FEG Webinar Replay: Navigating Uncertainty

The past few weeks saw a dramatic increase in market volatility with falling interest rates, plummeting oil prices, and equity markets entering a bear market. Hear from FEG Head of Research and CIO, Greg Dowling, along with FEG sector heads Keith Berlin, Christian Busken, and Brian Hooper to understand our perspective.



Greg Dowling:

Good afternoon and welcome to FEG's webinar, Navigating Uncertainty. I'm Greg Dowling, CIO and Head of Research, and joining me are the sector heads for Fixed Income, Real Assets, and Global Equities. That's Keith Berlin, Christian Busken, and Brian Hooper. We are here trying to provide some context, and a bit of framework for the recent market chaos. Just note that our comments will be broad-based. Every client has unique risk and return characteristics, different portfolios, different asset allocations, so we're not going to talk about how one manager has done versus another, but we're going to keep it more at the market and asset class level. We do think you will find plenty here that you'll find helpful.

Quick housekeeping before we get going. You heard this when you logged on, but to make sure we have proper audio quality, all participants are muted. And if you have any questions please use the question and answer tab located at the bottom of your screen. It's in the red box if you're following along on the slides. You may type in a question and send it to us any time during the call.

We're going to have approximately 15 or 20 minutes at the end of this webinar to go through questions. Because a lot of questions will tend to be very similar, we all have some of the same questions that we're looking to get answered, we might group those together and try to answer, so if we don't answer your specific question it may be because we're trying to get as many questions done as possible.

The goal today is to go approximately 45 minutes and leave that 15 or 20 minutes for Q&A. We're going to try to get you in and out in less than an hour.

And although we are talking about a market crisis, we do realize that this is a global health crisis. And our thoughts and prayers go out to anybody who is listening that is being impacted, either by through their health, or the health of a loved one, or maybe it's just an economic impact. If there's anything that we can do, truly, if there's anything that we can do, even outside of our normal consulting or advisory role, please just let us know.

So the agenda for today is going to start off talking about the coronavirus, market selloffs, and try to give an historical perspective.

Keith's going to then talk about the Fed actions and the fixed income markets. Brian's going to talk about volatility, valuations, and performance within global equities. Christian is going to talk about the perfect storm for energy markets and we certainly have had one, both from a supply and demand side.

I'm going to close with just a comment or two on diversifying strategies and then give a few summary thoughts. At that point, we will go to Q&A.

Greg Dowling:

Mark Twain is often credited with the quote that history doesn't repeat itself, but it often rhymes. One of my new favorites is Howard Marks of Oaktree wrote in one of his recent memos that nobody knows, but veterans guess better. And we don't know. We don't have a crystal ball. We don't know exactly when this is going to end but we do think that history can be a guidepost. And we can look at what those milestones may be to help give signal to when we may recover.

We can also look at bear markets and the history of bear markets to get a sense of what the magnitude and duration of this may be. And it has certainly been historic. So if we look at the last, the worst 10 days of the S&P 500, over the last week, we have two, the 6th and the 3rd. So Monday was the 3rd at 12%. Above it are The Great Depression and Black Monday, the crash of '87, not great company to be in. We also had the first and second largest decline by points and volatility has been all over the place, as measured by the VIX. It surpassed what it was in 2008. But probably the most notable thing so far has been the speed. It took only 16 days to go from all-time highs to a bear market. Again, company of the 20s, late 20s, since The Great Depression, and the crash of '87.

So we're going to look at two different scenarios. And the ones we've chosen are 9/11 and the Spanish Flu of 1918. Some people have talked about the crash of '87 merely because of the speed of the decline. But the cause and likely recovery are going to be very different. Same with 2008, both of those are crises that happened internally. So inside the financial markets and then bled out to Main Street. The two shocks that we're going to look at were really Main Street issues that came into Wall Street.

And so if you see these pictures here, the grounded planes, the gentleman walking in the surgical mask or flu mask, these are not from today, but these are from 9/11. Planes were grounded everywhere. And if anyone was in lower Manhattan after the towers fell, you would have seen these masks everywhere. It was a shock, it hit the system, it was unexpected and it took us a while to figure out what was going on. So we had the fear like we have today. We also had a lot of canceled events, canceled trips, canceled tourism. Even the Stock Market closed. Stock Markets close only for a handful of times, The Great Depression, World War II, Kennedy's assassination.

It closed for 9/11 and so even though there are certainly differences, there are some similarities. And the market fell pretty quick, but then it also recovered just as quick. And why did it recover? There were really three things. First was clarity around the situation. Now, this isn't that everything was great. It wasn't, but we at least got some understanding. We got through the fog of war and had our arms around the situation a little bit more because what the markets don't like is uncertainty. They're okay with risk. Uncertainty is a problem, but once we figured out what was going on, that was helpful. That was one hurdle was closed.

