February 25, 2021

Fiscal Stimulus… Forever?

Guests: James Camp and Brad Erwin

In this episode of Markets in Focus

2021 brought back talk of possible rising interest rates and inflation. Equity markets seem to reach new highs just about every day while questions are arising around the traditional safety of bonds. Matt Orton, CFA, Director and Portfolio Specialist at Carillon Tower Advisers, is joined by James Camp, CFA, and Brad Erwin, CFA, of Eagle Asset Management, to analyze the potential opportunities for investors focused on income.

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Transcript

Matt Orton:
This is Markets in Focus, a podcast discussing the latest market developments and insights from Carillon Tower Advisers. I'm your host, Matt Orton Director and Portfolio Specialist at Carillon Tower Advisers. It seems like equity markets are making new highs just about every day, while questions are arising around their traditional safety of bonds.

Matt Orton:
Today, we're going to talk about this topic and the potential opportunities and pitfalls of the recent historic stimulus due to the COVID-19 pandemic. I'm very lucky, and I'm joined today by James Camp, Managing Director of Fixed Income and Strategic Income and Brad Erwin, Portfolio Manager of Equity Income and Strategic Income of Eagle Asset Management. And we're going to further discuss these topics as we analyze the potential opportunities for investors focused on income.

Matt Orton:
Welcome James. Welcome Brad. Glad you could both join me today. The recovery that we've had from the March lows of last year was really nothing short of spectacular. I would argue, and I think many would argue, that it's largely the result of unprecedented monetary and fiscal policy actions. Are there any obvious distortions present as a result of these policies or is it still too early to tell? And I'm going to throw that over to James first.

James Camp:
Nice to be with you, Matt. Thank you for that question. It's helpful to recast the moments of March, 2020 to sort of get some context around the extraordinary intervention by the FED and ultimately by Congress, it's fiscal stimulus that followed. We had a complete collapse of the capital markets. So that was cross assets that included equities, fixed income. It included commodities and an unprecedented spike in volatility. So during the acute phase of the pandemic, as it were both in the medical sense and in the capital market sense, the federal reserve was absolutely necessary and requisite to get capital markets back and functioning. To wit, we had precisely zero corporate bond issuance in March that included investment grade or high yield.

James Camp:
Those markets were ultimately and rapidly healed in the face of rapid and broad reaching monetary support. The distortions will come up as we move through and begin to engage the real economy that because somebody was able to access the credit markets and shore up balance sheets in a temporary sense, if you will, that does not necessarily mean that the viability that going concern or in fact, the operating profitability of those entities are going to continue at the rates that valuations may indicate.

James Camp:
To us the corporate bond market was essentially reopened by the Fed. We had record corporate indebtedness issued in 2020, and I remind folks that low interest rates modify behavior. They modify investor behavior, they modify corporate behavior. These were necessary conditions for economic recovery, but they're not sufficient for growth and perhaps sufficient for some of the valuations that we're seeing. So our look see into the future tells us as we re-engage the economies we begin to get through the pandemic as it were. We're going to begin to see, this goes back Matt to your point about too early to tell, as we really have the economy functioning again. Where are we over levered? What companies were simply enabled to survive and yet will still continue to have operating challenges and ultimately what companies are going to thrive in a post pandemic environment, but to be sure low interest rates near zero or at zero on the short end, create liquidity, they create the appetite for risk taking. They are supportive of markets.

James Camp:
And I do remind our listeners that at this go round, unlike 2008, the Fed actually partnered directly with treasury to allow for the first time in history, direct asset purchases into the equity and corporate bond markets, much of those facilities are still unused, but that overhang or that safety net, if you will, still does impact. And in many cases distort the broader capital markets.

Matt Orton:
Yeah. That's a really interesting point. And I'm going to circle back to, I think, another potential impact of that, which we might see going forward, which is inflation. But before we do that, maybe I'm going to turn this to Brad now because we have such low interest rates and because companies were slashing dividends, as they were forced to focus on balance sheets, have these policies created any opportunities then for investors who might be focused on income since that's probably the biggest challenge that's out there right now?

