Interview With Natalie Trunow, Chief Investment Officer Of Equities At Calvert Investment Management: Recessionary Pressure In Europe Strong, Default Issues To Return

Includes: DIA, SPY
by: Harlan Levy

Natalie Trunow is Senior Vice President and Chief Investment Officer of Equities at Maryland-based Calvert Investment Management. Previously she was a Section Head and a Portfolio Manager in the global markets group at General Motors Asset Management.

Harlan Levy: What does the Cyprus mess tell you?

Natalie Trunow: I read about the situation a few months ago, but at the time, nobody cared. We have two pictures: One is the policy picture that markets were focused on for the past year and a half or so that seems to have appeased the markets. They were going to do whatever it takes to keep countries from defaulting. As a result, the sovereign spreads compressed, and the peripheral countries were able to borrow at lower rates.

But there's another picture in Europe that markets at large weren't paying attention to. That's the underlying economic fundamentals, not only in peripheral Europe, but in core European economies. That is a picture of pretty significant recessionary pressures within European economies all the way to the core. The markets discounted that information because of the policy moves that were being assigned the same weight as those that took place in the U.S. In the U.S, the policy moves along with the quantitative easing by the Federal Reserve did work, and deleveraging did take place.

But things are different in Europe, where the potential default, which is driven by market speculation on sovereign bonds, can't be avoided by policy action. A country default driven by a severe economic recession and inability to meet obligations is likely unable to be addressed by policy actions. And because the economic recessionary pressures are so pronounced and so strong in Europe - and especially peripherally in Europe, with Cyprus one example, however small - that over time the potential default issue will continue to resurface, and markets are being reawakened to that reality.

We were there a year and a half ago. Last year the consensus forecast was for Europe to recover and have 1 percent GDP growth, and last year it turned out to be negative, so the consensus was wrong. The same thing could be happening this year. The consensus earlier this year before the Cyprus situation transpired was again for recovery in Europe. And I don't know if that is achievable this year. Two years ago we were also saying recession in Europe could be more protracted and serious than markets anticipate, and that is what has happened.

So a policy step in Europe is not as effective as in the U.S., and policy moves need to be taken with a grain of salt. I think the underlying economic reality in Europe is finally seeping through into market performance, whereas in the past few months more credibility was given to the policy actions.

H.L.: How strong is the U.S. economy?

N.T: It's a relative statement, but the U.S. economy is expanding. It's having a very tepid recovery, but it's a recovery nevertheless. I cannot say the same of many developed economies in the world. How strong is it? It's less strong in the short term than if there hadn't been the sequester. It could have been stronger this year, but the actions that reduce spending and improve the budget strength for the U.S. for the long term are necessary. Despite the sequester I still think we will be able to maintain some expansion, although less robust.

What gives me confidence that the U.S. economy can continue to expand is the fact that the U.S. housing market has been recovering and providing a positive impact on the economy and consumer confidence, as well as contributing to employment in housing-related sectors, as opposed to being a drag on economic growth.

Our forecast for last year was that 3 percent growth was achievable without the sequester's impact. With the sequester, we're probably looking at 1.5 percent, but I think we could do a little better than that -- maybe 2.5 to 3.

H.L.: Do you see the job market growing, or is it stuck at under 200,000 new jobs a month, and if so, is that good enough for economic growth?

N.T.: I see the unemployment numbers gradually improving. We have seen a positive gradual improvement and a positive trajectory in unemployment numbers, so I do see those continuing to improve over time. I also see them improving at a faster clip in the second half of this year and next year. Housing is one of the biggest drivers, and consumer confidence and purchasing managers' and hiring MANAGERS’ confidence at the corporate levels are also big drivers in improving employment numbers. Those drivers will continue to get stronger.