Next, it was the monetary assistance. Alan Greenspan was actually on a flight over the Atlantic and was turned around when the towers fell. He had to conduct monetary affairs remotely, but they acted decisively. And then last, the government stepped in and it helped struggling businesses like the airlines. They guaranteed loans to the airlines. So the three milestones of eventually gaining clarity. That doesn't, again, that doesn't mean that everything is going to be okay. 9/11 fundamentally changed how we go about our day-to-day, how we travel, and so it's not a polly-anish view, just understanding what the risks are. Having the monetary and then having the fiscal.

So what do we have today? We have one. We only have the monetary side. There's a lot of government talk about large packages, but so far there's no action and it's likely going to take some time for that to impact us and we certainly don't have any clarity in terms of the number of cases in the outbreak.

1918, there's probably less that we can take away from the 1918 Spanish Flu outbreak, just because it was over 100 years ago. We had a very different economy. It was more agrarian, it was more geared towards manufacturing. But there's at least one thing we can take away and as you can see from this picture of Seattle policemen, they still had the flu masks and they were still wearing them. So not an invention of today.

Nor was flattening the curve. We've all seen the pictures of flattening the curve. Love this graph, it was in the Wall Street Journal's daily shot a week or so ago. And it shows the difference between Philadelphia and St. Louis. Philadelphia, which was hit a little bit earlier, ignored some of the information, still had public gatherings. In fact, this is a picture of a parade. Versus St. Louis, who took a little bit more precautions and started to do whatever social distancing looked like in 1918. You can see very much the difference in the number of death rates per 100,000 people. Thought that was fascinating.

But going to the markets, why we're here, why we're trying to figure out, and what you can take away from here goes back to clarity. So, for those of you who aren't as familiar with the Spanish Flu, and we all are becoming a little bit more familiar with all the historical pandemics, the flu of 1918 wasn't just a one-time affair. It was a rolling flu epidemic. It's really the flu of 1918, 1919 and 1920. And so we had a number of different outbreaks. And you can see from this chart, which has the DOW. The DOW does not recover until that last outbreak occurs. When it does, it moves very quickly, very quickly up. But it's not until that outbreak.

So what does that say about today? Well, it says that we should probably be watching what's going on in Asia right now. They were first in, so countries like China, South Korea, Japan. As China gets back to work, as they restart their factories, as they use public transportation, are we going to have another wave of outbreaks? Or, as some people have claimed, maybe just spring and summer in the Northern Hemisphere will start to wean the levels down only for them to reappear come late fall. And so this is what we really have to watch. It gets back, again, to clarity and the whole concept of risk versus uncertainty. Markets are very good with dealing with risk. They are not very good with dealing with uncertainty.

So we've got a lot of questions about how long this will last, how bad can it be? And again we don't have a crystal ball, but we can use history as a guide. And so we want to look at what bear markets look like. And right now we're studying bear markets in modern times. And how we define that is from 1950 on. So we're throwing out The Great Depression. The Great Depression is hopefully something we will never repeat. Markets were down 89% and it took until after World War II to recover. But bear markets have occurred a lot since 1950. In fact, they've happened every five and a half years. We sometimes forget because we've had such a long economic expansion. And the average decline is about 31% and it takes about 13 months to fully recover. But that's probably only half the story.

The story is hidden in averages. What we really need to do is look at what happens in bear markets during a recession and without a recession. So if it's a cyclical bear market that doesn't have a recession associated with it, those bear markets tend to be pretty mild, so down 23% and only take about 224 days to recover. But bear markets with a recession are down closer to 36% and take twice as long to recover from. On this slide we have a bullet point that says, "Unless fiscal stimulus happens quick, we are likely looking at a recession." We probably need to change the word likely to probable. Most economists that we've been talking with have said the odds are well above 50% and getting closer to 75% or 80% that we're in a recession.

So what does that mean? That means that we're probably mostly through the declines, being down almost on average, but this might be worse than average and so we could reasonably expect, again we don't know. We could reasonably expect maybe another down 10% or 15% from here. That wouldn't be out of the norm. But down another 10% or 15% is doable. It's not the end of the world and in fact, I have more good news for you because while we don't know what's going to happen in the next few days, next few months, really even the next quarter, we could look at history and have a pretty good sense that things will be better a year from now. And so the graph that we have is the returns after the worst one day S&P500 declines. And the majority of the time, a year later were positive. Not every time, the vast majority. But also those returns are pretty good. The average return is 18%. So again, while we don't know what tomorrow will bring, we have a pretty good sense that longer term, we're going to be fine and we're going to get through this.

And so with that, I'd like to turn it over to Keith Berlin to talk about fixed income and credit.

