Talk Your Book: Animal Spirits Live

0:04Welcome to Animal Spirits, a show about markets, life and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:34Let's get excited. Come on, Chicago. There we go. didn't open the bar early enough apparently folks uh to reiterate dave said thanks for for showing up i know um a lot of folks have a lot of things going on so to to get part of your evening is really special for us uh i know michael and ben need very little introduction but by way of how we met um i think it was really when our sales guys saw you at a conference and assaulted you which is probably what the police would have called it but after a few conversations we thought Well, maybe they're not as crazy as those guys were. And we've done this a few times together.

1:10I know we've got an interesting set of topics for tonight, some of which you'll guess. Maybe some new stuff you won't. We'll make some mistakes along the way. Most of them will be mine. You'll notice those. You won't notice theirs. They're very smooth at this. But I appreciate you coming along. Afterwards, if there's anything we can answer, happy to do it. But with that, Michael and Ben, I'll turn it over to you. Alex, thank you for the introduction. We have an editor, so we might be a little bit less smooth. in person. All right. So before we get into some of the meaty topics of the day through the lens of the financial markets, Alex, for people that are new to FM Investments, what's your story?

1:49How did we get here today? Yeah, it's been a weird road. Dave and I started this business about five and a half years ago now. Dave will check me on that or compliance who's in the room will check me on that. But the simple idea that there are really great alpha generators out there who often can't find their way into your portfolios. And the problem isn't that they're bad at generating alpha. It's that there's a whole business layer that needs to happen between those good ideas and ending up in everyone's portfolio. So we built the business to remove all of those roadblocks. And along the way, we've met some really great people, come up with some pretty interesting ideas, some somewhat off-the-wall ones, like the Benchmark Series, which is what really brought us together here, and have helped serve now$17 billion of your and your client's assets that we appreciate and look after every day.

2:34How many different managers and strategies are we talking here? So right now, it's about 60 different strategies. You know, there's probably some flavors of that. So a few of my PMs are in the room today will say, no, it's more, it's less. But about 60 strategies, about 85 of us who do this every day. And it spans the full gamut of asset allocation, asset style, primarily, though, in between institutional fixed income and equity. You're going to hear a lot about bonds today. So we did lock the doors. You can't actually leave until we're done. But it turns out bonds have been interesting for a while.

3:06So it's been a good place to be. All right. One of the most interesting areas or one of the most exciting areas of the ETF market from the perspective of where dollars are going are option overlay strategies. So when are you going to start selling calls against your fixed income? Come on. Like yield on yield. Let's go. You say that, but there's a few things in the works. So give it some time. I was joking. That's a terrible idea. You're really going to do that? You know, we've seen some buy-ride strategies. You know, if you're here, if you stop by and, you know, prayed at the altar of Our Lady of Margin call to see me downstairs, you know, there's a lot of people who would happily take that trade.

3:39Well, we were talking earlier about your benchmark series and the fortuitous timing of it. So you said five and a half years ago, so you guys launched the firm pre-pandemic, basically, right before the pandemic. Rates went to zero effectively in the pandemic. And you launched this series of bond ETFs 2022. 2023? Yep. Okay, which was great timing, because at that point, rates finally went back up. Because if you launch when rates are all sub 1%, what is the reception going to be? 0.0. Yeah, nil, right? We stuck the landing on timing, for sure. But it was a need in the marketplace, right? We built it not because we thought, hey, this is a great time for rates.

4:19Let's do a single bond product. It was, we wanted to be the first consumer of the product. We had portfolios who needed exactly what the US Benchmark Series, T-Bill, U2, U10 were. And it didn't exist. And frankly, it took us a while to actually get up the gumption to do it because we thought clearly someone had to try this. This had to have been thought of before. And we just couldn't find it. And after a few months of trying, we finally realized it just needed to be done. And maybe we were the right people to try. And so far, so good. There is$7 trillion, give or take, dollars in money market funds.

