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The Incredible Upside-Down Market: An Interview With Vineer Bhansali
The Incredible Upside-Down Market: An Interview With Vineer Bhansali
By Thomas Machado Monteiro   |  Dec 04, 2022 00:00
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  • chatted with Vineer Bhansali, CIO and Founder of LongTail Alpha
  • The Fed has already started shifting its priority from fighting inflation to preserving financial stability
  • Markets will likely be stuck to trade in a range that reflects earnings fundamentals

To understand Vineer Bhansali's market philosophy, we must look beyond the title of CIO and Founder of LongTail Alpha and realize he's a man of multiple talents.

As an ultramarathon runner, he never loses sight of the long run: ''I think markets go in cycles that can take years to play out." As a Harvard Ph.D. in Theoretical Physics, he dissects the Fed's ongoing monetary experiment: "I think monetary policy has not figured out what it is good at and what it can and cannot do." And as a jet pilot, he maintains calm amid this year's storm, waiting for clear skies to take flight once again: "we are in a period in which patience will pay off."

But as the former Head of Quantitative Portfolios at PIMCO for 16 years, Dr. Bhansali warns that investors must brace for a possible decade of stubborn inflation, with equity markets "stuck to trade in a range that reflects earnings fundamentals."

Earlier this week, chatted with the fund manager and author of five books on capital markets, including his latest, "The Incredible Upside-Down Fixed-Income Market." Early in November, you stated that we were probably pivoting from a state where inflation is the Fed's primary concern to one where it divides attention with other issues, such as US's financial stability. Powell's comments earlier this week appear to have leaned toward that direction, too. So, where do we stand in this tightening cycle?

Vineer Bhansali: I think the recent string of failures, such as the UK pension system going under, the collapse of FTX, and who knows what else we still have not read about, is raising alarm bells. I think the Fed has already realized that it might have gone too far, but at the moment, it is hard for them to change their tune for fear that they end up in the 1980s-style stop-and-go environment.

I am watching for signs of bank distress. By this point in previous cycles, some banks had already gone under. Simply put, they cannot survive a yield curve inverted beyond 50 basis points for any sustained period. This time the problems are hidden because banks are shoring up their income by lending at 4% to the Fed via the reserve facility and borrowing money from depositors for nothing. As soon as a bank breaks, the Fed will realize the problems underneath the surface. It is good to remember that the Fed is a bank, and it works for large banks, and its models all require bank intermediation.

IC: Will markets react badly if the Fed doesn't actually pivot but instead just pauses the cycle?

VB: I think the equity markets will be stuck and trade in a range that reflects earnings fundamentals. But certain areas, such as banks, will finally get impacted by the inverted yield curve. Also, the Treasury bond market is the most illiquid in decades, and negative carry in the yield curve and in the currency hedging markets will make it impossible for the Treasury to find buyers to fund the debt.

So yes, if the Fed does not pivot, bond markets could be in for another year of dismal performance, and that will take credit markets broadly with it.

IC: You recently also stated that you believe in sticky inflation at around 3-4% during the next few years. In such a scenario, what's the path of least resistance for the Fed's monetary policy?

VB: If inflation stays around 3-4%, we are possibly looking at a Fed that pauses tightening in the name of financial instability problems.

The Fed in this environment also somehow changes the way they talk about inflation targets. Instead of saying they want to hit 2% inflation, they can say something like 2% over a cycle on average or something like that, which is hard to measure and pinpoint.

With lower real rates, this could result in a mild selloff in the dollar. The reason it is hard to bet too strongly against the dollar is that not only does it reflect real fundamentals, but it is de facto the reserve currency of the world and, for now, the currency that yields the highest with little duration risk.

Other countries are facing even bigger pressures and can easily tip into a deep recession. So a compromise by the Fed in changing their inflation target in the name of financial stability is not a catastrophic outcome for the dollar, in my view.

IC: How does one structure its portfolio for a period of persistent inflation?

VB: I think if inflation persists for a long time, e.g., 5-10 years, nothing other than commodities, real estate, and other "real" assets will do well. Financial assets certainly will do worse. In the short term, I think TIPS are now attractive again, with a contractual inflation compensation or an "inflation tax refund."

Same thing with short-term treasury bills and notes; since they give principal protection and the opportunity to deploy liquidity into asset markets when they break, which will inevitably happen if the Fed keeps raising rates.

IC: Are bonds a good investment at the moment?

Yes, but I would keep the duration very short – a maximum of 3 to 5 years, and also keep quality very high, i.e., Treasury bonds, TIPS, agencies, agency mortgages, and very high-grade corporate bonds. Also, don't forget to keep an eye on various closed-end bond funds that are being liquidated and have to begin to trade at both attractive yields and discounts.

IC: Is the last decade's risk-on market already behind us, and thus, investors should brace for meager gains in the next decade?

I think markets go in cycles that can take years to play out.

Due to the excesses of central banks over the last decade or so, asset prices have become too high. Right now, we are in a period of correction from those excesses.

Opportunities always arise when the good and the bad assets suffer indiscriminate selling and provide opportunities to buy the good assets at low prices. So while forward-looking expected returns are still low right now, they are not all that bad in the context of the last decade of almost no yield. When prices fall to a point where the yield looks good enough, it is usually a good time to put money to work.

IC: So, do you see the present moment as a contrarian long-term buying opportunity?

Probably not just yet in the broad markets, but yes in some markets like TIPS, short-duration Treasuries, and other defensive securities.

I think we are in a period where patience will pay off.

Right now, we can earn 4% in Treasury Bills of very short maturity and keep rolling them over and over with no risk to the principal. Yes, the yields are lower than inflation, but I would rather have my capital and the option to deploy it in the future than get locked into a position that takes away my optionality.

IC: Will a tighter global monetary policy era help forge a more sustainable economy in the long run?

VB: I think monetary policy has not figured out what it is good at and what it can and cannot do.

The central banks have moved far away from just using interest rates. They are now buying and selling more bonds than any other participant in the markets. They are trying to manage expectations through their speeches but change course based on random events. I think central bank effectiveness and credibility is under question like it has not been since the great depression.

So, I do think the markets will become less sensitive to central banks over time, and what will likely emerge as the new version of policymaking will be the driver of asset prices in the future. This version will explicitly join the government's fiscal side with the monetary side.

That means less central bank independence and more government intervention in markets. But though this could result in stability, it could also result in crony capitalism, choosing winners and losers, and most likely more instability and volatility. Things that we do not currently expect.

The Incredible Upside-Down Market: An Interview With Vineer Bhansali

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The Incredible Upside-Down Market: An Interview With Vineer Bhansali

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