Anthony Danaher of Guild: Income Investors Need to Look for Growth When Rates Rise

Guild Investment Management |
Anthony Danaher

The first six months of 2015 are in the books, and investors don’t really have much to show for it. Stocks are more or less trading at where they started the year, albeit with quite a bumpy ride in between, and other major asset classes have not done much better. With so much uncertainty looming, investors may be wondering if the generous bull market may be winding down. caught up with Anthony Danaher, President of Guild Investment Management to discuss how to invest when rates start rising and why investors should be saving up some cash for another big gift from the market.

EQ: With the first half of 2015 coming to a close, how did the market perform to Guild’s expectations?

Danaher: There were a few different chapters in 2015's first half. The year started with a deflationary scare and strong bond market, and were replaced by worries about higher interest rates and higher inflationary numbers, and then it culminated in global geopolitical factors sending all the equity, currency, and bond markets into somewhat disarray just as at the close of the second quarter.

Underneath these swings, a constant throughout the quarter was that growth stocks in key growth themes kept outperforming, whether it was biotech or other healthcare, or certain technologies like social media and cybersecurity. So there were pockets of strength that stayed strong through the whole first half of the year. Some of the strong groups were related to the strong dollar very early in the year, and then when the dollar started to weaken versus the euro, you had other sectors and stocks that had underperformed because of the strong dollar start to do better. So again, it was a couple of different chapters.

In general, however, you had this give and take of macro fears of deflation or inflation and geopolitical impulses driving stock markets as a whole, but definitely there was a wide disparity between groups. I would say it was probably three different distinct environments in which to invest.

After all of that, the indices are very little changed on the year so far. It was a very circuitous route to get to where we started the year. It was frustrating for the long-only managers, but also frustrating for the active, tactical managers too.

EQ: As you mentioned, the potential rate hikes were one of the biggest themes at least in the US markets. After passing in June, the market now expects the Fed to raise rates either in September or December. How likely do you think that will be?

Danaher: We may end up getting both. There are certainly some people who think there should be multiple rate hikes. But based on the economics, we feel that they should and will be raised. But, on the other hand, if you look at certain global economic events and geopolitics, the Fed may have to defer. They're going to be data dependent. It just depends on the amount of chaos that is reigning in the bond markets and the currency markets. There could be a situation where the Fed defers even though the data keeps strengthening. They’re looking at the domestic data, but they've also indicated that they're going to be looking at global events, global data and global changes taking place before they act.

It is entirely possible they may defer to 2016. However, if you just look at the US economic activity with respect to employment, with respect to prices, with respect economic activity and home building, they should raise rates. They should start to normalize policy.

The key for the markets is when and how fast you go from a current yield curve that is 0% short term interest rate to 3% at the long. If it moves to 1% at the short end to 4% at the long end, those are still historically very low interest rates, so we don’t think it is a function of whether or not we're going back to higher interest rates, it's just the path of going from where we are now to where we are going.

Those are some sizeable moves in the cost of funding and as we all can see from the markets today there is a tremendous amount of borrowed money out there. Every incremental rise in interest rates dramatically changes the overall expected rate of return on portfolios of assets. Investors and asset allocators have to take that into consideration.

We do think rates start to go higher, but should they go back to historical norms? Probably not anytime soon. Rates should stay low.

EQ: Guild Investment Management sent out a note to clients earlier in June, and it did say that traditionally investors, particularly retail investors, are conditioned to look at bonds as a conservative area. Given that we're dealing with a lot of uncertainty right now, investors may be looking for bonds for safety, but that might be the worst decision right now. Can you elaborate on that?

Danaher: Since 1982, the bond yields have been in decline, bottoming in 2012, bouncing in 2013 and then falling again in 2014 into earlier this year. Rates in the US have been chopping out a bottom for a couple years. If interest rates start a prolonged rise, longer-term bonds are going to appear to be anything but safe.

Investors who have been investing for income may not recognize it at first, but the capital risk will be evident only after about a year of taking some pain. It’s not just longer term bonds at risk. There are alternatives to longer term bonds in investor portfolios. Lots of investors have hidden in bonds funds or even worse, hidden in equity like bond proxies. Bond funds and ETFs may have a lot of illiquid high yield or illiquid emerging market debt. These securities have gathered a lot of capital in recent years, and are supposed to act as diversified proxies of underlying investments. The problem is the assets underneath these funds are not that liquid, and when you start to get redemptions in those bond proxy funds, you could really start to see some disruptive trading activity and large declines in net asset values of these funds.

