Webinar Replay - Stock-Bond Correlation: A Global Perspective
Noah Weisberger & Bruce Phelps of PGIM IAS examined the historical pattern of stock-bond correlation across the globe.
With low interest rates and higher inflation likely to persist, among other perplexing factors, investors face a number of conundrums. Fixed-income investors are being forced to seek yields outside traditional benchmarks, look across the credit spectrum, and try to capture new opportunities in both public and private credit markets.
Albert Trank, Executive Managing Director and Portfolio Manager of PGIM Private Capital's Institutional Asset Management unit, joined CFA Institute’s 2022 Alpha Summit Global Conference for a session on Navigating Today’s investment Conundrums. During the discussion, Trank shared insights on opportunities across private credit markets and explored how investors can allocate capital to successfully navigate historic uncertainties and changing dynamics in global markets.
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>> Welcome, everyone. And thank you for joining this session, Navigating Today's Investment Conundrums. What a timely topic, given everything that's going on in the markets we hear in this conference, many of the concerns that investors have, it's a very geopolitically uncertain world. It's very economically uncertain. Who knows what public policy will do next and what influence it may have on the markets. That's what we'll be addressing today. And I really look forward to the discussion that we're going to have here. Al Trank, he is in CFA. He is the executive managing director and portfolio manager at PGIM Private Capital. So, a number of us in this conference, in this session have recently garnered our CFA as we recently achieved that designation, the CFA designation. And having done that, we all know the importance of fundamentals and fundamental value. However, when we hit the real world, we find that it often has other plans for us. And those other plans lead to this conundrum. What do we do in an environment where fundamentals begin to take a backseat to public policy? What do we do when the phrase market prices becomes an oxymoron? Two seemingly self-contradictory words, market prices? Is the market setting prices these days? Should we be navigating perceptions of public policy? Should we be investing in underlying fundamentals? Or should we be attempting to integrate the two? We have gotten ourselves in the industry. We've done it to ourselvesin adhering to this absurd performance cycle, three to five-year performance cycle. And it really is absurd. As an example, I did a study myself just for this. And I set up a simulation of 100 managers. And I assumed that they were all skillful, that they all had an inflammation ratio of 0.35, kind of not as high as everybody averages but higher than what everybody achieves. So, they all have skill. And I gave the market in this simulation some mean reversion. In other words, it is getting pulled toward value, just as it should be pulled toward value. If I simulate that and I fire these managers, out of these 100 managers, if I fire them when they've underperformed for five years, it's astounding that about 60% of them, 60% are terminated by year 15. Do we end up in this environment having to devalue value and elevate navigation? I know, Al, and in your environment, you have the maybe I'll say the luxury of dodging that a little bit because of your activities in private markets and private placements. What's your perspective on this overall conundrum that we're in? And how do you think private markets actually fit into that, private placements and private markets?
>> Yeah. Thanks, Brian, I think maybe I studied my CFA material too well that I still think that fundamentals matter the most. And certainly, that's the perspective that you have to take as a private investor. And I'm focused on the debt side where, you know, the best you're going to do is to get par back at maturity. So, you're definitely taking a very long-term view, it has to be a conservative view. And that timeframe really, really never changes. I think, you know, we can have this session at any time over history and we're going to come up with the five things that keep us up at night or that we're concerned with. And it seems that we always get through it. But, you know, as an investor, as a long-term investor, you want to partner with companies that are going to create value, that have good management skills that are going to navigate the markets, market conditions well themselves. And, you know, the private market is distinctive in many ways in addition to the timeframe.But, you know, the value proposition is simple that you're going to get incremental spread or yieldsover light quality public bonds and you're going to get financial covenants.If you're lending well, that's what you're going to get. And those financial covenants lay out the financial metrics in which the company needs to operate. And if they don't, it's an event of default and infinite accelerated and renegotiate your deal. So, those covenants very much align interests with you as a lender. And the company in management helps eliminate some of the agency risk and corporate lending. As you know, companies are trying to maximize equity value, shareholder value or the family's value if it's a private company. So, that alignment of interest is important. Itmakes the transaction much more relationship-oriented. So you get, you know, very strong disclosure from the company although it's not publicly available. And, you know, our experience in lending in the private market for, you know, decades probably, you know, over eight yearsdoing things in a pretty consistent way that, you know, it's very critical to get those warning signs very early. You know, we have dedicated workout teams. It's this critical part of your performance. But what's more important is to intervene early in any derogation inequality.