Keith Berlin:

Thanks, Greg. So I'm going to go through the Fed's response, interest rates, public credit markets and private credit markets. The Fed announced its second emergency reduction in the Federal funds rates in two weeks on Sunday evening, with 100 basis point decrease following the initial 50 basis point cut, bringing the new range to 0 to 0.25%. Additionally, the Fed announced 700 billion of quantitative easing measures targeting 500 billion in treasury purchases and 200 billion in residential mortgage backed security purchases. Unfortunately, these measures have been poorly received at this point by the markets.

Today, in fact, former Fed chairs, Janet Yellen and Ben Bernanke, urged the Fed to go beyond its authority and buy corporate bonds, which would be unprecedented in the U.S., but was effective in Europe when the ECB launched the corporate sector purchase program back in 2016. It's our view that the Fed is now all-in as far as doing whatever it takes for as long as it takes to stabilize the markets. The aggressive policy responses by the Fed helped to intensify the ongoing rally across U.S. treasuries. As market participants have priced in 0% short-term rates, a bold steepening of the yield curve has surfaced, a phenomenon that has historically preceded recessions.

In fact, as the chart shows, the past five recessions were met with precipitous drops in the Fed funds target rate, which is where we are today. We are eagerly awaiting the fiscal response, as Greg mentioned. Just this afternoon, the Treasury Department asked Congress for permission to temporarily backstop money markets to develop guarantee programs for the money market industry as part of the fiscal package. Things are continuing to develop rapidly.

Looking at interest rates, 10-year treasuries rallied from 1.9% to start the year to an intraday low of 0.3% on March 9th before settling back at 1.1% today amid considerable interest rate volatility. Also, the 30-year treasury rallied to an all-time intraday low of 0.7% on March 9th, reaching 1% for the first time in history before settling at around 1.7% today. We'll use my favorite interest rate chart to put the move in long-term interest rates into historical perspective. As even with the recent uptick in the 30-year bond yield, it remains at 150-year lows.

Things are moving rapidly, as I mentioned. And with yesterday's reversal in rates and today's move higher, twos to tens are now at 65 basis points deep. So it appears that at least in the short term, rates may have bottomed.

Traditional fixed income, which has a high degree of interest rate sensitivity has become a store of value at current levels as opposed to its historical place as an area to potentially add alpha. The table shows the negative asymmetry associated with owning treasuries today. Using the five year note as an example, which is the top line of the table, is a reasonably close to the experience of a core fixed income manager. You can see that if you own the five year treasury note today, and rates for the decline 100 basis points from here, which would effectively put the five year note at -0.3% by the way, the investor would earn only 3.2% within a one year holding period.

Alternatively, if you look at the right of the table, as rates rise from current levels and investors lose more and more money. Speaking of losing money, if you were to have bought the 30 year treasury at its low point at 0.7%, you would be down about 15.3% given the 100 basis point move higher than we've seen in just this recent amount of time. The bottom line to us is that duration is not your friend at such low levels of interest rates, even with this modest move off the bottom.

So let's shift gears into the public credit markets. High yield bonds and bank loans continue to depreciate in price, with spreads widening to about 850 basis points for high yield bonds yesterday, led by energy and the airlines. High yield is down about 3.5% to 4% today as well, so we could see spreads at around 900 basis points or more by the end of the day. Spreads for energy bonds had already widened prior to oil price war, which I know Christian's going to talk more about later, and they've moved to highly distressed levels as you can see in the chart on the left. With broad energy up at 1739 basis points over treasuries. They're likely higher today as well. As you might imagine with massive travel cancellations, spreads for airline bonds have also widened well into distressed territory of more than 1000 basis points.

We've begun to see other sectors selling off as well. And the downgrade to upgrade ration is moving more and more in favor of downgrades and we expect that to continue going forward. Bank loans are down as well, but they've held up relatively well versus high yield bonds and stocks. In fact, from February 24th to March 16th, bank loans fell by 10.9% versus down 13.3% for high yield and down 28.7% for stocks. So in this context, at least it seems reasonable to us from a capital structure perspective. Our view on all of this is that some of the best tactical entry points for high yield bonds in history and for distress strategies as well, have coincided with recessions, suggesting to us that an attractive entry point may be near.

Now there is no exact spread or price number that you can put on this, although we're clearly nearing a point where it is more difficult to lose money if you were to buy a high yield at this point and hold it over a three to five year period. But we are continuing to monitor the situation closely and are in contact with managers on a daily basis.

We'll talk a little bit about private credit markets and break it out between distressed and private lending. Our discussions with distressed managers have shown reasonable market to market movement in their existing funds in light of the increase in volatility. As you might imagine, we're seeing increased enthusiasm for potential distressed opportunities, albeit with a healthy awareness of the public health concerns plaguing the country. Existing distressed manager relationships anticipate putting new money to work as this opportunity set continues to evolve. On Monday, well-known distressed manager, Howard Marks from Oaktree, announced that they would begin preparing a new distressed fund. So that's just some good anecdotal evidence there for us. It's also important to note that at the bottom of past distressed cycles, we've typically seen purchases by Warren Buffet. So be on the lookout there for Uncle Warren.