A large amount of the investor money that has been plowed into these funds in many cases is ‘conservative’ money. It’s money looking for a cash return. It’s not looking for large volatile moves, certainly not declines. That is a risk that we believe investors need to be made aware.

EQ: So for investors, especially those interested in income-producing assets such as bonds and dividend stocks, how should they approach this market environment?

Danaher: Well, with all that being said, we are recommending people with income-centric portfolios to shorten their bond maturities as much as possible. If it's bonds you have to own because that is what your mandate suggests, you just don’t want to own many longer-term bonds as rates are rising you’re your mandate is more flexible and you just need cash returns from your investments, there are fast-growing stocks that pay dividends. We think those are going to be a better bet, but you can’t just look at the dividend rate. You have to look at dividend growth because in a rising interest rate environment, the market will not be kind to dividend-paying stocks or dividend-paying investments that are static payers. Investors will need some visibility of dividend growth for them to keep up in this environment.

So, fast-growing stocks that also pay dividends, and companies that are buying back their shares in order to create per share earnings growth and rising dividend growth are the ones we think can work. But your bond proxy investments, your bond funds, bond ETFs, your REITs, your utilities, your MLPs that have been very popular for people to hide out in and collect income; they could be in for tremendous pain. Too many income focused share could cause some significant declines in the portfolio, unless you are concentrated in those that are able to grow their payouts.

All that being said, if the geopolitical situation is so disruptive that the Fed is on hold, and that 0% interest rate environment persists even longer, then these bond proxies and income focused stocks will gain favor again and people will come back to them.

However, in the event that we start a rising interest rate environment, you just have completely transition the portfolio from just seeking income to looking for growth plus income, not just income. Remember we are just exiting a 32-year declining interest rate environment, where interest rates in much of the developed world have been negative. It would make sense for investors to get used to the idea that a new environment where rates start to rise is on the horizon.

EQ: So at the very least, you want stocks that can keep pace with the rising rates.

Danaher: That is correct. Dividend-paying investments that can grow those dividends and grow the cash flows that are going back to investors are better.

Fixed income or static dividend investments that have less visibility of growth will start hemorrhaging in portfolios as rates rise. As funds that own them start getting redemptions, it could just start a cascade of decline. You can’t ignore capital flows. It’s not just a function of how much you're being paid in an investment today. You also have to take into consideration who owns that investment with you, how much ‘short term’ money has plowed into it. When those capital flows are reversed, it can create a tremendous headwind for a portfolio. That is why income investors also should be tactical.

We do see some opportunities to earn dividends in a rising interest rate environment, but the truth is the opportunities are fewer than in a declining or stable interest rate environment. It is time to be more selective.

EQ: Looking at the equity markets. We have not really seen a correction in quite some time. What is the likelihood that we do see a correction or perhaps even a deeper decline before the year is over?

Danaher: A deep decline before the year is over is probably going to be a function of the macro. The macro-factors impacting are trumping micro-economic and company fundamentals.

When I say macro-factors, I’m talking about geopolitics, currency movements, interest rates, global solvency issues, or concerns about whether there will be more politically inspired debtor revolts. This could cause a much larger decline than we would expect based on the economic fundamentals alone. In general, global economic growth is modestly improving and interest rates are still very low; central banks are very accommodative; earnings are growing, so a large decline would likely be prompted by something global, macro in scope and not based on the company, industry, or business fundamentals. Yes, valuations are on the high side, but valuations are always higher when you get such low cost of funds.

We would look for a pullback of 5% to 10% perhaps in the US at any time. That is a normal market pullback. Anything greater than that is likely going to be accompanied with some other events.

Longer term, another big decline and crisis looms, but it is hard to say the second half of 2015 is the window in which those happen. If you think about the last 15 years since 2000, the stock market in the US has had two 50% declines in that period. Is the likelihood of a third greater or less? I would say there's one around the corner but it's hard to really say that it's going to happen here in the second half of 2015. I do think there's enough economic growth taking place and enough accommodative positioning by the central banks to keep that from happening this year. But we look forward to 2017 and 2018 with a very concerned eye towards the truth of what could happen.

EQ: We receive the Guild Investment Commentary newsletter every week and it's one of our favorite reads. There are a lot of different types of areas of the market that you guys always cover and you do a great job doing it. With that in mind, what are some areas of the market right now that you do like?

