Listen to Eddy’s interview on the “Money Life with Chuck Jaffe” podcast to hear his thoughts on inflation in the current market environment and how it’s different from the financial crisis a decade ago.

Transcript

Check Jaffe: Welcome to the Big Interview on today's show. I'm very pleased to be joined right now by Eddy Vataru. He is portfolio manager for the Osterweis Total Return Fund, ticker symbol O-S-T-R-X. You can learn more about him, the firm, and the fund at osterweis.com. Eddy Vataru, great to have you back on Money Life.

Eddy Vataru: Thanks for having me.

Check Jaffe: I'm really interested to chat with you because, well, I look at your commentaries among a bunch that I'm always looking at, but it was only 10 or so days ago, when you were considering whether or not to say, "This time it's different." Where you were looking at inflation and saying, "This doesn't look the same." Now, we're going to get to why you felt that way, but let's bring current events in, what's happened in 10 days. Well, on Wednesday of this week, the Federal Reserve came out and talked about inflation. So having written the piece, and having now seen the Fed, are you more or less convinced that inflation right now is maybe different than what we've seen for most of us in our lifetimes?

Eddy Vataru: That's a great question. I was actually pretty happy to see the Fed acknowledge that this time might be different. Maybe they read my piece. I don't think so, but who knows maybe they did. I'd like to think that they did, so I'll go with that. But the reality is, is the Fed is operating on a playbook that they've used for the last 12 years, or 13 years, since the last financial crisis. Significant monetary stimulus to right the markets. That's what they control. It's really the government that controls fiscal stimulus, but they obviously have a rooting interest in having some collaboration there. The Fed has been pretty vocal in this pandemic episode in terms of trying to get that from Congress. Which I think, Congress has been certainly more forthcoming and more interested in doing that than in the prior QE, but without going too much into that, the drivers of how we got here, and why I think this might be different. And why I think the Fed might've taken a little bit of notice it's just early days.

But you look at the drivers of the financial crisis and they were pretty profound. You had a major banking crisis. You had millions and millions of loans that were made, I would say without proper judgment, to put kindly. If you surveyed the landscape in 2009, 2010 of investors and consumers, they were decimated. Equities tumbled. I mean, S&P was below 700 in 2009. It's amazing to even think that that happened, to see where they are now, but home prices obviously cracked and fell pretty sharply. For many, homes are their largest asset and they own them on a levered basis. They don't own them free and clear. When you start printing money as the Fed did, to expect that that would generate this huge round of investment that's required to kind of, organic investment, in the economy that's required to get the economy back on its feet, the reality is we still had to lick our wounds and we did it for years.

We had to based on all of the bad practices and everything that led up to 2008. In my piece, I talked about why it's different this time because the driver of the market collapse in 2020, it was obviously pretty idiosyncratic and completely unpredictable, and the damage it did in the period that it did. I mean, there was literally a nearly a hundred percent shutdown in the economy for days and weeks. And then a very hampered economy for months. The issue is, once that was resolved, and the pharmas having a vaccine and moving forward, in theory, pretty much the entirety of the disruption should have been basically put behind us. I mean, yes, you have businesses that went out of business. You had to have reallocations of labor and whatnot, of course.

I'm not trying to diminish that, especially on a personal basis, but in the aggregate, if you look at markets now, certainly risk markets, all markets. I mean, crypto, alternative investments, collectibles, I mean, everything. Everything seems like it's on the moon. It's very different than 2009 and 2010. Clearly it was a condition that once you had a solution, the recovery could be quick, and we've seen that. I would argue we're still not at a hundred percent recovered because we still have, I'm in California, we only reopened for business literally yesterday in terms of having no mask constraints and whatnot. I mean, it's still not a hundred percent reopened, but I mean, we're pretty darn close. We have the solution in place to be reopened. I don't expect a multi-year draw down with healing balance sheets from banks, and healing balance sheets for consumers and investors.

This is very different. And yet the concoction that the Fed has created is not only the same concoction, it's actually probably three to five times the strength of the concoction that we got over a five to six year period a decade ago. So, I think it is different. We've seen some pretty amazing inflation reads over the last week or so in terms of six plus percent producer prices. Consumer price is obviously well above the two percent target.

We've had this long debate about whether it's transitory or persistent. I think the Fed's starting to realize, "You know what? We can't just say, it's all due to base effects from what happened a year ago when the economy was completely shut down." There is something here that might be a little bit more persistent. I think it's going to take us months to figure out, to see how it plays out, but I'm at least glad that they've made some acknowledgement in their meeting this week that the inflation is something that they needed to really be on top of. I still think they might be a little, might be too little too late. I think it might be a surprise to them, but at least there's some acknowledgement in the fact that it's on their radar at least gives me some encouragement that they're not flying blindly with quantitative easing infinity. That's good.

Check Jaffe: If it's different, and you truly believe it's different, which it sounds like you do, at what point do you start investing differently? Because we know that the market does almost everything in anticipation, but that's the market. The flip side of that is we all know, and I know you're aware, that the market can remain irrational longer than we can remain solvent. At what point do you change what you're doing so that your portfolio, or that you hope your investor's portfolios, reflect the fact that the environment going forward will be very different than the environment of the past?

