‘Cash flow is king again’ amid Fed tightening, market strategist says

FS Investments Chief Market Strategist Troy Gayeski joins Yahoo Finance Live to discuss asset allocation, stock market as investors await inflation data and cash flow outlook as Americans are racking up mortgage and credit card debt.

Video transcript

BRIAN CHUNG: Welcome to Yahoo Finance Live. Let’s check the markets as we dig a little deeper into the trading day this Tuesday, February 8th. It seems that all major indices are currently in the green. In fact, the S&P 500 was up about half a percent, the Dow Jones about 6/10 percent, the NASDAQ about 8/10 percent. We will see if these gains hold throughout the trading session.

Now, we know thematically that having cash flow is essential, whether it’s a second job or investing in the stock market. But how important is cash flow in the volatile year of 2022? Obviously, the trading session so far has been a bit difficult. Joining us now is Gary Gayeski, Chief Market Strategist of FS Investments. It’s great to have you on the program, Troy. I just want to ask you what do you think is the right spread right now, with a lot of these FAANG stocks and the kind of big market players that are having a bit of a hard time getting into it, let’s just say, at the start of this year.

TROY GAYESKY: Yeah, so listen, I think the broader asset allocation, you saw clients slightly overweight go-go growth and large-cap tech at the end of last year, entering this year. The biggest trend of the last two or three years is to shift away from fixed income and into cash flow. But we’re finally starting to see people pull back on some of their more aggressive growth, along with broader exposure to equities, to embrace alternatives again, especially those focused on cash flow.

And really, the last time we saw that was from 2001 to 2011, which was really a hangover function of the dot-com era. So as we’ve entered a market environment, where we have a lot more volatility, a lot more uncertainty, primarily due to Fed tightening and not economic fundamentals, it’s just an environment where flows of cash are kings again.

And if you can find strategies such as senior secured commercial real estate debt or double BCLOs pursued through interval fund structures that generate consistent cash flow, not only do you have a reasonable probability of outperforming the securities fixed income, but you also have a chance to outperform. stocks with much less volatility.

AKIKO FUJITA: So is this the alternative strategy you mentioned? I mean, your notes say, keep it simple. Stay away from these assets which are obviously going to be hit hard by higher rates. But who do you see as the main beneficiaries of a Fed rate hike beyond what you just mentioned?

TROY GAYESKY: Yes, so if you’re thinking of ways to generate attractive returns with reasonably low degrees of risk in an environment of rising interest rates, you obviously shouldn’t be pursuing strategies that focus on capital appreciation driven by a multiple expansion. It was in 2020 and 2021.

In a year like 2022 where you’re going to see multiple cutbacks, going into alternatives which these days are very user-friendly and can generate a high revenue stream of 5% to 6% which are incredibly economically resilient, like senior secured commercial real estate debt, is a very viable alternative, not only for fixed income securities, but also for equity exposures.

And that’s one of the biggest differences today, compared to 2000-2002, is that back then it was very difficult to access alternative sources of income like this, or alternatives in general. Now, thanks to the work of companies like ours and others, these are very user-friendly structures with lower minimums, 1099s, ease of access, unlimited IRA capacity. So when we think of the most economically resilient revenue stream, it’s certainly senior secured commercial real estate debt. But if you want to take a little more risk, if you focus on interval funds that have double BCLOs, you earn a very attractive return and also have the potential for appreciation over time.

BRIAN CHUNG: Troy, I want to highlight some data we got from the New York Fed this morning on household debt. And it’s interesting because it sort of touches on the topic of interest rate sensitivity. Households, which are mostly mortgage-based, have a lot of car loans and credit card debt, it can reach nearly $16 trillion. It increased by 2.2% from one quarter to the next.

Is there now a way to play on how people are trying to get ahead of higher interest rates by essentially locking in rates now? I know it’s a family photo. But obviously, as an investor, you try to think about it the same way. Rates will go up whether you cut it or cut it later this year. Should you already be covered for this?

TROY GAYESKY: Well, yes, so listen, it’s not too late to re-embrace floating rate securities, is it? So we’ve talked before about cash flow and how important it is to a portfolio today. But even better than constant cash flow, cash flow increases as the Fed increases. And that’s the definition of floating rate securities or floating rate private loans.

And look at this year. We have forecast four hikes for the Fed. We know some are at seven, some at five. We think four hikes more or less is the right amount. Isn’t it better to have some exposure to a security or income stream where you’re looking for a Fed upside relative to most assets, you’re terrified of the Fed upside. I mean, think about what happened to fixed income this year. Barclays AG is down 3%. Stocks are down 5 to 7 depending on the indices. And this is the direct result of the tightening of monetary policy.

So where you can focus on floating rate exposures, again, double BCLOs or senior secured commercial real estate debt would be examples. This is an area you should focus on. That being said, there are other alternatives as well. Market-neutral multi-strategy is a very good approach – a viable approach if you need daily liquidity. There is currently a huge amount of pricing inefficiency in the volatility markets that we can take advantage of and others can too. Tactical asset allocation strategies also make a lot of sense.

They just don’t have the cash flow characteristics we talked about earlier. But they have a reasonable probability of outperforming equities and fixed income securities with much lower volatility. So cash flow isn’t the only thing to focus on, but compare it to the last two years. We believe this is a much more viable strategy on a relative and absolute basis than at any time in at least the past two years.

AKIKO FUJITA: Troy, where does crypto fit into your overall strategy right now? We saw Bitcoin hit 45,000 again earlier today, although it is currently below 44,000. Is it time to get in, maybe add a bit more exposure, or think you, given the volatility on the equity side, that the risk is just too much to take?

TROY GAYESKY: Yeah, look, I mean, if you own crypto, you own it for the medium to long term as a hedge against continued government debauchery. Very large budget deficits, even if the money supply is currently tightening, it is more than likely to re-extend at some point in the next three to four years. We must therefore think in the medium to long term. In the shorter term, given the delay we have in the halving cycle and the fact that money supply growth is slowing, we believe the environment is going to be unstable. So you want to be careful.

And again, if you compare crypto, or Bitcoin in particular, or any other crypto asset similar to gold, there’s no cash flow, right? So you get nothing but gains or losses at the market price. In cash-generating strategies, you can sustain some degree of mark-to-market or even capital depreciation and still be positive.

So you know when you think about 12, 18 months ago the reason you want it to be as long as possible for crypto and bitcoin is because you were at the start of the shrink cycle half and money supply growth exploded. And you finally had significant adoption by institutions and deep-pocketed investors. Where we are today, we are late in the halving cycle, with money supply growth slowing. And so at the margin, if you’re trying to reduce risk, you want to reduce risk in cash flow generating strategies as opposed to crypto.

And remember, you should never own more crypto than you can tolerate losing a significant amount in the next week or four weeks, if it causes you stress. So we believe this is going to remain a volatile environment for crypto for the time being. And just like other strategies, it’s better to focus on holding or mitigating declines and generating a reasonable return than being a little too greedy, like a lot of people were into go-go growth stocks there a year or a year and a half ago.

AKIKO FUJITA: Yes, harm reduction seems to be the main theme that we will continue to hear about. Troy, it’s good to talk to you today. Troy Gayeski, chief strategist of FS Investments.

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