On the corporate sector and the private sector side, what we have today is more clarity and more visibility going forward in terms of what to expect from policy-makers. So the private sector has a more concrete set of factors to work with for the next three or four years. A lot of the uncertainties related to the political cycle, with the elections and with the sequester, have been largely removed, and companies are now going about their business and planning and are more likely to hire for the long term, so I see the unemployment rate improving. That's the upside.

The downside is that, ironically, as the unemployment rate improves, the likelihood that the Fed's quantitative easing will continue is reduced. That would not be good for interest rates. The rates will rise, and that will create a lot of pressure in the fixed-income market, with a potential bubble burst in Treasurys and other pockets of the fixed income market.

H.L.: What do you see happening in the stock market?

N.T.: I think the stock market will be reflecting the underlying economic fundamentals and continued economic growth in the U.S., so I think the U.S. stock market will continue to be relatively healthy in the long run, with some ups and downs. It might be a little choppy here, but in the long run the U.S. equity markets look attractive.

H.L.: How much of a factor is the big impasse in Congress between Democrats and Republicans?

N.T.: It certainly is a factor for Main Street as much as for Wall Street, and probably more for Main Street, because it impacts them more directly. It's a negative for the country. It's a negative for the economy. It's a negative for the stock market, and it's across the board.

It's a factor that is expected in the marketplace, and it's almost a certainty that there will be an impasse in Congress. Most market participants expect that they will just kick the can down the road, no "Grand Bargain," no big solution. Incremental improvements or changes are what's expected. Uncertainty is what creates indigestion in the securities market, so as long as the markets can form an expectation as opposed to having uncertainty, they can move ahead and get by, and they can look ahead. In a sense it's better to have a negative you can anticipate than the most uncertain outcome. In this case the market has formed an expectation as to the potential outcomes and scenarios for any political action or question, so companies can move ahead and make decisions as to how to run their business, and market participants can better make forecasts.

H.L.: Can situations like the JPMorganChase debacle be avoided?

N.T.: It's a tough case, because you're getting into an area of derivatives and hedging versus taking an active position in derivatives. What represents hedging as opposed to active trading can be a very difficult assessment to make for those who are not on the inside and are not intimately involved with the trading program. Regulators are a step or two removed from those activities and don't have the background or sufficient, timely information, so a regulator is not necessarily easily positioned to be proactive. That's why they are often in the reactive mode.

Even for people on the inside it's not trivial to get to the bottom of some of these trading programs quickly. The difference between hedging and active trading can be opaque because these programs and transactions can be very complex. It must be one of the most difficult areas for regulators to tackle.

Hedging is offsetting existing positions in order to manage risk exposures in the portfolio. Because of liquidity, cost and other considerations, one may be hedging with instruments that are not 100 percent reflective of the underlying positions which means there is basis risk. When you have basis risk, some derivative positions can be considered active, because you're now taking risk through hedging.

This form of resulting active position is one of the most innocent active positions that could result from hedging, because the hedging instruments that are available have basis risk relative to the underlying portfolio. Then you may want to offset the basis risk and take another position, and it could go wrong.

From here, there is a whole spectrum of active positioning that a firm could take with respect to the imbedded risk factors in the hedge portfolio. One may want to express a view on interest rates, GDP, corporate earnings etc. through derivatives. I don't want to speculate about the specifics of what JPMorgan traders were doing. One thing is certain, when any one position or trade becomes too big and starts to move the market or becomes widely known and anticipated by traders, it becomes highly prone to failure.

H.L.: Can regulators do anything more to mitigate such risk-taking to avoid disasters?

N.T.: Yes and no. As for more regulation so that the regulators will figure out what could go wrong and nip it in the bud before it happens, that's a no, because I don't think it's possible for some of the reasons we discussed. Regulators don't have sufficient resources, staffing information or background necessary to address all potential blow-ups in the financial industry. It's such a large and constantly evolving landscape.

