Published on January 20, 2023

In his latest webinar, Venk Reddy, CIO of our Sustainable Credit Strategies, explains that the Fed’s battle against inflation is likely to last longer than the market anticipates, which should keep rates higher over the near-to-medium term, creating attractive opportunities for investors seeking income.

Transcript

Paige Uher: Good afternoon everyone and happy new year. Thanks for joining our webinar today. It's entitled Welcome Back, Income. I'm Paige Uher and with me is Osterweis Capital Management's Chief Investment Officer of the Sustainable Credit Strategies, Venk Reddy. Venk and I joined Osterweis in May of last year and we were previously partners of Zeo Capital Advisors.

I am very pleased to introduce Venk Reddy, the portfolio manager of both the Osterweis Short Duration Credit Fund and the Osterweis Sustainable Credit Fund, tickers ZEOIX and ZSRIX. Venk has been managing both funds since their inceptions in 2011 and 2019, respectively. Today he's looking forward to sharing his thoughts on what he believes is a noteworthy paradigm shift in fixed income. Venk, the floor is yours.

Venk Reddy: Thanks Paige, and thanks everybody for joining us. I see a few familiar names in the group, so it's nice to reconnect with some of you and to connect for the first time with others. Today, we're going to talk a little bit about some data that we've been kind of analyzing over here over the last few months that we actually wrote up a little bit a while ago too that paints a picture that I think is worth our listeners hearing. So as risk managers, the way we think about how we manage our portfolios, our job is not necessarily to predict what's going to happen and be on the right side of that move, but more to consider many scenarios and evaluate which scenario that our portfolio and that our client's portfolios are positioned to perform as expected, regardless of what happens. That's our goal, that's the aim.

And when you do that, it's also important to consider what scenarios that we think the market and market participants are not necessarily considering as clearly. And this presentation really is one of those scenarios. It's not a prediction of what's going to happen, but it's something to consider and it's something that really can inform how one might want to position fixed income portfolios in particular for the coming year, the coming two years in a way that might be different than what is generally the conventional wisdom.

And with that, I think I want to start by posing the questions we get from clients and from folks that we talk to quite a bit. The focus very much is on, look, there's no shortage of opinions regarding the economy right now. And the main question is: When is the economic cycle going to turn? And there's a varying viewpoints on that in a matter of months in some opinions maybe it takes a little bit longer on the order of years in others.

But this really breaks down into four sort of core questions I think that we're going to address today. Number one, when will inflation reverse itself? Clearly inflation is one of the words of the year for 2022. When will consumer demand decline in the Fed's fight for inflation? One of the clear expectations is that they're aiming to reduce the demand that's in part pushing prices up. When will unemployment increase, which is another, while not necessarily a stated goal, it's certainly an outcome of Fed policy. And at some point, when will asset prices start appreciating? I think everybody's trying to figure that out, whether it's equity or other asset prices, fixed income. When do we see those start to go back up? So we're going to address each four of these questions over the course of the next hour or so.

And the first one will be when will price inflation reverse itself? And now to get ourselves started, we're going to do a poll to get a feel for the room and to wake everybody up. And so Paige, if we can launch the poll here, the question that I'm trying to get a feel for from you folks is when things get better on the inflation front, when affordability gets better, where is the biggest impact going to come from? Is it going to come from prices actually coming down? Is it going to come from consumer paychecks going up, or is it going to come because asset values start to recover and so there's another source of wealth for affordability for people to be able to purchase what they need to purchase? Paige, I don't know if we're getting results in, if we are we can...

Paige Uher: We are, I'm going to give it a few more seconds. I think everybody who is going to participate, I see them slowing down, so I will go ahead and post the results.

Venk Reddy: All right, so over half are expecting prices to come down and then folks expecting asset values to go up. So the good news is the bulk of this presentation is going to address those specific potential outcomes. The bad news potentially is that as far as we can tell in the data, consumer prices don't actually come down. So what you're looking at on the screen here is... So I'm going to quickly give you a point where you're looking at CPI as an indicator of prices. It's not the perfect indicator, but it's sufficient given that it's a major indicator of inflation. We're doing looking at CPI x Food and Energy and we're looking at the month-over-month numbers. So the idea is in a given month, prices go up and then the next month they might go up more. So there's not year-over-year, this is month-over-month.

And the reason that I bring this up is if you look back even in the '70s, even in the highest inflation era that we've seen in the last many decades, prices never really went down. Prices were negative seven times in any given month in 65 years and only twice have they gone down in two consecutive months or more. The one time they went down three consecutive months was 2020 when stores closed. And if you look at actually when prices got back to the level they were before they declined, that's what the high watermark column is here on this screen, you'll note that the longest period of time was 2010. That took about five to six months, but that was one month of a 10 basis point decline and then five months of zero, right? And so in all other cases, prices recovered back to their pre-decline highs. The CPI x Food and Energy recovered back to its pre-decline high in a really short timeframe.

