Larry Hatheway says violent rate move could be ahead in '17

Published Wed, Sep 7 201612:46 PM EDTUpdated Thu, Sep 8 201611:19 AM EDT

Larry Hatheway, head of multi-asset portfolio solutions and chief economist at GAM, a global asset management firm with more than $110 billion in investments, joined CNBC PRO to discuss the key investment trends he expects to emerge in the next 12 months, including a potentially violent move in interest rates. "What we could see at the turn of the year is an interesting scenario where the Fed might be preparing the groundwork for the next rate increase ... and if at the same time the ECB were signaling that it might see an end to its bond-purchase program, those two things taken in tandem could actually be the catalyst for an upward move in interest rates taking us back to perhaps the levels we were at the end of last year ... 50 to 75 basis points above present levels," said Hatheway. In this wide-ranging exclusive conversation, the former chief economist at UBS' investment bank also touches on: Coming rotation out of dividend-paying stocks. Reasons why the traditional 60/40 portfolio allocation doesn't work. The one metric that still matters the most for investors. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Larry Hatheway is head of Multi-Asset Portfolio Solutions and chief economist at GAM., a global asset manager of $110 billion in client investments. Prior to joining GAM in September 2015, he was chief economist at UBS investment bank where he also held positions as global head of macro strategy, global head of asset allocation, and head of fixed income and currency strategy. Prior to UBS, he held roles at the Federal Reserve, Citibank, and Manufactures Hanover Trust. Larry holds a Ph.D. in economics from the University of Texas, and he joins us now to talk about his investment approach and his outlook for the markets. Larry, thank you very much for being here. LARRY HATHEWAY: Pleasure. MIKE SANTOLI: Manufacturers Hanover. It's kind of a legendary name in the business. I know a lot of people who kind of trace their careers back there. LARRY HATHEWAY: Yeah, I was going to say, I think you just dated me. MIKE SANTOLI: Well, me too. LARRY HATHEWAY: That goes back to the '80s. But, yeah, it was a great place to start. MIKE SANTOLI: No kidding. Well, thanks again for joining us here. And I guess just from a really big picture perspective, I thought it made sense to start just where we are in the globe in terms of financial markets. You know, here in the U.S. the story is record highs for equities, record highs for bond prices, and very low bond yields around the world or negative ones. What does that mean for an investor, in terms of finding opportunity, finding value and really trying to preserve capital? LARRY HATHEWAY: Yeah, no I think it's right to put that perspective in place. We've traveled an awful long way in both stocks and bonds. Stocks since the second quarter of 2009, the low point of the bear market at that time for bonds, so of course it's been a multi-decade sort of story bringing yields down to these extraordinary levels that we now see. It's also of course a shorter-run dynamic after the sell-off of markets, particularly equity markets in the first quarter of this year. We've had now almost a six-month, uninterrupted rally with a brief pause around Brexit. But then, it really has powered ahead since then. I think that leaves us now in a position where we really have to question the sustainability of those moves. Joint moves higher in both bond prices and stock prices is not something that we should count on forever. At these levels, bond prices can only go higher, yields lower, if you are concerned about growth or abnormally low inflation. And either of those would be a negative for equities. So at some point, this positive correlation has to begin to turn. That suggests either some kind of a pause, maybe even a correction in those markets. But it also points towards the possibility of rotation, particularly within equity markets, away from things that have worked to some of the things that may have been overlooked. MIKE SANTOLI: And so many of those things that have worked have been stocks that behave an awful lot like bonds, right? I mean, yield-type plays, those that seem as if they're really mostly wanted for their income. Is that what you mean? LARRY HATHEWAY: That is what we mean. And we've termed them "bond refugees." That is, again, alternatives to bonds. They could be dividend-yielding stocks. Stocks that may have an applied dividend in the form of a share buyback. So those have been good performing parts of the market in this episode. What has also of course worked is momentum as a style. And those are the things that seem to me are getting a bit long in the tooth and where we may have to begin to look at alternatives. And we've seen inklings of that. There's been some more interest in parts of emerging markets, in cyclicals as examples of that rotation. MIKE SANTOLI: And to what degree is that move, and you mention this kind of inklings of more of a cyclical flavor to how markets have acted, emerging markets, stock and debt doing pretty well. And within even U.S. markets, you've obviously seen the sort of industrials, even transportation stocks pick up lately. To what degree does that have a fundamental basis? In other words, are we in a phase where there is a global growth pickup? Or is it just kind of prices finding a new level? LARRY HATHEWAY: Now, one of the things I think we've all seen since 2009 in this extended rally of equities is it's been kind of a show-me market. That is, companies that have performed have had to demonstrate earnings, cash flows, and in many cases also corporate action like dividends that would reward shareholders. There's been a shortening of the equity duration. People have not been essentially, with a few