Mark Dow: Expect Volatility In Fixed Income

December 28, 2015

Mark Dow is the founder of Dow Global Advisors, based in Laguna Beach, California. He is also the author of the Behavioral Macro blog. Dow has 20 years of experience as a policymaker, investor and trader, focused on global macro and emerging markets. He has been a senior portfolio manager at Pharo Management LLC, a portfolio manager at MFS Investment Management and a senior sovereign analyst at Putnam Investments. Dow began his career in Washington as an economist at the International Monetary Fund and at the U.S. Department of the Treasury. Let's start with the Fed interest rate increase. I assume you expected that.
Mark Dow: I didn't really know when it was going to raise rates. In my beginning-of-the-year piece, I think I'd indicated the second half of the year, but I really didn't know; it was data-dependent. To me, it's not a big deal.

My view has long been that the proponents of QE overstated its usefulness. And the detractors of QE dramatically overstated its harmfulness. That's becoming clearer over time. It was very helpful at the beginning to short-circuit the negative-sentiment feedback loop that was rippling through the markets, and it helped people repair their balance sheets faster. But it didn't spur growth the way the optimists thought it would.

It was just a matter of when the Fed could get to the point where it could raise rates where the market was psychologically in the right place. The market was pretty well prepared for this.

Uncertainty is going to be there and be even more acute in fixed-income instruments. For the past 10 years, everyone has been saying yields can't go any lower, and yields have kept going lower. Now we're at a place where a lot of people believe that yields are going to stay really, really low forever, or for a really long time.

So we now have a split market in terms of where yields are going to go. Because we now have two camps, whenever yields go higher, there'll be a bit of a panic. The people who believe in low rates are going to start questioning themselves, and some will get spooked out of their positions. And then in the phases when the economy slows down a little bit and rates come down, some of the people who have been looking for more inflation are going to lose their nerve as well.

In short, I can see a lot of volatility as we go back and forth between those camps as the issue of where today's normal is gets settled. There's a lot of uncertainty as to where yields should be. And it's no longer one-sided. That's the new phenomenon. Is this push and pull between these two camps keeping the high-yield bond downtrend a step-by-step process, rather than a full-on meltdown?
Dow: I think so. And it's not just high yield. It's mortgage REITs, MLPs, almost any levered vehicle. Even munis felt it a little bit. In the run-up to the rate hike, people got really nervous and they shed these types of assets. Of course, the high-yield bond market had the exacerbating coincidence of falling oil because it's such a large driver of the high-yield market.

For me, the most important takeaway from the Fed meeting is when Yellen in the press conference said that they're not going to spell out what the formula is that they need to see for further hikes.

They want us to watch the data and they want us to be uncertain. They want us, the financial markets, to stay on our toes. They don't want us to get comfortable with the rate path, because that might lead us to piling on too much fixed-income risk that could create financial vulnerabilities. This is super important. [Vice Chair of the U.S. Federal Reserve System] Stanley Fischer also made this point very forcefully back in March. What's the bigger influence on the high-yield bond market, what the Fed is doing, or is it really energy?
Dow: Oil's moving fast and it's scaring people. When people get scared, we don't get really picky about coefficients and weights; we just kind of react. And I think we're at that phase.

A lot of guys have been dipping their toe in oil over the past 18 months, and they have lots of positions in names they thought were safe—both high-yield names and stock names. So they're kind of hanging on and saying, "Hey, this has got to end." And it's proving very hard for these guys to hold on to these positions.

The important points to make here, for me, are a few. One, this is primarily about energy; it's not about the end of the cycle. Janet Yellen said something that I thought was great, something I've believed for a long time: Economic cycles don't have an age; that is, they don't necessarily die of old age.

A lot of people are saying the fall of high yield is a harbinger of the end of the economic cycle, the end of the recovery, the end of the credit cycle. It always precedes stock market sell-offs and bear markets and things like that. And that's not the case, for several reasons.

One, our recovery didn't start for a few years because we had to get out from under all that leverage. But also, our growth rate has just been so anemic. And typically, cycles end on too much optimism, when the business sector has invested too much and hired too much. And outside of maybe some unicorns in San Francisco, it's hard to make that case for the overall economy in the U.S., the case that we're too optimistic.

Every investor has to ask himself or herself, "Do I believe what's happening in high yield is a signal that the economy is rolling over? Is it an end of the credit cycle? Or is this a more idiosyncratic phenomenon, having to do primarily with the price of oil?" I think it's the latter, but that's a big call that everyone has to make for 2016. We've seen some big outflows in high-yield ETFs. Is getting out the right move?
Dow: I'm not interested in buying high-yield distressed debt—even if I don't think it's the end of the credit cycle. Not yet. If you've got the skill set for it, you might want to buy some of the stuff that's not oil-related that gets blown out along with it; that's a better play because people indiscriminately will sell.

People always are worried about the price of oil when they look at these securities. But it's not just the price. It's time in price. So if oil doesn't go down any further, but stays here for a year, the second- and third-tier oil exploration companies are going to go under, and only the first tier is going to survive.

When there's a big crash like this in oil, it takes a long time for things to heal. We're going to need to see mergers and bankruptcies in the oil space before we can feel more confident that it's over.

But it just feels to me psychologically that it's too early to be jumping into energy high yield. So it's a space I would still stay away from. But you keep your eye on it, that's for sure.

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