So the short answer is, unfortunately prices don't come back down and that has material implications. It's the reason that the Fed is not talking about deflation, they're talking about disinflation or lower inflation targets, they're trying to get inflation back to going up 2% every year, not getting the prices to actually decline. Now there's going to be some areas in which prices do decline, others in where they go up. But as a whole, as a core affordability measure, we shouldn't expect prices to actually come down.

One of the challenges with this is that currently the personal savings rate in the United States, so savings as a percentage of disposable personal income, is less than a third of what it was the last time we saw inflation around the levels that we see now. That's neither here nor there. We've had some fiscal stimulus in the marketplace over the last couple years, but the point of it is that there isn't as much of a cushion for folks that are feeling the strain of affordability to reach into in order to offset these higher prices. And so if you don't have the money in the bank to offset the higher prices, you need to get paid more.

And so what we are seeing actually also, and in part this is because of a labor market imbalance that we're going to discuss for a decent chunk of this presentation, but what we're seeing is there's also just a wage inflation pressure coming from inflation and lower savings rates. And the data you see on the screen here is from October. This is actually the year-over-year median wage growth as reported by ADP. And what we're seeing is that wage increases are actually spiking here, and this is October, but the most recent numbers are just over 7% year-over-year wage growth for the most recent period. But what's interesting is this is for people staying in their jobs. So someone staying in their job on average is seeing wage growth go up 7%. For people who are changing jobs, who are getting new jobs, that wage growth is 15%. They're getting paid over 15% more currently than they were a year ago as far as wage growth is concerned.

And so that is a meaningful takeaway when we hear the Fed talk about rates and inflation, right? I think we have to understand that in the '70s there was talk of a wage inflation spiral, right? Wages go up and it causes demand and then inflation goes up and it causes wages to go up and you end up in this infinite loop. And that's something that I think the Fed is watching very, very carefully because they understand that inflation does not go down, prices don't go down, and wages are going up, and there's a labor market imbalance in part that addresses that. But what the Fed needs to figure out how to do is reduce consumer demand in order to mitigate the inflation pressures.

However, this environment gives the Fed lots of support for a hawkish rate environment, hawkish rate policy. The problem also, by the way, as a side note, as I mentioned in the comment here, wage growth is just as sticky as consumer prices. So the challenge for employers and companies if they raise wages to offset some of the inflation pressures on their employees is they don't get to take them back down. Even in 2009, 2010 right after the Great Recession, we saw wage growth of around 2%. And notably, that's where the Fed's inflation target has been. So in all of this period here that we're looking at, some 25 years, we've seen wage growth that's exceeded the inflation target of the Fed and exceeded inflation by a substantial amount. So there's some argument for ongoing inflation being a catch-up.

And that's something that I think we need to really understand because the next question we're trying to address is, okay, well fine, Fed's raising rates, prices aren't going to necessarily come back down, but the Fed's trying to also reduce consumer demand in order to reduce the pressure of prices going up at a rate that they feel is unsustainable and that runs the risk of this wage inflation spiral.

And so with that, you're going to notice a pattern on each of these, we're going to ask a poll to drive us into the next section. And in this case, what we're going to ask you is: When you think of yourself or if you're an advisor, your clients, is anybody cutting back on spending at the moment? The Fed is raising rates? We're supposed to be reducing consumer demand, you're reading the headlines. I'm going to argue that the holiday period this year didn't necessarily make the case for it. But what I'm curious about is from our audience who's seeing spending cuts, maybe there's a little bit, maybe it's like I'm traveling like crazy, but I'm cutting back on other stuff. Or maybe you have clients that are really feeling the pain and are having to make some hard choices.

So I think the disproportionate percentage of the folks here are really on the no, or maybe a little bit, but not as much as maybe the Fed wants to see in order to feel comfortable that they're cutting demand. And so what we're going to go through here is a little bit of some data. The next two sections are where we're going to start talking about the labor market. And this next section is a little bit of a setup for what's going to come next. But let me get the right window focused here.

So when we start thinking about consumer demand, we really do have to talk about what we were just talking about, which is wage inflation employment. I mean at the end of the day, it's do people have the money they need to spend? I mean, we can use economic terms as much as we want, but really at the end of the day, consumer demand is about people having the money to buy the stuff that they want on a discretionary basis or need on an essentials basis. And, to some extent, that also informs what the Fed can do. And so at the moment we have an unemployment rate of about 3.7% at the top level for overall economy. And that is very, very low and it has been declining obviously since the pandemic because the pandemic, the unemployment rate spiked as you can see on the screen.

