Tad Rivelle, Chief Investment Officer of the Californian bond giant TCW, doubts that the economy will recover as quickly as the rebound in risk assets suggests. He's scrutinizing the magic of monetary policy and warns of a painful restructuring process in many sectors of the corporate world.
Everything is going to be fine. At least that’s what financial markets seem to believe: The S&P 500 stands at the same level as at the beginning of the year, and interest rate spreads on corporate bonds have largely normalized.
Tad Rivelle distrusts the widespread complacency. The Chief Investment Officer of TCW, overseeing more than $180 billion in fixed income assets, doubts that the economy will recover from its shock as quickly as risk markets suggest.
«The Fed has essentially driven a gigantic wedge between the fundamentals – which we don’t think are very good at all – and the capital market pricing», Rivelle points out.
In this in-depth interview with The Market/NZZ, he points out fundamental problems in the highly leveraged corporate sector. He also warns that even more extreme monetary policy interventions, such as Yield Curve Control, will only work temporarily, at best.
Mr. Rivelle, despite Covid-19 cases in the U.S. soaring, investors are betting on a rapid recovery of the economy. What’s your take on the current environment?
There were many indications of a late cycle environment already well established in 2019. We were seeing a pre-recessionary economy in front of us. This was evident in corporate profitability, in world trade and in the amount of leverage that had been built up in the corporate sector. So we look at the whole Covid situation mostly as a catalyst: It brought forward the recession that we were going to have at some point anyway, and then accelerated the downturn by intensifying the pain on a variety of different service industries, the most obvious being travel, hotels and similar sectors.
Yet, risk assets have staged an impressive rebound since the lows of March. What’s your view on the stock market from the perspective of a bond investor?
The Fed has essentially driven a gigantic wedge between the fundamentals – which we don’t think are very good at all – and the capital market pricing. Prices are reflective of a very high degree of optimism. Risk markets in general are embracing the idea that we are going to have a V-shaped recovery. This is a very odd notion since the current environment is really sort of two recessions: The recession that you were going to have to deal with anyway, and then this lockdown Covid-related situation as well. So, while it’s possible that we will recover pretty quickly from the lockdown, you’re still left with the deeper underlying issues.
Sounds quite sobering.
Just talk to someone in the airline industry, or in lodging or in commercial real estate. The realists are telling you that it will be probably several years before we see anything approaching a full level of recovery. Here’s an anecdote: In the commercial mortgage market, a typical securitization is made up of 40% hotel and retail loans. So how do you look at your typical commercial mortgage backed security and say «it’s as good as it was six months ago based upon the fact that current capital market pricing really isn’t too different than it was then»? That doesn’t make any sense. Here’s another point: At the end of the cycle, corporations are supposed to reposition themselves, adapt to the reality that is being revealed. Part of that is a deleveraging process. But what we are seeing is not a deleveraging but a re-leveraging. It’s the same old same old: We’re trying to fix the debt problem with more debt, kicking the can down the road.
And what about the residential mortgage market?
If you look at the totality of the market, something like 10% of mortgages are in some state of forbearance. But just because you are in forbearance, doesn't mean that payments aren’t getting made. In some cases, people ask for forbearance and then continue to make payments. On the other hand, there are people who didn’t make payments and either didn’t qualify or didn’t ask for forbearance. Anyhow, there’s a significant quantity of mortgages out there that are not being serviced. Not surprisingly, we expect a similar development with respect to apartment rents, although the collection rate thus far has been pretty good. How much of that relates to stimulus measures is unclear. If we end up with a high level of unemployment, I wouldn't bet that this situation is going to stay that way. Also, if you look at things like non-qualified mortgages – basically mortgages that were originated in many cases to members of the gig economy – you see delinquency rates at about 20%, maybe even 20 to 25%.
In an attempt to save the economy, the Federal Reserve is even buying corporate bonds. What are the consequences of this policy response?
