‘Fed priority remains taming inflation,’ portfolio manager says

Brandywine Global Portfolio Manager John McClain joins Yahoo Finance Live to discuss Wednesday’s FOMC meeting, how markets are digesting Fed Chair Powell’s decision to raise rates by 0.25%, Treasury Secretary Janet Yellen’s remarks on U.S. banking, and the outlook for the economy.

Video Transcript

JULIE HYMAN: Well, the Federal Reserve hiked interest rates by a quarter point and signaled there will be just one more hike this year before a pause, perhaps, at least if you look at the dots. It comes amid the turmoil in the banking sector.

Let's bring in Brandywine Global Portfolio Manager John McClain. John, yesterday as we talked about, we saw stocks go down. We saw the bond market move as well, not just because of Jay Powell but because of Janet Yellen as well and the comments she made about not necessarily offering universal deposit insurance. Do you think that their comments were at odds with one another, and sort of what was your takeaway as we heard both of these folks speaking?

JOHN MCCLAIN: Yeah, I mean, I do think that they were at odds with each other, and I think that the markets sold off a bit because we're a little bit concerned that, you know, one side is not talking to the other. But I think we did learn a lot after yesterday's press conference, and that is the Fed's priority remains taming inflation and that they believe they've got the targeted tools at their disposal to handle the banking crisis.

So the Fed has this dual mandate, right, of price stability as well as unemployment. Unemployment's fine at this point. And I believe Wall Street wanted to bring in the banking crisis to the Fed's mandates, and, you know, I think we heard from Yellen that, hey, we're not backstopping all deposits at the moment, and I think it's at the moment right now. I don't think the market is comfortable with the targeted response that we've seen. I think we're going to have to do more and that this is really probably the second or third inning of what we're going to see in terms of a banking crisis in the US.

BRAD SMITH: If you're an investor this morning perhaps trying not to fight the Fed but to anticipate, at least, what the Fed may do in future and after future meetings as well, perhaps you're also looking at this line that Fed Chair Jay Powell had yesterday of a period of below-trend growth economically. What would you be taking away from that to really kind of set your own positioning following the Fed chair's press conference and the FOMC decision yesterday?

JOHN MCCLAIN: Yeah, I mean, this is a classic response in terms of the economy to a meaningful Fed tightening cycle here, which is we were already starting to see leading indicators showing the economy is starting to trend down here. And now with the banking crisis, we're going to see the economy continue to contract and move materially lower over the intermediate time frame.

So I think that, you know, really even if we solve, you know, the confidence issue with banks through targeted policy, banks are going to hoard capital, and that's going to be a problem for the real economy. So you need to position your portfolios to be able to deal with a slowing economy.

JULIE HYMAN: And what does that position look like, John?

JOHN MCCLAIN: Well, I mean, you know, there's a lot of interesting things in the marketplace. I think right now equities are clearly overvalued given what we believe to be a declining earnings environment. We also believe that Treasury yields are still attractive here. And certainly with an inverted curve, there's a temptation to allocate much more towards the front end, but duration is a bit of your friend in a, you know, declining economic environment.

And actually from our perspective, we believe high yield is the riskiest low-risk thing that you can allocate to in your portfolio. With yields at 9% right now, that's pretty attractive and certainly materially higher than what we see inflation at.

BRAD SMITH: One of the other comments that we got from Fed Chair Jay Powell yesterday was really regarding the banking turmoil that has ensued. Do you believe that the continued commentary that we've got from Powell, from Yellen is enough to soothe clients of all of the banks right now, especially as they're rolling out all of the necessary backstops in order to make sure that consumers know that the banking system is safe, that businesses know that as well, and that there is not a moral hazard, perhaps, that we should be concerned about there?

JOHN MCCLAIN: No. Again, I still think it's the early innings. I think the market is heavily focused on First Republic to see how that is going to eventually play out. If that bank were to get subsumed or potentially the equity gets wiped, I think that you could see additional contagion spreading to the next number of banks here.

I think really what we've seen is that banking business models are impaired relative to two weeks ago. The cost of capital for them is going up materially. Their profitability is going down materially, and they're going to be-- we're going to see materially more regulation as well. So I think that we're going to see more targeted policy, and I think it's going to end up with insuring all deposits for a finite amount of time, probably a year, and with the Fed exercising a heavy hand and saying we're going to regulate banks much more aggressively, particularly kind of the small banks, you know, the sub-$250 billion in assets bank. We're going to regulate you heavily, and it's going to be in your best interest to continue to merge.

JULIE HYMAN: John you're a high-yield guy, so I've got to ask you a high-yield question because you manage that kind of debt. You mentioned in your note to us that high yield is pricing in 10% defaults. That is 10% of all high yield defaulting. You see defaults below that. And yet what I'm hearing from you is a decent amount of pessimism, so it's interesting to me that you actually think the market is overpricing the chance or overestimating the chance of more defaults. Can you kind of explain that to us?

JOHN MCCLAIN: Sure. Absolutely. Why do you get in trouble as a high-yield borrower? You get in trouble if you've got a looming maturity and you can't roll that debt, and you get in trouble if you don't have enough earnings to cover your interest expenses. And we don't see either one of those as being a material issue in the marketplace today.

It's really where is high yield as an asset class from today's starting point? Leverage is really low. Interest coverage is very high because companies borrowed aggressively in '20 and '21 at low coupons for long duration. It's like you or I getting a 30-year mortgage at 2 and 3/4% in 2020.

The maturity wall is very light as well. So there's not a lot of maturities coming due over the next couple of years. The credit quality is drastically improved in the high-yield asset class. The BBs are north of 50% of the market, and the last time that they defaulted at north of 1% was actually in 2002. And additionally, we see higher recovery rates in the effect of-- in the event of a default.

And so the other thing that we're hearing-- and it's a material positive for the asset class-- is management teams are now focused on interest coverage and debt reduction. They're focused on paying down debt because their cost of capital has gone up 500 basis points over the past 15 months. So now that capital is expensive and it's much more scarce, management teams understand that they need to focus on running a clean balance sheet to be able to take advantage as the economy starts to flow.

JULIE HYMAN: Sort of on a related note here, Torsten Slok, chief economist over at Apollo, was out with a chart this morning that looked at capital markets effectively freezing up since SVB went under. Particularly US investment-grade issuance-- on the far left of the screen-- has been pretty much nonexistent since March 11, and he talks about that the longer this lasts, the worse it will be for the broader economy. Do you agree, and how long do you think that things are going to be shut?

JOHN MCCLAIN: Yeah, they're not going to be shut long. I mean, I think if you go back and you look at the GFC, capital markets really closed for about six to nine months, which is the longest we've observed on record. During COVID, that was weak. For high yield, it was probably about 45 days.

And I think what that chart brings up is an interesting point that we highlight to our clients as one of the key themes for 2023, which is that companies have an access to a variety of forms of capital that will provide depth and breadth of funding sources for quality businesses. So if you think about below-investment-grade markets pre GFC, that was just US high-yield bonds. Now we have European markets, the leveraged loan market, private credit, convertible debt, and even private equity as a venue for companies to access capital in this type of environment.

So we don't think that the market is going to stay closed for an extended period of time. And even if certain markets stay closed for a period of time, companies will have access to a variety of different venues of capital.

BRAD SMITH: Brandywine Global Portfolio Manager John McClain. John, always a pleasure to get some of your time and insights. Thanks so much for joining us this morning.