Debt Ceiling Goat Rodeo

Heading into the next Federal Reserve meeting, Rareview Capital’s CIO Neil Azous explains his “Sight Beyond Sight” analysis on the US economy, debt ceiling, and shines light on two segments of the market that investors may be overlooking.

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Summary – IBKR Podcasts Ep. 73

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome to another IBKR podcast. I’m your host, Andrew Wilkinson of IBKR’s Traders’ Insight.  I’m delighted to have back with me Rareview Capital’s Founder and CIO Neil Azous. Welcome, Neil. How are you?

Neil Azous

Thank you, Andrew, for having me always great to be here with you at these critical junctures in the market.

Andrew Wilkinson

Well, let’s talk about the last critical juncture. We skipped the meeting because of the banking crisis. Is that a good call? Just take a pause and see what develops.

Neil Azous

I think so. We went up and down in a lot of different markets during that period and we’re back to some version I guess of normalcy in this new world. So, it made sense to take a pause or a breather and reconvene now.

Andrew Wilkinson

A lot of kicking and screaming, but not a lot of action at the end of the day. So, Neil heading into the May 3^rd Federal Reserve meeting. How do you see things? What’s the market pricing?

Neil Azous

I think this is our fifth podcast ahead of a Federal Reserve meeting. I believe we conducted these in June and September and December of last year and January of this year. We’ve come full circle in this rate hiking cycle that is from the first hike to potentially the last hike. So, the bottom-line up front, Andrew, is that it’s no longer about how many more hikes or whether the upcoming meeting on May 3rd is the last hike. But when is the first cut and how many cuts will there be?

So, we ask what is priced into the bond market currently? Well, the modal outcome that the market is currently pricing is for ¼ percent hike at the May 3rd Federal Reserve meeting. Then we have a pause in June and then interest rate cuts start in July. And there’s a little over 1 ½ percent of cuts priced all the way out to September 2024. Armed with that information, Andrew, it’s also prudent to ask where is the asymmetry in the market? Well, there are two outcomes that are asymmetric. One would be if the Federal Reserve raised again by 1/4 percent in June. That results in those cuts I just mentioned, starting to be pushed out to a later date and the second one would be a cut that starts in July. That’s more than 1/4 percent at any meeting, after all, why wouldn’t the Fed cut more than a ¼ percent if they have to recalibrate fast because they overshot the neutral rate by so much, or if they hiked by 75 basis points three times in a row. Who’s to say that they can’t cut by that same magnitude at any point along that cutting cycle?

Andrew Wilkinson

Something I’ve been meaning to ask you about is the debt ceiling. Is it time now that the market could be held hostage to government bipartisanship? What do you need to know about the debt ceiling and how are you factoring this risk into managing money?

Neil Azous

So, we formally trademarked the term here at Rareview Capital called “Sight Beyond Sight”. Meaning, we place value on being able to see across different asset classes, discover new opportunities and spot potential impending danger. And we call this perspective, Andrew, Sight Beyond Sight and with every significant event on the horizon, we start our analysis by asking what is the Sight Beyond Sight? We asked what is the Sight Beyond Sight regarding the debt ceiling? Well, we believe it has little to do with the actual X date of the debt ceiling or whether that X date gets pulled forward to June from July and August. Or, what happens if there’s a technical default? I believe those views are pedestrian and they’re pretty hashed out in the marketplace.

The risk to portfolio construction is not a technical default. Why is that? It’s because that should support front end fixed income as the Feds reaction function would likely lean dovish. And that would help a balanced portfolio. The risk really is the degree of fiscal austerity when the deal gets done.

Let me explain that or provide some background on what I mean by that. Back in 2011, the stock market sold-off after a deal was made to raise the debt ceiling because the agreement contained more fiscal austerity than the market expected. The domino effect was that economists revised down their growth outlook very fast and that was enough to force investors to sell stock. So, let’s apply that. Same thought process to today’s backdrop regarding the debt ceiling.