But what's also notable, and this is really the point of this particular chart, is productivity and unemployment tend to be pretty correlated, right? Productivity is typically measured as productivity or GDP per hours worked. And so you can think of it as, for best lack of better choice words, as a per-head productivity measure. As unemployment comes down, as more and more people get employed, productivity in our economy declines. You don't get the same return on dollar with lower and lower unemployment as you do if you're going from let's say whatever it is, 10% to 6%.

The point of this is to say that the impact of a Fed policy that increases unemployment is not as painful at a 3.7% unemployment rate as it would be at a 5% unemployment rate because the impact, when I say painful, I should really qualify impact on GDP, right? It surely is painful to the folks that lose their jobs. And I think the Fed is very, very keenly aware, Jay Powell is extremely aware of his full employment mandate and the fact that the Fed's mandate does not come from Wall Street, but it comes from Congress, the American people. And so I think they generally loath to intentionally cost people their jobs. But at the end of the day, to the extent that it is a natural outcome of monetary policy, it's not as impactful on the economy at where we are now to where the Fed thinks we're going to go of around 4.7% as it would be otherwise, which gives the Fed a little bit of room to run on making the tough decisions to maintain a more hawkish monetary policy.

The other issue the Fed is facing, and this is something that they have talked about quite a bit over the last few meetings, and Jay Powell has brought up in his last couple of press conferences, is the job openings in our economy are very high. Actually, we have more job openings now than we've had in a while. I'm going to show you that in a second. And meanwhile, labor force participation is low. And so there's a lot of talk about the fact these can reconcile, right? The Fed is hopeful, I think to some extent, or could be hopeful that if folks are feeling enough pain, they'll come back to the labor force, the participation will go up. Meanwhile, job openings will come in. These two things can converge and the Fed can continue to be aggressive until these things converge. As long as they converge, someone who needs income or who needs more income or who needs to have the ability to negotiate a higher salary is benefited when there is more demand for workers than there is supply.

I want to quickly caveat here. When you look at the participation percentage change numbers in this whole presentation, and this is a good one to point out, we're always doing it relative to where it was at the beginning of the chart. So typically labor force participation in our economy is around 60, low 60 percentage, the 62, 63%. And so whatever the number was in that general area in fourth quarter of 2018, this is showing that participation has dropped since that point. So we always normalize it so that's just something to be aware of.

Now, the reason I mentioned the job openings is because as you can see here, the dark blue line on the screen is the job openings. So this has been since 2000. It is not a surprise, given the labor market imbalance, that there are a disproportionately high number of job openings. What is a bit of a surprise and what really kind of woke us up to something else going on here is that it is not proportionate with the rate of people quitting. Obviously we're going to see in a tight labor market that not many people are getting laid off so that's not a surprise necessarily. But separations as a whole and hiring as a whole, the job openings is disproportionate historically relative to those other measures.

And so something else felt like it was going on, there might be more to this story. So to wrap up our conversation about consumer demand, I think the challenge that the Fed is facing is as long as you have more demand than supply in your labor markets, as long as you have the wage inflation, as long as you have these upward pressures on goods and services, it's going to be very difficult to hurt consumer demand, because affordability is not as at risk in the medium term, in the short and medium term, I think as many people think.

And so the question then becomes, okay, well what can make affordability more at risk? What can actually result in less demand? And to some extent it's people losing their jobs. So the next question that we have to ask ourselves if we're really trying to think in Fed policy terms, is when will the unemployment rate increase, right? So we've talked about the fact that prices don't necessarily go down, we've talked about the fact that a labor market imbalance is going to make it difficult to reduce consumer demand. And so now we're kind of thinking about how we get that labor market back inline. When does unemployment increase? How does unemployment come back to a higher level?

So I'm going to survey the group again and ask you what you think unemployment's going to be over the next few years. And so just to give you some context, unemployment hasn't been less than 3% since the early 1950s. We are currently in this three to 4% range. The Fed is currently projecting 4.7, which is that next tier up. The long-term average for unemployment in our country since 1948 is in the five to six range. And then when we are in a recession, or crisis in our economy, that's when we peak over six. It's typically not over six unless we're in that type of a situation.

So with that, that gives you some context of where these ranges came from, especially given that the long-term average is in the five to six range. And what do we have here, Paige? So I think most folks agree with the Fed that it's going to be a little bit higher at the 4.7, some folks thinking it's about the same, and then there's a decent amount expecting something that's a little more dire or that goes back to a long-term average.

Long-term averages are interesting, right? Because if we actually move forward here, let's see if I can get this to pull forward. We're going back to labor force participation. And what you can see over the course of 52 years is if you look at longer term periods of time, we're so focused on looking at since pandemic or since 2008, if you look at longer term periods of time, what you'll notice is labor force participation has been declining since basically like early 1990s. And this is well before the recent decline from the pandemic; this is well before we've seen this decline that you see at the tail end of this particular chart. It's a long-term secular trend that doesn't really have much to do with the current economic cycle.

