Perspectives on Investing in Periods of Crisis
Last Updated: June 1, 2020
Ralph Segall, SBH’s Chief Investment Officer, and Nick Foley, Fixed Income senior portfolio manager, share their perspectives on investing in periods of crisis, including many of the time-tested principles we are using to help our clients navigate this challenging environment. They also share their thoughts on the current state of the equity and municipal bond markets and opportunities as we move forward.
[Amy Cramer] Welcome to Segall Bryant & Hamill's podcast, Investing in Periods of Crisis. I'm Amy Cramer, portfolio manager in our Wealth Management group. Given the exceptional degree of economic and social disruption this spring triggered by the outbreak of COVID-19 and reflected in the financial markets, we thought it would be helpful and timely to share insights with you on the current market environment. We'll also touch upon several of the time-tested investment principles we're using today to help clients navigate through this challenging time. With us today is Ralph Segall, one of the firm's founders and chief investment officer here at SBH. Ralph has over four decades of experience investing through many market cycles both in good times as well as difficult ones. We will also be hearing from one of our municipal bond specialists, senior portfolio manager, Nick Foley, who will discuss what he has seen in the municipal bond market in recent months and he'll share his view on the investment opportunities moving forward. Now, I'd like to turn it over to you, Ralph.
[Ralph Segall] Thank you Amy. My name is Ralph Segall and I'm the chief investment officer here at Segall Bryant & Hamill. I'd like to talk to you about how we've been approaching, thinking about investing in this period. What is unusual is the nature of the economic distress. We're contending with a pandemic that has cut off a service economy at its most vulnerable point, the face-to-face contact of a service provider and his or her customer. We've never seen an economic downturn that hit a service economy like this, and that's pretty new for us. What isn't new is that the financial markets have behaved in exactly the way that you would expect if you were expecting a crisis. They've behaved just like a canary in the coal mine signaling distress, massive distress in this case, in both the fixed income markets and the equity markets, not just in the United States but all around the globe.
What we've seen is a huge deal of liquidity provided by fiscal and monetary authorities. In the United States, we've seen three and possibly a fourth one being debated bills to provide aid and assistance and relief. The first one was called the CARES Act and its follow-ons. We've seen the monetary authorities, the Federal Reserve in the United States, providing liquidity, almost seeming to return to activities of quantitative easing. It may seem a little bit paradoxical then for me to say that we've seen, also seen in the financial markets a great deal of illiquidity and the downside which was up until March 23rd, we were seeing prices of securities falling as investors were just throwing things almost out the window in order to get liquidity. And since March 23rd, we've seen almost a straight up rise as investors have started to regain some confidence. This is an example to us of illiquidity in both directions and it signals to us a very volatile market. All right you might ask, if that's the case, if it's a volatile market, what should we be looking for or what should we be thinking about? It seems to us that until or unless we have a firmer view of the pathway in which the new normal will evolve, it is next to impossible to be able to form investment judgments about the fundamental valuations of companies. We don't, we can't know who, will win in the new normal and who will lose until we have some idea of what the field on which players are playing looks like. So what can we do? Well, there are several things that we have been saying to clients in this kind of circumstance. Number one, keep in mind and have a firm understanding of what your portfolio was created to do. If it's been invested with a long-term investment horizon in mind, stay the course. Investing is always an exercise in balancing the here and now, and tomorrow. Think of what would have happened if you had sold out of your portfolio of stocks in 2008 and 2009. It would have been very hard to have gotten back in and you might have missed a good deal of at least the first part of the upside. Second, evaluating your portfolio in just the first five months of 2020 might not be the right prism to look through. Think about it this way. By our calculations, the very strong rise in the stock market in 2019 was almost 95% due to higher valuation rather than growth in fundamental earning power. So if gains in 2019 were the product of excessive enthusiasm, that balloon will surely burst during the first quarter of 2020. If you look at the entire 17-month period that we've been through, it may not change where you stand today as we come to the end of May. But in fact, we find that many balanced portfolios of our clients were actually higher today than they were at January 1st, 2019. Of course, I'm adjusting for inflows or outflows. In other words, a different way, a different perspective, may leave you thinking that the world isn't quite so bleak and action isn't required immediately. In times of higher volatility such as I've been describing, doing less may actually save you more. That said, we're taking advantage of the opportunity to make lemonade out of lemons we've been presented with by actively pursuing tax loss harvesting strategies both by doubling up on holdings that have declined since the date they were originally purchased or by selling them out entirely. In either case, we plan on waiting 31 days to either unwind the double up that is sell the original holding or replace stock that sold. We're doing this with holdings of course where we believe the investment thesis stands a good chance of remaining intact.
Last but surely not least, in times of stress one wants to be invested with or associated with the best athletes. In the equity markets, the highest quality names which we think correlate very highly with companies that earn strong returns on invested capital have historically held up the best in stress. In the fixed income markets, these tend to be the strongest credits. In a little bit, Nick Foley is going to be talking to you about opportunities that we see in the municipal market all built from the same common starting point. Key to this last point however is to understand how the underlying economy will emerge from the forced shutdown. We believe some companies that had excellent franchises and prospects will see their fortunes changed, and vice versa. In such times, there is no substitute for experiencing in assessing how these changes will be reflected in the prices of stocks and bonds going forward and that is what we bring to bear on behalf of our clients all the time. And now I'm going to turn it over to Nick Foley to discuss how he's seeing opportunities in the municipal bond market.
