July 11 Webinar Replay - Osterweis Strategic Income Fund Q2 Update

Shawn Eubanks: Good morning everyone. My name is Shawn Eubanks and I'm the Director of Business Development at Osterweis Capital Management. We'd like to welcome you to our second quarter update for the Osterweis Strategic Income Fund. As usual, I'll moderate a panel discussion with Carl Kaufman, Craig Manchuck, Brad Kane, and John Sheehan.

Good morning, Carl, Craig, Brad, and John. It's great to be with you today. Carl, I'll start with you. In the team's most recent outlook, you wrote that you expect the current economic conditions to persist for at least a few more months. Can you explain why and what you're seeing that makes you think the next quarter will look a lot like the past quarter?

Carl Kaufman: Thank you, Shawn, and thank you everybody for joining. In our latest outlook we drew our inspiration from the Otis Redding classic "Sittin' on the Dock of the Bay." It's been quite a boring market this year for bond investors because really, we're all just sitting around waiting for something to happen, but the theme of the song is patience, and sometimes the best thing to do is just to sit back and wait, especially when there's nothing happening, don't force it. For us, it's starting to feel like the economy is just grinding forward. Not much has changed. It is slowing a bit at the margin. And to be clear, we're not complaining, but we are a little surprised that it's taking so long for something to happen.

Everybody knows that the point of the Fed's tightening program is to contain inflation, but the causality is somewhat indirect given the tools that they have to work with. Higher rates are supposed to slow the economy, putting downward pressure on all kinds of prices, especially financial assets. That hasn't happened as the S&P keeps making new highs quarter after quarter since about the beginning of '23, the economy just hums along and risk assets have mostly delivered positive returns. As we look at the current economic conditions, it seems like we can expect more of the same. We're always on the lookout for recency bias, but I just see no reason to change that outlook at this point.

Shawn Eubanks: Thanks, Carl. So you're saying two things. The Fed tightening program is working slower than expected, and second, you think the current status quo isn't going to change anytime soon. Is that correct?

Carl Kaufman: That's correct, but they are related. In fact, the reason we don't think things are going to change is precisely because inflation, while coming down a bit, remains stubborn. Clearly it's moderating. And you saw the CPI today was a 10th better than expected. But as economist Jim Bianco pointed out, that low inflation readings have as much to do with what happened a year ago as they do today. And a year ago we had easing inflation, which means that in the next few months there is the possibility that we could see higher year-over-year inflation numbers. It's just math. But given that the Fed continues to say they're relying on the data, we think it could reduce the likelihood of near term rate cuts. Although people seem to be coalescing around September now, they've been coalescing around a different month for the last year and a half. We'll see if they're right this time.

In either case, the yield curve should remain mostly static for the next few months at least. At the same time, the labor market is still fairly healthy even though unemployment has ticked up a little bit. But it's been assisted by very stimulative federal legislation and continues to keep the economy moving, driving up financial asset prices. We don't see any imminent structural changes and expect the current dynamic to persist until it doesn't, and then we'll be ready.

Shawn Eubanks: Thanks, Carl. It sounds like kind of a good news, bad news situation. The economy's still healthy, but inflation refuses to go away. John, another point the team makes in the outlook is that the Fed is doing more than just raising short-term rates. They've also been reducing liquidity in the system to help tame inflation. Can you explain what's happening there?

John Sheehan: Sure, Shawn. So post the Covid lockdowns, the Fed used two primary tools to support the economy. First, they took their policy rate to zero, but that is really just in the very front end of the curve. It's an overnight rate. So they wanted to get longer term interest rates lower still. So they went out into the open market and purchased bonds. That's what quantitative easing is called. So the corollary to both of those is they've raised the policy rate up to the five and a quarter, five and a half range, where we've sat for a longer than usual period. And then, the corollary to quantitative easing is quantitative tightening, where they're letting the portfolio of Treasuries and mortgages mature, and that drains liquidity from the system. As the bonds mature, the Treasury pays off the bonds, and the Fed takes the cash out of the marketplace versus the maturing bonds that they have.