And so that posed an interesting point. So we're going to dive into this period here that's highlighted in blue. So we're going to dive into the period roughly since the peak. The peak really was a little bit later, but roughly since the peak of labor force participation. And we're going to look at this and we're going to break it out by demographics. And so this is what we find interesting. What I find interesting is that somewhere around the late '90s, early 2000s, labor force participation has been pretty flat-ish for most of the age demographics, right? 35 to 44 declined a little bit over time, but the stark change was that 16 to 24, workers ages 16 to 24 in the economy, their participation in labor force dropped substantially, and workers aged 55+, their participation in labor force increased substantially, almost proportionally. So not quite, there were more 16 to 24s declined than there was 55+ increases.

Now, part of this could be a function of sort of the acceptance of younger workers in the workplace. There are a lot of generational items that are impacting these numbers, but I think the biggest issue here is that the baby boomers turned 55, the oldest of the baby boomers turned 55 in 2001. And so what we're seeing here really is a material shift in our labor market. And that material shift really started in the '70s when the baby boomers came of age. But the material shift of participation in our labor force is a major increase in 55+ participation and a drop in the 16 to 24 demographic.

The reason this is interesting is because of something Jay Powell has said... Well, it's interesting because this chart, honestly, I kind of expected something to show that the baby boomers had increased their share of the labor market, I did not expect it to look this stark. But Jay Powell in his last two press conferences commented on labor force participation and highlighted that what we're actually seeing, and these numbers are since pandemic, you'll notice that every demographic is basically unchanged or slightly up actually in participation rates since pre-pandemic levels except for 55+.

So what people think is, if we go back to thinking about labor force participation as a way to offset this supply/demand issue in the labor force, I think the thing that's going to get in the way of that argument is retirements. If folks are retiring, here's what happens, right? Someone retires, technically they're leaving the labor force, but they're not coming back unless they truly end up in an economically difficult situation. So they leave the labor force. But then on top of that, that 55+ employee gets paid a lot more than a 20-year-old. So let's say the $2 that are getting paid to the 55+ employee actually now goes to hiring two $1 employees in a younger demographic. And so those $2, they're still dollars being used for demand, it's just they're split up into a couple more folks.

The employment rate, you run the risk and the employment rate stays low for a much longer time because now we're employing a group that's been historically underemployed as another group finds themselves out of the labor market due to retirements. But this isn't like a job loss, right? When someone retires, they're actually spending money. They're actually just spending a different kind of money, right? It might be spending savings or retirement.

 

Venk Reddy: That's something that I think is rather important to consider, that we might be in a situation where unemployment is... it may increase a little bit. It's certainly at risk of increasing some, the Fed's expecting it to increase. But the level of unemployment increase we need to see to see consumer demand come down, to see inflation come down, it may just not be in the cards with what might be a demographic shift, as opposed to a short-term economic hiccup with respect to the labor markets. That brings us to the question I think a lot of investors are asking, especially if we are looking at our 401(k)s and our retirement accounts for 2022, is when are things going to start going back up?

With that, we have I think another, one last poll for you all, which is: What proportion of investors of you, of your clients, do you expect, and really for those who are advisors, I'd be curious what you think about your clients, do you expect to become net sellers of their stock or bond portfolios in the next 10 years? Because that's a headwind, right? We might be in a situation where just like last year we had quite a number of folks that were sellers of portfolios, at least tactically, or for tax law harvesting reasons. So, what do we expect to happen over the next 10 years? Paige, do we have results on this one?

That's pretty even. I'm going to guess that that's probably pretty even for demographic reasons, as much as it is for anything else. But it looks like folks are, there's some folks that are in it to win it and staying in their investment portfolios and that there are other folks that are going to, for one reason or another, whether it's to raise cash for supporting retirement or to be tactical as well, are looking to make a sale, so that that's pretty even. I think what's interesting is, I'm not sure, I was just talking about seeing what the next 10 years is going to look like, but I think we want to look at the last 40 years first. I think what's really important to recognize, and this really dovetails with the retirement of the baby boomer generation, what we're facing, what we just faced, I should say, is a 40-year tailwind for price appreciation and capital gains in the marketplace.

I think everybody on this call has seen some version of this data that's on the screen, interest rates coming straight down after the '70s, which gave tailwinds to fixed income markets and equity markets going effectively straight up, with a few hiccups here and there. So, I think the reason this is important to pay attention to is it's not just that's how the markets were, there are actual structural reasons why these charts look the way they do, and we're going to go through a bit of a timeline for those. Starting with in 1974, the Fed set Reg T margin at 50%. It's not that there was no margin before, it just moved around a lot. If I've learned one thing in my career, at least, it's uncertainty leads to inaction, and so investors probably weren't as eager to use margin when it could be 75% one year and 25% another.