Brad Erwin:
Thanks, Matt. So, no doubt that massive monetary and fiscal stimulus in addition to a low interest rate environment have inflated assets in several areas. We saw that in 2020 with substantial moves in large cap tech, especially those higher growth technology companies that have benefit from lower rates, as well as work from home plays. As we moved into 2021, we've seen a continuation of those assets, maybe bubbles almost, where we've seen a liquidity move toward alternative energy, think about electric vehicles, wind solar companies that have been beneficiaries of a new administration. We've seen tremendous flows into those special purpose acquisition companies. SPACs as they're called. As well as to Bitcoin, which I certainly am no expert in, but no doubt that the retail investors heavily engaged again, as we exited 2020 moved into 2021.

Brad Erwin:
So, to get to your question, we think that's a good news scenario for traditional income investors that were largely forgotten in 2020. You think about financials, energy, materials companies, industrials, even REITs, R-E-I-Ts, as well as utility companies. Those have been multi-year under-performers. And with that under-performance becomes dividend yields that are quite attractive. We think that the return spectrum with high dividend yields and the opportunity for appreciation as the economy heals, is quite substantial. We saw early signs of that in Q4 2020, where some of these sectors reignited in terms of their capital appreciation, but we're reminded that only small shifts from an allocation perspective away from those trillion market cap companies, those large cap tech companies would drive substantial appreciation in those more income oriented sectors that we mentioned earlier. So ...

Matt Orton:
Yeah. And so one follow-up question on that, when you have sectors like real estate and energy, sometimes the dividend yield is high for a reason. How do you go about assessing whether or not there's potential for these companies? Avoiding the value traps, as some might say?

Brad Erwin:
Sure. So one of our mantras is to make sure that we perform fundamental equity research, every day and that really surrounds such important elements as high levels of free cash flow generation, very strong balance sheets and simply the opportunity to grow. And so as you differentiate companies, those three elements are key to differentiation, to make sure you don't get stuck in some of those traditional high yield companies that stay high yield companies.

Matt Orton:
Absolutely. It's a very, very valid point. And now I'm going to flip it back to James, because I do want to come back to that one word earlier we mentioned, which is inflation. James, maybe you can dig a little bit deeper because I know you're a believer that we're going to see inflation pick up next year outside of just base effects. Maybe you can share with our audience why you believe we could see a real pickup in inflation going forward.

James Camp:
Well, Matt, I will tell you, inflation is going to be the story of 2021 for one of two reasons. It's going to show up or it's going to be nonexistent. Either case is consequential for different reasons, with different outcomes. We are looking still, even with a 10 year treasury that is backed up down to about 1% at real rates, meaning net of inflation, still negative. If you could imagine back in the March April experience we bottomed in 10 year, treasuries at 35 basis points, a decidedly negative real rate of return. But if we look at the landscape coming into 2021, a couple of things stand out first with the fiscal stimulus, which is in many forms, been direct payments to businesses and to consumer, we are seeing consumption really at pre-COVID levels and yet output in terms of creating the goods and services for that consumption is significantly still below pre-COVID levels.

James Camp:
And if you look at commodity prices and you see the rapid increase in things like energy, lumber, copper, and the like, and you see a synchronization of stimulus around the world and a re-engagement of economies. It appears to us that we're going to have a significant output gap that there's going to be a uptick in inflation off the zero bound and what the bond market will do, and this is important for listeners to understand, that flow of funds dominates the interest rate cycle. And in 2020, we had record in unprecedented flows, both from the federal reserve directly and from market participants in the capital markets, into bond and bond like products. If that flow of funds reverses, you can see an abrupt about face in interest rates. And our way of looking at this is the markets don't have to be convinced that inflation has become unhinged only that it's moving significantly off the zero bound, which we believe it is, for those flow of funds to reverse.