exceptions been willing to look too far out in the future. They want immediate payoffs. So your question is well placed. If we're going to get rotation it's got to have a fundamental underpinning behind it. I think in cyclicals there is some reason to believe that we could see improvement, particularly in industrial areas of the world economy. We've seen some drawn-down in inventories, true in the United States, some recovery of industrial production. What we're also seeing as corresponding evidence is that the currencies of those parts of the emerging complex, they're not pure yield plays. Korea, Taiwan being examples, are also beginning to perform as people begin to think that those industrial parts of the world economy may perform a bit better in the second half of this year and looking out to 2017. MIKE SANTOLI: You know, it seems as if one of the premises of a lot of investors right now is that growth is scarce and yield is scarce. And so high prices are justified for either companies that are growing quickly or more quickly than the markets. And of course, for sources of yield. Is that going to change? LARRY HATHEWAY: I don't see anything that's going to really change that fundamentally. It doesn't appear as though we're going to see let's say, a fascination with overall high growth in the world economy that, for example, drove share prices in previous episodes, previous bull markets. This is still fundamentally about an earning story. And that is really about what is happening near term in the economy. There always will be of course exceptions. We can find some parts of the market related to technology that will encompass futuristic views on growth that got telescoped into today's multiples. But they seem to be exceptions rather than the rule. MIKE SANTOLI: And in terms of yield, you have a lot of people justifying where bond yields are right now and saying, "There just kind of isn't enough to go around to meet the demand for I guess relatively secure income." LARRY HATHEWAY: That's true, and of course it's not just here in the U.S. where you see these low yields. Yields in the United States are in part also low because of how low or even negative they are in other parts of the world. We've all seen the headlines about $10-- $11-- or $12 trillion worth of negative yielding data. And that's suppressing yields everywhere in the world. It's hard to actually see yields rise much until you see a fundamental change in the outlook for interest rates, particularly in Western Europe, possibly in Japan. Although I think in Japan, one would have to wait quite a bit longer. The turning point for Europe might come a bit sooner than some people think. And that of course could be a catalyst for a change in the overall tenor of bond markets. I don't anticipate it in the coming weeks, but I wouldn't be terribly surprised if that became a 2017 story. MIKE SANTOLI: So in 2017, what, the European Central Bank feels as if it's done enough? Or there's another reason for the turn? LARRY HATHEWAY: Well, we have to recognize a couple things. First of all, if oil prices stabilize around these levels, the mid-40s to say $50 per barrel, then because the base affects European headline inflation, the rate of inflation that E.C.B. tracks will now move above 1% from levels a full percentage point or so below that. European growth on average now is above its long-term trend. And you can see that in terms of job formation. It may be weak, but it is above its trend. And at that point, we have to really begin to ask whether the E.C.B. which I think was rather uncomfortable in its move towards both unlimited or near unlimited asset purchases and negative interest rates, which it adopted earlier this year, whether it might begin to have a rethink. And let's flash back to the summer of 2013. The so-called "taper tantrum" was simply about the end of bond purchases at the pace at which the Fed was then conducting them. What we could see, the trend of the year is an interesting scenario where the Fed might be preparing the groundwork for the next rate increase. December seems the most probable date now for a rate hike from the Fed. And if at the same time, the E.C.B. were signaling that it might see an end to its bond purchase program, those two things taken in tandem could actually be the catalyst for an upward move in interest rates, taking us back perhaps to levels we were at the end of last year. In other words, 50 to 75 basis points above present levels. That could be quite an interesting story for capital markets. MIKE SANTOLI: Yeah, interesting story, and really would represent a pretty violent move in the short term, just because of where those bond prices are right now. Right? LARRY HATHEWAY: Absolutely. MIKE SANTOLI: Yes, and you mention the taper tantrum of 2013. So that's when Fed Chairman Bernanke simply was trying to handicap when the Q.E. program might wind down. And bond yields and U.S. Treasury yields shot higher just on the expectation. So interesting. And so you mention the Fed may be looking at a December rate increase. Obviously, if the Federal Reserve were operating kind of in a vacuum without a lot of these other global factors, perhaps it would have gotten closer to its previous expectation of four interest rate increases this year. Now the markets seem to feel as if even one is not a guarantee. Does there have to be some adjustment there? Some coming together of those views, what the Fed might do and what the market expects? LARRY HATHEWAY: Yeah, I think markets have been pretty surprised by the Fed. Not necessarily by the actions that it didn't take in the first half of this year, but by its reluctance to actually go back to the kind of rhetoric that it was talking about at the end of last year when it started this process of rate hikes. So if we again recall, in the first quarter there was obviously concerns about