Quarterly Webinar Replay

Chris Zand: Hello, and thank you all for joining us today for the Osterweis quarterly call. I'm Chris Zand, and joining me for today's discussion are Chief Investment Officers, Carl Kaufman, Nael Fakhry, and Greg Hermanski. Unfortunately, John Osterweis is unable to join us today due to a scheduling conflict, so I'll be opening today's session with a broader perspective on the first quarter's activity. From there, our panelists will discuss the key forces shaping markets, our current portfolio positioning, and our outlook for the remainder of the year. And as always, we'll conclude with an audience Q&A. So with that, let's jump right in. The first quarter was certainly an eventful period, and while the conflict in the Middle East ultimately took center stage, it was really the convergence of several important themes that shaped the quarter. As everyone knows by now, oil prices moved sharply higher almost immediately after the conflict began, and those aftershocks are still reverberating through the economy today, particularly in inflation and investor sentiment.

Another major storyline has been AI and its potential to disrupt the software industry. That shift has led to a meaningful repricing across parts of the technology sector with valuations compressing, even where fundamentals remain relatively intact. That'll be something we'll come back to a little later. At the same time, we saw increasing scrutiny in the roughly $1.7 trillion private credit market following a long period of rapid growth. Another area we'll talk about in more detail. Policy also played a role. The Supreme Court overturned the administration's initial tariffs, prompting a swift response with new measures that have effectively kept inflation pressure in place. And while those are some of the most economically significant headlines, there were also a number of other geopolitical events, including the U.S. operation in Venezuela to capture President Maduro, the ongoing conflict in Ukraine and Russia, as well as the blockade of Cuba, all of which added to heightened uncertainty across markets.

Yet, despite all this, markets remained relatively resilient with major indexes ending the quarter only modestly lower. So why did markets hold up as well as they did? There are a few reasons from our perspective. First and foremost, momentum was strong coming into the quarter. Investors were leaning into a constructive backdrop with still healthy labor markets, moderating inflation, and growing expectations that the Fed would soon begin cutting rates. All of these factors helped push markets to all-time highs in January. Additionally, despite the volatility, underlying corporate fundamentals remained relatively intact, supported by strong consumer spending. There was also ample liquidity in the system, and frequent policy messaging by the president and the administration also helped steady sentiment, all contributing to markets ending in the quarter only modestly lower. And perhaps not coincidentally, shortly after the end of the first quarter, a ceasefire was announced, helping spark a market rally here in April. So with that context, I'd like to bring Carl into the conversation now. Carl, could you start by providing an overview of how fixed income markets performed in the first quarter?

Carl Kaufman: Sure. And good to be with you today. And for the people that are watching, this is not a fashion statement. I had cataract surgery and I'm wearing these therapeutically. Fixed income markets were mostly flat for the period. The Agg fell by, I think, 0.05%, which is essentially zero over the three-month period. The high yield index declined 55 basis points, which is also pretty nominal. In other words, the bond market mostly tracked the equity market, which is to say investors largely shrugged off the headlines from the first quarter. More accurately, fixed income investors were focusing more on the current economic fundamentals and corporate earnings, which remain favorable. The first quarter is coming in near 15% growth, which is above where people were expecting. I think they were expecting 12% up from the initial annual 10% forecast that they always have. And markets seem to be treating the oil shock as though it's a temporary situation and are instead focusing on the longer term.

Chris Zand: Thanks, Carl. That all makes sense and very helpful. Let's go back to something I mentioned earlier and spend a minute talking about private credit. It's been getting a lot of attention in the financial press lately.

Carl Kaufman: Of course. Private credit is where companies borrow directly from private lenders, bypassing the regulatory overhead that comes with public transactions. Probably the most important thing I can tell everyone is that we do not invest in private credit. So if you've heard anything bad about it, you don't have to worry about it affecting your money here. And secondarily, we share the broadly held opinion that even if the private credit market experiences more distress, it shouldn't trigger a systemic crisis. Having said all that, we do think private credit is likely to experience additional losses over the near-to-medium term. There have been several high profile defaults recently, and redemptions are rising above what is statutorily allowed by these funds triggering sponsors to put up gates. The entire market is under pressure right now, but in our view, today's problems have been years in the making. It just didn't appear overnight.