At the end of the day, the Fed fixed it at 50% and that gave the market some certainty. We're going to talk a little bit more about the leverage effect in the marketplace next. But let's go through the timeline a bit first. In 1975, Vanguard was founded. To me, that's really significant, because Vanguard presented the notion of investible indices. I've always been of the belief that if you're going to benchmark to an index, it needs to be investible, that you need to have an alternative, and that alternative should be something that you can actually invest in. And so, Vanguard brought investible indices to the marketplace, which made benchmarking a lot more practical. In 1980, the 401(k) rules went into effect so the Revenue Act of '78 went into effect in 1980, which basically created 401(k)s. It started this long-term secular shift from defined benefit retirement plans to defined contribution retirement plans.

There's a really important aside on this, which is we don't want to dismiss the psychology of no longer knowing for sure what you're going to get at the end, because that uncertainty creates a lot of anxiety. That uncertainty creates this need to say, "Okay, well, since I don't know what I'm going to get at the end, I need to make sure I make it as big as possible where I take extra risk in my retirement accounts to make sure that it's big enough. Because if I don't, then I don't want to end up with not enough." So, it actually incentivizes the psychology of risk-taking, which, with the tailwinds that we're seeing in the marketplace, maybe worked out. It's sort of a chicken and egg issue, right? In 1984, Morningstar was founded, and what that allowed, that democratized short-term benchmarking, that gave the entire world of individual investors, it made it easier for advisors to actually take what was sort of a market practice of benchmarking over whatever timeframes one wanted to use and really allow you to say, "Okay, how'd I do this month, and how'd I do that month?"

And really look at investment portfolios as short-term benchmarked against indices. All of this is along the backdrop of this range of 1964 to 1982, which is the range demographically of when the baby boomers turned 18. We have a structural change in the marketplace between higher incentive or less anxiety around using leverage, the ability to benchmark and democratize that, invest in benchmarks and democratize short-term comparisons of investment portfolios. The driver of retirements to defined contribution and then the baby boomers coming of age and coming into the workforce, driving this 40-year tailwind on markets that if we're talking about baby boomer retirements, it's going to be no secret that we're talking about the possibility of those tailwinds coming to an end.

Before we get into that, though, I wanted to talk a little bit about leverage, because the other thing that I think is worth pointing out here is that this particular period that we're talking about since the '70s has been a period of higher returns and lower variance in the markets, and I'm using the S&P 500 for this, than it was for the period before the mid-'70s. What you're looking at here is these are rolling returns, so it literally does not matter what month you bought the S&P. For a 10-year period, five-year period, three-year period or one-year period. But on average you are going to make more in the last 46 years than you would've made before, and you're going to do it with less variance. It's less likely, it's still somewhat likely. These numbers aren't tiny, the standard deviation numbers, but it's less likely that you wouldn't be able to meet that return expectation.

The reason this is important, and this is why I'm kind of bringing up leverage here, is in the kind of late '80s, early '90s, there was a lot of financial engineering that was coming into the marketplace. One great example that really hits close to home for me because before I managed a mutual fund, I was in the private LP and the hedge fund world in relative value and sort of leverage-based product is portfolio margining. The way portfolio margining works, right, I think folks are probably familiar with Reg T margining, but I'll explain Reg T margining, it's super simple. If you're long at least, you put up 50% of what you're long and then you need to keep 50% there. If it goes up, then you have more than 50% posted, you can take some cash out, and if it goes down, you need to post more cash in order to make sure that you've got 50% collateral on the value of your investment.

Portfolio margining was different, and it was really designed for long-short portfolios to get better leverage treatment than you would get on Reg T where you are basically, if you're long and you're short, you'd be posting 50% and be posting an additional 50% above and beyond the proceeds of your short. Portfolio margining was meant to make that more efficient. It was meant to say, "Okay, look, if you're long, let's say Apple, and you're short IBM, there's some amount of correlation I can expect between those two things and therefore, I think when one goes up, there's a decent chance the other one's going to go up. So the amount of risk that you have on the page is actually not as much as we think, and so we don't have to post the full amount of value at risk. The actual value at risk is lower.

The reason this works is because the market has started, in that period of time, began to equate volatility with risk. It began to say, "Look, volatility is the same as risk. If you have lower volatility, then you have less risk and therefore you can lever more because you have less at risk." This is not entirely wrong, don't get me wrong, actually. It works in periods where you have low volatility. I think the biggest challenge though is if volatility increases as we've been seeing, then we start running into these situations where the amount of risk embedded in a portfolio actually turns out to be higher than maybe historical volatility has indicated. That's particularly notable, because leverage has been going up in the marketplace quite a bit for the better part of the - call it since 1974.

