ED HARRISON: Welcome to Investment Ideas. I'm your host, Ed Harrison, and we're talking to Michael Lebowitz today. He is a partner at Real Investment Advice and also a partner at their subscription service, RIA Pro, as well as a portfolio manager for RIA Advisors. Now, he's going to talk to us about where we are in the business cycle and what that means in terms of a steepening yield curve and how you can invest based upon that. Let's get right to the interview.
Michael Lebowitz, it's a pleasure to have you on Investment Ideas.
MICHAEL LEBOWITZ: Thank you for having me.
ED HARRISON: Well, we were talking about this before that, in this show, we look at a six to 24-month timeframe, you were telling me that you have a few investment theses over the medium term, six to 18 months. Tell us a little bit about that.
MICHAEL LEBOWITZ: So, from a broad level, I think we're getting perilously close to a recession and what does that mean? So, I have a deep background in fixed income. So, two of my ideas have to do with corporate bonds and with a steeper yield curve. First one, as you know, curves invert before a recession and then they come out of it and they steepen, and they steepen very quickly. I have a feeling this time we may not invert, we may have seen the lows already, that the yield curve 2s, 10s may have troughed. Other yield curves have inverted. But there is some steepening going on, the 2s, 10s curve has steepened 10, 15 basis points at this point. And I think that it just may not invert, and the steepening will be the potential recession signal that we're getting.
So, the question is you can put on all kinds of steepener trades using euro-dollars, using Treasuries. But how can more of an individual investor or any type of investor take advantage of a steeper yield curve? And what we have recently recommended to our clients is two companies, Agency, AGNC and NLY, which is Annaly and they're mortgage REITs. And essentially, in a very basic sense, what they are are mortgage portfolios. They borrow money short term, they buy mortgages, they use leverage, they hedge.
The steeper the yield curve, the more money they make. The more leverage they take on, the more money they make. The less they hedge, the more money they make. And those are the three basic components of their profits scenario. So as the yield curve steepens, it should be beneficial to them like it is for banks, a steeper yield curve.
ED HARRISON: When you talk about mortgage REITs, these are companies like what's their business model- commercial or?
MICHAEL LEBOWITZ: So Annaly and Agency specifically, I really like them because they are almost 100% government-guaranteed mortgages. Fannie Mae, Freddie Mac, Ginnie Mae. So there's really no credit risk you're taking. You have re-fi risk, you have duration convexity risk, but you really don't have the credit risk. So, it's about as pure play on the yield curve as you can get. And that's what I like about it. Other REIT, there are other mortgage REITs that do take credit risk as well. And I'm not saying that we don't like those, but I just like these just because they're pure.
ED HARRISON: So, tell me about the economic thesis behind this, because when you were talking about it, you introduced it. You said that it could be a recession, wasn't necessarily a recession. Where are you on that issue?
MICHAEL LEBOWITZ: As you know, this is the longest economic expansion we've had in modern US history. So obviously, a recession coming should not be a surprise to anyone. Now, I think that we're in the window of a potential recession, doesn't mean we're going to have a recession. But growth has slowed sharply, both here and globally. And I think that's due to the fact that there's a lot of stimulus that's rolling off. We had a huge increase in the fiscal budget, fiscal deficit went from 500 billion to over a trillion so that extra 500 feeds growth because all that money is spent. Some of that was related to the hurricanes and to the fires in California. We had the corporate tax cut. And both of those are now over a year old.
So, the benefits are waning quickly. At the same time, we also have QT still going on. And the lagged effects of the higher interest rates from as early as last December, that was only six months ago, are still having effect. Throw into that slow and global growth, you have what- UK, Germany, Japan, China, and a host of other smaller countries all have PMI readings now below 50. US is still above 50, but pretty close. And some of the regional surveys have dipped below. So, I think the window is there. The question is what will cause this, what's the shock?
ED HARRISON: And so, let's look at it in aggregate terms. So, let's say that we're looking at an economy that its baseline growth level is of the order of 1.5%, 2%, something like that. And then you take in what you were calling the roll off of the stimulus, throw out a half 1% as a result of that, and that takes you into the stall speed below 1% where a lot of these things you're talking about, but what about like the shock? What takes you to that next level?
