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Breaking down the risk inflation poses to the market

Robert Cohen, Director of DoubleLine's Global Developed Credit Group, joined Yahoo Finance Live to break down his thoughts on inflation trade.

Video Transcript

ADAM SHAPIRO: And welcome back to Yahoo Finance Live. 15 minutes to the closing bell. Quick market check for you. We're watching the Dow up more than 560 points. The S&P 500 is up over 50 points. And the NASDAQ is up over 95 points. The yield on the 10-year, by the way, 1.48. The reason I bring that up is we've been talking a lot about inflation. And we're inviting into the stream someone who can help us strategize our portfolios when you're worried about inflation or if you want to use it to your advantage.

Let's bring in Robert Cohen, director of DoubleLine's Global Developed Credit Group. It's good to have you here. And help all of us understand something. And if what I say is inaccurate, correct me. But there was a discussion earlier in the day that I heard, in which they pointed out that the 10-year and the two-year, the spread is actually flattening, which wouldn't that mean we're headed toward a recession? Or at least, that's what bond investors are telling us. Because we're hearing counter to that. So as an investor, how do I make heads or tails of the 10-year actually being below 1.5 and the two-year possibly rising?

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ROBERT COHEN: Yes, hi. Thanks for having me. It doesn't necessarily mean that we're on the precipice of a recession. What it means is that inflationary concerns on the long end of the Treasury yield curve are abated or mitigated because the expectation for what people refer to as persistent inflation is coming down a bit I think mainly because people are looking at what were the big drivers of inflation in the latest print. And they related to things like airlines and used cars, things that presumably should be transitory with respect to inflation.

So I think it's just suggesting that it's, all else equal, a little less risky to be in long duration bonds. Because the Fed's going to hopefully take care of inflation. I think that's what we saw, particularly after there was signaling that the Fed is going to maybe taper a little sooner than planned. So I think that was sort of the Fed recognizing that inflation got a little bit higher than they expected it would. And they are at least watching this and are willing to act if necessary. And I think that's what makes investors in the long bond a little bit more comfortable.

JULIA LA ROCHE: Robert, Julia La Roche here. It's hard to believe it's been over a month since we last spoke at DoubleLine. Would love to kind of hear an update from you on your own views as it relates to inflation and how much of a risk you think this might play.

ROBERT COHEN: Yeah, so I think we've always said inflation is a risk. It's not a certainty. It could be transitory. But I think there are many reasons to consider why maybe it won't be. You were just talking on an earlier segment about airlines. American Airlines announced that it's having to cut some of their traffic because they're unable to ramp up flight operations. So transitory comes down to what's your time horizon. It seems like in the case of American Airlines, it's taking a lot longer than they thought. That's maybe one little point.

But if you look more broadly, some of the key components of inflation, the owner's equivalent rent, which is the way that CPI computes housing expense, 25% of CPI. And it hasn't moved up. Owner's equivalent rent hasn't moved up as fast as the housing market has. So I think that could provide upward pressure. Certainly, we have wage inflation coming. And the persistence of that is hard to tell. Time will tell. I think it's hard when you're paying premiums now to get employees back in to deal with that and mitigate that as time goes on. So that's something we have to watch.

And we have corporations now onshoring manufacturing in a way that we haven't talked about in decades. So, for example, semiconductor capacity is being brought back onshore. Some analysts expect that that could be as much as 30% more expensive than manufacturing in Asia. We've talked about in the past about critical healthcare infrastructure coming back to the US.

We manufacture a lot of pharmaceutical and healthcare supplies in Asia. That was something that was a concern that people are bringing back onshore. All these could potentially be drivers of more persistent inflation. But I think it's too early to tell. We view it as a risk that you have to manage when you're managing investment portfolios.

JULIA LA ROCHE: Yeah, something that DoubleLine is certainly known for is managing for that risk. So I want to bring this up with you because my conversation with Jeffrey Gundlach at your offices, he mentioned floating rate corporate debt being very interesting to him. That is your area of expertise. How can the viewers at home think about playing the inflation trade in the context of their portfolios? What would be a smart move for them?

ROBERT COHEN: Yeah, I think in order to understand the floating rate trade, you have to understand where we were and how we got where we are now. So at the onset of the pandemic a little over a year ago, credit spreads blew out. And the opportunity in corporate credit was in the most beaten up areas. So you could play transportation, gaming, retail, sectors that were the most displaced by the pandemic and had the most opportunity for recovery.

So, as an example, CCC high yield had a yield of 19%, 20%. Now it's compressed down to sub 6%. So we've gone from this immense opportunity with the market being beaten up last year to a point now where spreads are very tight. And inflation concerns and interest rates are part of the discussion. So with all of that spread compression, we've now moved to a period where corporate credit is less of a reflationary and beta trade and more of a carry trade and more of a credit selection consideration.

So in that environment, you have to think about what does well to allow you this carry trade with mitigated downside risk. That's what gets us to bank loans. If you take investment grade credit, it has a very long duration of nine years. It has a yield of two. That yield to duration relationship we find very dangerous in an environment where rates could be rising. Our outlook basically since the beginning of 2021 is that we favor bank loans. We had an overweight on bank loans.

ADAM SHAPIRO: Right.

ROBERT COHEN: We were neutral on high yields. And we were underweight investment grade. And so the idea simply is all about duration. In an environment where spreads are tight, and we have this carry trade now, you want to be in an asset class that has lower duration and a little bit more credit protection if volatility hits.

ADAM SHAPIRO: Right. Robert Cohen is director of DoubleLine's Global Developed Credit Group. We appreciate your being here.