The best way to address excessive risk taking is to create leverage points to impact the incentive structures within the industry such that taking outsize risks in activities related to systemic risk in the global marketplace is penalized in a way where it's going to make people think twice before they do that. For example, before the financial crisis, clawbacks were practically unknown in compensation schemes. They were very rarely part of incentive structures for bankers, investment bankers, and other investment professionals. But it's now becoming more acceptable as a practice. What that does is help prevent extreme risk-taking in hopes of large short term payoffs without appropriate consideration for potential long-term implications. It helps folks focus more on longer term, broader impacts because that they're not going to get the full benefit of a trade or specific activity in the short run.

I also think that the internal controls within financial firms guided by regulators will do a better job than regulators themselves trying to understand every single activity in the financial industry and trying to predict the outcome. Self-regulation is more effective and impactful than top-down regulation. But self-regulation doesn't happen on its own. So, regulators need to make it urgent that companies self-police and self-regulate. There need to be sufficient sticks and carrots in place for that to happen.

Things like bail-outs often act in the opposite way, because that allows for a backstop that sends a signal to companies that if you mess up and if you're big enough, we'll back you up, and things will be fine. This sends the wrong signal. If a legal professional does something unacceptable, disbarment is the very harsh punishment that follows. Something similar needs to be in place for financial professionals on a broader scale than what exists today. I'm a fiduciary, and that's the highest standard in the business and it helps investment advisers and financial planners self-police and avoid excesses in their practice.

The Fiduciary duty standard requires investment professionals to act in their clients' best interest. This approach helps instill an internal culture that helps prevent extreme risk taking. This standard doesn't apply to other industry participants like broker-dealers and insurance agents.

Proposals have been made in the House and the Senate after the financial crisis to apply the fiduciary standard more broadly in the financial industry but a strong industry lobby was successful in pushing back. However, I think that in the long term the proposed changes will be implemented and that would be helpful, because it would impose internal controls that will help avoid some of these tail risk events, which are often caused by activities that people engage in on the extreme side of the risk spectrum seeking short term payoff.

H.L.: Do you think Congress can act on such proposals now?

N.T.: It's a good question. On the one hand you can say that if such action was not possible after the biggest financial crisis on record and one of the biggest market crashes, what is it going to take for that to happen? Is the lobby that strong? Maybe it's a generational change that has to happen. The cynical part of me says it's not going to happen very soon. My guess is that the question will resurface again and will ultimately be resolved. We could have a smaller event, smaller in terms of global impact, AN event similar to JPMorgan's "London whale" fiasco, which affects a smaller sliver of the industry but comes to light in a more significant way and triggers the question of culture of self-regulation.

The core of it is self-regulation. Company management, CEOs and CIOs need to put in place appropriate incentive structures that discourage heavily the kind of risk taking that can trigger broad industry-wide implications and on the other hand reward thoughtful analysis of risk and potential outcomes of whatever activities they undertake. And regulators can help with that. If companies are scolded for lack of risk controls on a regular basis and fined, the industry standards will improve over time.

H.L.: How threatening to the U.S. economy are JPMorgan-type situations?

N.T.: In terms of how threatening these situations are to the economy, I think the banking sector is much less threatened today than it was before the financial crisis because the level of alertness by regulators and firms themselves to some of these risk-taking activities is higher than ever before.

The banking sector is still very large, so the sheer size of the sector and the interconnectedness of the various economies in the world is still very important, but the level of scrutiny of potential risks has changed. The probability of big events with big ripple effects throughout the globe has diminished, because there's lots more focus on risk and risk-taking throughout the system. I could guarantee that Jamie Dimon took some very serious steps to address the causes of what happened and to look at other parts of the organization to make sure similar activities and risk taking practices are being looked at and are being taken care of. Companies like JPMorgan are precedent-setting, and they become part of industry practices, because the large investment banking firms and banks will talk about these situations internally and will try to address the issues accordingly. I think, net-net, it should have a positive impact on the industry, because folks will try to preempt or prevent these situations from happening in their own firms.

Disclosure: I am long AAPL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.