4:54And the money is not slowing down, despite the fact that the Fed has lowered rates twice. Are you surprised that money is still pouring into money market funds? And then a corollary to that is one of your most popular strategies, T-bill, great ticker, has almost$4.5 billion. And it seems like that has not really slowed materially. Are you surprised that investors aren't extending their duration or what? Well, we see some investors doing that. We keep talking about it. And we see flows coming into the middle and longer into the curve in our products. But when you're still getting 4 % on a nominal rate, if we did that on a tips basis for you, you're getting 6.5%.

5:33The question is, is that enough to coax savers into risk assets? And so far, the answer is no. You see that with the two-handle, maybe things change. But right now, you're used to a decade of zero. And all of a sudden, you get 4.5 % for buying a government bond and just sitting there, not having to think about it. There aren't that many more attractive opportunities for folks who wanted the security of cash. A few weeks ago on our show, I talked to Michael about the fact that the markets have been just racking of late, right? If you look at the past 12 months in the US stock market, the small caps and large caps, we're up, I don't know, 40 % or so.

6:08And I was saying, you know, this has been a lovely bull market with a little pause there for 2022, which wasn't a lot of fun. What's with the lovely? Who describes a bull market as lovely? I do. Someone who's invested in it. And so I'm just trying to figure out the juxtaposition of, OK, things changed in the election. It seems like, OK, now maybe there is some euphoria because markets took off. Even though we've already been up a lot, they took off even more. But how do you square that with the fact that money still is pouring into T-bills? and money is still pouring into money markets. Is there just money everywhere that it can just be spread out and sprayed?

6:43Or what's going on here? I think there is money coming in from all sorts of sources, right? And what it's not doing is finding its way to just one part of the market, which is good, right? That's what we used to see. A lot of that money that we're seeing today used to go to private funds or things that we couldn't readily track, right? We just didn't see it as much in the statistics. They were locked up in outside enterprise. So I think we're seeing a lot of that. We're seeing a lot of those funds that people invested in 5, 10 years ago that had lockups that now have cash available, and they're not re-upping.

7:12They're putting it into the public markets. They're holding onto the cash, waiting to see what happens. But to your point, a week and a half ago, we really got animal spirits back in the market. Things were pretty good, but then we just got a shot in the arm. And that sort of sudden sense of euphoria, of loveliness, if Michael will allow us, is, I think, going to keep happening. I mean, folks want to see these things continue to rise. And there's a lot of powerful forces behind that. It's only been a week since the election and the inflection point in the markets. Are you noticing a different tone from the advisor clients that you serve?

7:48Well, I mean, I think we'd ask folks who are here that and get a better answer. But somewhat, I mean, I think there's a sense of, OK, this wasn't a fiasco. And regardless of who voted for whom or what you were hoping would happen, the big fear for markets was this wouldn't be decided today, that we would be sitting here talking about lawsuits or all sorts of other crazy things. And none of that happened. And the market was really happy about that. I think investors should be really happy that the market reacted exactly as we'd want it to. Took it in stride, went back to worrying about inflation, jobs, and fundamentals, which is what we're trained to actually work with.

8:22There don't seem to be a lot of fears right now. I know certain investors are always scared of something, but it kind of seems like everyone in the pool, not scared of much. Do you think investors should be afraid that rates are moving up again? Because there's always a narrative attached to this. And Michael and I always talk about this. When rates go up, it kind of is choose your own adventure, right? Well, rates are going up because the economy is stronger. Or no, no, no, no. Rates are going up because people are worried about the economy and inflation is going to come back. Or no, actually, it's bond vigilantes.

8:51So when parsing through this stuff, do you think there is a line in the sand where, oh, actually, we should start worrying if rates get back to 5 % or something in that range? Who are these bond vigilantes? Alex, have you ever met one out in the wild? Maybe it's us. Maybe we didn't know. I mean, we've certainly seen a lot of folks who are happy to buy bonds no matter what happens in the market. So, you know, there's a lot of opportunity there. To answer your question more broadly, I mean, if the short end were moving because the Fed had to start a hiking cycle, you know, that would be a warning sign.