Many of the borrowers in the private credit universe are companies that would have formally issued debt at the lower quality end of the high yield market, namely in the Triple C space. In other words, private credit has become the go- to destination for weaker borrowers, which has simultaneously led to an improvement in quality in the high yield market as these lower quality companies leave. As an example, the high yield market has less than 10% bonds rated Triple C or lower versus 25% in 2008. And roughly 60% of our market is now rated Double B, which is the highest rating in non-investment grade versus about 45% in 2008. So to net it out, private credit has actually been good for us, even though it is creating problems for investors who are exposed to the asset class right now.

Chris Zand: Thanks, Carl. Very helpful overview. Let's shift gears now and talk about the Fed. Can you bring us to speed with what's happening there? For those who haven't been following closely, confirmation hearings for the new chair, Kevin Warsch, began this past week.

Carl Kaufman: That's right. The hearings were contentious at first with the committee arguing about whether he would be a White House hand puppet. We're not sure whether he will be or not, but we believe his tendencies do lean towards cutting rates, much like Miran who was sort of put on the Fed by the administration. However, the Iran situation is complicating that as its inflationary effects have not played out yet. We haven't even gotten to planting season yet, and fertilizers you know, is one of the byproducts of the Middle East. However, the Iran situation is complicating in that its inflationary effects will not lend itself to an easy sort of narrative about easing. There is a story recently I read that Chinese exporters across a wide swath of industries have started to raise prices 20, 30 plus percent due to their increased energy costs. And I doubt the importers will want to absorb most of this, so expect to see that passed along in higher prices.

Assuming the Fed, and they had their meeting today, so we can read them and there's not much change. They left rates unchanged. Assuming the Fed sets its policy based on economic data rather than the desires of the White House, we are not expecting cuts in the near term. Keep in mind that so far, corporate earnings, as I mentioned, are pretty strong and well ahead of expectations. Also, there's the issue of the rising deficit, which keeps upward pressure on the longer end of the curve, which the Fed does not control. I mean, we're pushing towards 5% today. We'll see if we break through this time or just touch it and pull back. Fortunately, the economy seems healthy enough that cuts are not necessary and it can certainly absorb these rates.

Chris Zand: Thanks, Carl. Let's turn to equities now and bring Greg and Nael into the conversation. Greg, we're roughly about a month into the second quarter now and markets have started off strong. How are you thinking about near-to-medium term outlook?

Greg Hermanski: Good afternoon, everybody. Obviously, as we think about the near- to mid-term outlook, the situation in Iran remains pivotal to that outlook. We anticipate at least some type of economic disruption even after the Strait of Hormuz is opened permanently. We think that it's going to take months, if not years, to fully recover from the supply shock that was caused by the war. Oil production equipment, it's going to need to be repaired. Production is going to need to be ramped up after being offline for so long. And incidentally, that's really good for oil field service companies, including Halliburton and Schlumberger, but it's going to cause a bunch of disruption. We also think that inflation numbers are going to drift higher for a bit before... It's going to take a while for them to come down. And we agree with the prevailing opinion that oil will likely settle at a higher point than it was pre-war.

Overall, we came into this year optimistic about the economic environment, and most of the positives are still intact. It leaves us with an underlying economy that appears to be reasonably healthy despite the recent headwinds. For example, labor markets are holding up well even if hiring has slowed a bit. Business investment remains robust, largely driven by AI. Tax cuts to the 2025 budget bill have also been stimulative both to businesses and consumers who've received breaks, and that's translated into higher spending. So once the war is finally in the rearview mirror, we're cautiously optimistic about the near-to-medium term, but we need to see the war to end and see what the ramifications are going to be.

Chris Zand: Thanks, Greg. Now, given all that, Nael, how is the U.S. consumer really doing?

Nael Fakhry: I'd say the U.S. consumer is doing okay. That's the main takeaway. The health of the consumer is critical to the overall health of the economy, as we've said, and you've probably read elsewhere, the consumption represents about two-thirds of all economic activity. So it's a critical factor. And I think a really important building block is unemployment. So unemployment is 4.3% as of the latest reading, and real wages are, meaning wages after inflation, continue to rise actually. So nominal wages are growing slightly ahead of inflation. So that's a really important starting point. It means people are employed, they have jobs, and their wages are keeping up with inflation, so they're spending, and that is continuing. All that said, it's also important to consider that, as Greg just touched on with respect to oil, oil and energy spend in general doesn't have the same impact on consumption that it used to have.