What we're looking at here, and this data ends in 2017, not because we didn't want to update it, but because the New York Stock Exchange stopped requiring it be reported. But the New York Stock Exchange up until 1917... 2017, sorry, required broker-dealers to report their margin balances. So, what we ended up doing is taking that, we normalized those margin balances to 1960, and we actually adjusted for market performance, right? Because if you have $100 of margin balance and it goes to $120, but the market went up 10%, then the actual amount of leverage only increased by half that, and so we normalized this to 1960. What you can see is, up until about 1974 when the Fed put in Reg T margin, margin balances were roughly, if I'm going to make the assumption, this was not a terrible assumption, that prior to 1974 most portfolios were unlevered, then you can see that right around the time Reg T margin was set at 50%, the average margin balance increased to the point where at least those margin accounts were now two-to-one levered.

Then as we get into the '90s and portfolio margining and this notion of volatility as risk become more and more popular, you can start seeing that the level of leverage in the marketplace increases. This is notable for a couple of reasons. Number one, this works again if you have... You don't have margin calls as long as things are going up, you run into the risk of margin calls if things go down. Then if interest rates stay high, as the Fed is increasing interest rates, the cost of leverage goes up. If your expected returns in a portfolio decline, but your cost of leverage goes up, I mean, the worst scenario is when your cost of leverage is higher than your expected return, then there's no value in the leverage. But what it does certainly say is that higher interest rates make leverage less attractive. One of those tailwinds, right, we're talking about baby boomers retiring as one... Baby boomers coming into the workforce as a tailwind, retiring as a headwind, we're talking about leverage potentially being less attractive as another tailwind.

I don't think we're ever going to see the end of indexing or short-term benchmarking, so those tailwinds probably stick around for a little while. But at the end of the day, I think that we are running into a risk that those factors that drove the last 40 years of price appreciation in the marketplace might actually be coming to an end. Coming back to where we started, we started by asking, "When is this economic cycle going to turn?" It's going to be in the quarter or months, or if you're somewhat bearish, it's going to take a year or two, and I think we're asking the wrong question. I think the question we should be asking is, "When are we going to see the paradigm change?" We have just been in a 40-year paradigm of tailwinds, and we might be going into not a new economic cycle, but a completely new paradigm for the marketplace.

I'm not saying, again, this is not a prediction, not saying this is definitely going to happen, but I do think that it's worth considering, if these scenarios, if these demographic shifts actually are taking place, what does it mean if the labor force imbalance doesn't actually get better just because unemployment goes up a little bit or the like? If we can't bring wage inflation into... If it can only be in check so much and we can't bring prices down, what does that look like? What does that paradigm actually look like? What happens if those tailwinds we've been talking about actually turn into headwinds? Okay, so I'm not being doomsday, I have to apologize. This slide looks so doomsday, but I'm going to explain it and I'm going to tell you why it's not so awful. When I came into the marketplace, and I'm sure a lot of folks probably have heard the same thing, conventional wisdom is that you should expect about a long-term 8% return expectation out of the equity markets.

But what we can see is that... and that was true up until about the mid-'70s. Then from the mid-'70s to now, it's been more, it's 11.4, right, is the numbers through October, that's been the long-term, after the decline for this year. Had the S&P 500 returned just 8% a year since 1975, it would be 75% lower than it is today. I am not saying that the equity market's going to go down 75%. However, what I am saying is, I just saw a report, I think written by J.P. Morgan, that they're expecting an 8% run rate for the equity markets on a forward-looking basis as well from here. I think, though, if we want to think about this over longer terms, if you believe that on a forward-looking basis the equity market is more likely a 5% returning vehicle or a 6%, or an 8%, you pick your number, I don't think the market has to go there right away.

But I do think that we're running the risk that we might be in a medium-term, call it years or even decades, medium- to long-term period where our markets, where our risk markets actually don't go up. They may not go down, but they basically just chop around kind of sideways until they catch up to what would be a reasonable long-term return expectation. This is notable because when I mentioned indexing before, obviously as active managers, not just myself and Marcus and the portfolios that we manage, but as a firm, as Osterweis. As active portfolio managers, we carefully select individual securities, whether it's in our equity portfolios or in our fixed income portfolios. We're carefully selecting risk. That's the way we go about managing portfolios.

To be fair, I think there's been a lot of talk in the marketplace about active management being "dead," but I think it's easy to say that when the markets are going up and to the right. It's easy to say that when the markets are going to bail out. If you buy good, bad, and ugly as a broad market slice, indices are unmanaged risk and so you can't expect risks to be managed in an unmanaged risk index. It's designed. An index is designed to buy everything, not just to buy the good. But when the market's going up and to the right, you can bail out a lot of poor investments in a portfolio as a result.