9:20But the market is pretty diverse. There's a lot of things happening out there. For 10 years, sitting at almost 4.5 today after a pretty nice yield rally today. So prices are dropping. But I don't think that's anything inherently to worry about. The curve is trying to figure out policy that is yet to exist for things that have not yet happened or even been promised. So there's a lot of guessing. Well, the two years gone from, I don't know, 3.5 % to 4.3%, I think. Is that signaling maybe not as many cuts as we thought? I think the theory that we were going to zero is coming out of the market, right?

9:55We never subscribe to the theory that we were getting back to 0 or 1%. I think there's also a lot of fear that there'll be some inflationary policy coming down the pipe, and the market is getting a little bit ahead of itself. I mean, that was a pretty strong yield rally for what happened. But that said, I don't know that it's any immediate cause to worry. the underlying fundamentals of the economy, both real and financial, are super strong. Things are just kind of working themselves out. One of our favorite theories for why rates rose is attributable to Warren Pies. And he basically said that the rise in yields is not people that are not trusting our ability to pay us back and the demanding higher rates.

10:38It's that people were offsides, positioning for a weaker economy, perhaps a recession, lowering rates. Obviously, that didn't come to fruition. And they're just getting back on sides. And it's more about positioning than fears. So this is actually a good thing. Yeah, I think that's right. I mean, coming into November, a lot of economists were still saying there was a 15%, 20 % chance of recession, which last year, they said there was 100 % chance of recession this year. And they've all been wrong. So I think there's been a lot of pre-positioning and lack of faith in the economy. I know someone who we talk about from time to time, Jared Dillian over at Daily Dirt Map, says debt is a great expression of optimism.

11:20And there's a lot of optimism. It's a lot of things to be optimistic about, whether that's the bond market, the equity market, or folks' belief in themselves and the ability for the economy to weather all storms. And I think we should bet on that because everyone else is. Is the Fed making a policy mistake by continuing to lower rates without incorporating the fact that, yes, Inflation is coming down. There's no need for Fed funds rates to be 200 basis points over inflation, whatever it is. But maybe they're missing the forest for the trees. If growth picks up, if asset prices keep doing what they're doing, are they fanning the flames of the fire?

11:59So in two years, we might be able to say, yes, they should have done it. I mean, everything in hindsight is usually a little bit clearer. But this was a sort of preemptory cut. I was calling for 25 last time. We got 50. I'll give myself half credit two times ago, not just because 25 is half of 50. But the Fed is basically saying, we should have done 25 spread out in a nice, even way. We had some bad data. We couldn't get there. Yeah, that was an admission. They were wrong. Yeah, they basically were wrong. Like, it was a, oops, now how do we go from here? And it's weird to hear the Fed share say that.

12:32But they did. And they moved on. I think we're going to see this cut cycle continue on for a while in this rate because that's what they said they're going to do. They want to keep doing it. They want to be seen as apolitical. They seem to be OK with making a preemptory cut. They're not going to be OK with a preemptory hike, even if all of the news says it should go there. That's a pretty bold statement from - Do you think that we get another hike in the cycle? Well, I think that would mean there's a new cycle, sort of by definition, right? But I don't think we're going to see one for a while.

13:03You could see a prolonged pause in 2025 if CPI ticks back up, if GDP remains as strong as it is, if it turns out there are policies that are obviously and immediately inflationary, then they'll pause. To start hiking again would send one of those true fear signals to the market. ED HARRISON I was looking at your website today at Benchmark Series, and you have, based on your ETFs at the different maturity levels, you have a yield curve built, right? And the short-term yields are still higher than the long-term yields. So don't we want to see short-term yields continue to come down to make the yield curve more normal?

13:36I think there's an obvious desire for historical reasons to see the yield curve in a totally normalized environment. But we've been dealing with the yield curve in some pretty funky shapes for the last two, three years now. And things seem to be fine, kind of testing the theory that maybe it doesn't have to look exactly that way. Now, it is kind of odd that if you go back to theory, you're saying the government's more likely to go out of business in 90 days than in 10 years. I mean, that's just sort of bizarre. But somehow or another, that's what the market seems to want. And the bill auctions, they're fine.

