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

Chuck: It's time for the big interview on today's edition of Money Life and I am joined right now by Eddy Vataru. He is Portfolio Manager for Osterweis, the Osterweis Total Return Fund, and its ticker symbol OSTRX. It is a fixed income fund and if you are looking for more information, Osterweis, which is O-S-T-E-R-W-E-I-S, osterweis.com, definitely worth going to see the commentary of Eddy and his co-managers.

Eddy Vataru, it's great to have you back on Money Life.

Eddy Vataru: Thanks a lot, Chuck, great to be here.

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Eddy, we have a lot of headlines, we have a lot of things that are worrying people that we're kind of waiting to see play out, but let's start with, is there anything that particularly worries you or is this not necessarily normal, but kind of a different shade of normal, not fully abnormal, if not what we're used to?

Eddy Vataru: Well, there's a lot going on. We grappled with inflation or coming to grips with inflation pretty much through the middle to end of last year and as we've come to learn, it's been a little more persistent certainly than the Fed thought, but certainly than a lot of people thought. Unfortunately right now it's really dwarfed by some of the geopolitical issues that you see going on and I'm certainly not expert in those, but those are really dominating the headlines right now. With that, you are seeing some pretty wild gyrations in risk generally. As it impacts equity markets is more obvious, but it's impacting fixed income as well. It's a tricky landscape right now. We're really dealing with several different forces in our markets that are impacting volatility, liquidity, and valuations.

Chuck: You as a portfolio manager, how much are you changing what you do, looking at things, maybe rotating into what you think is next?

Eddy Vataru: Well, it's an interesting question because the real issue here is timing. One thing that's important to note is if you're sitting in cash, you are not going to lose money and that's a good thing. It's always good to have a safe haven and a place to wait for a better opportunity. But as you're looking at, in my markets, for example, I look at mortgage spreads, I look at corporate bond spreads, we're starting to get to levels that make these investments look a lot more compelling, but we don't know that we're calling a bottom or a wide level in these spreads because again, there are several different forces.

Besides the geopolitical headlines, we are going to be entering a period of tightening and unwinding all of the quantitative easing that we've had, or at least some of it, that we've had over the last couple years because of the pandemic. There are some obvious headwinds for deploying risk, but we're also seeing valuations and interest rates and, in particular in spread products that are getting to points where taking a dip might make a little bit of sense.

Chuck: On the one hand, everybody's worried about interest rates going up. On the other hand, if the Fed does four 25 basis rate hikes, we're adding 1% to rates that are still going to be certainly within historic lows.

Eddy Vataru: Sure.

Chuck: They're not moving up so much that people go, "Oh my gosh, 1%, that's it. I can't afford things."

Eddy Vataru: Yeah.

Chuck: Are we overblowing the impact of rate hikes right now?

Eddy Vataru: Well, there's a huge disconnect between what inflation is and where interest rates are. When you're looking at CPI and basically any measure of inflation, PPI, CPI, PCE, everything is 5, 6, 7, 8, 9% and you're staring at a yield curve where everything is below 2.5%, so there is a pretty dramatic disconnect between the two. That's been there for a while, but what's new is that finally the rate market is starting to accept that the Fed, which is pretty late to this party but they're finally doing it, needs to tighten policy a bit. How they do it and what they achieve we'll see as the year goes on.

But what's interesting, what's happening right now, is that we've gone from an environment where rate hikes have been pushed out, they're months out, they're years out, et cetera, and now looks like March we're going to get our first and now the debate is, "Oh, wait a minute. Are we going to get these every meeting? Are we going to get 50 basis points in March? How high and how quickly can these guys raise rates?" Because if inflation is 7.5%, what's a 25 bp or a 50 bp, or even 100 bps going to do in terms of tightening the economy in a way that will bring inflation back under control. That's the thing that's really spooking markets right now, and why you've seen spread product, like I said, mortgages and corporates, do poorly, even relative to Treasuries. And Treasuries, as you know, have risen in yield pretty dramatically year-to-date, not just in the front end, the shorter maturities that are repricing the trajectory of the Fed policy, but also longer maturities have also risen in yield pretty sharply over the course of the year so far. It is a tricky environment, but it is one, like I said, where we're starting to see potential for some opportunities as these spreads get to levels that are compelling enough to take a dip in.

Chuck: The solid economic underpinnings seem to indicate that, yeah, we can correct, we could go to bear market, but we're not likely to stay there for long. Is all of this about transitioning from where we've been to what's next?