The debt ceiling increase that the House, which is Republican, is preparing currently has about $4 trillion of savings over 10 years with the short-term debt ceiling increase. That is a lot of fiscal austerity on its own merit. But here’s where things get dicey, Andrew. When you combine that potential full $4 trillion of austerity with the negative impact on growth from the Federal Reserve interest rate hiking cycle and potentially tighter lending conditions from the regional bank issue that starts to really, really add up. Let me explain that. So, for example, if you take paid forecasters at their word, they believe 1 1/2 trillion dollars of fiscal austerity over 10 years detracts approximately about a half a percent from GDP. These same PHD’s believe that the tightening of regional bank lending will also take away another half a percent of GDP. So, in this instance, you know, we believe that it’s likely that investors will try to look through a combined 1% of GDP production that’s spread out over several years. However, for the $4 trillion the Republican House is asking for is just too much fiscal austerity. Meaning, if that reduction starts to move closer to 2% of GDP plus the tightening from the Fed hiking cycle and the reduced lending from regional banks, that will just be too much to handle for the stock market.

Ultimately, that’s why we believe the truth will lie somewhere in the middle, meaning both bodies of Congress and the President, will probably settle somewhere around 1 1/2 trillion dollars of savings over 10 years. This is not just about those numbers and the economic drag or the potential detraction of GDP. There are some qualitative reasons why we are less concerned about the debt ceiling. So, neither political party is asking for a material rollback of anything related to the Affordable Care Act, the Inflation Reduction Act, or the tax cuts and JOBS Act. That’s pretty good because it means we’re not trying to push through legislation that’s too hard to handicap in this short period of time left. Next, anything that includes savings, whether it’s one million or one trillion, is arguably a win for the Republicans. A primary goal for Republicans in this debate is to curtail fiscal spending or at least stop the one-way train. So, getting even 1/3 of what they asked for, meaning 1 1/2 trillion dollars over 10 years that accomplishes some version of that.

Thirdly, the Republican led House will probably pass a bill in the next two or three weeks, and the passage of that bill transfers the risk of default and the “de facto blame” to a Democrat led Senate. This sequence is important and therefore it will probably force a negotiation. That’s why the risk of default is less than 15% in the market consensus. And finally, Andrew, no Sight Beyond Sight on site would be complete unless we identify the tail risks of the debt ceiling. One that I particularly am paying attention to is a tail risk that Speaker McCarthy in the House is ousted by his party for not digging his heels in for $4 trillion of savings over 10 years. That would turn this debt ceiling into what I call a goat rodeo, meaning it’s something disastrously wrong, and there’s nothing left to do but sit back and watch the train wreck.

Andrew Wilkinson

Let’s get back to breast tax and talk about inflation and recession. What are you hearing and seeing out there regarding portfolio construction and what is review capital doing about it?

Neil Azous

The number one adjustment we’re seeing in portfolio construction is the increase in the use of liquid alternatives by financial advisors for their clients. For example, on average, financial advisors currently allocate about 14% of their assets to alternative strategies. If you look at an aggregation of the various surveys that are most up to date, they say they’re planning to increase this allocation to about 18% over the next two years. So, at that point industry dominant portfolio, the 60-40 stock bond mix, will be more like a 50-30-20 portfolio of stock, bonds, and an alternative mix. The essential point here is that both financial advisors and retail investors are not just getting comfortable with implementing alternative techniques into their portfolios, such as the use of leverage and shorting, but they’re asking for it to deal with these inflation and recession fears that may persist over the entire decade.

Andrew Wilkinson

Are there one or two segments of the market that are interesting to you that not enough investors are paying attention to?

Neil Azous

I appreciate this question a lot, Andrew. It’s a big world out there. There are many asset classes or regions to seek opportunities. It doesn’t always have to be about risk on or risk off, or the US stock market. So, to answer your question, yes, there are two spaces that are pretty interesting to me currently.  The first one is Japanese equities and the second one is US municipal bond closed end funds and I’ll start with the opportunity in Japan. So, here’s the new thesis developing. The big story has been in Japanese markets this year is that various fiscal bodies, along with the Tokyo Stock Exchange have moved to push companies to focus more on their cost of capital and their stock prices via what’s a “name and shame” approach.

