DoubleLine's Jeffrey Sherman: Where to Invest as Fed Hikes Are Imminent

Q&A March 14, 2022 at 04:06 PM

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In raising interest rates at a rapid clip, the Federal Reserve is expected to shift into a new, likely surprising mode: As it institutes increases this year, "it will do so irrespective of what happens in the stock market," Jeffrey Sherman, deputy chief investment officer at DoubleLine, of which Jeffrey Gundlach is CEO, tells ThinkAdvisor in an interview on March 11.

"A lot of investors, during the last few decades, have learned and relied on that if the stock market goes down in price, the Fed will change its behavior and change its path and become more accommodative," Sherman says.

"However, this year, a midterm election year, the Fed will focus on inflation and will do so even at the expense of some of the risk markets, like the stock market. The Fed is behind the inflation curve."

In the interview, the chartered financial analyst, who oversees DoubleLine's investment management subcommittee and is lead portfolio manager for multi-sector and derivative-based strategies, says in addition:

"Outside of the Ukraine conflict, inflation is the biggest risk for the stock market."
"The era of easy money is over, at least for the time being. That means you want higher quality, safer assets."
Though the stock market is "nervous," there are "developing opportunities."
Owning some value stocks is "important."
Sectors that look "pretty interesting" include consumer staples, health care and financials.
Expected slower economic growth "could lead to a recessionary problem in 2023."

Sherman, whose popular interview podcast is "The Sherman Show," also discussed how high he believes the inflation rate will rise this year, as well as how, specifically, DoubleLine upgraded the credit quality of its portfolio in January to reduce risk.

ThinkAdvisor held a phone interview with Sherman, previously a portfolio manager and quantitative analyst at TCW, who was speaking from Los Angeles.

Last month, DoubleLine moved its corporate headquarters from Glendale, California, to Tampa, Florida. Most employees still operate out of the L.A. area.

Here are excerpts from our interview:

THINKADVISOR: Please talk about why the Federal Reserve's actions are particularly significant now.

JEFFREY SHERMAN: It's paramount to focus on the Fed's policy. The market expects it to hike rates more than six times this year. I think they're on that path.

They could surprise at next week's meeting with a larger hike than the 25 basis points that the market is pricing in.

The Fed is going to continue to raise interest rates throughout the year and will do so irrespective of what happens in the stock market.

A lot of investors in the last few decades have learned and relied on that if the stock market goes down in price, the Fed will change its behavior and change its path and become more accommodative.

However, this year, a midterm election year, the Fed is going to focus on inflation and will even do so at the expense of some of the risk markets, like the stock market.

What's your outlook for the stock market for the next few months?

The market is very nervous now; it was already nervous before the Russia-Ukraine war.

But there are developing opportunities. The stock market is starting to look like a place where some investors want to step back in a little.

We've seen a change in leadership: The market was technology- and communications-driven. But the tech-related assets — the disrupters — have come under significant pressure. And I'm not sure if they'll bounce back in the short term.

If that's the case, what do you see as the better bet?

You want to tilt toward value. Owning some value stocks is important. Focus on things that are in the cheapest parts of the market but are high quality.

The traditional value areas that have been cheap over the last few years have started to really hold up well. Consumer staples, health care, even the financial sector are pretty interesting.

If we get some downside [movement] in the market, you'd want to buy some of the growth names.

What should advisors be telling clients in view of rampant U.S. inflation?

Own high-quality assets. I can't stress that enough. It's a time of uncertainty. The inflation rate is high.

The Fed is set to go significantly faster in hiking rates than we've seen since the global financial crisis.

But that's going to take a little bit of time for markets to digest.

What will be the impact on investors?

The era of easy money is over, at least for the time being. That means you want higher-quality, safer assets.

More of your fixed income portfolio should be domiciled in the U.S. and heavily invested in the U.S., not in other parts of the market.

You need to be extremely patient and not get caught up in the whipsaw nature of markets.

Be patient about fixed income?

Yes, very patient. But there's a point where you're going to want to start buying some of the riskier segments of the market, though right now is a little too early to be stepping back into that lower-credit-quality tier.

What sorts of investment changes has DoubleLine made this year?

At the end of January, we started to upgrade the credit quality of our portfolio. We sold some of our emerging market debt that was riskier — which would struggle in a volatile market — to buy Treasurys.

We also bought high-quality investment-grade corporate bonds because it will be more volatile out there. And there's going to be a tightening [interest-rate] policy.

We reduced risk pretty considerably. We haven't had any knee-jerk reactions. We're watching credit markets and are starting to see a nibble into the market.

We're beginning to want to buy a little more risk, but we haven't done so yet.

