world, but there's certainly some names that have come to the fore, go away. There's a lot of volatility and a lot of interesting moves there, but from my lens, which is fixed income, I'm purely focused on Jackson Hole, purely focused on what the Fed is going to do, where they're going to take the fed funds rate, how high is it going to go. And I think that the idea that we can engineer a soft landing and not have to hike rates too, too much and everything will be okay is a little too rosy of a picture for where we are.

Chuck: You say that everything's focused on the Fed. One of the phrases you used in a recent commentary was that you had not seen what you considered a meaningful drop in inflation. How much has to be in meaningful, and is there a difference between what is meaningful to you and what is meaningful to the Fed and how the Fed responds? Can it be meaningful to us if it doesn't make the Fed change course?

Eddy Vataru: So, that's a great question and there's kind of a couple layers to it, so let me just start with what's meaningful. Remember, the Fed is targeting 2% and even though they abandoned the 2% target in 2020 as part of FAIT, and we can talk about that a little further and maybe some policy error that happened with that kind of approach, we are now in a position where we're coming back at 2% from way above 2%.

Now to me, there is little difference between 9%, 8%, and 7% when your target is 2 and the Fed has not abandoned their 2% target, so to me, when I look at, like I said, Jackson Hole coming up and I think about Jay Powell and decisions he needs to make, they're obviously not happy. They wouldn't be happy at 6 or 5 either, right? And as long as they're steadfast at 2, that's going to require them to keep hiking rates until they get something that is within the ballpark of 2, and we're certainly not there yet.

Now, one interesting thing they could do, and it's too early to do this, is for the Fed to say, "You know what? Our perception of neutral here is just out of reach. That we think neutral is probably closer to 3, 4% now. So, why don't we target that and then we'll get to 2 later?" I think they'd be soundly discredited if they changed their target at this stage in the game without putting up a real fight to get to their original long-term target of 2.

So, I feel like that's going to compel the Fed to be as hawkish as possible. I mean, the most dovish members of the Fed seem to be the most hawkish ones now. Everybody's pretty uniform in trying to set market expectations that interest rates need to rise and they've been doing that over the last few months. So, we'll see. I think Jackson Hole will provide a little bit more color into that, and in my mind, a little more conviction around the fact that the Fed really is going to push for higher rates to get inflation under control.

Chuck: You actually in that pretty much answered what was going to be my next question, because I wanted to ask whether or not you thought there would be an interim step or if they would at some point say, "Hey, it's okay if we're settling back to 2 over a couple of years." You said it's not going to be okay for them to necessarily say, "Yeah, we can live with 4 or 3%." How long do you think it will take them to get to where they're satisfied and we're at 2% inflation again?

Eddy Vataru: Yeah, and that's what's tricky about this is that they've acknowledged that there is a pretty significant delay between rate hikes and realizing it in the data. And by data, I mean inflation data, but I also mean the economy as a whole and all of the underlying macroeconomic data that we look at. So there is a little bit of threading a needle, there's a little bit of finesse that needs to be done. I don't know the Fed to be characterized by their finesse. It's pretty difficult when your primary tool is a blunt-force instrument like the fed funds rate.

So it will be interesting to see how it plays out, but in my comment about risk assets and equities in particular, I feel like the scenario where the Fed would hike quickly and then we create a recession and then they would cut and therefore everything would be okay, is really kind of a ridiculous theory. That you're rooting for a recession to make the Fed stop sooner, to become more accommodative to kind of get risk assets going again and I just don't see that happening. I think the Fed's going to hike steadily. They're not going to take jumps of 1%. They've already done 75 bps. That's probably their greatest step size, but they'll probably tone it down. They'll anchor into something closer to say 4% down the road.

I think the real key though is whether the economy can withstand that. And if it can, which I think it actually might be able to for longer than folks might think, that means they're going to keep rates higher for longer. And that's where being a fixed income investor, I'm really focused on well where are 2-year yields and where are 3-year yields and what's the trajectory of this 12 to 24 months out? And I feel like the Fed will probably have at least as high a terminal rate as the market is pricing in, but probably stay there longer than the market's pricing in. And I think that's where risk assets may come under some pressure.

Chuck: When you talk about the looking out at yields 2 and 3 years down the line, let's talk about the playbook that a fixed income investor should be following when we have this kind of rising rate environment and the situation you describe, because I know from reading your commentaries, it's not necessarily what I would've expected it to be. Then again, I'm not a veteran fixed income investor.

Eddy Vataru: Yeah and when you have years like this, in general across the markets where we've seen fixed income have its greatest negative return in what, 40 years or thereabouts, I don't know who is a veteran of this. But what I would say is this, I think there's value within... because you're now earning a return on cash and that's continuing to improve as long as the Fed is raising rates, that's a good place to be. And whether that's in commercial paper, short Treasuries, and by short, I mean under a year, I mean very short instruments that you can roll into new cash instruments as they mature. That makes a little bit of sense to me. I also think that when long yields get high enough and by long, I mean kind of 20-year, 30-year type rates, 10-year also, but 10-year locally looks a little bit rich to me compared to the rest of the Treasury curve. It's actually the lowest yield on the entire Treasury curve is the 10-year point. So that makes it a little tough to love.