MICHAEL LEBOWITZ: It could be anything- a change in consumer sentiment, it could be something with Iran, it could be storms again. There's a whole host of things- trade wars. There's a whole host of things going on. It may just be people retrenching, consumers retrenching, corporations retrenching just a little bit. And it's probably you know what, whatever is ultimately deemed as the cause, the shock is something that we're not talking about. And it doesn't really matter. The point of the matter is that the potential for recession is higher today than it's been since 2015-2016.
Will we go into recession? I don't know. But we do know, if we go into recession, the Fed only has 250 basis points of easing to do. We know that fiscal stimulus or we should assume that fiscal stimulus is not very likely, given that you have an election coming up and a house that will probably not vote for anything that helps the economy in a meaningful way, which would help Trump. So the odds are stacked against the economy.
ED HARRISON: I want to circle back to these specific companies that you were talking about. But I want to talk about the market thesis from where you're going. I know that you have a piece that's coming out or that has come out about basically people grossly underestimating the Fed. And that this is playing into your thesis of the steepener. Can you explain that when you say grossly underestimating the Fed?
MICHAEL LEBOWITZ: Yeah. So, that's the name of the article, The Market's Underestimating the Fed. And what's interesting was, we look back to the '70s and we said, how well did Fed Funds future, six-month in particular Fed Funds future predict what would happen six months later? And every single rate cycle, and by rate cycle, increasing and decreasing. The market has underestimated what the Fed would do.
ED HARRISON: That is tightening or loosening?
MICHAEL LEBOWITZ: Correctly. And even during the '90s, there were two slight easing cycles, I wouldn't really call them a cycle, but they did ease of two or three times, four times. And even those were underestimated.
ED HARRISON: So, you're talking on the back end of the '94-'95 tightening that they eased and that was underestimated by the markets.
MICHAEL LEBOWITZ: That was the Orange County and then they had long term capital a few years later. Same thing, even those were slightly underestimated. But what we found is that when the Fed is cutting rates, on average, the Fed Funds futures are underestimating its six months in advance by over 100 basis points. And at times, during the cycle by over 200 basis points. When they're tightening, it's not as bad, it's less than 50 basis points. And this last tightening round was even less because I think the Fed really did a good job of telling the market what he was doing.
But even the last tightening cycle, Fed funds were underestimating it slightly. So we look ahead, and right now, Fed funds and euro- dollars and everything else are pricing in roughly 75 basis points by the end of the year. If we are going into coming in on a recession or the Fed just wants some insurance, and we are indeed starting of rate cutting cycle, 75 basis points could turn into 100, 150. If the future is anything like the past. So, the idea of the curve steepening could be much greater, a greater steepening than anyone is anticipating right now. And that's what I like about these- they're curves stepeeners in the equity market, essentially.
ED HARRISON: And when you talk about curve steepeners, basically, what you're talking about, the concept that long rates are falling less aggressively than short rates?
MICHAEL LEBOWITZ: So, I believe it'll be a bullish curve statement, where short rates plummet, long rates come down.
ED HARRISON: And so now, let's go back to these specific entities that you were talking about. You were talking about Annaly and you were talking about AGNC, tell me about their dynamics and why they are a good proxy for the steepener.
MICHAEL LEBOWITZ: So, first of all, they are the two biggest. There are other ones, there's another five or six at play just in Fannie and Freddie, Ginnie space, that I would recommend as well. Their leverage for- I'm going to talk specifically about Agency and Annaly, their leverage is not what it was in 2008, it has come down decently. They trade at a slight discount to their book value which is a positive. And again, they're set up from a portfolio management perspective to take advantage of lower borrowing rates and mortgage rates that may come down slightly.
The prepay risk is a little different this time than 2008. We were at zero rates for- was it five, six, seven years? About six years. So, everyone had a chance to re-fi down into a three and a half, three and three quarter, 4% loan. And that was when Fed funds were at zero, and short rates were very low. Rates have come up slightly. But if we get rates all the way back down to zero, you're only getting mortgage rates back to where they were give or take a little bit. So, yes, there will be some re- fis. But it's not going to be a re-fi bonanza like we saw all the previous rate cutting cycles.
ED HARRISON: The first thing that pops into my mind is the concept that actually, we're not going to get a whole lot of bang for the buck out of this curve steepening. And in fact, you may have some distress from borrowers. So, I think specifically about corporate borrowers. We had David Rosenberg on here a few days ago, and he was talking about BBBs being a huge part of the portfolio. Can you tell me- because I know that you are looking at other parts of the fixed income world, what do you see with that?