James Camp:
So the broad story about inflation in 2021 is going to be re-engagement of the economy, employment picking back up, unprecedented stimulus, pressure on commodities, and a gap between consumption and output. Remember, we came into COVID, this COVID recession, which I call a recession of choice, in pretty good shape from a corporate balance sheet perspective and from a personal balance sheet perspective. And in large measure the equity markets in the economy of 2020 reflects some of that resiliency that follows a long-term expansion in a brief, albeit severe, recession that we chose to have.

James Camp:
So those are the things that we're looking for. Now, the converse of all of that is going to be if inflation continues to be absolutely a non-starter, it continues to hover around the zero bound. And we convince ourselves both from a market standpoint and also from, potentially, a congressional policy standpoint, that money printing is without consequence. I'm afraid we may continue down that path. And my feeling is both markets and both real data on the inflation front will push back and push back relatively hard against that notion.

Matt Orton:
And so how much do you think some of the bills that are currently being debated in the political landscape, you've got a $1.9 trillion stimulus bill, there's talks four to $5 trillion of additional infrastructure, we heard. The new Treasury Secretary, Janet Yellen, speaking about the need to act now, when rates are low. Do you think that might cause too much inflation? How do you think that will impact the path of inflation going forward?

James Camp:
Yeah, Matt, I think the questions will be, we'll never know if we overshot until we get there and this particular Fed, and I think now with a former Fed chair, Yellen, at Treasury, there is going to be a proclivity to believe in this sort of monetary theory that we can continue this, especially in the teeth of this crisis. I do believe that with the body politic, given that we are at a very narrow majority, given the makeup of the Senate, that it's unlikely that we're going to have a significant tact towards a significantly more progressive agenda in terms of spending. Now, having said that, we still have a major gap in terms of potential versus real GDP. We still have scores of people, hundreds of thousands, filing initial claims. There is going to be absent inflation data, a temptation to continue on the spending path.

James Camp:
What I suspect happens is in Q1, Q2, when we do begin to get these year over year comps, these base effects, as you called them, we're going to see some headline numbers that are going to be jarring, and there's going to be more pressure to slow down both the fiscal and monetary stimulus. And if employment does pick back up and we all hope and pray that this COVID vaccine rollout goes well, and we begin to get some sense of normalcy. I think we will pull back from those very, very large numbers that are being touted as we speak today.

Matt Orton:
One area of the market that certainly has benefited from the assumption we're going to see a pickup in inflation, that's benefited from the pickup in interest rates has been the more cyclical pockets of the market. And Brad, since you cover energy and industrials, which happened to be some of the most cyclical pockets of the market, what are your thoughts on these more economically sensitive areas going forward? And has your team been finding any interesting opportunities and are they too expensive right now?

Brad Erwin:
Sure. Yeah. Thanks, Matt. So, we've made it very clear that, to James's point that we are in a healthcare crisis and that the economy will follow the key metrics related to COVID. Initially it was new cases, infection rates, hospitalizations. As we move to the summer of last year, our focus very much shifted toward vaccines. We were very encouraged with existing vaccines and their efficacy. We expect a third option any day now. Good news is while the vaccine distribution has been slow, momentum is picking up, I've noticed over a million vaccines administered this past Saturday. So as those vaccines are administered, we expect the pinup demand at the consumer level to kind of unleash. You think about travel, both flying and at the hotels. We expect folks to go back and return to their favorite restaurants. We believe employees will, to some extent, return to their offices.

Brad Erwin:
The point is, we expect energy consumption, overall commodity consumption to also pick up. We think the resurgence in capital spending and industrial production that will follow a resurgence in those commodity prices will resurge. The broadening of economic growth, it will be key to the broadening of the equity market participation. In fact, many of those sectors, you think about industrials, energy companies, even financials are likely to see an acceleration in their earnings growth as we move toward 2022, really all through 2021, we should see acceleration. While last year's winners, we'll start to see substantial deceleration. So we think that the stage is set for a pickup in those cyclical sectors. We have been active in the portfolio, in terms of adding to those sectors, both in terms of kind of the mid part of last year, all the way through the fall and into 2021.

