(Click here to sign up for the Delivering Alpha newsletter.)
The market has seen huge price swings this year, whether it’s equities, fixed income, currencies or commodities, but volatility expert Paul Britton doesn’t think it will end there.
Britton is the founder and CEO of the $9.5 billion derivatives firm, Capstone Investment Advisors. He sat down with CNBC’s Leslie Picker to explain why he thinks investors should expect an increase in the number of worrying headlines, contagion concerns and volatility in the second half of the year.
(The following has been edited for length and clarity. See above for full video.)
Leslie Picker: let’s start – if you could give us a read on how all this market volatility is factoring into the real economy. Because there seems to be some difference at the moment.
Paul Britton: I think you’re absolutely right. I think the first half of this year has really been a story of the market trying to reprice growth and understand what it means to have a 3.25, 3.5 handle on the fed funds rate. Really, it has been a mathematical exercise for the market to determine what it is willing to pay and a future cash flow position once it enters a 3.5 identifier when stock valuations. So, it has been a kind of story, what we say is of two halves. The first half has been the market determining the multiples. And there really hasn’t been a huge amount of panic or fear within the market, obviously, outside of the events that we see in the Ukraine.
Picker: There really hasn’t been this kind of cataclysmic fallout this year, until now. Do you expect to see one as the Federal Reserve continues to raise interest rates?
British: If we had had this interview earlier in the year, do you remember when we last spoke? If you had said to me, “Well Paul, where would you predict the volatility of the markets would be based on the broader base markets being down 15%, 17%, even 20% or 25%?” It would have given you a much higher level as to where they currently are. So, I think there was an interesting dynamic. And there are a wide variety of reasons that are too boring to go into detail about. But ultimately, it really has been an exercise in the market determining and getting the balance as to what it’s willing to pay, based on this extraordinary move and interest rates. And now, what the market is willing to pay in terms of future cash flow. I think the second half of the year is much more interesting. I think the second half of the year is ultimately coming to poke around in balance sheets trying to determine and account for a real and extraordinary move in interest rates. And what does that do to balance out? So Capstone, we think that means that CFOs and ultimately corporate balance sheets are going to determine how they’re going to fare based on an admittedly new level of interest rates that we haven’t seen in the last t 10 years. And most importantly, we haven’t seen the speed of these interest rates rising for the last 40 years.
So, I struggle, and I’ve been doing this for so long, I struggle to believe that that’s not going to catch certain operators that haven’t filed their balance, that haven’t filed debt. So whether it’s in a leveraged lending space, whether it’s high yield, I don’t think it’s going to hit the big multi-cap IG credit companies. I think you’ll see some surprises, and that’s what we’re preparing for. That’s what we’re preparing for because I think it’s phase two. Phase two could see a credit cycle, where you get these idiosyncratic moves and these idiosyncratic events, which for people like CNBC and CNBC viewers, they might be surprised by some of these surprises, and that could cause a change in behavior. at least from the point of view of market volatility.
Picker: And that’s what I meant when I said we haven’t really seen a catastrophic event. We have certainly seen volatility, but we have not seen large amounts of stress in the banking system. We haven’t seen waves of bankruptcies, we haven’t seen a full-blown recession; Some debate the definition of a recession. Are those things coming? Or is it just that this time it’s fundamentally different?
British: Ultimately, I don’t think we’re going to see, when the dust settles and when we meet, and you’re talking two years from now, I don’t think we’re going to see a noticeable uptick in the number of bankruptcies and defaults and so forth. What I think you will see, every cycle, that you will see headlines on CNBC, etc., that will make the investor wonder if there is contagion within the system. Which means if a company launches something that really scares investors, whether it’s the inability to be able to raise funds, increase debt, or whether it’s the ability to have some problems with cash, then investors like me, and you’re So I’m going to say, “Well, wait a second. If they’re having problems, does that mean that other people within that sector, that space, that industry are having similar problems? And should I readjust my position, my portfolio to make sure that there is no contagion? So ultimately, I don’t think you’re going to see a huge increase in the number of defaults, when the dust has settled. What I do think is that you will see a period of time where you will start to see a lot of headlines, simply because it is an extraordinary move in interest rates. And it’s hard for me to see how that won’t affect every person, every CFO, every American company. And I don’t buy this notion that every American company and every global company has their balance sheet in such perfect shape that they can withstand an interest rate hike that we’ve [been] experiencing right now.
Picker: What does the Fed have in terms of recourse here? If the scenario you described plays out, does the Fed have tools in its toolbox right now to be able to get the economy back on track?
British: I think that’s an incredibly difficult job that they’re facing right now. They have made it abundantly clear that they are willing to sacrifice growth at the expense of making sure they want to extinguish the flames of inflation. So, it’s a very large aircraft that they’re handling and, from our point of view, it’s a very narrow and very short strip of runway. So to be able to do that successfully, that’s definitely a possibility. we just think it’s [an] unlikely chance that they’ll land the perfect landing, where they can dampen inflation, make sure they get criteria and supply chain dynamics back on track without ultimately creating too much demand destruction. What I find most interesting, at least what we discussed internally at Capstone, is what does this mean from a future standpoint of what the Fed is going to do from a medium to long-term standpoint? From our point of view, the market has now changed its behavior and that from our point of view makes a structural change… I don’t think that its intervention is going to be as aggressive as it has been these last 10, 12 years post-GFC. And the most important thing for us is that we look at it and say, “What is the actual size of your answer?”
So a lot of investors, a lot of institutional investors, talk about the Fed put option, and they’ve had great comfort over the years, that if the market is facing a catalyst that needs calm, it needs stability injected into the market. I’ll argue very strongly that I don’t think that put option was, what is described as obviously the Fed option, I think it’s much further away from the money, and more importantly, I think the size of that intervention, so Essentially, the size of the Fed’s put option will be significantly smaller than it has been historically, simply because I don’t think any central banker wants to go back to this situation with runaway inflation. So that means I think this boom and bust cycle that we’ve had over the last 12 or 13 years, I think ultimately that behavior has changed, and central banks are going to be much more in a position to let the markets will determine their equilibrium and, ultimately, the markets will be freer.
Picker: So given all of this backdrop, and I appreciate you laying out a possible scenario that we could look at, how should investors position their portfolio? Because there are many factors at play, a lot of uncertainty as well.
British: It’s a question we ask ourselves at Capstone. We run a large complex portfolio of many different strategies and when we look at the analysis and determine what we think some of the possible outcomes are, we all come to the same conclusion that if the Fed is not going to step in as quickly as they once used . And if the intervention and the size of those programs are going to be smaller than they were historically, then you can draw a couple of conclusions, which ultimately tell you that, if we have an event and we have a catalyst, then the level of volatility to which it will be exposed will simply be higher, because said like that, an intervention will be further away. So, that means you will have to hold volatility longer. And ultimately, we are concerned that when you do get the intervention, it will be less than the market was expecting, and that will also cause a higher degree of volatility.
So what can investors do about it? Obviously, I’m biased. I am an options trader, derivatives trader and volatility expert. So [from] My point of view I look for ways to try to incorporate downside protection (options, strategies, volatility strategies) within my portfolio. And ultimately, if you don’t have access to those kinds of strategies, then you’re thinking about running your scenarios to determine, “If we do get a selloff and we get a higher level of volatility than maybe we’ve experienced before, how can I position my portfolio? Whether using strategies like minimal volatility or more defensive stocks within your portfolio, I think they are all good options. But the most important thing is to do the work to be able to ensure that when you are running your portfolio through different types of cycles and scenarios, you are comfortable with the end result.