To shift gears a little bit into private lending, private lenders are showing us some challenged credits and they are not immune to the market conditions that are prevailing today. We expect modestly lower marks at the end of the first quarter versus fourth quarter 2019 and materially lower marks in the second quarter. It's too early to tell, but of course they have to be lower. As with all of our recommendations at FEG, we've been particularly thoughtful with who we've hired in the private lending space. As direct lending became a phenomenon, we avoided new players and focused our allocations on very experienced lenders who have weathered multiple cycles. Our lenders have generally been focused on more defensive sectors in recent years with sound accredit underwriting in their transactions given their knowledge that we've been late in the cycle for some time.

In our experience, lenders who have weathered recessions in the past with fully invested funds, saw lower IRRs but exhibited strong multiples. And this is what we and you should expect from them in this period as well. For new funds, these same lenders have either raised the fund recently or in the market now, which should provide them with an opportunity to lend fresh dollars and more favorable terms than they could have just a few months ago. And this shows the value of vintage year diversification.

So at this point I'd like to turn it over to Brian Hooper to discuss equities.

Brian Hooper:

Thank you, Keith. I'd like to start by just showing what a wild ride we have been on. The U.S. equity market was on an unprecedented bull run since the global financial crisis in 2008 and the bottom of early 2009. This chart illustrates since the bottom of the global financial crisis, what an incredibly strong and consistent uptrend we experienced in the U.S. equity market. What this chart also shows is that the equity market extended well above the trend in late 2019 and early 2020 as you can see in the early part of the shaded yellow box. But as of Monday, had fallen essentially as far below that trend as it was above it just a month prior. This is driven by broad declines in equities, but an active equity manager even referenced that the bottom 10% of companies in the S&P500 have lost more than half their value.

This sharp reversal in trend has taken not only the U.S. market but essentially all global equity markets into a technical bear market. Technical bear market, meaning falling 20% or more from their peak. As of the end of trading on Monday, most equity markets were down more than 30 percentage points. Factor in a slight rally yesterday and another decline today and we're still roughly in that neighborhood. Often in sharp downturns, correlations can increase and markets generally decline in concert. This has largely been true for equity markets, but the exception being small and microcaps as indicated in this chart, which have been especially hurt by global economies essentially grinding to a halt. What we haven't included, but is worth mentioning, is while long only equity funds struggle through steep declines, many long short equity funds have helped limit losses as designed through their short positions.

As my colleague, Greg Dowling, mentioned earlier this is the fastest move from bull market to bear market territory in history for the U.S. equity market. And there is a possibility that markets could continue to fall, but history tells us that equities are nearing the declines of an average downturn for a bear market amid a recession. And market moves beyond this point are fairly rare.

There is also a possibility, however, that we could be nearing an inflection point, if the U.S. and other countries' response to the pandemic are able to slow the spread of the coronavirus and we begin to see peoples' lives somewhat return to normalcy. China and other nations hit early by the coronavirus could be a guide to what to expect in the U.S. and the rest of the world.

On the point of those countries hit early by the coronavirus, China is actually among the countries that has declined the least, buoyed by stimulus measures. But Chinese equity markets are negative and have fallen double digits in 2020, but it is the other Asian markets that are heavily reliant on Chinese economic activity that have fallen the most.

For example, tourism is a major industry for Thailand and with the Chinese responding to the coronavirus spread by essentially shutting down its economy, the tourism industry in Thailand has experienced massive pain. Thus, as this chart indicates, Thailand is down nearly 40% in 2020 alone. That being said, if history is any guide for us as investors, health crises are painful but often are short-lived through the lens of long-term investors. We include a chart here that illustrates how previous pandemics and health crises affected global equities.

This chart, from Ned Davis Research, highlights the SARS epidemic in particular. SARS was a troubling virus that originated in China, spread to many other countries similar to what the world has experienced with coronavirus. Albeit, coronavirus appears to be more widespread. Global equities sold of precipitously leading up to the formal announcement of the crisis by the World Health Organization. However, the inflection point for global equities was near the formal announcement by the WHO, which closely mirrors what occurred in other health crises. Governments are forced to respond to these crises, if they hadn't already taken measures to combat the problems. And the equity markets have historically responded favorably.