Danaher: The most attractive areas from a macro perspective continues to be Healthcare—especially biotech—and certain areas of technology. When you look at Health Care and biotech, you have tremendous advances in the technology there. We were just talking about this in the office, that what's happening in biotechnology and drug development is the same thing that has happened in the technology for oil-field development. The technology has improved so you have fewer costly failures, fewer costly ‘dry holes’ in the oil patch, and fewer costly drug development mistakes in the drug patch. New medical technologies are exciting and making for more opportunities.

When you look at technology, not all areas of technology are as attractive. Semiconductors, for example, are having their typical cyclical swings right now. But within Technology, cybersecurity is an interesting area. You're going to continue to hear about cyberattacks and the companies in that space are trading at very high valuations, but the companies operating in this space are also having money thrown at them left and right by various industries and governments around the world. For instance, one large US bank basically has issued a blank check to fight cybercrime. That blank check goes into these companies, so there are some very fast growing opportunities within the overall technology market. Robotics is another exciting area. These areas will continue to grow.

At the same time, you also have some consumer technologies. This latest Fitbit (FIT) IPO has done a lot better than many people had thought. People were surprised that they were profitable. But this is the thing, there are going to be areas of the US consumer economy or the global economy that are very attractive for short periods of time. It’s hard to know whether or not it's a fad, whether or not these are going to be replaced by other technologies. But in the meantime there's always new, exciting technologies taking hold, capturing the imagination of the consumer. These can be opportunities for investors. It's just a function of doing your homework. There’s a lot of research that goes into finding these new technologies and figuring out which ones have more visible, longer futures.

EQ: On the flipside, for those looking to protect their portfolios during a bit of volatility here. What are some of the most significant headwinds or potential storylines that you're watching just to make sure that we don’t stumble into a 10% correction or deeper?

Danaher: Some of the issues that have just come into light here are:

Greece has gotten to a critical stage. There are a lot of people that don’t know how the Eurozone and the euro currency could unravel, should it unravel. There’s a lot of conjecture about how that will happen. That in and of itself creates uncertainty. There’s bound to be a period of fear and risk-off attitude. There’s a lot of borrowed money in the market, and that borrowed money gets tapered back. People reduce their exposure.

China’s stock market had a big rally this year, but its recent volatility and its decline over the past couple weeks has to be on the radar as something investors should watch.

Another cause for concern later in the year is if you were to start to get rising prices, if the inflation numbers were to lift off from their very low levels to higher numbers, where people start extrapolating much higher future level of inflation, then you're going to have really tremendous problems, especially for the bond funds, Utilities, REITs and some of the other areas that are interest-rate sensitive. At the same time, even though higher interest rates might be a function of and accompanied by faster economic growth, if it's at all perceived that prices are rising faster than the Federal Reserve is comfortable with, then you get a shift in expectations. That will create a lot of portfolio dislocations in certain areas.

Energy is another area to be careful in. The West is in the middle of a negotiation with Iran about how much oil, if any, is going to be put on the world market. At the same time, you also have a lot of oil companies in North America that have curtailed their hedging programs early in 2015 because prices were so low. At some point, they will want to hedge their ramping up production. As they going to have to put on hedges, it will keep a lid on oil prices.

On balance, I think the macro-factors overseas have a lot to do with too much debt. Such as in Greece or, earlier this week it was Puerto Rico. Are these a function of indebted government borrower deciding that it may be better to not pay back their obligations? If that starts a chain reaction of other governments of other municipalities thinking that they may be better off not paying those obligations, then that could lead to a debtors’ revolt, and the world and the leveraged markets are not ready for that.

EQ: That sounds like a very scary situation. Is there anything that you want to leave us with in terms of closing comments or final thoughts or things that are going on at Guild that we should be aware of?

Danaher: Of course there are certain areas that do have headwinds, but there are areas that have some very attractive fundamentals.

One of the exciting things that keeps coming back to us is when you look at the overall wealth that's been created in the markets over the years, it's in business development. It’s growing businesses. It’s in equities. So we look at the equity market as continuing to be an area of opportunity.

It is going to have big declines at some point in the future, but we think it is very important that investors not be so complacent as to think that it's always going to give them a steady 7% to 8% return a year. As I mentioned, we saw two big declines in the last 15 years. I think investors are aware of that, but what happens is as people get greedy, they start to look at the last five or six years of very strong equity market performance and they start to extrapolate.

We think the market has gone up far enough that you should really start to be more selective about what you own, and also be more selective about when you own them. Performing is going to about how tactical you are.

We do think there's an opportunity right now to have some cash in the portfolio, maybe larger than normal cash balances because opportunities are going to be created. We’re working on a buy list for when you get one of those big declines, which in the long-term view of an equity investor, those big declines are gifts.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:


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