Shawn Eubanks: John, why do we think inflation's been so stubborn, given how much the Fed has been doing?

John Sheehan: It's a great question and very actively debated. First, the magnitude of the support from the Fed was unlike anything we've seen before. So I think there's just a natural process of that tremendous amount of liquidity working its way through the system, but there are forces at play that are counteracting some of what the Fed is trying to accomplish. Carl alluded to it, but first and foremost, the federal government has been spending money, which has been very stimulative to the economy. And then, in terms of quantitative tightening, there's a couple of offsetting features within the monetary policy where the Fed initiated a reverse repo program, which allows money market funds to place cash with the Fed at an attractive rate.

And then also, because the Treasury has been running at such a significant deficit, they've been funding a lot of that deficit with T-bills. So the TGA, which you can see here in the slide, that's the Treasury General Account. So if you think about it, that's the checking account of the U.S. Treasury that's held at the Fed. So pretty much those two, the TGA and the reverse repo facility have almost completely offset the roll-off through quantitative tightening.

Shawn Eubanks: Thanks, John. That's a really interesting analysis. I haven't seen it anywhere else. Brad, given that we're expecting the status quo to continue a little longer, would you mind updating us on the portfolio positioning?

Brad Kane: Sure, sure. Well, as Carl mentioned CPI came in today a little better than expected, and it was clearly a sign that we've seen over the last couple of months that potentially the economy is slowing, but we're not expecting the economic conditions to change dramatically. It is going to be a slow grind, and so we're not really making much changes to the portfolio. In this market, especially with the economic stats coming down a little slower. And it looks like the Fed may want to cut sometime this year, which is what people are now estimating. We've seen risk assets rally, and so you've seen bond yields decline, spreads have gotten tighter. They're getting much less attractive when you move out on the maturity spectrum. So the payoff for extending maturity and moving down in the credit quality is not something we want to be doing right now.

As we've been talking about for quite a few quarters now, the inverted yield curve has really been our friend and we've been leaning hard into it. We're keeping the portfolio on the shorter end and getting paid. Historically, we weren't getting paid on cash and then post the Fed raising rates, we're now getting paid to actually hold larger amounts of cash or short-term bonds in our portfolio. And for us, this is a defensive way that's becoming more an offensive way of playing the market and staying out of the longer maturities with lower yields. So again, we're leaning into the yield curve, we're keeping the portfolio shorter, and higher cash balances, and getting ready for the times when there will be better yields in the market, and then we'll put some to work at longer maturities.

Shawn Eubanks: Thanks, Brad. Craig, can you talk about what's happening in the new issuance market? It sounds like you're not being super active now, but it'd be interesting to hear what's happening out there anyway.

Craig Manchuck: Sure, Shawn. Thanks. New issue market has been reasonably active. It's not anywhere near what we saw back in 2021. Year-to-date activity has brought in about $172 million, excuse me, $172 billion of deal activity. A lot of that has been refinancing. If you compare that to the full year, 2021, of $512 billion when the market was very active, you can see we're running quite a bit behind that. However, '22 and '23 we're $117 and $194 billion, so we're slightly ahead of that pace from last year, but nothing crazy. 60% of that has come from financials, consumer discretionary, or energy. Those are really been the most active areas. Not a lot of new deals coming, not too many first time issuers, a few here and there, but we just haven't found a lot of value there. The most interesting thing I think that we've seen that's been going on in the market has been an increased frequency of liability management exercises, something that people should be paying attention to as you're reading in the media and the press.

That just means that lawyers and bankruptcy advisors are jumping in and trying to get things started earlier on companies that are sort of feeling a little bit of stress and distress, and that's something that we've got our eyes on very closely in an area where we've been fortunate to avoid so we don't have to get involved in any of those things, because historically there have been some coercive exchanges that caused debtholders to have to exchange their par debt at some sort of a discount. But that's been a fairly new phenomenon and probably one of the more active areas in the market out there for creating new securities. We'd just like to stay away from that part of the world, because those are typically more troubled companies and they take a lot of time.

