DoubleLine Deputy CIO: "The Coronavirus Outbreak Is Way Beyond The Fed's Control"

Submitted by Christoph Gieger of TheMarket.ch, an NZZ publication

Jeffrey Sherman, Deputy Chief Investment Officer at DoubleLine, expects the Federal Reserve to give in to the pressure from Wall Street. He advises investors to keep their emotions in check and shares his best investment ideas in an environment of fear.

The Interview

It's not for the faint-hearted: Due to the global outbreak of the Coronavirus epidemic, the US stock market has lost 12% in one week. International equities have suffered similar losses.  Despite the violent turmoil, investors shouldn't be led by emotions, advises Jeffrey Sherman. "Make sure you are patient. No move is better than a bad move," says the deputy chief investment officer at the renowned investment boutique DoubleLine.

In this in-depth interview, Mr. Sherman explains why markets are primarily driven by fear of the unknown. Despite the flight to high-quality assets, he believes US treasuries are overpriced after the strong rally in recent days. He also spots risks in supposedly safe US investment grade corporate bonds.

According to his view, there are better opportunities in the structured credit markets. He also likes corporate bonds in Latin American countries such as Mexico, Brazil and Peru. If the outlook clears up and fear recedes, he believes commodities are the best place to bet on a rebound.

Mr. Sherman, the US stock market had its worst week since the financial crisis, the yield on ten-year treasuries dropped to a record low. What is your assessment of the situation?

There has been a lot of complacency within the financial markets, especially in the U.S. Now, something exogenous has started to wake them up, and having stretched valuations, people got nervous: Rates have started to move down and the stock market started to fall apart. The whole idea of nothing bad can happen got eroded very quickly. All of a sudden, fear is ramping, and it’s fear of the “known unknown”: We know the coronavirus outbreak is bad, but we don’t know how bad it’s going to get.

What do you think will happen next?

Bull markets are not always dying because of their own demise. Exogenous factors tend to help end them. For instance, think about the tech boom back in the late nineties. People always say that tech stocks just blew up, but an important catalyst was Y2K. It was this idea of something exogenous that panicked people and then fed into a selling frenzy.

But the Nasdaq Composite Index didn’t peak until March 2000.

I’m not saying Y2K crashed the world, but when you have fragility, it's typically these exogenous things that can cause a change in sentiment. Y2K caused people to take a second look at those very stretched valuations and made them skeptical. All of a sudden, they started asking themselves: “Wait, why do I own all this stuff?” I’m not saying, we should panic or this is the end of the bull market. We’ve had other pullbacks before. But the crux of the matter is that valuations have been stretched for a while, we have been building massive debt loads and the fragility is there.

What are the biggest risks with respect to the coronavirus epidemic?

We haven’t seen something like this in a long time. Back in 2003, we had SARS. That virus incubates quickly and you are only contagious when you show symptoms. But when you have a Coronavirus infection, you are contagious without showing symptoms for a long time. That’s what has panicked people. It’s fear more than anything. With treasury yields this low, it’s undeniably a flight to quality.

Yet, other safe haven assets like ten-year government bonds in Germany, Japan and Switzerland didn’t hit record highs last week. Why not?

If I want to hide in cash in Europe right now, I have to pay a negative yield. Here in the U.S, I have at last a chance to make some money: People are buying treasuries because it’s a high-quality asset with a positive yield. Interestingly, many international investors are not even hedging their currency risk at this stage. We believe this is also the reason why there was some resilience in the dollar last year and this year until recently.

What is going on in the credit markets? Do you see any signs of stress?

Down the capital stack, lower quality stuff is being sold. The pressure is significant on the high yield market where stress is coming from anything leisure related: hotels, gaming, and definitely energy. It's a complete sentiment shift: People want to own quality. But for me, it’s hard to want to buy treasuries when the entire yield curve gives me a negative real yield. At DoubleLine, we think inflation will end the year at almost 1.9%. Today, that’s greater than yield on the long bond. If you go out and buy treasuries, you have to think we’re going to have a global pandemic which is going to lead to a global recession. But that’s way too early to tell.