Matt Orton:
Looking forward, I think, one of the big questions in everyone's mind, almost how we started this conversation with markets continuing to make new highs, how much of that optimism and pick up in industrial production, increase in energy demand. How much of that do you think is priced into the market right now?

Brad Erwin:
Yeah, we think one of the mistakes investors make is in looking at valuations at economic troughs. And so valuations on current year earnings are not cheap. There's no doubt about that, but we recognize the importance of looking toward normal earnings and out year earnings. So you think about earnings growth and earnings expectations in 2022 and '23, stocks are actually reasonably priced. They're certainly not cheap, but we think there's a lot of momentum, especially with what we've seen so far, both really in Q3 and we're seeing it so far in Q4 earnings reports, is that companies are exceeding that expectation. So those numbers that we thought were trough numbers are being revised higher, which is also going to revise higher both 2021 and '22 numbers. So, valuation is not a large concern for us.

Matt Orton:
Yeah, well, that's great. And I think that's a great point, it's everything's based off of expectations and meeting expectations is absolutely critical. So I know one of the questions that's on our audience's mind is to do with asset allocation. So to kind of bring everything home from what we talked about, when you look at some of the near-term challenges we have, where we are in the market and your expectations going forward, what do you think of the current model of a 60/40 or 70/30, set it and forget it type portfolio. Is that going the way of the past or are there new ways to take advantage of the dynamic between equities and fixed income? And I think what people want to know, what are you recommending to clients who need stable growing income?

James Camp:
Well, Matt, our approach here has always been to be agnostic about capital structure and income generation between being an owner of a company or a lender to the company in the form of equity and debt respectively. And if you look at the periods post 2008, you have to recognize that the capital markets in large measure be dominated by central banks, which can move interest rates whimsically higher, lower, depending upon different market dynamics, but importantly, the evergreen need to generate income does not have to go by the wayside through these fits and starts of interest rate moves.

James Camp:
In fact, you can be very opportunistic. If we go back to the period, that was the March experience of 2020, there was a massive outflow from mutual funds and passive investment in the bond space, in the face of the dramatic uncertainty, the spreads or the yield advantage for high grade corporate bonds relative to treasuries and municipal bonds by the way, was as generous as it had been since '08, so that window of opportunity created some of the best bond returns that we've had in quite some time in 2020, despite beginning of the year at absolute low levels.

James Camp:
So that episode, if you will, was able to be taken advantage of. So when we look at income and income generation, we think a flexible model, a balanced model to be sure, but to allow the teams collectively to use the best thinking to what part of the capital structure do you want to use for income generation based on economic outlook, based on where we are in the rates cycle, based on where bond spreads are. And in fact, based where a dividend and dividend sustainability might be, as we scroll the clock forward, I will tell you, that most of the returns from intermediate high-grade fixed income, at least near term had been earned. We gladly pass that baton over to Brad at his colleagues, where not only are dividends continuing to be paid, but in many cases increased. And we look at this sort of shuttering in place, both as a society and as a economic backdrop, that many of these corporations have been conservative in their deployment of capital to shareholders.

James Camp:
So as interest rates begin to move up, which we have foretold and forecast, as corporate bond spreads have ratcheted way down from those very opportunistic levels in the spring of 2020, the ability to pass the baton back and forth is absolutely critical, from not only an income and income compounding opportunity set, but from a risk reduction set. So for us, the model of 60/40 is antiquated. It is all based on the ability to collaboratively look at high quality investments and be flexible into where you generate that income from. So I would say that going into 2021, duration will be less rewarded, interest rates are biased higher, pure credit will be less rewarded. We like in many cases, as I mentioned, being companies for income at this point, versus lenders to them at ever lower yields.

Matt Orton:
And Brad, maybe the same question. James mentioned dividend growers, I know that's critical to what you do. Maybe you can give a few closing thoughts on asset allocation.

