An Interview with Tim Sauermelch, CFA, Senior Portfolio Manager SEI Fixed Income
We recently had an opportunity to sit down virtually with one of SEI’s top bond managers, Tim Sauermelch, and talk shop. In our discussion we covered a lot of ground, including how technology has played a role with their team’s management of portfolios, macroeconomic and historical views, possible challenges that lay ahead and wisdom for navigating these volatile markets.
Mr. Sauermelch has been with SEI since 2006 and now serves as Senior Portfolio Manager with SEI’s Fixed Income Portfolio Management Team and is lead manager for SEI’s Real Return, Global Short-Term Bond, UK Index Linked Gilt and UK Gilt funds.
CAS: Since you joined SEI in 2006, how has your team evolved over the years?
Tim Sauermelch: One of the biggest changes has been the electronification of trading. Today, most of the trading is done electronically whereas 5 years ago a good portion of the trading was still done via telephone. With technology growing leaps and bounds, this has also allowed my team to grow assets while maintaining headcount.
CAS: Tim, walk us through the economic backdrop for the bond markets today.
Tim Sauermelch: The elephant in the room is inflation - we are seeing inflation rates that we have not seen since the 1970’s and it’s affecting all markets. This is not just a US centric problem, this is basically a worldwide problem and we are seeing the ramifications of the policies from depths of the pandemic, global supply change bottlenecks, production holdups, etc. So how have things progressed and how may they play out in future? The Fed had to go at inflation very aggressively, other central banks have followed suit and we have seen a very abrupt turnabout. At this point last year, the Federal Reserve was characterizing that inflation was transitory, maintained an ultra-easy policy, portrayed that supply chain issues were largely to blame and inflation will work its way out of the system. Clearly that did not happen, and in my personal view, the Fed held onto easy policy much longer than should have. History has taught us that when it comes to inflation you kill the monster when it’s little. The Fed did not do that, which was a hard-fought lesson that we learned during the 70s and 80s during the Volcker era (Fed Chair from 1979 to 1987). For whatever reason, this Fed decided it would try to allow inflation to work its way out of the system and then step in preemptively and fight it. Clearly in hindsight that was not the best decision. We are now at the point where the Fed is having a very difficult time containing inflation and they are behind the curve. At this point, once inflation is embedded it is very difficult to get out of system without a major economic downturn.
CAS: With the yield curve being inverted, what is the bond market telling us?
Tim Sauermelch: How the yield curve has reacted has pretty much been as an economic textbook would expect. There’s been a sharp shift in Fed policy expectations as well as actual follow through with aggressive interest rate hiking – this has impacted the front end of the yield curve significantly. The 2-year Treasury, relative to September of last year when the Fed changed its position relative to inflation, is about 2.5% higher. Pain has been felt across the entire yield curve spectrum, but it’s been very severe on the front end of the curve. At any given point of the yield curve there are very dramatic shifts and we would have to go back to the 1970s to see a 2.5% jump in a 2-year Treasury in that short of a time window. It’s been a very interesting and challenging environment for anyone holding fixed income. Today, the curve is inverted – this is where the 2-year Treasury is yielding more than the 10-year Treasury. What the bond market is saying, assuming it’s a reasonable pricing mechanism for economic expectations, is yes, the Fed is going to hike, and yes, the Fed may eventually snuff out inflation. But there’s going to be demand destruction along the way, the economy is going to contract and the Fed is going to have to reverse course at some time.
CAS: Assuming we have a recession in the next couple years, paint us a picture of what the that recession may look like.
Tim Sauermelch: We talk about this all the time; this is a hotly discussed topic and we think that if we do get to a recession, it may not be as shallow as the Fed’s hoping to engineer. Why do we say this? The Fed is so far behind the curve that they may have to continue to hike rates to get inflation under control while there is material demand destruction, a point where consumers may decide it’s not worth purchasing something due to high prices. But this is a notoriously difficult thing to forecast. The fear is we end up in an environment where the Fed has to continue to tighten, despite the fact that we could very well already be in a recession. This is the worst-case scenario for the Fed and the worst-case scenario for an economic profile. But it’s too early to make this call. I do think there is a very high probability that we find ourselves in some sort of a recession in the next two years. I do not think the Fed will admit to this, but the Fed needs a recession. I think best case scenario is we get a soft landing or softish recession, we see 4.5% unemployment rate, maybe enough to take off some of the froth of the inflation markets. History does not show this with inflation this high, and with the Fed behind the curve, the Fed will have to go at inflation very aggressively.
CAS: What kind of opportunities are you seeing?
Tim Sauermelch: Given the nature of your investment goals, you are now getting offered yields that we have not see in more than a decade. For long term investors, you can very easily lock in 5% yields on long dated investment grade corporate bonds right now. This has not been offered since the crisis in 2008, barring some brief bouts of idiosyncratic risk that was short-lived. You are now getting the opportunity to pick up some cheap, high-quality securities relative to history that investors can hold to maturity. For an investor with a long-term horizon and not worried about the day-to-day fluctuations, this is a great opportunity.
CAS: Why has the U.S. dollar been so strong recently and what’s the impact as an investor?
Tim Sauermelch: U.S. assets are favored in the world today. The other part of the equation is the interest rate differential between the U.S. and other countries and economies. For the European Central Bank (ECB) and Japan as an example, their Fed Fund equivalent short-term interest rate is much lower than the U.S. These are two major economies that tend to have investors that go offshore for their portfolios. The broad dollar strength is probably less meaningful than the dollar strength to the countries and economies that tend to favor U.S. assets. What’s going to drive the currency relationship between the respective countries going forward? Nothing to me that indicates the U.S. Dollar is going to weaken versus the Euro or the Yen despite the fact the U.S. Dollar is relatively historically elevated.
CAS: Final thoughts and wisdom for our clients?
Tim Sauermelch: Pick investments that you are comfortable holding for the foreseeable future. Markets are likely to be volatile during mid to late timeframes in a cycle of interest rate hikes. Short-term volatility is going to be extremely elevated. If you look back over history, these short-term bouts of volatility tend to have very little impact for an investor with a reasonable time horizon. Stay focused on your goals, don’t panic about short term volatility, look for compelling opportunities and opportunities where you are comfortable holding the risk and getting offered levels of return that you have not in quite some time.
CAS: Thank you so much for your time, Tim, and your insights into the current state of the fixed income market. If any of our readers have additional questions or concerns, please contact us at Ciccarelli Advisory Services.