Loomis Sayles' star bond manager talks about rising rates and trade wars

Trade wars could lead to stagflation, Dan Fuss warns

Apr 19, 2018 @ 4:12 pm

By John Waggoner

Dan Fuss has 59 years of experience in the investment industry, and 42 of them have been with Loomis Sayles. He has run Loomis Sayles Bond fund since 1991, rolling up an averaging an 8.99% annual gain. Over the past 15 years, the fund has outpaced the Bloomberg Barclays U.S. aggregate bond total return index by 3.94 percentage points a year — a record that few of his competitors could match. InvestmentNews senior columnist John Waggoner spoke with Mr. Fuss about bonds and the new risks facing investors.

John Waggoner: How many rate hikes do you think we will have this year?

Dan Fuss: We're heading to the 2% mark in inflation, and possibly going through it. So another two, another three hikes this year. [Boston Federal Reserve Bank President] Eric Rosengren actually said another three.

JW: Are companies increasing wages?

DF: I see something a little different. Compensation has more variability. A lot of the investment management firms and some service firms keep the wage increases small or they don't increase at all once you get to a certain level — but they do pay bonuses. But on the benefits side, health insurance charges being paid by the company are being shared more with employees. I don't know of any exceptions to that.

JW: Why are companies so reluctant to spend?

DF: I've heard industrial companies — most notably, Caterpillar and Deere — make a point of saying that things couldn't be better. However, in their planning, they now have contingencies: If the trade barriers start, their expansion stops. They are not going to expand in the face of a possible trade barrier. It's not in the statistics, because in general, the industry analysts are coming back with pretty optimistic things. We know raw material prices so far for industrial production have not gotten out of hand. Once you start to see the uncertainty, you say, I'm going to wait and see what happens. Sanctions and tariffs can damage the economy.

In addition, they can do brutal damage to international relationships. Frayed relationships — cutting diplomatic staff — that's serious stuff. Once you're starting to mess with the quality of peoples' lives, you have to ask, 'What are the side effects?' The Chinese message of doing live-fire drills in the Taiwan straits, that's a pretty clear message. You don't have to wonder what that means. If we're putting on tariffs and hurting them, they can also respond by putting tariffs on us, some of which will hurt.

JW: So tariffs could hurt economic growth?

DF: Based on data and observations, you can say things do look good in the economy. I hope we'll be able to continue, but a number of people say, 'We'll have to see what happens with trade.' I'd be broader than that and say, I'd be concerned with trade and geopolitical developments that are broader than trade, but heavily influenced by trade. When I'm thinking about our investment policy, I start with the geopolitics. I don't get to the economy until step four, and I don't get to the Fed until step six, because they're doing the same thing. They are looking at the geopolitical situation, and also looking at the movement of people in the Mideast and South America, and how those things affect the cost of money in those areas.

When you look at domestic politics and politics around the world, you have some problems in predictability, which is the nicest way you can put it. Same thing in Europe. You don't want the central banks locking horns with each other. Then I ask, what is going to surprise us? The Fed, in my opinion, is trapped by circumstance. They have a domestic mandate that's spelled out. The mandate doesn't cover what's happening in Asia or Europe, and yet the impact of what they do in those areas is severe. I agree with the sanctions because of the chemical warfare in Syria. But if you start putting sanctions that hurt people who aren't involved in the war, you get political unrest.

JW: At what level will the Fed stop raising rates?

DF: In a perfect world of economic growth with 2% inflation, they would still overshoot a little bit andend up with fed funds at 3.25%, maybe 3.5%, then settle back toward 3%. If that's the case, once you settle in at 3%, that puts the 10-year Treasury note just a smidge over 4% and the long bond at 4.5%.

The Fed doesn't want to ruin a good thing. As soon as they see something implode on tariffs or trade barriers, it will scare them. They have a structural blind spot there because that's international government policy. If I were them and see tariffs come in, I'd increase estimates on inflation and decrease it on the economy. The old name for that is stagflation. It's going to be a slowing economy with rising inflation — the worst of all worlds.

I want to keep the geopolitics just a bit removed, but it's the overwhelming variable. It's not a good thing. There is some good news there: To the degree North and South Korea want to declare the war over, that would be a good thing. We could get that artillery out of the hills over Seoul and not threaten to blow each other up — that would be a good thing. I can't see harmony increasing very much in Europe, but I could be wrong on that. But I don't see the unification of Europe stretching to having a single government. And if I were Vladimir Putin, I'd be more worried about what's east of him than what's west of him.

And China's an entirely different thing. We have a large group of people, finally unified autocratically, and is very likely to run into the Western European dominance as personified by the United States. And that could lead to the Thucydides trap — Athens versus Sparta. [The Thucydides trap states that when one great power threatens to displace another, war is almost always the result.] How this gets resolved is even more critical than some of the examples from earlier in history, because the nature of the weaponry we have is awful. As bad as the one big world war in the first half of the last century was, at least we couldn't blow up the whole world. Now we can. So you have work these things away.

You might say, 'This is a long way away from figuring out whether the Fed will raise rates two times or three times.' But we think of the yield curve and economic growth measured in quarters, but what we have is a mishmash — kind of like some of the models of the neurons firing back and forth. In general, rates are going up, unless the Fed has to blow the whistle and say 'Stop' because something has happened. Right now, they have no reason to stop. However, looking out further, you have a situation developing that could cause lower economic growth and higher inflation. In that case, are they going fight inflation or promote growth?

JW: Where would you put bond money now?

DF: The Loomis Sayles Bond fund is 35% in reserves, and the average maturity of the fund has been cut more than half from where it has been for years and years. It's down to 5.5 years now. What are reserves? Some is in the bank, about 20% is in T-bills and another 15% is in a little bit longer-dated Treasuries and related things. We don't include anything with calls in there. By the way, the reserves are not idle — they may be the best-performing area. The fund's yield is in the mid-3% range. It's not a high-yield return, but it's pretty good. We're more cautious on the credit side than we were, both in the loan area and in high yield.

Next year, economic growth could be 2.8%. Could it be way below that? Yes. Could it be higher? Not by a lot. The big issue is not what the Fed is up to. The big influence is geopolitics and how that affects the economy, inflation and what the Fed does.

(More: David Herro on the best opportunities in international investing)

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