14:13I mean, the other systematic way to assess the health of the market is to say, are people showing up to the Treasury auctions? And is the government having a hard time issuing debt? They're not. So there's plenty of investors, Michael said the recession unwinding, that were betting on bonds as more of a trade than an investment. It's funny. Our podcast producer, Duncan, he said he bought TLT when the Fed announced they're going to make cuts. Yeah, why don't Duncan to the bus? Sorry, Duncan. But from the day the Fed first cut rates, the eight trading days after that, TLT was down eight days in a row.

14:45Yeah. And he couldn't figure it out. And why is this happening? A lot of people were, I think, implicitly making that bet. But as an advisor, I didn't want to see rates go right back down. I wanted to see rates stay in the 4 % to 5 % range because that's better to just clip that coupon as an investor, right? We should want this as fixed income investors, correct? Yeah, no, the higher rates in that sense are good for bond collectors. And if you look at, say, the IG market, you're going to see now most of the return is actually coupon. That's certainly true in the high yield market, where if you're not at least equal weight to benchmark, you're losing out on the carry there.

15:23And a lot of folks who were buying bonds for total return, hoping that there was some convexity sitting there that would give them this really sweet return when rates went exactly the way they hoped. they've been a little disappointed. But if you were buying it more for income, why we call it fixed income, you've been pretty happy with what you've got. And as long as you are in the more liquid side of the market, things are still healthy. So spreads are tight because the economy is good. Defaults are low. They should be tight. It would be weird if they weren't. One of the other reasons why they're tight is because I think investors are happy with the absolute level of returns or yields from their investment green bonds.

16:01I remember, I think it was during the pandemic, like Microsoft issued bonds at like literally like 2.3%. I was like, who the F is buying these? Like why? Literally why? And so if you're only getting 100 basis points spread or whatever it is, the number is, but the measuring stick is 4%, it's still a pretty juicy return. Yeah, no, I mean, look, there's a lot of opportunities in all aspects of the market today. I think there's fewer of those bonds floating out there now. And a lot of them have made their way to portfolios that are going to hold them to maturity. So as a new investor of the market, you have to ask what's actually available, what's out there.

16:37The new issue market, though, remains strong. Yields are good. Coupon rates are reasonable. So you get a nice return. If you look at the 80 basis point spread of two-year new issue debt versus two-year treasury, that's a nice space. And if you look at the default rate in the IG space, it is very low. And it will probably stay pretty low for the foreseeable future. And that probably is true of the high yield market and certainly the muni market. We were talking about tips out there over a Modelo, which is a great thing to do with drinking beers. Neur alert. So I was looking today at the break-evens.

17:10I think the five-year break-even is 2.4 % or something. I mean, the break-evens were negative in the pandemic, I think. I know that there were some investors who got burned by tips. Michael and I heard from a ton of people that emailed in and said, what's going on here? I thought inflation was coming following the pandemic. I put my money to TIPS, and then they got killed when rates went up. And they acted more like bonds than they did in inflation protection. But if you have a higher yield now and a higher real yield, aren't TIPS just a wonderful opportunity at the moment? We think so. We have to ask also, why did folks so much despise TIPS last year, two years ago?

17:46It wasn't that they didn't like TIPS. They actually got the inflation protection, they thought. They are really bonds underneath it. It's that they bought bonds that were three, five, six years duration. So your inflation protection work, just your duration hurts you far more than you saw the immediate impact of that inflation protection. Hold on to that bond for another three, four years. You're going to get your money back plus all the inflation that you thought, and it'll be a pretty healthy, real return. We think folks just need to reassess, what were you getting? I think most folks thought they were buying tips, they were getting T-bill plus inflation protection, and they weren't.

18:20And that's the next, as it were. Alex, this may be a non-sequitur of the conversation. You could punt if it is. But one of the biggest themes in wealth management has been the rise of private markets, specifically private credit. Yep. So loans being made to companies that can't tap public markets. Any thoughts on those markets, what they're doing to issuers or anything that investors should know about? I think you'll see a lot of debt issued there. There are some by issuers who can top public markets but have found it's easier to do this, right? Or they have other debt stacks that they can more readily refinance without a traditional underwriting process.