MICHAEL LEBOWITZ: Great. So, that's another trade idea. We wrote a paper. It's available on Real Investment Advice called, The Corporate Maginot Line. And essentially, what has happened is that the amount of BBB has exploded, while as a percentage of the corporate world, everything else has fallen off. Just from 2000 to today, BBB was about 20%, it's now over 40% of the whole corporate bond market.
So, in the corporate bond world, what is not widely recognized by those outside of the corporate bond world is the way credit ratings work. And many investors, institutional are you're either investment grade or you're junk. And investment grade can't really go to junk, they have credit officers, they want to stay ahead of that curve, they don't want bonds going to junk because they have to sell it. And usually it's a fire sale.
ED HARRISON: Meaning that in their charter for investment, it says you can invest in securities rate below this level.
MICHAEL LEBOWITZ: Below BBB levels. Right, right. And some of them can own a small percent, maybe some can own a slightly larger percent. But at the end of the day, investment grade managers do not want to own junk debt or cannot own junk debt. So, unlike a stock investor, you may be limited to technology stocks, but balance sheet is irrelevant. You could buy any tech stock in the whole spectrum. And that's a big difference.
So, you have this big investment grade world, and you have a shrinking junk bond world. But now all of a sudden, if you start getting bonds moving from BBB to BB, you have investors that need to sell, and you need to find investors in the junk world. So, it becomes a question of how much, obviously, one or two bonds here and there is not going to make any difference. But in the short run, if you get a decent number of bonds rolling over, there's 2.6 billion right now in BBB.
ED HARRISON: Trillion.
MICHAEL LEBOWITZ: Trillion, trillion, I'm sorry, think about if a quarter of those roll over to BB, there will eventually be buyers, there's a buyer at every price. But most likely, you'll have some liquidity issue. And prices will drop pretty sharply.
ED HARRISON: But that's not just for the fallen angels, the ones who go to BB, but it could infect other parts of the market.
MICHAEL LEBOWITZ: Well, and I've traded corporate bonds, when you have those bonds that are starting to teeter, you don't want to meet with your credit officer, you just get out beforehand. It's worth taking a low hickey on the price and getting out versus going to meet with the credit officer.
ED HARRISON: And so, what's the trade idea? What's the investment idea?
MICHAEL LEBOWITZ: So, the trade idea- and keep in mind-
ED HARRISON: And this isn't a current idea, but rather one to think about if we had the recession call that you were saying could or may not happen?
MICHAEL LEBOWITZ: It's something to think about maybe to prepare for, maybe even to do, we've done some of it at our portfolio management. And essentially, what I would advise is moving up in credit, stick with the really good BBBs that you think are solid, or move up to A, AA, not many AAAs to move into. And you're going to lose a little bit in yield. But spreads are so compressed that you're not giving up a whole lot.
And the beauty of the trade, I think is if this does happen, if we go into recession, if a bunch of BBBs get downgraded, they're not going to be able to get bought quickly. Junk bond prices will really struggle, and you also have the whole passive investing in junk bond with the ETFs. So, there's going to be other selling in junk and the potential opportunity to pick up what I would say are generational returns from companies that are not going out of business, but that no one wants to hold. It's somewhat similar to the subprime crisis.
ED HARRISON: That afterwards investors came in and they got the right to use-
MICHAEL LEBOWITZ: 10, 20 cents on the dollar against stuff that matured to par later.
ED HARRISON: Well, there's a political element to all of this, actually, interestingly enough, because even though the Fed may cut more aggressively than people are saying, they're pressuring 75 basis points, and then the Fed cut 100, 150, they could go all the way to zero before it's all over. Is that what's going to happen, given the amount of pressure that Donald Trump is putting on the Fed right now? That situation is very opaque. Can you talk to me about how that plays into this thesis?
MICHAEL LEBOWITZ: Yes, and that's what makes all of this so difficult. If there weren't the whole beltway opera going on, I would say it's- if we go in a recession, Powell's going to drop rates to zero, like every Fed governor had- not to zero, but every Fed governor has aggressively lowered rates. But as you know, Powell has threatened to fire- or Trump has threatened to fire Powell starting way back in December, January. And he's continued on that rampage. And he's picked it up in the last week or so as well.
So, the question I have is will