The Federal Reserve's recent about-face on interest rates – holding the federal funds target rate range to 2.25% to 2.50% following some very rocky markets and modest inflation at the end of 2018 – has created some significant implications for investors.
Not only did the Fed's closely watched "dot plot" change from two estimated rate hikes in 2019 to none, it also indicated that it would stop shrinking its balance sheet. In a recent video interview, Magellan Financial Group CIO and Lead Portfolio Manager Hamish Douglass sat down with Magellan's General Manager, Distribution, Frank Casarotti to chat about the Fed's new position.
In the following wire some of Douglass' key discussion points are summarised, including how the manager has responded to this recalibration, why predicting what will happen in 2019 is fraught with danger, and how a little bit of Berkshire can go a long way.
Don't always bet on black
Firstly, Douglass was quick to point out that the Fed had not simply "changed its stance" on interest rates – it had done what he described as a "complete backflip". He noted that at the end of 2018, the central bank was predicting maybe another two or three rate increases this financial year, while also flagging its intention to shrink its balance sheet.
Enter 2019, and not only was it signalling that it probably wasn't going to increase interest rates any further this year, it said it was going to stop shrinking its balance sheet. So, with quantitative tightening suddenly off the table – a move that Douglass dubbed a "very material shift" – the question now surrounded how this has changed Magellan's market outlook.
"First of all, I would say having a very strong view of what's going to happen in the next 18 months is very dangerous. That is dangerous because nobody knows. Even the Fed does not know what's going to happen," Douglass said.
Douglass believes there are a number of scenarios that could play out. Importantly, he said the probability has now increased that the current interest rate cycle is going to be shallower, and that is going to have an impact on how Magellan approaches its portfolio.
"But we're not going to put a bet on black that there'll be no inflation and interest rates won't have to be tightened. Because if we do get inflation, particularly in the United States, and the Fed has effectively been running too loose a monetary policy, and they had to tighten ... If that actually happened, hold onto your seats with what's being priced in the markets at the moment," he said.
"We're not saying that will happen, but no one can tell you definitively that it won't happen either. And even the Fed wouldn't tell you definitively it won't happen.
"So, I would say we've probably moderated our view on the cycle, but we're still cautious and we're going to keep a cautious stance of how we construct the portfolio to make sure that if the Fed's caught in the wrong direction here, we don't get caught in the wrong direction."
Just add a bit of Buffett
Douglass also chatted about the most recent update to Magellan's portfolio holdings and how a small position in a company named Berkshire Hathaway had crept its way into the portfolio. He also elaborated on the logic behind the purchase, noting that even though Magellan had never owned Berkshire Hathaway before now, both Warren Buffett and Charlie Munger have been huge influences on his way of thinking.
"They really brought the thinking of Benjamin Graham (author of The Intelligent Investor) and Phil Fisher (author of Common Stocks, Uncommon Profits) together … So, they've been very influential on our thinking of the types of stocks we would buy and how we would go about it," Douglass said.
"And Berkshire Hathaway actually fits into our defensive equities portfolio. It gets incredible performance when markets go down, mainly because there's $100 billion of cash – the business is so resilient – and it tends to go down very limited amounts when markets fall."
Douglass is also effusive in his praise of the group's core insurance business, going so far as to say there "is nothing like it" anywhere else outside of Berkshire Hathaway and that it possesses "massive" competitive advantages.
"They're underwriting workers' compensation, but also a lot of catastrophe insurance. As far as I've ever witnessed, hurricanes don't tend to follow stock market cycles. They don't tend to be correlated with each other," he said.
"So fundamentally, the business is not that correlated with the stock market, and it's got a lot of downside protection."
Something that has lately been weighing on the minds of many investing disciples of both Buffett and Munger is their advanced age, and whether their genius and stock-picking nous will remain with Berkshire after they have both moved on to the next dimension.
But Douglass said this is not something Magellan is factoring into its own valuation of Berkshire Hathaway.
"There is no doubt that when Warren leaves Berkshire Hathaway, there's a whole lot of retail shareholders that would probably sell their holdings. And in the short period after, their share price would probably get hit," he said.
"It's probably one of the reasons we have a relatively small holding, because if that was to happen, that would be a wonderful buying opportunity for truly one of the great businesses of the world."
… and about that inverted yield curve
Another thing front of mind for investors has been the inversion of the US yield curve in late March, dismissed by some but heralded by others as a prelude to recession. Douglass appears to be firmly in the former camp.
He explained that while inverted yield curves have typically been predictors of recession in the past it has been due to the economy going strongly. In other words, there had been a bit of inflation and the central bank had been trying to cool inflation: "They keep jacking up the interest rates and therefore they effectively take the short-term rates above the long-term rates, and it inverts."
"And because they're doing it to slow things down, effectively you often get a recession because it's late cycle."
But as Douglass pointed out, we have recently seen an inverted yield curve at much lower interest rate settings to where you would have typically seen the curve invert previously, while at the same time the Fed has stopped increasing interest rates.
"I think when it's being inverted, it's from a much lower base, and the Fed's not trying to put the brakes on. So, I do think it's very different from where it would typically predict a recession."
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