What are the chances of a global recession?

China's contribution to the global economy is four times of what it was during SARS. Also, it’s hard to believe the Chinese data. We just don’t know if people are really getting back to work. Supposedly, Shanghai is almost back to full employment, but we won’t see it until the data comes through for another couple of months. We were recovering from the bad economic data of the summer, and this looks like another wrench in it. That’s why you see German data deteriorating once again, even if the latest PMI headline number went up. So here’s an outlandish idea of what the Coronavirus does: Maybe what you start to see is fiscal stimulus in Europe. The Germans may say: “We don’t have to run a surplus right now; we need to get money in people’s hands”. Maybe this is a catalyst for Europe to start stimulating the economy on the fiscal side, because the ECB cutting rates is not going to solve the problem.

With the financial markets in turmoil, all eyes are on the Central Banks. What are your expectations when it comes to monetary policy?

The market is bullying the Federal Reserve. Absent the Coronavirus outbreak, the Fed would have no reason to cut interest rates. Economic data was improving, the job market is strong, and wage growth is back at 3%. So I feel really bad for Mr. Powell. At the FOMC meeting on March 18th, he was hoping to go out there with bravado, pounding on his chest like King Kong and say: “Man, I saved the economy”. Now, the Fed has another challenge, but this is something way beyond its control. The Coronavirus can’t be fought with interest rates. This is a matter of confidence.

How about the chances of an emergency meeting?

I don’t think they have an emergency meeting to cut interest rates. But they are going to have to look at how fearful the market is. And, if there is still a lot of fear, they will cut interest rates because the market needs it. If it gets worse, the Fed may even give you a 50-basis-point cut. As of now, we’re running a death toll of less than 3000 people globally. That’s very unfortunate, but that doesn't make it a pandemic. So if sentiment changes, bond yields could move up thirty or forty basis points in a month. That’s why we’re worried about duration. Maybe you want to own treasuries against fear. But at this stage, it's hard to really want to buy more.

What is the Fed going to do in terms of its “Not-QE”-program?

We criticize the Fed a lot, but they did what they had to do. They had a problem back in September when the effective Fed Funds Rate was outside of their target range. So they came in quick and heavy. The liquidity facilities have undeniably got the market back in line. But after the Fed’s balance sheet is back up again, they’re not going to rewind it; not in this type of market. Then again, we also have an election coming up and the Fed doesn't want to be perceived as helping President Trump.

We’re heading right into Super Tuesday with no less than fourteen states voting on March 3th. How will the presidential election impact the financial markets?

Both sides are kind of crazy: We got crazy Bernie, and we got crazy Donald. So the Democrat’s plan is to fight crazy with crazy. I don’t think Bernie can get his socialist agenda done, but I don’t know how to read him. Bernie is true to his roots and he has a very big fan club, also here in California. And, his supporters are sticky, like Trump’s people. So it’s very hard to predict what’s going to happen at this stage. The market thinks Bernie is going to win the Democratic nomination, but that he can’t beat Trump - and “can’t” is a very dangerous game. In investing, it’s like thinking “I can't lose”. It’s gambling at that point. Remember, a lot of people couldn’t see Trump winning in 2016, either. It’s way too early to tell and more importantly: You wouldn't want to bet your portfolio on it, either way.

What’s your outlook for the U.S. economy against this backdrop?

A big-time slowdown in China will also hurt the U.S. But if we grow at 1% instead of 2%, that’s not going to kill us. It’s all about the job market and jobless claims where we are still very near the lows of the cycle. Also, you’re talking of a budget expansion of about 4.5% of GDP. That's an eerie number since it’s essentially where nominal GDP came in last year. So this is a financed scheme: All of our growth is coming from the expansion of public sector debt, and I don’t even bring in private sector debt or personal loans like mortgages. Since the financial crisis, the whole economic expansion was fueled on debt. It’s been a completely financed ride. I don’t see that stopping. Trump wants to spend more money, and the Democrats are good at spending as well.