So this is the largest oil shock in history, but if you go back to the late 70s when there was another massive shock also related to the Middle East, about just under 10% of household spending was on energy. Today, that stat is below 4%. So in other words, oil shocks don't have the same impact today that they did 40, 45 years ago, and that's largely because of technology and other shifts away from crude oil. So if you think about appliances, light, LED lighting, cars in general, they're just more efficient because of new technologies. And then you obviously have the rise of hybrids and electric vehicles when it comes to cars, so they just either use less gasoline or no gasoline, and then there have been shifts towards natural gas and renewables and away from fuel oil for the production of energy and for heating. So the economic hit of higher oil prices today is a lot less impactful than it used to be, which is really good news for the consumer and therefore for the broader economy.

All of that said, the middle and low income consumer has been pressured for years now, as we've been talking about for years of inflation, years of rising interest rates relative to where they were, we think interest rates are actually more at a normal level today, but still they're much higher. So if these oil prices stay high and they persist, you can't ignore it, and they'll eventually start biting the consumer. So as Greg just said, we think a resolution that restarts the flow of oil is really important, and that'll help sustain the economic recovery.

Chris Zand: Thanks, Nael. Very helpful. Now, in your latest quarterly outlook, you talked a bit about how AI is changing the way investors think about software companies. Could you take a moment and discuss what's happening there?

Nael Fakhry: Sure. The punchline here is that we've reduced our exposure to software companies. We weren't overly exposed to software companies even before the AI age that started a couple years ago, mostly because of valuations. But software, we talk a lot about our quality growth framework, companies' durable competitive advantage, they can reinvest to drive growth and they have good governance. These companies, software companies, fit that framework really well in the past because they had a durable competitive advantage and they could reinvest to drive growth. The durable competitive advantage often was they had really high switching costs because all the data of a company or even a consumer sat within the company. It was often the data is very sensitive. It's costly to switch. Years of code that was developed by these companies, it was very hard to replicate and was constantly being optimized. That was another major barrier.

So you had this very significant ... And there are also regulatory barriers. There's very significant durable barriers that gave these companies competitive advantages. Well, they also had very little capital requirements. So they were extremely profitable, generated a lot of cash, and the runway for growth was almost endless. I mean, you think about these companies capturing the opportunity of consumers and businesses switching from analog to digital, all the company has to do is hire a sales team and go out and capture those customers. AI has totally changed that landscape for a lot of companies and not only software companies, but also for some information services businesses and others. And the reason is that you can create AI, you can create software using AI almost instantaneously now, this whole concept of vibe coding. Google talks about how 75% of their software that they code now starts with AI and then the engineers check it, and that's up from 50% a few months ago.

So we think software just has much lower barriers to entry and the runway for growth has eroded. Not true of all software. There's certain companies that are protected in our view, but we've reduced our exposure there. And where we're overweight is other sectors like the industrial economy, which we've actually long been overweight. Think about waste management companies, manufacturers of niche components, distributors, commercial aerospace. These are areas that AI can't really disrupt. If you think about certain narrow sectors of the Real Estate sector, Health Care, and then within Technology, we favor the infrastructure companies, the cloud infrastructure companies, for example, over the application companies. So for many of these companies, AI is probably a cost-saving and it's driving demand. So we really want to be positioned such that AI is a tailwind, obviously, rather than a headwind. And I think that's how we've shifted the portfolio.

Chris Zand: Thanks, Nael. That makes a lot of sense. Given everything we've just discussed, Greg, can you walk us through our current overall portfolio positioning?