Similar to the equity market trend chart discussed earlier, valuations had also extended to levels that were well above historical averages. With sharp declines in the last month, equity prices look quite scary, as do valuations, but when we have fallen to even further declines in valuations from this point, specifically 2008 and 2009, there was legitimate fear that the financial system could fail. We aren't there. Valuations are likely to bounce around in the short term for sure, including periods where they may fall further from where we are today. Especially with the heightened volatility and lack of clarity on future earnings with the U.S. and many other countries essentially shutting down their economies. But at this point, many valuation metrics have actually fallen below their long term averages.

We are also starting to see some signs emerge out of China and other Asian nations what to possibly expect on the other side of the peak of coronavirus cases. This crisis has led to a sharp decline in valuations to be sure. However, when the market stabilizes and the impact of the pandemic becomes more clear, the historically low interest rate environment continues to be supportive of elevated valuations relative to historical norms.

One of the strongest trends during the longest bull run on record was the outperformance of growth stocks versus value stocks. This was largely tied to the weak performance of the financials in energy sectors, which comprise a significant part of the value indices and much less of the growth indices as well as the strong returns from the technology sector, which comprises a small part of the value indices and larger portions of growth indices. While the signs have changed and markets have shifted from positive to negative returns, the theme of growth outperforming value remains. Financial stocks have been among the hardest hits in the downturn and energy is the same as the oil prices have fallen sharply. While there is potential for trends like this to persist for many years and through the different parts of the cycle, value stocks often exhibit cyclical characteristics that can benefit in periods where markets and economies reverse from a recessionary period to start a new cycle of economic growth. As a result, a balance of growth and value exposure can still be warranted.

And finally, a few comments on private equity. Private equity is inherently difficult to time. How companies perform in stressful markets often determine the success for private investments, especially amid periods of declining markets. Paper gains account for most of the early returns for recent vintages, whereas older vintages have long-term returns mostly baked in. Many of the tech titans of today rose from the tech bubble in the early 2000s. But the economic environment does not always have a big impact on private companies themselves. A study by Kauffman Foundation found the number of new firms and new establishments, those of existing firms establishing new locations, varied little based on economic environment. Other studies, including one published by Inc. Magazine in 2008, highlighted of the 500 fasted growing companies, 48% were founded during a recession or a bear market, essentially 50/50. This furthers the point that trying to time private equity is a challenging endeavor.

So with that, I'm going to pass it over to my colleague, Christian Busken.

Christian Busken:

Thanks, Brian.

Within real assets, we cover three broad areas, real estate, public and private, natural resources, including energy and other commodities, and infrastructure, including power generation and midstream energy. For this call, I'll focus most of my remarks on the energy markets, oil prices, and midstream energy infrastructure, specifically MLPs and midstream C-Corps, as these are the areas where we've seen the most significant declines. I want to emphasize that markets are shifting rapidly based on many factors and our views reflect where things stand as of this week.

First, a few comments related to real estate. While lower interest rates are generally a positive for property investors, the broad slow-down in economic activity will affect property values as distances delay decisions ranging from office leasing to new construction. Not surprisingly, the real estate sector is experiencing the sharpest declines year-to-date are the hotel and retail sectors, driven by a drop in travel and spending. Less economically sensitive sectors, self-storage, data centers and infrastructure have held up relatively better. We know that REITs are currently trading at a 20% discount to net asset value.

Let's move to a review of the events in the energy markets over the past two weeks. As most are aware, OPEC and certain non-OPEC countries met in Vienna in early March, but failed to reach an agreement on production cuts. Prior to the meeting, the market had anticipated additional production cuts along with an extension of those previously agreed to cuts which expire at the end of March. Notably, Russia refused to agree to additional production cuts, A decision that could be aimed at adding pressure to use shale producers who benefited from stable oil prices over the past several years and captured market share from OPEC.

Subsequently, Saudi Arabia announced cuts to pricing for crude oil and indicated it would boost production, effectively entering a price war with Russia. On Monday, March 9th, oil prices fell 25% to approximately $31 a barrel, representing the largest one day decline since 1991. As of today, oil prices have fallen into the low $20 per barrel range. I want to emphasize that we've been here before. In early 2016, oil prices fell into the mid-$20 per barrel range, but subsequently rebounded into the $60 per barrel range. The implications of sharply lower oil prices are potentially far reaching for the global economy. Energy companies will likely cut production, leading to lay-offs and banks holding loans to energy companies could be negatively impacted. Additionally, energy has become a higher portion of the high yield debt market, as Keith mentioned.

This diagram shows that China has been a significant driver of demand growth for oil over the past five years. And the slowdown in China's economy will impact demand for oil. Additionally, with the drop in air travel and a slowdown in global economic activity, oil markets now face both a supply and a demand shock.