Eddy Vataru: Potentially, the way I think of it more, especially since I have a fixed income lens, is that when you had the dramatic rally in 2020, really most of it was in 2020, what you were doing was pulling forward returns that you would've realized over the next set of years, and maybe with equities, there's an element of that as well. Again, not really under my purview to say what fair value of equities is, but when you consider the outsized returns you've seen in equities or the outsized returns you've seen in real estate with double digit home price appreciation over the last couple years, those are not sustainable levels. When you suddenly have a dip, we haven't seen that in housing yet, but I think we will. We've started to see it in equities. All you're doing is kind of reversing back a little bit of these pulled forward returns, the returns that were really contingent upon this hyper easy policy that we've had.

It's not entirely surprising and I wouldn't call this a glaringly great opportunity to buy this dip, at least in terms of equities, but what I would say is just generally speaking, when I look at fixed income, I'm seeing spreads that are back to pre-pandemic levels. I think about the markets back then, and they were relatively fair valued for spread product and bonds. That makes a little sense. Now that the landscape is different because obviously with tightening, the Fed is going to be unwinding some of their portfolio, rates are going to be rising. I'm really focused more on the spread component of the market and really keen on hedging out potential interest rate component or that part, which might continue to rise if the Fed had to be more aggressive.

But again, there's a lot of factors at play. The geopolitical stuff is front and center this week, but in the next week, next month, or even into next year, we're still going to be talking about inflation because I think the Fed's going to have a really hard time getting 6, 7% inflation down to 2, which is their longer term target and how they do that and what policies they achieve or employ to get there is really going to be what will tell us what's going to happen. It's murky.

I wrote a piece a couple months ago about how the Fed should balance rate hikes with reducing balance sheet, even using asset sales as a way to address some of the, I don't want to say excesses, but some of the froth that we've seen in markets and some of the froth and speculation, and what you would do is you would use rate hikes to cool the economy if the economy overheated and you'd use balance sheet reduction by selling assets to really attack inflation because I would argue that a lot of the inflation that we've seen, besides the supply chain stuff and all which I know is real, but a lot of the kind of asset valuation issues around inflation really stem from the Fed's purchases. I believe and I kind of came up with an approach that they should be able to balance both in terms of having a policy that really is dynamic and addresses the real issue that might plague the market at any given time, whether it's, like I said, an overheating economy or in runaway inflation.

What was a little disturbing to me at the last news conference that the Fed hosted was it was really about rate hikes and fighting inflation through rate hikes. If you're really aggressive with rate hikes, you really are going to stifle the economy. That's not really the way to fight the inflation, a lot of which was created through the purchases themselves. I felt like if there was a way to distinguish between overheating economy and inflation, the Fed has the tools they need to distinguish between the two and address each individually, that would be a better response and maybe they wouldn't need nine rate hikes in all these subsequent meetings. Maybe they could take a more balanced approach, but we'll see.

Chuck: Yeah. Well, I will also point out for my audience who probably didn't see that piece, if it's the one I'm remembering, you were basically questioning whether or not the Fed was ignoring its own inflation data in terms of the way it was acting. So ...

Eddy Vataru: Yeah.

Chuck: What you're saying, we'll see, yeah, the answer is that we'll have to see if the Fed is actually sticking up to what it says it's going to do, or if it's going to be data dependent and if it's going to pay attention to the same data you're watching.

Eddy Vataru: Yeah. One of the pieces of data that I watch is called the underlying inflation gauge, which is published by the Federal Reserve Bank of New York and it is specifically a measure of persistent inflation. I was laughing last year when we were having this transitory versus persistent argument about inflation and I was watching this gauge and it's published every month along with CPI and it was rising from 1.5 to 2.5, now it rests in the 4.5 to 5% area so I could look at CPI and say, "Okay, 7%, 7.5% CPI, five of that's persistent. That needs to be addressed. These are numbers that the Fed has. Yeah, I find a lot of what ... I think one of the things I've written about is don't follow what the Fed says, follow the numbers, follow the numbers they even produce because they know this data and I feel like maybe part of the reason that they've been a little bit reluctant to be straightforward about this is because they fear it would rattle markets.

Again, understanding that, yeah, that could be a byproduct of doing that but you also have markets that have been hyper stimulated through all of this quantitative easing and a little bit of a correction certainly makes sense, but it's an unenviable task for them to engineer a smooth landing in markets, given the pull forward of returns that we've seen over the last couple years especially in a lot of risk assets.

Chuck: The old adage, and it applies more on the stock side than it typically does on the fixed income side is don't fight the Fed.

Eddy Vataru: Mm-hmm.

Chuck: But it does apply on the fixed income side. So-

Eddy Vataru: Absolutely.

Chuck: If you are wary of what the Fed is doing, but you're not fighting the Fed, how is that impacting what you would suggest people invest in when it comes to fixed income right now and is not fighting the Fed different now than it has been?