What should investors do in this environment?

Make sure you are patient. No move is better than a bad move. Sure, this correction makes things more attractive, but you don’t have to step in after week one. These are just things you can’t really forecast. For instance, think about what happened with 9/11. That hurt travel for about three years. Heck, we still have to take off our shoes and keep our plastics in there at the airport. So keep watching, reassess the situation and don’t get caught in emotions which is the hardest thing to do. Assume this is going to take longer than you think. If you didn’t chase this latest rally, you’re in a good position. That’s my advice: Just make sure you don’t feel you have to check your portfolio every day. If you have to, you are off-sides.

Where do you want to be extra careful?

Don’t chase the investment grade market. There’s a hidden risk in there called duration. For the U.S. Aggregate Bond Index, the duration is north of eight years. That’s the longest since its inception. What scares me about Corporate America is that we have extended the leverage out very high. Today, leverage ratios in the investment grade space commensurate with a recession: They’re not foretelling of a recession, but today’s leverage levels are typical to what you see in the middle of a recession. Usually earnings have to collapse to get you to these levels. So the leverage continues to get higher, the yields get lower and the quality of the asset compared to the leverage doesn't look as good. Interest coverage is fine, but interest coverage will deteriorate in a recession because earnings go down. So I’m not scared of defaults, I just don’t like the risk-return tradeoff.

Where do you spot better opportunities for investors?

There’s a lot of ways to still bet on the U.S. The securitized credit market is one area where we’re taking those bets. It performed decently last year, but lagged other credit markets. The interesting thing about the securitized market is that the bulk of it has physical assets behind it. Think about solar, wind farms or hydroelectric plants. You can invest in freight, cargo or shipping deals. There’s a lot of stuff out there with physical assets that back the cash flows, the leverage is a lot lower and there is more flexibility if we get some inflation. You can also go into the residential mortgage market: You have people that need to buy, that need to move and there’s physical property behind it.

Where else are good places to invest right now?

Another thing that we look at as a credit play is emerging markets. Here, you want to focus more on corporates because the sovereigns have too much duration. You can take dollar denominated investment grade debt for a commensurate credit risk versus a U.S. company, and you get a yield pickup of hundreds of basis points with less duration. So if you look at EM corporates, you can buy a decent quality investment grade portfolio with attractive yields, and maybe even put 20% of it below investment grade.

On which countries are you focusing on in the emerging markets world?

I would not try to catch a falling knife right now. So I would not be in Hong Kong or in Korea. Looking at companies that have good businesses, you are going to have to buy some commodity producers just because they have been really beaten up. Our EM team feels like Mexico, Brazil and Peru are the places to be right now. They have a little exposure to Eastern Europe, but they are not heavily invested in Eastern Asia.

Based on the Barclays Shiller Cape Sector Index, you’re also managing a fund which invests in stocks. What are the most attractively valued sectors right now?

Since we’ve just rebalanced the fund, I can only name two of the sectors that have been in there for a long time: Tech and communications, and they will continue to be in there for sure. We’re not owning energy. Even though energy is cheap, the momentum is horrible. I think the U.S. needs to wake up to the idea that it is the new swing producer. Despite all these OPEC output cuts, the U.S. still sets new records in terms of production. We need to learn to dial the spigot back a little bit, but these E&P companies are levered and have problems. So you can easily see crude going down to $40 which will cause even more trouble for these companies.

And how about commodities in general?

It’s hard to be in the commodity space today. But fear can subside or erase too - and that would be a good time to look at commodities again. If there is a place that should see the rebound it is commodities. We also like them for the anti-dollar play, but we have to get through this global turmoil right now. I want to see some stabilization globally to be more constructive. What’s more, you should own precious metals for a “what if”-scenario. But I’m not a buyer of gold here. Unless the world is going to get more dire, I wouldn’t add to gold at this point.