Eddy Vataru: I think the Fed meeting this week really turns the chapter on that. We've kind of moved into a new era of the progression of the stimulus that we're going through. It's not so foreign now to think about the taper conversations. Maybe you're getting rid of one of the "thinking about thinking abouts" that Powell was famous for saying last year. We turned the page. It's easy for me to say, "Well, the answer to your question is it happened this week with the Fed meeting on Wednesday." But the reality is, is that meeting is just the start. Yes, we've moved on from this era of easing money forever to, if you study the dot plots and all that, it's not like things changed that much. We're still talking about rate hikes years out, maybe creeping into late next year.

There's a whole lot of runway between now and even late next year for the economy to really expand pretty dramatically with all the stimulus in place. I would say the event this week is certainly a chance to reassess that, but we have to stay ahead of that anyway. I mean, we thought the Fed might start to acknowledge it because my thought was, if the Fed did not acknowledge it, I would really have lost faith in the Fed's ability to control things, if and when, to really get away from them.

Check Jaffe: All that being the case, it sounds like on the one hand there's significant change, and on the other hand if I ask you where you're investing, it would be the same investment approach, the underpinning things, but the same areas of investment that have appealed to you for a while are still appealing, yes?

Eddy Vataru: I mean, more or less. My primary focus is investment grade fixed income. Within investment grade fixed income I focus on corporate bonds, mortgages, Treasuries primarily. There hasn't been a ton of change there. I do focus on TIPS, and TIPS have cheapened a lot in the last couple of days as a result of this move. This move has certainly created, I think, some new short-term opportunities and some more volatility in the market that I think will be attractive. But in terms of kind of our overall paradigm, or how we think about the world, I still have this overarching view that inflation is a problem. I prefer to be defensive on taking any interest rate risk. I acknowledge it as the wind blows, we can have markets go up one day and down the next in terms of interest rates.

There's certainly going to be a lot of short term movement as folks recalibrate their expectations, but I don't see anything in terms of what the Fed did this week, other than kind of a tepid acknowledgement that inflation might be a problem, to really change that overall view. For me, mortgage spreads are relatively tight. Corporate spreads are relatively tight. They could stay there. Mortgage spreads have loosened a little bit, but not enough to make them particularly attractive. I mean, the QE that we've seen over the last year has really driven spreads to multi-year lows. Finding opportunities in fixed income right now is challenging. I think the nice thing about the Fed action this week is it kind of shakes things up a little bit, and creates some volatility and some more opportunity, but we're at absolute levels right now that still are not particularly compelling, especially on the interest rate front.

Check Jaffe: Eddy, the time flies by when we get a chance to chat. I wish I had more time because I've got more questions. Instead, I'm going to be relegated to your commentaries until we get you back on the show again. I look forward to the next conversation already, but thanks so much for this one.

Eddy Vataru: Thank you.

Check Jaffe: That's Eddy Vataru. He's portfolio manager for the Osterweis Total Return Fund, the ticker symbol O-S-T-R-X. If you're looking for more information, osterweis.com. Up next on Money Life, Howard Dvorkin from debt.com. We'll be talking about how to avoid debt and properly plan for Amazon Prime days.

The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. The index does not incur expenses, is not available for investment, and includes the reinvestment of dividends.

The Bloomberg Barclays U.S. Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility and financial issuers.

Investment grade includes bonds with high and medium credit quality assigned by a rating agency.

Fed refers to Federal Reserve.

Treasuries (including bonds, notes, and bills) are securities sold by the federal government to consumers and investors to fund its operations. They are all backed by “the full faith and credit of the United States government“ and thus are considered free of default risk.

Treasury Inflation-Protected Security (TIPS) are a type of Treasury security issued by the U.S. government that is indexed to inflation in order to protect investors from a decline in the purchasing power of their money. As inflation rises, TIPS adjust in price to maintain its real value.

Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.

The producer price index (PPI) is a group of indices that calculates and represents the average movement in selling prices from domestic production over time.

Yield is the income return on an investment, such as the interest or dividends received from holding a particular security.

Spread is the difference in yield between a risk-free asset such as a U.S. Treasury bond and another security with the same maturity but of lesser quality.

A basis point is a unit that is equal to 1/100th of 1%.

Mutual fund investing involves risk. Principal loss is possible.

The Osterweis Total Return Fund may invest in fixed income securities which are subject to credit, default, extension, interest rate and prepayment risks. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in in debt securities that are un-rated or rated below investment grade. Lower-rated securities may present an increased possibility of default, price volatility or illiquidity compared to higher-rated securities. Investments in foreign and emerging market securities involve greater volatility and political, economic and currency risks and differences in accounting methods. These risks may increase for emerging markets. Leverage may cause the effect of an increase or decrease in the value of the portfolio securities to be magnified and the fund to be more volatile than if leverage was not used. Investments in preferred securities have an inverse relationship with changes in the prevailing interest rate. Investments in Asset Backed and Mortgage Backed Securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. It may also make investments in derivatives that may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. The Fund may invest in municipal securities which are subject to the risk of default.

Osterweis Capital Management is the adviser to the Osterweis Funds, which are distributed by Quasar Distributors, LLC. [OSTE-20210618-0248]