China growth, potential financial or hard landing risks, market turmoil. The Fed stepped back from further normalization. And then with an eye toward Brexit and possible spillover effects, it also was reluctant to move in the second quarter this year. But if you look at the landscape now, it's hard to see China, at least at present, as a source of considerable economic or financial risk. Brexit seems to be a uniquely U.K. problem, not one with particularly strong impacts anywhere else in the world. And there's no other part of the world right now that seems to be throwing up significant new risk. And as we were discussing earlier, capital markets have been very buoyant. The cost of capital has come down. One would have thought that with that sort of way paved clear that the Fed would have been back let's say more aggressively, somewhat more hawkishly talking about rate increases. Now, there has been a little bit of movement in that direction recently from several of the notable Fed F.O.M.C. participants like Bill Dudley of the New York Fed. But my sense is that they are actually going to come back around. Because if they focus domestically on the U.S. economy, it's hard for them not to pursue normalization. We are nearly fully employed. There are more and more signs that there's a whiff of wage inflation occurring in the U.S. economy. Core consumer prices, at least in C.P.I. terms, are above the Fed's target. Core P.C.E. is likely to follow that. All sorts of reasons why the Fed wants to get back on that gradual path of rate normalization. MIKE SANTOLI: And of course, as you mentioned earlier, we're now looking at year-over-year increases in energy prices. Right? I mean, we've kind of lapped those big declines of last year in oil. So it seems like the headline inflation might come around as well at some point. LARRY HATHEWAY: Right. MIKE SANTOLI: Let's bring it to where it leaves investors strategically. What areas should be emphasized in terms of asset classes right now? What are the expectations really for asset class returns? LARRY HATHEWAY: I think in general, they're low. And therefore, I think as a starting point, now this isn't necessarily for all investors. It depends so much on their tolerance for risk and their investment horizons. But I think a central premise ought to be about capital preservation and lowering one's expectations to things that are more realistic. The big double-digit returns that we've seen in stocks and bonds in the last half-dozen years, indeed, even in 2016 year-to-date, are largely I think behind us. We may capture parts of that in other bits of markets that have not performed so well. Long awaited hope that European earnings might drive share prices there a little bit higher. Emerging markets we've already discussed. But in general, it's about developing strategies that are fairly comprehensive, that are multi asset, but also embody different kinds of strategies to try to subdue volatility in portfolios and to generate steady returns going forward. MIKE SANTOLI: And that would bring you, I assume, to some certain alternative strategies and not pure owning stocks and bonds, public securities specifically. What are some of the areas that seem promising right now? I mean, it's interesting in the sense that we've gone all this way into a bull market, at least globally speaking. And hedge funds have had a hard time. There's been a rethinking maybe of some alternative approaches. So what do you think makes more sense here? LARRY HATHEWAY: Yeah, so the first thing to note is, I'm sure that the standard way of looking at multi-asset investing is really the right way for this environment. And typically that's been taking some mix of stocks and bonds, the quintessential 60/40 portfolio and hoping for some degrees of diversification. As we mentioned earlier, correlations there have all too often been positive, which has tended to both compound returns on the upside. Nice to thing to have, but potentially introduces risks on the downside. So I think 60/40 portfolios won't work very well. And it's a reason why one should also be a little bit wary of so-called Smart Beta, which looks at allocating between asset classes on the basis of market directionality, even in some subcomponents of the markets. I think Beta as a proposition is less attractive now. So coming to the earlier question, it is about hedge fund replication strategies, but appropriately mixed. And that could be done across different asset classes, relative value propositions within asset classes, looking at things like correlation and volatility to be sure. But also trying to disperse portfolios across different types of returns, what we call factor returns. So those could be credit as a factor, equity momentum as a factor. Other style variables like size or quality could be thrown into the mix. And so too can some other exposures, for example, to emerging markets or to commodities. And appropriately diversified across factors as well as asset classes with these relative value, let's say alpha-generating properties is I think for me the best way to build that stability into portfolios. Incremental returns, yes, but stable ones as well. MIKE SANTOLI: So you would be really coordinating characteristics of markets. You talk about these factors. So it's some sort of a quantitative approach to combining what seems to make most sense or what's working for the environment. LARRY HATHEWAY: Yes, it is. I wouldn't say it's sort of at the high end of, let's say, quantitative research. A lot of these things I think are relatively well known. But you do have to look at individual propositions, say of pair trade and try to understand what is the dominant driver of that trade? What factors seem to be important for its performance? Feel comfortable about taking that associated risk, and then take that as one of perhaps a dozen or more