18:59You're going to see a lot of ETFs and other products that take these Wall Street products and try to bring them to Main Street. And that's going to be a real experiment because the thing about it being private is it doesn't have all the conventional rules. And there's generally one or two people who get to decide what is and is not allowed in that. So are they really going to try to do private credit and ETF structure? Well, they should have doing it. But also, aren't there rules that you can only have 15 % of the fund in things that aren't liquid? So what does that even? Well, yes. And I think 85 % of the fund is going to be mostly liquid stuff, some less liquid versions of it.

19:36But even of that 15%, even if you found a way to create a swap or something else where you were impersonating elements of that private credit, who's setting the market? Those things aren't redeemed and created every day. So there needs to be a liquidity provider in the middle. That liquidity provider is going to set the price. And when things are good, that's probably a fair price. When things are not, we haven't yet tested what that looks like. Set it all once again. The number that we read was private credit makes up maybe 5 % to 6 % of the IG market. And so it's still a pretty small amount.

20:11But does it ever get to a point where that money somehow impacts spreads in investment-grade credit? Or is that just so big that it doesn't really matter? I'm going to guess it's so big it doesn't matter for the foreseeable future. Certainly, private credit gets an awful lot of attention, despite being 5 % of the market. In our inbox, it does. It's 5 % of the market, but 95 % of advisor inboxes these days. And I always say that it's the easiest sale you could ever make. Yield is an easy sale. So if you tell an advisor, I'm going to get your clients 10%, 12%, 14%. Multi-distributions? Yeah. No vol?

20:45That sounds amazing. My question is that asset for your client is a liability for someone else. How do these companies taking on these loans keep running when they're paying 12%, 14 % on their debt? Loans to pay the loans. More loans. And I think this is the cynical view is this is a great opportunity for folks who issued that debt to find a whole new set of investors to allow them to refinance it off their books and try again so they can refinance this. Because so much money is pouring in. It sounds like musical chores. The fear is that it becomes that. And that's what the regulators will need to determine if that is going to happen.

21:24How do they stop it? And, you know, the unknown there, if one, it will be approved in that state. and unknown if it is approved in that state, if that's what's actually going to happen. But it seems like that's a good bet. But do you think that these big players, the big private Apollos and KKRs and Blackstones and Blackrocks of the world, if they just say, listen, we're putting 5 % or 10 % of our client model portfolios into private credit, there is enough of a wave to keep this stuff going for a lot longer than people would assume? Yeah, no, they could move enough of their own asset base to create a microcosm here.

21:59Sure. But at some point, if the returns don't actually materialize, right, you wait your five or your seven years and your IRR is six, not 14, all of a sudden, I think those assets start to go somewhere else. And that's more likely than, because a lot of people are saying, this is going to be a calamity in the next recession. This is going to be a huge come to Jesus moment. But I would think that just lower returns than you expect is probably more likely. Yeah, once you're afraid you're not going to get any of your money back, you're happy to get most of it back. So if you went from thinking you're getting 14, afraid you're going to get zero, and you get eight, you're all of a sudden pretty happy.

22:33And that may be the outcome. There may be enough fresh money for a while that some of the funds don't have that risk or don't have that reality. But eventually, something has to give. And you can't keep running 14 % return, no vol, forever. There just isn't enough in those private companies. Alex, one of the questions that we got in our inbox probably every week, and I don't know that we're equipped to answer this, maybe you are, is the deficit keeps going up. The pace at which it's going up is accelerating. What are your thoughts? Should investors be worried that the US government is going to run out of money or there's going to be a crisis in the bond market?

23:14And what are your thoughts on the deficit and what it means to investors? That's an easy one to answer. Probably a good opening line at Thanksgiving, too. No one will get mad at that. Yeah, no, not at all. You don't have to tread carefully. We're not going to run out of money. We have a printing press, and they know how to use it. So I think they'll avoid that. The incoming administration historically has tried to talk down the strength of the dollar. So that gives us some room to make more dollars to pay some of the debt. But we will eventually get to a spot where we now owe enough money on our current money that we have to issue more money and pay more money to do that, that we get to the spiral similar to the private credit cycle, where now there will be something we'll have to give until there's a major change in the amount of debt we need to function every day.