But I do think that when you do sense that we are getting to kind of a terminal place where the maximum amount of bearishness is priced in and the maximum amount of hawkishness I would say is priced into the trajectory of the Fed. And we might see some of that start this Friday, by the way, depending on how hawkish Mr. Powell is. There might be some value in paradoxically owning longer Treasuries and owning that barbell so that when you do start to have that potential for a slowdown in the economy and whatnot, there is more value and you always see this every time the curve flattens and inverts, it's the long end that leads the way when this happens.

So a barbelled combination of very short cash-like instruments, which now are delivering a yield, as well as longer duration assets, specifically Treasuries, I think makes sense. And down the road, mortgages could become more interesting when interest rate volatility declines. Corporate bonds are a little bit tricky because if we are engineering a recession, ultimately, that's probably the least favorite place to be within fixed income.

Chuck: Do you worry that in this kind of environment, whatever kind of bonds you're buying, you're going to see default rates go up significantly? Because the bond market's pricing it like we're going to see a default crisis almost and yet we haven't had one of those in a long time.

Eddy Vataru: Yeah, I focus on investment grade so really the only part of my universe that you'd see that is in the corporate side because on the mortgage side and Treasury side, if I'm worried about the Treasury defaulting, we have some problems.

Chuck: True.

Eddy Vataru: And similarly with agency mortgages, you don't have default risk as a primary concern. But for the rest of the market, I'm not super worried about higher rated credits defaulting. I think that's more of a concern for high yield and lower rated credits. But like I said, I do think that the economy can keep its course and be a little bit more resilient than folks might give it credit for. And that ultimately leads to higher rates in my mind. So, some of what you've seen in credit markets and the widening that you've seen and we've seen it in mortgages too, is just a buyer strike from fixed income. It's outflows from the sector all year long, the asset class, all year long. And the bid for the product at this stage with higher risk-free rates requires somewhat wider spreads and that's what we've seen.

Chuck: From the standpoint of what the central bankers are doing, and you talk about how you're watching the Fed, the issues that the Federal Reserve is combatting are being combatted around the globe by central bankers all over the world. Are you looking at anybody else and thinking they've got a better idea, they're doing it better, I want to maybe invest more there or I kind of wish we were doing it their way?

Eddy Vataru: We really focus more on the U.S. market. And the problem when you start looking at other central banks, I don't know that Europe or Japan, which would be my two go-tos if I were looking for an alternate, either one of those provide a very good template for where we're going. And remember both, in very different ways, have adopted some pretty spectacular policies. And we're the ones that are actually probably best on track to combat inflation compared to certainly Japan, they're not trying at all. And Europe, with the negative rates they've had for years, we're well ahead of them in terms of this battle that we're fighting. Europe has its own set of issues that are beyond the scope of a U.S. domestic investor, also especially related to natural gas and energy prices that they're dealing with because of the geopolitical issues, obviously, but out of Russia and Ukraine with that battle.

So, I tend to really focus on the U.S. and we have tended to be a little bit ahead of the rest of the world in terms of combatting inflation in this case. And maybe that's a little bit of a sad statement, but they certainly could have acted sooner. And I've been harping about that for quite some time, but we're on this trajectory now and I don't see them changing course. And I think it's appropriate to follow their lead and pay attention to the data as it comes through and navigate the course that we're weaving here rather than take cues from elsewhere.

Chuck: You mentioned a little while ago that of course the terrible start we had to the beginning of the year, not something that investors were used to or could have necessarily foreseen or really relate to, because it hasn't happened in our lifetimes necessarily. But in a recent commentary, you were talking about how there are some familiar hallmarks here. So what - can we look back? Where is history a guide to what is happening now? What's the appropriate comparison?

Eddy Vataru: Well, it's tricky because the set of factors that got us here is unlike anything else we've seen before. And the absolute level of rate that where we are is also quite a bit different than previous instances where we've been combatting inflation. I mean, we're not at the double-digit inflation levels or double-digit level of interest rates that we saw in the late '70s, early '80s. We don't look anything like the dotcom bust of 2000. This doesn't look anything like the housing bust of '08, even though home prices have appreciated dramatically. They've appreciated on the back of low mortgage rates and the fact that affordability had improved so much. So now, yes, we are going to have a slowdown in housing, but that's because double-digit home price appreciation is never sustainable.

And we are not in a crisis of underwriting. It's not that we're going to have bad loans that came out because folks borrowed that shouldn't have borrowed and were never going to pay the mortgage back. We're not going to see that, so you're not going to have the hardship of '08, '09, '10. You're not going to have this real financial crisis in that sense. So it's very difficult to take cues from the history of events in my lifetime. Maybe you have to go back to the '70s or the '50s or some era before this, but it's just very difficult to adapt clues from those periods.

And it's a great question because I do like to, as they say, "history doesn't repeat but it rhymes." I do like to take clues from what we saw in the past. And there isn't really anything, any set of factors from the past that maps to exactly what we're dealing with now, which makes sense. We're dealing with an incredible amount of accommodation that was born of a shutdown that was related to a pandemic. There's really nothing like that in the history that I can tap from directly.

Chuck: Well, Eddy, we'll see how it shakes out and down the line, we'll talk with you again to see how your take on it is adjusting and changing. Thanks so much for joining me on the show.

Eddy Vataru: Sounds great. Thanks a lot for having me, Chuck

Chuck: That's Eddy Vataru. He is Chief Investment Officer at Osterweis Capital Management, lead Portfolio Manager for the Osterweis Total Return Fund. That's OSTRX, and you can learn about it and him and the firm and his commentaries at osterweis.com. We'll be back to wrap up today's show in just a moment.