The idea is to force companies to improve their profitability and get their stock prices above their book value and the response to that is that there’s a new significant tailwind of rising buybacks and dividends. Just recently, I think I’ve seen three different companies raise their buyback to somewhere between 15 and 25% of their float, to give you an idea of the magnitude of this tailwind. Secondly, valuations are low in that sector. Corporates hold a material amount of cash and about 45% of all corporates are trading below book value. So, there’s a lot of companies that have scope to buy back their stock and increase their dividends and the same sort of backdrop applies not just to corporates but also to households.

If you think about where we were 25 years ago in around 1988, 1999, they had about 5% in cash. Now they’ve got 55% in cash and equities are only 10% now where they were weighted around 30% in 1999. We’ve got a significantly reduced equity allocation and 10x the sort of amount of cash that could be deployed by Japanese households. And then finally, the economy is seeing what I like to call something idiosyncratic. They’re getting an independent boost from corporates investment in restoring their production and wages have started to grow. This makes Japan a bit more immune to a US recession. And of course, you can just fill in the usual stuff after that that you know interest rates remain low on an absolute basis, currency has stabilized, etc.  You kind of have a nice cocktail of ingredients here for the Japanese market to perform and potentially outperform and it speaks very much to the international markets outperforming this year and adding a level of diversification to it.

The second opportunity is in in US municipal bond closed end funds, this is a niche market. There are four potential ways to make money in municipal bond closed end funds, and this is the only instrument I know that has this many potential ways to make money.

Firstly, the underlying bonds can go up, so there’s NAV appreciation. Secondly, because they’re closed end funds, that structure tends to have a high-income distribution profile. And thirdly, there’s potential for broad discount to NAV tightening since they all traded a discount. And then, the last one is what’s called discount to NAV capture.  Specialists have the ability to see what is expensive or what is cheap and rotate amongst those various closed end funds to capture changes in those discounts.

Quantitatively, there is the most fear priced into the municipal bond closed end fund sector since the global financial crisis. The discounts in our target universe have widened to around 14% from around 4% at the end of 2021. So, that’s a little more than a 10% discount widening. If you use that or apply that in statistical Z score measures the discount to NAV is now in the 98th percentile of cheapness. And then in addition to analyzing, you know that that cheapness and the discount to NAV, we also like to compare the annualized distribution yield of municipal bond closed end funds to the traditional cash municipal bond universe.

Historically closed end funds, their relative dividend is around 2 1/4 times greater than the cash bond market and currently it’s only around 1x which is the lowest relative dividend ratio in decades.  Typically, distribution cuts in the Muni bond closed end funds sector are around 15% during a run-of-the-mill or garden variety fed hiking cycle. During past extreme cycles, those cuts reached as high as 25%. Well during this cycle as you can imagine given how the speed and degree in which we raised rates, Muni closed end funds have seen their dividends cut by almost 40%, so pretty dramatic. The three key determinants for owning a municipal bond closed end fund, one, the discount to NAV, two, their relative dividend yield to cash Muni bonds and then, three, the absolute distribution yield have pretty much the most attractive starting point since the great financial crisis. The conclusion is this, if you own some or plan to hold them over the medium term, you shouldn’t sell them right now. Conversely, leading up to the first interest rate cut in July by the Federal Reserve, there is a very strong case that an allocation should be made to that sector.

Andrew Wilkinson

Brilliant, we appreciate having the path mapped out ahead of the May FOMC meeting, Neil Azous, CIO at Rareview Capital. Thank you very much for joining us today. And don’t forget folks to check us out at ibkrpodcasts.com. Thank you, Neil.

Neil Azous

Thank you, Andrew. Have a great day.