But if the market doesn't constantly go up, if it's actually going to kind of sit where it is and chop around a bit, unless you are an extremely tactical investor that likes to try to buy low and sell high and take advantage of a sideways market that's chopping around up and down, the reality of it is that we end up in a very different world where you can't count on price appreciation, you can't count on capital gains. I think we got to a place where folks were including an expectation of price appreciation and capital gains in their return expectations in their portfolios on a forward-looking basis. I don't think we can do that. If these scenarios come to pass, look, if we're wrong and this is just an economic cycle and we go into a mild recession and then we come out of it, or the Fed lowers rates or what have you, then everybody wins for the most part.

We end up in a situation where we're getting through '23 and then things recover potentially beyond that, and we have a much more sort of typical economic cycle. But if this scenario plays out, if the baby boomer retirement actually does have the material headwind that we think it might, and if consumer demand is hard to temper and we end up in a very different environment where the Fed is fighting inflation for longer, I think we end up in a world where we need to think about strategies in portfolios whose core objective is not necessarily to capitalize on broad market price appreciation but is a lot more selective. It's not that some stocks aren't going to go up or some bonds aren't going to benefit from that environment, but it's not going to be all of them, and it's going to matter. Security selection's going to matter again.

When it comes to fixed income in particular, if you're not seeing the price appreciation that comes from declining rates, which you might still, but if you're not seeing the price appreciation that comes from declining rates, then income matters, right? Prices right now are a bit unpredictable, and the demographic headwinds I think limit the expectation that you're going to see capital gains kind of bail out a portfolio that doesn't yield. Then we talked about the demographic results, the demographic impact of... and the labor market impact. But I do think we're in this world where if this comes to pass, right, we're going to have higher inflation for longer and higher interest rates for longer. This isn't going to be a rates go up and then they come back down, which is what the market is quite frankly expecting. You see a downward sloping yield curve and there's some expectation that a recession's going to push rates back down.

I actually do think that this Fed is extremely reticent to use the Fed put. I think that it's not just me. I mean, Marcus was just talking about this to me yesterday and the day before. I mean, we talk about this a lot. We think that I don't think the Fed is really going to appreciate... I mean, the Fed really appreciates that the consequences of keeping, lowering rates, and I don't know that if the market is betting on a Fed put, I think that's probably a bit of a mistake. I think more likely what we should be expecting is that the Fed is going to maintain their hawkish stance.

I don't think that the Fed wants to get as hawkish as some folks think, because I do think that they take... Like I said, I think they take their full employment mandate very, very seriously. I mean, I'm not in the camp of folks that believe the Fed kept rates too low for too long because they didn't know what they were doing. I think more likely they kept rates low for longer because Chair Powell, if you go back and look through all of his press conferences, he's very explicitly focused on minority unemployment, and it wasn't coming into check post-pandemic as quickly as the broader market unemployment numbers. I don't think the Fed is eager to put people out of work unless they absolutely have to, so I don't think they're going to be overly aggressive, but I do think that they're not thinking about a pivot here. I think anybody who's betting on that, you run the risk of being disappointed.

I'm going through these bullet points. I've already talked a little bit about return expectations. I think I've beaten the dead horse about not betting on price appreciation, but really, income matters. I think we're back to a world like the '60s where people invested in fixed income for income, not for income and price appreciation. As long as you can get from point A to point B and have your capital preserved, then the income is what matters, and things are going to move around in the middle. It's not like the markets are immune to mark to markets, but I do think it's important to focus on the current income. But if we are in a world where inflation runs higher and rates stay higher, then there is probably some demand for credit risk in order to have enough of a cushion over that purchasing power to be able to have income that maintains purchasing power in a portfolio.

I mean, at the end of the day, you want to be able to earn more than prices are going up or the same amount in order to maintain purchasing power. I think that's something that that's probably going to require some amount of credit risk. Look, we are corporate credit managers, and our Total Return team has structured products as ways in which they find and take responsible and smart credit exposures. But at the end of the day, you choose your credit risk, but at the end, I think it's going to be important to get that excess return. It can't be indiscriminate, it can't be, because if you do that, then you're introducing more risk. You're inducing default risk if you're choosing a way of getting credit that doesn't differentiate between higher quality credit. When I say higher quality, I don't necessarily mean highly rated, right? Ratings and risk are very different but are actual quality credits versus just buying anything that's in the marketplace.