Brad Erwin:
To add to what James mentioned. It's extremely important to remember that our program is not just about sustained dividend payers. It's about growth in that dividend stream. And so we're very excited as we move along into 2021, we expect dividend growth to accelerate, especially as companies were apprehensive in raising those dividends in 2020, for specific evidence in the month of December alone, we had four of our companies announce a dividend policy changes. All four of companies announced raises, the average raise of those four companies was 13 and a half percent. So very strong momentum exiting 2020. That may be a high watermark in the short term, but no doubt companies were apprehensive in raising in the middle of COVID. They have great balance sheets to James' point, they have great cash flows, they can raise, and we expect them to raise as we go into 2021, '22 timeframe.

Matt Orton:
Absolutely. That makes a ton of sense. And like you said, flexibility is going to be key going forward. So before we close, maybe one last topic we can cover is looking at any sort of distortions or where performance may be ahead of itself in the market right now, are there, and is there anything that concerns you James in the market going forward right now?

James Camp:
Matt, as we intimated the strategy of stable and steady income, which again, we believe as a center of the plate investment strategy, particularly for our growing retiree population, while certainly hit its mark in terms of the objective of a portfolio, such as that, if you look at it broadly versus S and P or other indicators, it was out of favor from a style standpoint. And so what we do see happening, as we continue this market high after market high, these expanded valuations in many sectors of the marketplace, is what is perhaps imprudent risk-taking particularly at the retail level. I know of particular interest, the amount of open call interest in retail, buying call options on markets. You see special purpose acquisition vehicles, which are these instruments that simply aggregate capital for the hope of acquiring companies in the like. While this does not remind me, analog or otherwise, of the tech correction of 2000, valuations are stretched and there are financial products, financial ideas in a more active, independent retail investor involved in things that, to us still seem speculative.

James Camp:
So that to me, is one of the big stories that we'll see in 2021. It is unlikely that those things end well and back to the general question of balanced portfolios, of fundamental research, of objective-based investing in this case for income, those are evergreen and those are unwavering to us. And I think clients and investors are well-suited to stay true to that knitting and not chase these things that can particularly be menacing in next couple of quarters.

Matt Orton:
Absolutely. There's definitely a lot of froth out there. And like we said earlier, flexibility is going to be key going forward. So thank you very much, Brad. Thank you very much, James, and thank you to our listeners and until next time, take care.

Matt Orton:
Thanks for listening to Markets in Focus from Carillon Tower Advisers. Please find additional episodes and market insight at marketsinfocuspodcast.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time I'm Matt Orton.

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Investing involves risk, including risk of loss.

Diversification does not ensure a profit or guarantee against loss.

This material is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature, or other purpose in any jurisdiction, nor is it a commitment from Carillon Tower Advisers or any of its affiliates to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical, and for illustration purposes only. This material does not contain sufficient information to support an investment decision, and you should not rely on it in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and make their own determinations together with their own professionals in those fields. Any forecasts, figures, opinions, or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions, and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements, and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

Past performance does not guarantee or indicate future results. There is no guarantee that these investment strategies will work under all market conditions, and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investing involves risk and you may incur a profit or a loss. Investment returns and principal value will fluctuate so that an investor’s portfolio, when redeemed, may be worth more or less than their original cost. Diversification does not ensure a profit or guarantee against a loss.

Risks associated with Fixed Income investing: Many investors consider bonds to be “risk free” investment vehicles. Historically, bonds have indeed provided less volatility and less risk of loss of capital than has equity investing. However, there are many factors that may affect the risk and return profile of a fixed-income portfolio. The two most prominent factors are interest-rate movements and the creditworthiness of the bond issuer. Bonds issued by the U.S. government have significantly less risk of default than those issued by corporations and municipalities. However, the overall return on government bonds tends to be less than these other types of fixed-income securities. Investors should pay careful attention to the types of fixed-income securities that comprise their portfolio and remember that, as with all investments, there is the risk of the loss of capital.

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CTA21-0125 Exp. 2/25/2023