Eddy Vataru: Well, it's a great question. I've generally found in my career that "don't fight the Fed" usually is a little more applicable in the rates to zero direction than it is in the other direction, just from my own personal experience over the last 20 plus years. But at the same time, remember that when my career started back in 2000 where interest rates were versus where they got to over that period. There's been an 18 to 20 year, I would say, relative bull market in interest rates over that period. There's really the noteworthy Greenspan hike to five and a quarter and sail off into the sunset that he did in the mid-2000s. But besides that, we've really been in a period of falling rates and lowering rates over the last forty years, really, if you go back to the early eighties.

Now given where inflation is and given what's going on generally in the economy with the economy being pretty strong, it doesn't defend interest rates at these levels, but if the economy's strong and if we see a reasonable response to tamping inflation, again, there are a lot of ifs. As an investor on my side, I don't mind owning exposure in companies, for example, that have good business models, that are profitable, if it's an equity pay its dividend or has growing dividends, but really more from a fixed income side to be able to be a going concern and pay investors on their underlying debt or in my case in particular mortgages, which that's less of an issue since it's government guaranteed.

What I'm saying is if you have a strong economy, inflation aside, because interest rate risk can be hedged, the relative level of spread is getting to a point where it actually looks a little bit more interesting, given some of the outflows we've seen from fixed income and some of the sales that we've seen, we're starting to see some opportunities, again on a hedged basis, given that the Fed might be pretty hell bent on its quantitative tightening. You're right, you don't fight the Fed, but in terms of spread levels, we've seen a complete reversal back to pre-pandemic levels in a lot of these asset classes that have gotten ahead of themselves.

Chuck: I want to ask in the limited time we have left here about one particular asset class that is near and dear to your heart given what we see with inflation. You mentioned mortgage securities.

Eddy Vataru: Mm-hmm.

Chuck: We've seen tremendous home price inflation and all the rest.

Eddy Vataru: Yeah.

Chuck: What is that doing? We know how important the mortgage market was to the financial crisis that we saw back in 2008.

Eddy Vataru: Yes.

Chuck: When you look at this market right now and you have to deal with the mortgage companies and the mortgage securities, et cetera, does this look like anything you've seen before? Is this again, same tune over again or is this something different?

Eddy Vataru: I think it's very different. The only similarity between the two periods is that you have some pretty dramatic home price appreciation. The root cause of that is quite different. What I would point to more than anything else is a quality of underwriting and lending standards in general. There were a lot of loans that were made in the early, mid-2000s into the late 2000s that led to the crisis that really, in my mind, precipitated the crisis that were poorly underwritten and probably loans are extended that shouldn't have been. We're not seeing that now, right? What we're seeing now is yes, we have home price appreciation, but we haven't seen a degradation in the quality of the underwriting that matches or even looks anything like what you saw 15, 17 years ago.

Now, the difference is where do we go from here? Do home prices keep going up? Certainly they have momentum and home prices certainly exhibit some momentum, but affordability has dropped dramatically, just in the last three months and you were able to get a mortgage in the high twos, say 275, three, four months ago. That same mortgage is now over 4%. Even though it doesn't sound like a big difference, maybe 1, 1.25% difference, the actual difference, and this is what's different now than 2008, is the base where you're coming from, the way I think of it is how much higher is my interest payment compared to what it would've been? If you take a 275 mortgage, or let's just say three to make the math easy, let's say it goes from 3 to 4.5. My interest payment is rising by 50%.

Conversely, when you go back years ago to the bad underwriting, and of course people back then were borrowing irrespective of what rates were because they were purely playing speculation so they were happy to borrow at 6, 7%. It didn't matter if they could turn around and make a flip or whatever the case might be. We're not seeing that level of speculation in this market driven by this shoddy underwriting, but back then, even if rates were to rise 100 basis points back then you're talking the difference between 5 and 6%, which again, on a percentage basis is only 20%. There's a material affordability difference with rates rising from such a low level now and I feel that a lot of the affordability has filtered into home prices that it's easy to see home prices start to revert with the 4% mortgage rate. I don't think that's going to turn into this calamitous credit event because the underwriting was strong. I don't see an '08 event repeating in that respect, but I do see home prices leveling off and even potentially starting to head lower if we maintain these higher levels of interest rates.

Chuck: Eddy, great stuff, always is. Thanks so much for taking the time. I look forward to our next conversation down the line.

Eddy Vataru: Sounds great. Thanks again.

Chuck: That is Eddy Vataru. He is Portfolio Manager for Osterweis Total Return, OSTRX, the ticker symbol, osterweis.com for more information. The Market Call is up next. Christopher Zook from Caz Investments will be here talking stocks when we come back.