It’s like Alice in Bondland. In March, we were experiencing a free fall: Spreads on fortress balance sheets – corporations like Intel, Procter & Gamble, Disney and Exxon – widened to levels we have never seen in our professional lives. But even as we experienced this fall into the abyss, what was shocking, is once the Fed stuck its hand into the markets, you saw an utter rebound in prices. However, that doesn’t change anything fundamentally relating to the need for companies to reposition. Neither does it change anything material with respect to where structural unemployment is going to settle down when the «funny money» works its way. Basically, the Fed is funding operating losses. Once the money starts to run out, a lot of businesses are going to be faced with an awful reality: They either get another government handout to kick the can further down the road, or they are faced with the fact that they are not viable, and therefore the jobs that they are supporting are going to go away.
Risk premiums on high yield and BBB corporate bonds have come down significantly since the darkest hours of the crisis. Were central banks able to avoid a major default cycle?
The Fed hasn’t fixed the underlying problems, but it has masked all the symptoms. Central banks are supposed to listen to markets and watch the information they are producing. The Fed has completely obscured the message. We don’t really know what businesses are viable because everything is viable at the moment. Therefore, you don’t actually know what the underlying level of stress is. All you know is that you look at numbers that haven’t been seen in our professional lives: This kind of economic contraction, as it relates to movements in GDP, has never been experienced. So the idea that risk markets will look at a once in a century kind of decline in economic variables and then basically turn around in a matter of weeks and say «everything is going to be as it was in January almost» is a big leap of faith from a pricing standpoint.
Where do you see the biggest disconnects?
In a lot of places, certainly in the debt markets. Almost every company we know of has already pulled its earnings guidance. But even with the pulling of earnings guidance, investors are essentially willing to accept – or to operate as a base case on – that we are going to have a rapid return to the level of profitability we saw before this Covid situation. Yet, leverage ratios are rising. In a variety of different industries there is going to be a significant amount of restructuring that will be required. There are also a lot of industries that are going to see enhanced costs associated either with the disruption to their supply chains or with a need to change the process by which they provide services or manufacture. But for the moment, this is all overlooked.
This time, it’s not just central banks opening the spigot. Governments are on a spending spree as well and run massive deficits. How are chances that we are getting inflation down the road?
Inflation is not all that well measured and probably less well understood than most people believe. When you get into a conversation about inflation, it’s usually about questions like: «Isn’t there excess capacity?» It hasn’t been very common in recent decades, but there used to be plenty of instances in which people start to lose faith in their country’s fiat currency. Maybe it’s losing a war, maybe the government is collapsing. Whatever the reason, inflation appears because nobody views the currency as a stable store of value. What I’m getting at: The Fed has had the luxury of issuing trillions of dollars of IOUs to people around the world and they have been willing to accept them in recent months. That’s because if you had to store your wealth somewhere you wouldn’t have stored it in commercial real estate, in an emerging market currency or in any number of other places. Consequently, a dollar – which is basically a zero-interest perpetuity – looked pretty good relative to other stores of value.
Will it stay that way?
There is always some limit to these processes, when people no longer view their currency as stable. And then you have inflation, and it will be a shock to people. I’m not saying that’s going to happen. I’m simply saying if you do one helicopter drop after another after another, you will keep doing them until people don’t want your dollars anymore under the same terms that you initially issued them. And then you do have inflation, irrespective of whether you have too much supply and too many unemployed people. The subtext here is: I don’t know if we are going to have inflation, but I would be skeptical of people who say that we won’t have it.
Against the backdrop of ever more money printing and exploding deficits, you would expect a rise in interest rates. So far, we’ve seen quite the opposite. Where are the bond vigilantes?
The vigilantes are cowed because they believe that at the moment the Fed has the ability and the will to – if need be – practice Yield Curve Control. Consequently, you probably don’t want to get too much of the short side of the long bond or however you ultimately express your opinion. So for now, the Fed has established itself as being pretty firmly in control of asset prices. Remember, it wasn’t that long ago that the Fed had protested the notion that they target asset prices. «It’s not what we’re in the business of,» they claimed. That’s a joke.
Do you think the Fed will implement Yield Curve Control? And more importantly: Would it work?
YCC works as long as people are willing to view the dollar as a stable store of wealth. That’s because the Treasury issues debt and the Fed has to buy it by issuing more dollars to somebody. YCC has worked in war time but with rationing, price controls and a lot of other programs that are hard to imagine today. Then again, a lot of things have happened recently that are very hard to imagine. So would YCC work? Initially, sure, but it doesn’t have the intended stimulative effects. Places like Japan or Europe show that economic growth is not just a function of suppressing rates. It doesn’t do anything for your long-term growth. What’s more, it’s so detrimental to your banking system that you probably regret doing it for any extended period of time. But as we know: Once you break the glass and implement these programs and policies, it’s really hard to undo them.