This slide shows the break-even price per barrel of oil in various U.S. regions as well as Saudi Arabia and Russia. While break-even prices are low for Saudi Arabia, the prices actually required to support fiscal spending and social programs is much higher, closer to $75 per barrel. And while Saudi Arabia can issue debt, its foreign reserves have dropped substantially over the past five years, leaving less cushion to weather lower prices. Therefore, key questions remain about the impact on Russia and Saudi Arabia of lower prices for an extended period of time. We believe, given the dynamics in the global markets, current prices are not sustainable longer term.

Now let’s shift to midstream energy infrastructure. This area is comprised of MLPs and C-Corps. The companies in this sector own and operate assets crucial to the energy supply chain, gathering and processing, storage, transportation and refining. The midstream energy sector has traded in tandem with commodity prices with declines that have closely tracked the drop in oil prices as investors anticipate the distress in upstream will directly impact midstream energy companies. Additionally, selling by leveraged closed end bonds has further contributed to the recent downturn. Again, I want to emphasize that we've been here before. Having covered midstream energy since 2007, I can say that the declines during 2008 were equal to what we're seeing today.

We also note that the larger midstream companies have been leveraged over the past five years and are better positioned to weather a downturn. And we've seen significant insider buying at several large midstream companies over the past month.

Given the current situation, what are the implications for investors? Because many clients have an exposure to private energy, we've been in ongoing discussions with our managers that understand the impact of current market conditions. We expect to see markdowns in asset values, in private energy funds for first quarter of 2020. Managers use a number of inputs into their valuation process. Apart from commodity prices, these include reserves, production rates, operating costs and estimated capital expenditures. Managers also apply a discount rate commensurate with production profiles. For example, a discount rate of 10% will typically be used for proved reserves.

Other considerations related to private energy include the fact that many private energy groups hedge a portion of their oil and gas production to mitigate commodity price volatility. Many of our managers use limited leverage and acquired assets at attractive valuations during the downturn and were sitting on gains heading into the current downturn. As is always the case, those with capital to deploy, should be able to find compelling opportunities amid the distress.

I'll now turn it over to Greg Dowling for some additional remarks.

Greg Dowling:

Thanks, Christian.

All right. Well we've hit our main food groups of equities, fixed income and real assets. Just wanted to give you a quick thought or two on the risk buying strategies. This has been a much maligned area during the bull market as anything hedged not fully exposed is expected to underperform. Now it does provide diversification but now it's adding true value in risk mitigation. And that's the reason that we have them in our portfolio. So if we would look at the worst 20 months ever of the MSCI ACWI, so a global equity index from 1990 through 2019. And we choose 1990 because that's when we have good hedge fund data from. In every single one of those worst 20 months, hedge funds were down less, and considerably less. And in a couple of occasions were either flat or positive. And as we've seen early returns from hedge funds, and this is a very wide group and we had seen some do better than others, but on average, they're doing much better than the equity markets and other risk assets.

And so this is why we have them in portfolios, to provide that ballast because when losses occur, especially large losses when you get down 20%, 30%, maybe 40%, you have to be up so much more to catch up. So avoiding negative compounding in a situation like this is important.

So a few summary thoughts before we go to Q&A. Stay calm, we'll get through this. We want to think about rebalancing. Now there should be no haste in doing this. It should be organized and it should be thoughtful. And you need to look at your own investment policy statement and where your ranges are. Many of you will probably get in close to those ranges. And we say no hurry because this might be a little bit longer of a decline but also in talking with our fixed income managers, there is some wonkiness in some of the spreads that we're seeing out there. So better to do this in a well-organized manner than to do something haphazard. But maintain that discipline.

Also, be thankful that you're diversified. So diversification was tough during these last 11 years where it was a very narrow market led by mega-cap U.S. stocks. But because we don't know when external shocks happen, or any shocks can really happen, we have no crystal ball, diversification being a fiduciary is important. It means we're going to be down a lot less. We're still going to be down. We're going to be down a lot less. And because we're down a lot less, we can be opportunistic. Now, the active managers in your portfolio are already doing this. They're not doing it in a major way. And most that we've talked to are starting to nibble, whether it's on the distressed debt side or looking for quality equities that have fallen into their price range. They're starting to nibble and eventually there'll be the opportunity for some more tactical shifts within your own portfolios.

The most active that FEG has ever been with tactical recommendations was really in 2009, midway through 2009 into 2010. Not at 2008. It just takes some time for the dust to settle, but once the dust settles and if you're diversified you're going to be able to take advantage of these opportunities and set your portfolio up for returns for the coming years.

There are many unknowns regarding this virus. Going back to my section, I would look for three things, trying to get clarity on when we hit peak cases here in the U.S. If there are additional waves, we could look at Asia to give us some sense if this happens. So because does it come back in the fall. We can look for the government and how quick and how effective is their fiscal stimulus package. We know the Fed's there. It hasn't boosted markets, but it's really not supposed to. That's not the medicine we need. But it's helpful in keeping the liquidity of the markets going. So once we have all three of those, we do think we'll start turning around.