[Nick Foley] The municipal market is especially subject to market dislocations due to the construct of the underlying market. It's often overlooked that the muni market is made up of nearly 70,000 different issuers and over one million different bonds. To put that into context, the corporate market is about 50,000 bonds so the muni market has about 20 times as many bonds. When you think about price discovery and making markets you can imagine how difficult it is to even make markets on 50,000 bonds. But when thinking about how to trade in price over a million bonds, you can see the underlying difficulty. So this market is still largely traded over the counter where there's daily price discovery. Going back to March when there was a large period of illiquidity, you can imagine how quickly this can break down. So at this point in March, we saw a dramatic spike in yields which we feel like was mostly driven by illiquidity. It is worth noting at the start of March we actually were at one of the lowest yield points ever in the history of the municipal market. So is a quick and easy ride obviously going up, it is illiquidity drove yield higher. But where we sit today is that muni yields are still elevated versus Treasuries to their historic norms, although they have come back quite a bit. We are seeing some interesting opportunities in the market for assets that we think are being mispriced versus what their actual underlying risk profile is. However, the thing we think we're adding the most value to right now is just avoiding landmines. In my whole career, I have never seen as many single A, double A, highly rated bonds in which there's serious questions around how they're going to make their next debt service payment. We think they have the ability to see through this, understand revenue streams, find the good projects from the bad, the good credits from the bad. Their ability to not only add value from a yield total return perspective but really to also protect from what we think are credits they may face and serious headwinds going forward. One of the most serious headwinds that we've talked about extensively over the last couple of years we think has grown pretty significantly, and that is pension risk. Pensions as people may or may not be aware of public pensions have been adding pretty significantly to the risk profile of their underlying portfolios. This means shifting more money away from bonds and more money into things such as stocks, levered loans, high yields, a variety of other risk-related assets. At the meantime, so while this happened obviously given what's taking place in risk assets, they've obviously seen a decrease in their rate of return or obviously a fall in that asset level. But the most damaging part of what's taken place is the yields have fallen dramatically, especially on the long end of the yield curve. Now, why that's important, the pension largely discount their long-term liabilities or who they ultimately or the amount of money they ultimately need to pay out. They discount that back using a certain rate, and so if the Treasury rate has fallen dramatically, the municipal rate has fallen dramatically, the weight in which they discount back those liabilities has basically made out those liabilities and how much they need to pay, swell dramatically. And so while they've seen their assets fall, they've seen their liabilities actually rise. It's a little complicated. So you're fine if you're not following along exactly, but basically what we think is that what we saw as a very uncertain medium-term, possibly slightly longer-term, risk has really been pulled forward by what we've seen in the last couple of months. So we think that risk, which we've always been cognizant of and we invest around in all of our different investment strategies, has really been pulled forward in that municipalities will really need to deal with it in a much sooner time frame than say where we were even just a year ago. From a yield perspective, we've seen yields drop dramatically. Obviously, municipal bonds have come down but obviously the Treasury curve has fallen dramatically, too. The Federal Reserve dropped their rate back down to near zero at the end of March. This was very helpful in stabilizing markets as well as the multiple programs they had put in place. However, as we look out and we think about where short-term yields may be going, we see a serious picture of deflation over the near term. Now, as we look out further that picture becomes a lot more cloudy. We've seen a significant amount of stimulus and as well as we're not exactly sure how the increase in the monetary system and the increase in debt will eventually flow through into rates. However, with that being said it would be hard not to overlook also that outside of the United States we still sit with a number of countries actually with negative rates. Currently, France, Germany, Japan, Sweden, Switzerland all have 10-year bonds that actually yield a negative rate. That means obviously if you give them money, they eventually in 10 years give you back less of that money essentially. It's an odd conundrum for everyone us included as well. It's certainly a new prospect to be thinking about even though it's taken place over the last few years. However as we think about how that affects the yields in the U.S. there's obviously a huge headwind for yields to rise as we said with all of those negative rates. So with all that being said, it should continue to be a very interesting environment for investing in the municipal market over the next few years. We see some really interesting opportunities presenting themselves but obviously we're being very cautious about where we're taking risk and how we're taking them.
[Amy Cramer] Thank you Nick and Ralph for sharing your perspectives. We covered a lot of topics relevant to what's happening in the markets and in the economy right now and how to navigate what could be likely continued volatility in the weeks and months ahead. As we conclude our podcast, I want to thank all of our listeners and wish you all and your friends and families continued good health moving forward.
IMPORTANT DISCLOSURE INFORMATION Opinions expressed are current opinions as of May 2020. The opinions expressed in this audio are solely the opinions of Segall Bryant & Hamill. You should not treat any opinion in this audio as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of the manager’s opinions. The opinions expressed in this audio are based upon information the manager considers reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this audio does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The manager’s opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this audio.