Shawn Eubanks: Thanks, Craig. Carl, any final thoughts before we open it up to Q&A?

Carl Kaufman: Yes. I just want to thank Otis Redding for doing such a great job summarizing our views on both the economy and our portfolio positioning. Who knew he was such an astute financial observer? As always, we're going to keep taking what the market is offering and do our best not to stretch for yield or quality. And with that, I guess we'll turn it back to you for Q&A.

Shawn Eubanks: Thanks, Carl. Before we open up the floor to Q&A, here's the fund performance slide and we'll follow it up with some key portfolio statistics for the Osterweis Strategic Income Fund. Our first question was sent in before the webinar and it's about the presidential race, the election's coming up very soon, and one topic that hasn't gotten a lot of focus is that the Republican candidate is threatening to assess a 10% tariff on all imports. Can you comment on what you think the implications would be?

Carl Kaufman: Sure, I'll take that. Clearly someone's got to pay for those tariffs. A lot of sectors in China are not doing really well right now, so their ability to absorb that is probably weaker than it was the last time he imposed tariffs. So it's probably going to be inflationary, prices are going up and we'll have to see if he follows through on it, whether it's across the board or whether he has a change of mind. It's hard to say. He has to get elected first. We tend not to try to speculate or make bets as to outcomes that are in the future. We wait for them to happen and then make an assessment. But as I say, it seems to have downside risk as well as possibly upside risk if we get more on-shoring. But so far, it seems that some of these countries that we don't like to trade with have found workarounds to get things here without tariffs. So I assume that would continue.

Shawn Eubanks: Hey, John, we have a question about the slides that you went through a little bit earlier. Can you break those down a little bit more please? The TGA offsetting the quantitative tightening.

John Sheehan: Sure. What we were focused on there is an explanation as to why inflation has been as sticky as it has been, and then why the Fed using their typical tools to restrict liquidity into the financial markets, why hasn't that hit risk assets a little bit more? So the first slide is really just an explanation of how a lot of the quantitative tightening has been offset. And then, the second slide, which I didn't discuss, this is the money supply. And if you roll the clock back far enough, before we had a Fed that was very transparent and held press conferences and told us exactly what they were doing, the money supply was very closely watched and something that was looked at to determine the level of liquidity in the system and what the monetary policy of the Fed was.

So we thought it was interesting that despite higher rates, despite the fact that they've been undertaking quantitative tightening, the money supply really has not contracted at all. So there's a very high correlation if you look at S&P versus money supply, it's very highly correlated. So both of these slides are just trying to peel back a little bit of some of the counterbalances to the policies from the Fed and probably why inflation is taking longer to reprice and why some of the risk assets are sitting here at all-time highs.

Shawn Eubanks: Thanks, John. So while we're waiting for any additional questions to queue up, we have one here. Is there any limit to how long quantitative tightening can be offset by fiscal mechanisms? I would think it would eventually lead to increasing yields.

Carl Kaufman: That is theoretically correct as the textbook would tell you. However, we see how much debt, governments like Japan have put on relative to GDP, and they haven't affected yields. Of course, they have different demographics than we do, but I would hope that at some point our government faces the fact that we shouldn't be adding these tens of trillions of dollars of debt on the balance sheet and expect no consequences. So clearly, as you point out, the big consequence is crowding out, which I've been reading about for 40 years hasn't happened yet, but it could.

Shawn Eubanks: Thanks. That was our last question, Carl or anyone on the team, any final comments?

Carl Kaufman: No, I'd say hopefully we're in for a little more fun in the second half than we've had in the first half. It's been great. Making new highs is always fun, but as you know, we all live for corrections, so we can buy really cheap bonds. Whether we get that or not, we'll just have to wait and see. In the meanwhile, we'll just let our feet dangle on the dock. Thank you very much for calling in everybody, and thank you for your support.

Shawn Eubanks: Thanks everyone.