And stay tuned for more updates from FEG. We've done a lot on this area in different sections. We've done a deep dive on energy, given what's going on. We've talked about private capital markets. We have a whole section dedicated just to the coronavirus that we've been updating just about every other day. And so if you would like to have that information, you can go to our website. You could also subscribe at FEG/subscribe and get that information right to you. We also want to hear from you directly. So where webinars are part of our toolkit, sometimes having direct conversations are best because they can be tailored to your portfolios. So our consultants and advisors are reaching out, but we'd love for you to reach out to us as well. Whatever we can do to help you make better decisions.

Greg Dowling:

And with that, we're going to open it up to Q&A and we've got few Q&A questions here. I'm going to take the first one and then there's a few fixed income questions. And so one of the questions was, "Is the 60/40 portfolio dead? With zero yields for the near term."

Greg Dowling:

And I think we would say, no. Maybe the roles have changed a little bit. You used to be able to get more capital appreciation return from fixed income, but fixed income can be historic value. And with rates as low as they are, once we get through this, there is a exceptional earnings yield on equities. Most equities have dividend yields that are above the 10 year. And so with that, you could still get that return from equities and a little bit more of defense and quick sell-offs from fixed income. But fixed income is not going to be able to carry you as much. And we'd also even say that while 60/40 is great, we would diversify even more. So we've always been fans of diversifying and having such things as real assets in your portfolio, diversifying strategies. It is probably going to be harder just to have a fixed income portfolio that gets you the returns you need. And for clients that are accreditor qualified, maybe looking to areas in the private debt space or other areas might provide that extra yield if you could afford some of the illiquidity.

And with that, Keith, do you want to read some of the fixed income questions that have come in.

Keith Berlin:

Sure. I have a question as it relates to rates in the yield curve. So the question is, "When optimism returns, do you expect a big steepening of the yield curve as well as a movement upward in interest rates?"

Keith Berlin:

I think there's two parts to that question. The first one is it's certainly possible. But given the asymmetry in the rate market today we don't think taking on duration risk makes much sense. The other part of that is that long end of the curve probably will rise before the Fed is able to raise overnight Fed funds targets, given that they're going to want to wait and see the actual improvement in the economy. So I would say yes, you will probably see a steeper yield curve as optimism returns. And the Fed would be behind the curve in raising rates. Of course they could raise it in a dramatic fashion. Historically they have been slower to raise.

Keith Berlin:

Let me go to the next... we also have one on private.

Greg Dowling:

Yeah. There's one on the private market and the question was, "What will private managers do for some of their portfolio companies?" And Keith, I thought maybe you could take that in that private debt, the majority of private debt goes to sponsor led. So what are the things that people are doing?

Keith Berlin:

Yeah, there's two parts. One was on the business fundamentals and most of our managers are saying we've had a strong January and February and that's kind of baked in the first quarter numbers. Clearly March is going to be a challenge and so the second quarter is going to be key and pretty clearly that's going to be a challenge for folks to address.

On the supporting existing businesses, I think managers, especially the lenders that we've put money with, learned a lesson in the crisis about being fully drawn. They also didn't have subscription lines to better manage capital calls. And my sense is that they will have some dry powder to support existing deals, which is a good thing. Whether 10% or so is enough, remains to be seen. But we also think that sponsors will support their existing investments, given the amount of dry powder that they have. Some cynics out there would argue the other way and say that they'll step away from their deals, but I think the deals that they have confidence in, they will be supportive of that. There's a big equity cushion going into these deals and so we're optimistic they will support those deals.

Greg Dowling:

Great. Question that also came in is, "With most advisors conveying caution and patience, who is doing the selling, driving down the market?"

Greg Dowling:

The market dynamics have changed quite a bit. This is an institutional market, at least the U.S. market is about 80% institutional. But of that institutional marketplace, it has gone largely passive. And when you own passive indices, it's a little different than owning companies. So if you love a company, maybe you buy more. It's sort of sometimes things get hidden in the averages. So some of this is just blind index and ETF selling. Some if it is risk parity. So there's been a lot of rumors out there about risk parity unwinding. A lot of trading is algorithmic. Many of it has volatility triggers tied to value at risk. So those things are kicking in. There are also trend following managers who will tend to follow the trend down and it could be probably shorting into these markets.

So it's a whole host of things that I think the question was is it frightened retail investors? And there are a lot of retail investors out there. A lot of this is just blind, more systematic selling, but fundamental investors, some of the managers that we work with are kind of watching the decline. Clients, I mean, it's falling as we speak today, are starting to nibble. And so once things start to, we get to clarity on the situation, we get a little bit more information about that stimulus package, I think you'll see fundamental buyers step in in a big way. But right now we're in a bit of an air pocket. So hopefully we get to the end of the air pocket quickly.