>> There's a monetary school shall we say called endogenous money. And the view there is that central banks don't actually create money. They can't control the money supply. What they can do is control reserves. And that's a source in the system. But ultimately, its creation of money depends on what the private sector does. And in this instance, the private sectors credit facility has taken a big hit since the global financial crisis. Disintermediation is regulatorily driven to a large degree and that makes central bank's jobs harder. So, in this environment, it is the credit facility that takes the reserves and ultimately creates money in the system. And it wasn't really being created. And the reserves kept growing and money supply didn't get created to the degree that maybe the Fed would have liked and to the degree that was ultimately inflationary. How does that impact the way each of you invest? How do you think of the central bank's, the public policy role and again, kind of coming back to the demand for credit? But the entire credit function of the economy, investing, yes, public, private, the yield curve, short-term interest rates and relative to longer term interest rates, it's a huge, huge influence that exists across markets that is somehow trying to be influenced by policy but not necessarily -- policy is not necessarily in control of it. Does that -- what kind of perspectives does that provide and maybe even from the perspective of currencies as well?
>> Certainly, anything divided by zero is infinite. So, there's been a tremendous incentive to take risk and buy assets and invest. And we certainly see that in terms of asset valuations. The low interest rate environment has clearly had an impact on institutional investors like insurance companies and pension funds that have, you know, have many old liabilities at fixed costs. And so for pension funds, trying to meet a 5 or 6 or 7%, you know, define benefit plan hurdle.That's created a lot of push into private markets certainly. And, you know, I've kind of seen an evolution there where it was long.The domain of insurance companies exclusively with 70% fixed income allocation so plenty of illiquidity to focus on privates. Then the low interest rates pushed investors into higher yielding private asset classes like directlending which is single B, floating rate market, the market created by the policies and change in reserve requirements of the banks out of the global financial crisis that you referenced, Brian. And I think institution stepped down very efficiently and provided those vehicles for investment. And endowments, of course, have long been, you know, leading investors in private equity. So, a big push into the private asset classes based on low interest rates. And, you know, it's creating a very substantial demand in areas where capacities is pretty limited. So, that puts a lot of pressure on the pricing on the terms that created value in the first place. So, in some ways, we look at this dislocation potential for recession favorably because, you know, wider spreads and better terms are likely outcome. And as well, you'd expect to see a shakeout in the asset management industry as, you know, a lot of people have been drawn into these asset classes.
>> Just to get your thoughts on this, the economic implications of the zero rate and then the unwinding some of this liquidity.
>> Increasing rates are obviously going to have a much more dramatic impact on lower rated companies. And, you know, we've seen clearly the substantial increase in commodity prices and gas prices. You know, the initial COVID supply chain issues and those increased costs were kind of handled by companies pretty well, like past those price increase [inaudible] consumers well. But at some point, the consumers are going to choke, right? They're coming out of COVID eager to spend money. They've been, you know, locked up for a couple of years. But, you know, gas prices are $7in California. It's going to eat into consumers' spending power. And that, you know, that impact is going to affect companies that, you know, are covering interests at much lower levels. So, we have a credit on our mezzanine side so a risky side in the business of a beverage company. Aluminum was a big input that caused increase on aluminum exactly equals their EBITDA for last year, just that price increase alone. Obviously on the investment grade book, a different story, there's much more room to accommodate things like that. But in addition, you know, lower quality companies generally will borrow in the floating rate markets. So, you know, this nonparallel shift yields a substantial increase in short-term rates as well, going to have a more dramatic impact where higher quality companies generally have, you know, a pretty good portion of fixed rate debt. So, I think, you know, those are some of the more immediate impacts. We might see a lot of pressure on higher yielding companies, lower quality companies.
>> OK. And Anne [assumed spelling], we'll shift over to you here with the same thing. But as we go through this, maybe for all of us to potentially opine upon is we are talking about increasing nominal rates. But then the question is how restrictive is all of this when we are actually seeing real rates that have been quite negative, still negative, maybe less so than before but likely to be low for a long period of time? How do we interpret that as to the paying the price for profligacy during this period of low interest rates?
>> You know, there's a lot of pension plans that are looking to diffuse their liabilities, looking to transfer their liability off balance sheet and the low-interest rate environment made that very difficult to do. So, I'd expect to see a lot more of that activity with the increasing rates. And, you know, again with respect to terms and covenants, they become more valuable when there is volatility, when there is economic stress. And, you know, the thing about private companies which, you know, our primary issue in the private market is that, you know, they can look exclusively at the long-term value creation. They don't have to worry about quarterly earnings. And you get a lot of suboptimal behavior when you're really focused on managing the quarterly earnings reports. So, I think in some ways, you know, that form of ownership and others as well do have distinct advantages. And if you look at private portfolios at least in our own and I think it's comparable to others, there's only about 5% overlap with issuers in the US credit index relative to our investment grade books. So, there is the opportunity for, you know, more substantial named diversification and as supply chains expand, you know, there definitely is going to be a reshuffling of the deck a little bit in terms of opportunities. And, you know, a lot of that's going to fall to private companies.