similar positions, similar-size positions that pull together a portfolio of these types of returns that they themselves embed degrees of diversification. MIKE SANTOLI: You mention that beta doesn't seem particularly attractive right now. So beta is basically just owning the market. Right? So just playing whatever, getting exposure to whatever the market is doing. Obviously that's been a dominant mode of how investors have been operating right now in essentially buying index funds passively, just taking what the market gives them. You've had some thoughts on this, in terms of how we should think about indexing, index returns. What's the place for passive investments right now? LARRY HATHEWAY: Right, so passive investments I think can be thought of as vehicles. And in that sense, they're not purely passive. I mean, one perhaps doesn't have to be absolutely precise about this, but passive usually is following a market cap-weighted index rather blindly. So one can use instruments that are low cost. ETFs obviously provide an opportunity in this space. But to combine them within strategy. So low-cost ways to execute strategies that themselves are not necessarily purely market directional. To use that term again, beta, but embed perhaps other risk characteristics that look more attractive. Like, for example, still residual yield in emerging markets is an example of that and certain areas of credit that may look to be oversold. These can be exploited through some of these low-cost strategies. But the key here is low cost but also active, as opposed to something that's purely passive. MIKE SANTOLI: And I guess to dial it back a little bit again, if we've had these kind of carefully assembled portfolios, it seems like they make sense for the world we have right now. Are there big kind of unrecognized risks that you can point to right now? In other words, are we on the verge of something that's going to upend our assumptions about how the markets operate, whether it's a recession? Obviously, you can never predict a shock, but do we seem to be ignoring anything that seems like a big threat? LARRY HATHEWAY: Yeah, so let me come back to that but first weave in perhaps just that last part of this together. One of the ways in which traditionally people have invested and it's very common sensical, it comes from the roots of finance, is obviously a mix of stocks and bonds and portfolios. The problem today with bonds is, 1) they don't generate the kind of return that you'd like to see. But they probably do, and this will come to the discussion of risk in a moment, embed quite a bit of volatility. We don't necessarily see it today, but there are coil springs there. Negative yields we know in the long run are not sustainable. And nor are yields well below the rate, let's say of nominal G.D.P. growth in an economy say like the U.S., which would suggest that Treasury yields should be several hundred basis points higher than they are today. So from that point of view, both in return terms, but embedded volatility terms, they should look unattractive. And they are I think unattractive. And therefore, I think part of what the art of investing today is to develop what we might call synthetic or even hybrid bond-like instruments that would still belong in portfolios, offer some yield, but perhaps without all that embedded let's say, volatility, which itself is mostly about duration and to some extent about credit. And if we can avoid those structures within them, then I think we're enhancing portfolio returns. Not just in a short-line sense, but in a long-term sense about building stability into wealth management. Coming to the issue though of the risks that are out there, I'd say that markets are perhaps overlooking several. The first is the one we've just finished discussing before, which is the need for the Fed to proceed with normalization given the advanced cyclical position of the U.S. A second also alluded to before is that perhaps people are complacent about monetary policy in Western Europe, which may be closer to an inflection point than people think. A third would have to be China, which has been a source of risk in markets in recent years. China is still the world's most imbalanced economy domestically. And there's also still significant pressure on the capital account as Chinese investors would like to take their money off shore, which tends to put downward pressure on the renminbi. And the last thing the world needs of course is a weak renminbi that imparts a deflationary bias to other parts of the E.M. or even to the world economy as a whole. So certainly those are three areas that to me represent potential volatility points for markets and risks that we should be aware of. MIKE SANTOLI: There we go. People call it avalanche patrol, perhaps. Just keeping an eye on what could get destabilized there. LARRY HATHEWAY: Right. MIKE SANTOLI: Appreciate that. Larry Hatheway, thanks for your time. LARRY HATHEWAY: Thank you very much. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

"What we could see at the turn of the year is an interesting scenario where the Fed might be preparing the groundwork for the next rate increase ... and if at the same time the ECB were signaling that it might see an end to its bond-purchase program, those two things taken in tandem could actually be the catalyst for an upward move in interest rates taking us back to perhaps the levels we were at the end of last year ... 50 to 75 basis points above present levels," said Hatheway.

In this wide-ranging exclusive conversation, the former chief economist at UBS' investment bank also touches on:

Coming rotation out of dividend-paying stocks.
Reasons why the traditional 60/40 portfolio allocation doesn't work.
The one metric that still matters the most for investors.

PRO subscribers can also read the entire transcript of the exclusive interview below.