Greg Dowling:

So there is a question about the U.S. dollar, Brian, so on currencies. Do you want to take that question?

Brian Hooper:

Yeah, sure. So the dollar in many ways is behaving as we would have expected, where a lot of the safe haven currencies, the yen, the Swiss franc, the U.S. dollar, for sure, have seen continued depreciation in an environment like this. Continued depreciation in reference to the U.S. dollar specifically. So there was some weakness late in 2019 as the dollar was somewhat extended from a valuation standpoint as well. But what you all can see in these environments, not unlike fixed income, is a flight to safety. And so those currencies, the U.S. dollar and yen and Swiss franc as I mentioned, tend to be those safe haven currencies. And so what we're seeing there is somewhat to be expected.

But in fact, just was in contact with a dedicated currency manager earlier today and got some interesting feedback from them that there are some odd things occurring in terms of spreads within some of these less liquid currency pairs and some challenging environments to be a currency trader. So outside of the U.S. dollar and some of these more reserve-based currencies, there are some interesting things occurring that not necessarily interesting in a good way. There are some concerning things occurring but that's what we need to be aware of in our monitoring as we talk to, not only dedicated currency managers, but also active equity managers because currency certainly plays a significant role in short term returns and volatility for equity. So I would say, in general, behaving what we would have expected, but there are a few smaller issues that we're closely monitoring and talking to managers about.

Greg Dowling:

Thanks, Brian. So Christian, there was a question about MLPs. So, "Do larger elaborate energy pipeline companies have significant counterparty risk even though their contract fees are fixed?"

Christian Busken:

Okay. So larger leveraged pipeline companies, they have exposure to a broad range of counterparties across the spectrum in energy. So those could be large diversified EMP companies or they could also include some smaller more marginal companies. We certainly expect that we will see continued bankruptcies in the upstream sector. We saw that happening over the last few years. Certainly likely to continue today given where prices are. The contracts with midstream energy companies are all structured a little bit differently. So it's hard to make a specific characterization of what those look like. But I would say we will probably see contracts being renegotiated as the energy sector continues to work through the turmoil that it's experiencing.

Greg Dowling:

Very good. All right. So question regarding private capital and it says, "What implications does this have for PC commitments and adjustments needed?" Maybe I'll start with this and then if Keith or Christian want to jump in.

Greg Dowling:

So I think fundraising for itself, so new fundraising's probably going to get pushed. So some of those people that were planning to come back to market end of first quarter, early second quarter, they're probably pushing back their time line or at least extending things to give investors some more time. I think current funds, the GPs are very aware of the tension that exists between potentially having great things to buy but also forcing investors to sell maybe at an inopportune time. And so they're trying to find balance there.

There was a lot of pushback in 2008 and 2009 so they are very aware of that. I would say the one difference would be credit lines. Credit lines are being used much more by private capital managers to boost the IRRs, and so things that have been outstanding for a long time on lines may cause some need to cover those lines. And so we'll just kind of have to wait and see, but I don't think it will be as bad as fears in 2008 but there probably will be some calls but maybe that will be helped out by those new managers pushing off their final closes.

Keith Berlin:

I would just say on the private debt side, pretty clear that if this continues, we'll see an increase in distressed mangers coming to market and likely to be able to raise big money. And on the lending side, I think the thing to think about is what is that risk premium between private, which tends to be pretty stable, and public, which is now widening towards where private coupons and private all-in yields are. So that'll be interesting to see if people choose to allocate to the public markets, given how wide high yield has moved and bank loans and maybe they skip one on the private debt side. It's something to think about more strategic allocators, but some may do half and half, something like that. Christian?

Christian Busken:

Yeah. It will definitely put a damper on fundraising, particularly in energy. It was challenging to raise an energy fund last year. It just got a lot harder recently. On the real estate side, there's a lot of dry powder on the sidelines to the tune of a few hundred billion dollars. At the beginning of the year, there were over 900 private real estate funds in the market looking to raise capital. I don't know if all those funds will get raised. They probably won't. So in the real asset space, a lot of cross currents that will impact fundraising. As far as drawing down capital, it really depends on the strategy and what the manager is looking to do, but there will certainly be some distressed opportunities arising in energy.

Greg Dowling:

Well, very good. Well, I think we answered the majority of the questions. We're right at about an hour. For any questions we didn't answer, we are happy to take them live. We are easy to track down. Most of you know how to reach us, and if not, you could look at our website and feel free to either call or email us. Wanted to let everybody know that we will send a replay and the presentation for all attendees so if there's a slide that you wanted to use or review, it'll be available to you. And please look to our website and see if there might be some additional resources that you can use. And let us know how we can best serve you. Thanks for your time today.




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