From our perspective, if we're thinking about how our clients, we're seeing our clients position core fixed income portfolios or using us in their portfolios, it is what we think of as the portfolio for whether it's the next few years, the next decade, it's a combination of income and risk diversification. We're going to conclude with a little bit of a picture of the fixed income market here, which some of you have already seen from me. One, there are two main risks in most core fixed portfolios or most fixed income portfolios. There's duration, there's credit. There's no free money, so our view is, you get expected yield in a fixed income portfolio, you get a lot more if you take both credit and duration, which is that top right corner, that's broad market high yield. You get a lot less if you reduce both risks, in this bottom left quadrant, which is essentially a short duration investment grade.

But in the middle, I think most core fixed income portfolios are taking on duration and keeping their credit ratings at least on the higher end of the spectrum. But the reality of it is, credit's not good risk or bad risk. Duration's not good risk or bad risk. They're different risks, and if you can diversify a fixed income portfolio across these two risks, then you end up in a situation where no one risk can overwhelm the portfolio, but they should give you comparable expected returns, comparable outcome expectations by choosing one or the other. Shorten duration and accept some credit risk or lengthen duration and reduce some of that credit risk. What we'll see is, when we do the analysis across all taxable bond managers, nearly half of all funds that are available are in this, what would be the traditional kind of Agg-type core fixed income portfolio.

The world of shorter duration credit is materially underrepresented, both in what's available as well as in portfolios. But again, if you can diversify a little bit... I would never advocate that someone put all of their core fixed portfolio into this top left quadrant. But if you can diversify the risks so that you have a situation where, look, if rates do come down, if a different scenario plays out and the Fed does lower rates, those duration portfolios are going to perform well. If not, if you need the income, then the shorter duration credit portfolio, I believe, gets you more consistently toward that objective.

The two together should present a portfolio that, in our view, is more likely to be a portfolio that will deliver as expected regardless of what happens. That is a portfolio that may not be the best performing thing in the year and it's not going to be the worst performing thing in the year. It's going to allow you to focus a lot more on other areas of your client's portfolios or your own portfolios that are very deserving of attention, especially if there's growth still in the objectives of those portfolios over the course of the next handful of years and decades.

We're going to go right into Q&A. Somehow, I've managed to use up the full hour. I don't think anybody will be surprised by that. But I'm going to go ahead and answer the one question, the one more question that we have in the Q&A that I haven't addressed, which is the question about the secular labor force participation rate decrease among young people. The question is, "How much of that decrease among young people is due to changes in secondary education, which is staying longer as goal for joining the labor force?" I think that's a huge piece of it. That's why I think that the increase in participation of the older generation, or the older demographic, it doesn't fully offset the decrease, because I do think a big piece of it is kids staying in school longer.

Quite frankly, I don't know how many folks here on the call have teenagers, but I think fewer of them are actually getting jobs, because that demographic is 16 to 24 and more are going to very expensive summer camps. A big piece of it I think is the continued education of, and in some ways a discouraging in our society of, younger folks working sooner. I don't have a strong opinion about that at this stage, but I do think that a decent chunk of that comes from there. But it also, there's an opportunity as baby boomers retire and as there's more money and jobs open and more money to allocate, to bringing folks into the labor force.

I think that's another argument for wage inflation, because at the end of the day, if an employer needs to hire, and that's the demographic that's most available, they'll pay what they need to pay to get people in to train them. Whether it's good or bad, that shift might reverse itself a little bit or at least reset.

Paige Uher: Thank you all for joining us. If there are any other questions since we are at time, please send those directly to us and we can schedule a follow-up call or get back to you. With that, thank you, Venk. Appreciate your time and all of the work on putting this together, and thank you all for participating.

Venk Reddy: Thanks for joining us, folks.

Opinions expressed are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Nothing contained on this communication constitutes tax, legal, or investment advice. Investors must consult their tax advisor or legal counsel for advice and information concerning their particular situation.

ESG refers to Environmental, Social, and Governance.

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

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

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.

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.

Standard Deviation is a measure of dispersion that represents the degree to which an investment’s returns vary around a mean. The greater the Standard Deviation, the more volatile an investment’s returns were during the period measured. This statistic is calculated using the population standard deviation formula: Standard Deviation = Square root of [(Sum of squared deviations from mean)/(Number of returns in the period measured)] If the return periodicity is less than one year, the standard deviation is multiplied by the square root of the number of periods in one year in order to arrive at an annualized measure.

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A yield curve is a graph that plots bond yields vs. maturities, at a set point in time, assuming the bonds have equal credit quality. In the U.S., the yield curve generally refers to that of Treasuries.

Duration measures the sensitivity of a fixed income security’s price (or the aggregate market value of a portfolio of fixed income securities) to changes in interest rates. Fixed income securities with longer durations generally have more volatile prices than those of comparable quality with shorter durations.

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

Investment grade bonds are those with high and medium credit quality as determined by ratings agencies.

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