It’s only three and a half months until the U.S. presidential election. How do you observe the race for the White House from the view of the bond market?
First, the economy is always the running mate of the incumbent president. That’s an important issue for Mr. Trump, obviously. Second, just as information has been destroyed in the capital markets by the interventions of the Fed, my sense is that the political market has also destroyed a lot of information. The rancor and the politicization of everything in the United States basically means we don’t really know where people stand on issues. It’s maybe a little bit what happened in 2016: People relied on information and on polling assuming that the political market would generate good information. Yet, the only thing we really found out was that it’s not until the election that we actually know where people stand on issues.
What would a Biden presidency mean for financial markets?
I don’t know that any of the traditional categorizations of Republicans as fiscal conservatives and of Democrats as «Tax and Spend» apply any more. Just look what has happened in the last few months: If you would have asked me at the beginning of this year about the Fed buying corporate bonds or potentially even equities, I would have been very skeptical. I would have said something like: «According to Section 13 of the Federal Reserve Act, the Fed can’t do such things, they can’t take such risks.» But governments find ways to break the rules and break the law when they want to.
What’s your investment advice in this kind of environment?
We still believe that you should take your cue from the fundamentals and that you shouldn't change your opinion just because market prices are reflecting a different view. In our opinion, a recession is not so much a shortage of demand as it is an inefficient, improper allocation of labor and capital. For instance, it takes time for the commercial real estate market to restructure itself and to reflect what preferences actually are going to look like: Will demand for offices rise because people have to socially distance? Or, will they drop because people work from home? How much retail is going to disappear? How many hotels are going to disappear? I don’t really know what the balances of those factors are. But my point is: If you go into a forbearance process, there is a long period of time where you don’t know who’s going to survive.
What does this mean in terms of a prudent investment strategy?
Right now, people are saying: «We’re in forbearance. Nothing bad has happened, so let’s just assume the best.» As a bond investor, that’s not the way you are supposed to do things. So be patient, wait for opportunities in the commercial mortgage market because they are going to come. The corporate bond market has re-levered, and without transparency with respect to future earnings, neither the entirety nor certain segments of the market are probably going to re-price. Today, we see correlations of risk assets basically go back to one, all presumptively driven by central bank policy – and in our opinion, you’re not supposed to participate.
What’s the best way to position yourself for such upcoming opportunities?
You want to stay liquid since liquidity is what gives you the ability to respond to a change of valuations in the future. If you’re an investor in a relatively high tax bracket and if you are investing in higher quality, it’s probably not an unreasonable thing to be in municipal bonds that either reflect obligations of some of the more fiscally strong states and/or essential services; things like water and sewer bonds. But you don’t want to be down the capital structure in structured credit and you don’t want to be exposed to industries that are likely to undergo a significant amount of restructuring, whether that’s Covid-related or related to the recessionary dynamics even prior to the virus.
Speaking of liquidity: What about U.S. Treasuries?
If you’re a longer-term investor, you’re not supposed to be in Treasuries. Even when you buy the long bond at 1.3%, you have to ask yourself what your long-term inflation expectation is. Most investors would probably conclude that you are looking at a negative real rate situation for much of the treasury market. So I don’t think you are going to find long-term gains on your capital in Treasuries. But if you are using them as a liquidity vehicle and you are investing in T-Bills or two-year Treasuries, that seems like a perfectly reasonable enough thing to do.
What should investors look out for in the coming months?
All of the data is almost useless at the moment. For example, pick some very basic numbers like the unemployment rate. Due to problems with the survey, it’s not clear how many people actually lost their job. What's more, in many situations there has been fraud as was reported in the unemployment program in certain states like Washington. And, here’s the elephant in the room: Government programs have ensured that many businesses will be there for some period of time. But we don’t know what’s going to be around in six months. So you have to take all the data with a big grain of salt right now. Just assume that it’s bad, but we can’t really say a lot about it.