(02/29/12) The Right Funds for this Environment

In part two of MoneyShow.com’s interview with Gene Needles of American Beacon Advisors, he discusses factors in the global macro picture that investors need to be aware of, and what kind of mutual funds they should buy in response to world events.

Kate Stalter: Let me follow up asking you: What are some areas, therefore, that you like for your clients at this point? And what might be some factors, either in the global macro picture or other areas, that you believe investors should watch out for?

Gene Needles: OK, well let’s start with the factors first, because I think that will inform the decision on where you want to be.

I think that if we look at the global macro picture overall, it’s clear to me—I think it’s probably clear to anyone if they think about it for any period of time—that really the credit markets are what are driving the marketplace these days.

The credit markets, depending upon how you measure it...if we just measure it on actual securities outstanding, the bond market is roughly about twice the size of the equity markets globally. If we were to measure it, however, and include derivatives off the credit markets, you’d find that the credit markets are about ten times the size, including derivatives, of the equity market.

Let me explain that a little bit better; these are just rounded numbers here. You’ve got global bond markets at roughly $100 trillion, and global equity markets somewhere between $50 and $60 trillion, depending upon where the market is at any given time.

Again, if we add derivatives—you can go to the Bank for International Settlements, and they have a Web site and they’ll show you the nominal exposure for different derivative instruments—if we use credit-default swaps and we use equity-based derivatives, etc., you’d see that the interest-rate and credit-default swaps are north of $500 trillion. So, they’re ten times the size of the actual equity markets.

Yes, there are some derivatives associated with equities, but they’re only about $5 trillion or $6 trillion. So we’re talking about potential exposure in the marketplace for the credit/interest-rate market at $500 to $600 trillion, compared to $60 to $70 trillion for the equity markets and their derivatives.

That’s a big difference, and particularly when there’s a lot of turmoil in the market, it can cause a big impact overall. Not just on those individual markets, but economies as a whole.

If we think back to the 1990s and even the tech bubble, we’ve all been very centered on the equity markets. We think of that as a proxy for economies, business in general—and to some extent it is—but at the same time, the sheer amount of money that is devoted to credit markets and derivatives of those markets dwarfs those equity markets.

What we’re seeing right now is: When things don’t run smoothly in those markets, they do have dramatic impact. So if we read the headlines, they’re not really about the stock market, or they haven’t been for the last couple years. They’re about credit, they’re about currency, and they’re about curve or interest rates.

We’re of the opinion, for the next three to five years they’re going to continue to drive these markets, because what has happened, in fact, is we spent the last decade outliving our ability to pay back what we were borrowing. It doesn’t matter who you’re talking about—it’s Europeans, it’s the United States, etc.

But ultimately someone’s going to pay this price tag. It’s just a question of who that’s going to be, and there’s a lot of maneuvering to determine who in fact that will be. Will it be the Greek taxpayers, will it be the German taxpayers, and/or the French taxpayers? Will it be the bondholders for the Greek debt? Or in some way, shape, or form, could it be American or even Japanese taxpayers, as the central banks maneuver their currency to avoid being noncompetitive in world markets?

I would say to any investor, if you’re looking out three to five years on your portfolio, those are the three things you want to look at. You need to look at the credit markets, you need to look at the currency markets, and you need to look at the yield curve.

If you, or your advisor, or the portfolio managers your advisors select for their client, can keep your eye on that ball, it will inform your decision about the stock market and your portfolio at large.

So where should we be investing given all that? I guess that was your second question, and I think there are some obvious answers to that.

I think that you certainly want to be taking some risk in this environment, and I think some of the best bets out there from a demographic trend are emerging markets. They just have a potential to outgrow the developed nations.

If you are also in fixed-income instruments, you want to make sure, in my opinion, not to just be in one currency, because it’s not clear to me—or to I think anybody—how this will all play out over the next three to five years. So I don’t think you should be entirely dollar-denominated or euro-denominated or emerging-market denominated.

I think in terms of income, because another thing that’s taking shape in addition to these geopolitical machinations, is the fact that there is a real hunger for income, from a demographic standpoint.

The population of most developed countries, the United States in particular, is aging. They need to live off the income from their investments as they retire, and they’re left with a situation where traditional income instruments, traditional bonds, are at historically low interest rates and probably not able to provide them the income that they need in retirement. So they’re looking elsewhere, and I think there are some good selections to look elsewhere.

One of them would be dividend-paying equities. The yield on dividend-paying equities is at or near all-time highs, relative to Treasuries, and I think represents a pretty good value right now in the marketplace.

You see other investors reaching out on the credit spectrum. We already talked about credit, that it’s going to be something you need to be aware of and cognizant of in the marketplace. So I would say if you’re going out on the credit spectrum, you really want to select a manager who is adept at that, who’s done that for a long time seeing several market cycles, not someone who’s just entering the fray at this point in time.

So that begs the question: What kind of mutual funds would you buy? Well, OK, I buy equity income funds. I think that makes a lot of sense in this market. I would buy emerging-market equity, and to some extent emerging-market debt products.

I’m very high on flexible products in the marketplace, particularly in the bond market, where you might have a manager who has the ability to make money in the bond market not just from yields, but from credit and currency as well. So the ability to play credit, currency, and curve.

The last thing I’ll say is a little self-serving here, but that all sounds well and good: if you can play credit, currency, and curve you’ve got this licked. Well, it’s pretty hard to do.

One of the more recent products that we’ve developed is a product called our Flexible Bond Fund (AFXIX), and what we’ve done there, in addition to giving the subadvisor to this product discretion to go basically anywhere in the world to derive total return from credit, currency, or curve, they can go negative duration, they can go long and short credit and currencies, etc.

In addition to that discretion, we’ve added diversification, and we’ve added multiple managers to that product. For the same reason I described earlier, the benefits of a multiple manager approach, I think a flexible product screams out for that. Because invariably, one of those managers is going to bet wrong.

If we’ve done our job right, we think all these managers will perform well over the long term. But our real goal is to make sure our investors do well over the long term. And to do that, they have to be able to stay the course. If we can mitigate that volatility with a multiple-manager approach, then I think it’s a win-win not just for us, but for our investors as well.