Gravity Exists

discussion

A Focus on Process

April 18, 2022


In a career spanning almost three decades, Stuart Katz has overseen investments in public and private equity and debt markets with experience spanning traditional and alternative investment strategies. In his latest role as the Chief Investment Officer at Robertson Stephens, he applies skills collected in the institutional space to the needs of wealthy families. The modern Robertson Stephens is a wealth management reboot of the storied Silicon Valley investment bank. In its new form, the firm works with entrepreneurs as a personal, rather than corporate, advisor. Gravity Exists spoke with Katz last week and asked how he manages risk for his firm’s investment clients in the face of mounting inflationary pressure and geopolitical uncertainty.

Let’s start with the obvious. CPI data for March released last Thursday registered a 40-year-high. How do you see the macro situation setting up for US markets?

All roads lead to the Fed. The Fed’s anticipated actions dominate market sentiment, whether in equities or fixed income. To date, the FOMC indicated they have been behind the curve. Markets are now pricing in an 85 percent chance of a move of 50 basis points during the next meeting in May, with total tightening priced for 2022 at approximately 220 basis points. That’s in addition to the 25-point hike last month.

These expectations for aggressive Fed policy have moved the yield for 10-year treasuries up by more than 30 basis points in just one week, to 2.7 percent; the first time the 10-year has closed above 250 basis points since May 2019.

The Fed is trying to strike a balance to fight inflation without destroying economic growth. Unfortunately, history is not on their side. It is now likely the Fed will be forced to raise interest rates at a pace to eventually defeat inflation but at the expense of growth. This could tip the US economy into a recession.

Do you think a recession is a foregone conclusion?

Predictions require a crystal ball, which we don’t have. So we focus on the process and try to formulate the best- and worst-case scenarios. Our base case expectation is that, although a recession in 2022 is unlikely, there is an increasing probability and possibility of one in 2023.

How are you positioned to manage these best/worst-case scenarios?

One of the two challenges facing investors is rising interest rates. There may be debate over the speed or magnitude of these increases, but the direction is clear. The other issue is slowing growth. Even if the technical definition of a recession doesn’t occur, the prospect of reduced growth seems clear.

Right now, it seems equity markets are fighting the Fed at a broad index level in that the S&P 500 is trading at a PE multiple of approximately 20 times. It’s hard to reconcile multiples like that with an environment of rising rates and declining growth.

One rationale justifying high multiples and elevated index levels is belief that the Fed will successfully fight inflation without triggering a recession. Alternatively, they could be justified if corporate earnings guidance remains strong when Q2 earnings season kicks off this week. While the earnings reports from the last quarter are likely to be solid, senior executives believe investors will focus on companies’ ability to pass inflation through to consumers going forward.

If one or both views become consensus, current valuations may be justified. But based on how either scenario appears unlikely, it remains very difficult to be broadly bullish on equities.

How does this setup play into your view of bond markets?

Similar to equities, it’s very difficult to be broadly bullish on fixed income. There have been dramatic moves in bond markets, and the yield curve has flattened or even inverted. Historically, we expect credit markets to move in an inverse direction from equities. When equity prices have a material drawdown, the price of credit often goes up as investors seek a so-called ‘safe haven’ for portfolios.

Unfortunately, equities and bonds are increasingly positively correlated in the current environment. Year-to-date, both equities and credit are down, with investment-grade bonds declining by almost 9 percent.

So, the critical question at this juncture is: In the face of correlating markets, how does one position defensively for persistent inflation, rising rates, and slowing growth?

How do you approach that dilemma?

Within our core allocations, we are positioning defensively. We have increased weightings of value stocks and high-quality, dividend-paying stocks in our equity portfolios. These have robust cash flows that higher interest rates won’t discount because of stronger, predictable business models.

Similarly, we’ve been biased towards shorter duration credit within our fixed income portfolio to help mitigate, not eliminate, the challenges of rising interest rates. We do, however, think there are attractive opportunities for active management in the medium- to longer-duration portion of the curve and believe astute managers can construct credit portfolios where risk is priced properly.

Have you changed your overall weightings, reduced exposures to any asset classes, or increased others?

Now is the time to rethink a traditional 60/40 portfolio of equities and fixed income and move into a 50/30/20 mix of public equities and fixed income and allocate the remaining 20 percent to alternative strategies. We believe the alternative strategies part of the portfolio needs to be constructed intentionally to address macro challenges.

We can accomplish this in several ways. One is through exposure to real assets, such as multifamily housing and single-family rentals. Another way is by making private equity investments in sectors such as healthcare, which can be resilient within the multiple compression and economic headwinds facing the broad public equity markets.

These allocations tie into durable, secular trends influenced more by the fundamentals of their industry. In the case of healthcare, we are trying to capture a demographic shift as 10,000 Americans a day turn 65. Healthcare broadly represents about 20 percent of our economy, and that portion will only increase as our population grows. In a space like private healthcare equity, we look for managers who can influence outcomes, recruit top management teams, prioritize capital allocation, and find opportunities. That combination of control and expertise allows them to influence outcomes to improve fundamentals and cash flows in a way that is impossible for a passive investor in a public company.

We approach alternative credit allocations similarly. We seek a distressed credit investor who can navigate difficult conditions. A lot of high-grade, fixed-income paper is covenant-light, lacking the teeth to negotiate with borrowers when something goes wrong. A manager with expertise in evaluating risk based on a company’s prospects and negotiating favorable terms can provide a hedge in the portfolio. Someone who plays offense when public markets are playing defense. This can be particularly valuable if the economy does tilt into recession.

Ultimately, any alternative we select — whether a hard asset, equity, or credit — will provide a differentiated source of return while capturing a thematic trend as a complement to our core allocations. Ideally, we’re dampening overall portfolio volatility while generating stable income.

Robertson Stephens CIO Stuart Katz takes a disciplined approach to prepare for best- and worst-case scenarios.

Stuart KatzRobertson Stephens CIO Stuart Katz takes a disciplined approach to prepare for best- and worst-case scenarios.