You just said you bought some corporate bonds. But when you and I talked last October, you advised being cautious in that market because there was high interest-rate risk. Why did you buy in January?

Because we tried to put more interest-rate risk back into the portfolio. We wanted to buy some of the areas that were beaten up a little, and corporate credit was [one].

We only bought a couple of percent of our portfolio and the highest-quality stuff.

We're getting out of some riskier things, like emerging markets [as noted above] and non-U.S. sovereign debt.

What are your thoughts about emerging markets, then?

They're starting to look like a developing opportunity again. But we're not [investing more in them] right now. We want to take a little more caution.

We think the [Russia-Ukraine] conflict will go on for a prolonged period, and we want to feel comfortable taking that risk.

The truth is, we're getting there.

What's the biggest risk for the stock market right now?

Outside of the Ukraine conflict, it's inflation. The inflation data is going to get worse in the near term. This week, [growth in] the CPI [consumer price index] came out at 7.9%, which is, effectively, a 40-year high.

It's not happening just with commodity prices, like oil and food, it's rampant throughout [the economy].

We continue to see pressure in goods in general, as the supply chain shortages have led to significant price hikes. Yet we haven't seen any retreat in goods consumption.

What's really going on in the housing market?

The shelter component is a large piece of the CPI. But it isn't even reflected in the CPI numbers yet. We know that house prices are up 25% on average; rents are up close to 10% on average.

How high do you think the inflation rate could go?

If oil prices stay elevated, you can easily see the CPI [up] 9.5% this year. If inflation retreats to what it was prior to the Ukraine conflict, inflation probably will run in the high 6s to low 7s.

It's going to be very difficult to get that number down, and that's why the Fed has to be pretty aggressive. We've seen a lot of money-printing since the pandemic that created all this inflation.

How do you rate the Fed in doing its job since the financial crisis of 2008-2009?

The Fed is behind the inflation curve. They've had too loose a policy for too long, and they're going to tighten it.

We've gone from an era of extremely easy money and a lot of extra money in the system, due to all the fiscal packages that we received, to the Fed's now going to behave very restrictively in trying to tighten.

Just what does that mean for investors?

Likely repricing of the risk market. We've seen some of that: There's definitely a repricing of the fixed income market in Treasurys.

The period of easy money ended last year, and we're going into a new environment where the price of money is higher: Borrowing costs are higher. That's what the Fed is trying to do.

But monetary policy takes months to get through the system. With midterm elections coming up in November, they want to try to stymie inflation.

So they really have to hike in the next four or five meetings to try to at least slow down some of this [rising] inflationary environment.

How much do you think the Fed will raise rates this year?

There's the potential for them to hike 50 basis points to try to get in front of this inflation.

Is there any good news in fixed income?

As painful as it's been in the fixed income market, it does have the ability to generate higher future returns. Today, high-yield bonds yielded 6%.

Last year, they were down to about 3.5%: Junk bonds were yielding in the mid-3s. Today, that number crossed 6%.

This means that there's a developing opportunity from a credit perspective. It's starting to look very interesting for fixed income investors to want to buy more credit exposure — if the Fed doesn't engineer a recession and we're able to get through this.

What else are you looking for from the Fed at the meeting?

How they project out for inflation. The rate of growth of the economy last year was almost 5% real. That's likely to slow and probably get closer to 3% this year.

And if we have those elevated commodity prices, maybe it will go down to about 2.5%.

So do you see a recession in the near future?

It's still not very recessionary in 2022, [though slower growth] could lead to a recessionary problem in 2023. But right now the growth engine seems to still be driving the overall economy.

What else do you expect the Fed to discuss at this next meeting?

Guidance on their balance sheet. This week, it bought its last bonds for quantitative easing. So they're no longer expanding their balance sheet.

[Fed Chair] Jerome Powell has said they want to reduce the size of their balance sheet this year.

What I'm looking for is how they're going to approach that unwind.

That's the other big wild card in the marketplace. The last time the Fed tried to reduce its balance sheet, it caused problems in the fourth quarter of 2018: The market went down almost 20%.

I'm very skeptical that the Fed can both hike rates and bring down the balance sheet and not cause volatility in credit and equity markets.

Is there a silver lining?

If we get more volatility, the second half of the year could be a good opportunity for investors to buy more credit assets.

Much of investing is, of course, for folks' retirement. What's your advice for advisors and their clients when it comes to retirement planning?

People want to make money very quickly. But the key to success in retirement is to start saving early.

If you can't start saving early, do it very often. By saving more each year, you can try to up your plan. That's how you get the benefit of compounding.

Don't get "lifestyle creep": As your income goes up, try not to spend as much as the increases that you get. Try to save an incremental portion of those.