Greg Hermanski: Sure. The biggest change to our portfolio positioning was what was just mentioned. We reduced our software positioning to just a couple names. We have also opportunistically added a couple of positions that we believe have strong upside, but they tend to be more defensive in nature. As always, we continue to focus on companies that fit our quality growth framework and generate growing free cash flow. Companies that generate strong free cash flow can use it to either grow their business organically, grow their dividend, grow through M&A, or return capital to shareholders through share repurchases, and all of those are positive outcomes. Currently, around a third of our portfolio is defensive, which means those companies are either countercyclical or acyclical. In other words, their performance should remain largely unchanged or potentially improve should the economy weaken. The remainder of the portfolio is more offensive in nature. These are companies where we see outsized growth opportunities and are industries that tend to do particularly well in a strong economy. In every case, our investments are in high quality companies with strong moats that have clear opportunities to improve and grow their businesses.

Chris Zand: Thanks, Greg. Very helpful. Let's build on that. Carl, can you outline our current portfolio positioning on the fixed income side?

Carl Kaufman: Sure. This shouldn't come as a surprise to anybody. We've been pretty consistently conservative for the past quite a few quarters. Given all the uncertainty in the markets right now, we're still defensive and that means keeping a healthy dose of dry powder, which gives us the ability to hunt for bargains during periods of either singular bond weakness or market weakness, which so far has been in very short supply. We're keeping duration low, which generally reduces our volatility. We continue to focus primarily in the non-investment grade market for most of the portfolio, and we have been investing opportunistically when we see bonds in companies we like that have longer lifespans. We continue to invest in the short-term busted convertible market, which have higher yields and better balance sheets than bonds of comparable maturity in the high yield market. So we have been finding some longer-dated opportunities recently, and we have been putting some cash to work and taking down our cash for it a little bit.

Chris Zand: That's great, Carl. Thank you for that. Earlier you mentioned that you didn't think it was likely that the Fed would cut rates anytime soon, even if the new Chair is confirmed. Could you provide a little more color around your expectation for interest rates and your outlook for fixed income more generally?

Carl Kaufman: Sure. As I mentioned before, the inflationary impacts of higher oil prices should drive inflation to the point where near-term rate cuts don't make sense. There are other reasons too. Keep in mind that a new Chair is just one vote. Today's vote was eight to four, and the dissenters weren't dissenting about raising rates or keeping them flat. They were dissenting about the language of a downward bias being included in the statement. So even though you do have a change at the top, you still need a majority to move rates. Economics 101 tells us that when supply is abundant, prices fall. And as you know, the federal government continues to borrow liberally, which means that the supply of Treasury bonds is not going to decrease anytime soon. So I would expect bonds, especially at the mid to longer end, to remain elevated, and we will have a pretty steep yield curve.

As for the economy, I think it's generally strong enough to support rates at their current levels and even a little higher at the long end. So there's no pressing need for the Fed to cut. Taken together, we think that the yield curve is likely to remain range bound, presumably with a slightly higher bias. And of course, the direction of the conflict in Iran will continue to influence how things play out. But our outlook remains similar to what has been for a while. We see a lot of potential headwinds. Our base case is that the bond market is not a cause for worry, but neither is it glaringly cheap. We tend to buy when other people are bailing, and that is just simply not the case right now.

Chris Zand: Thanks, Carl. Very helpful. Now, one concern I hear from clients has to do with the U.S. Treasury market. Treasuries have long been a bedrock of our financial system, and investors from around the world have been happy to lend us money in exchange for a risk-free return. But global alliances are shifting and things are evolving. Should we be thinking differently about that demand, and is there a risk that it could change or soften?

Carl Kaufman: I mean, it could, but I don't think there's any imminent risk. The Treasury markets are still the deepest, most liquid markets in the world. The other large sovereign markets, or put another way, the alternatives to the Treasury market, namely Japan, Europe, have much weaker economic underpinnings. In the case of Japan, much higher leverage to GDP ratios. This may explain why investment-grade corporate spreads have remained so tight as people look to maybe de-emphasize Treasuries a little bit and buy Corporates. Now, some of these hyperscalers, et cetera, could be argued have stronger balance sheet and income statements than the federal government. So that's why investors are not demanding huge spreads over Treasuries to buy those. But certain things could change over time, depending on how things evolve. While other countries are proactively trying to lure some of the investment capital away from the U.S., I have found, and I think you've noticed, when the world experiences a major hiccup or unexpected event, we still see the money pouring into Treasuries as a defensive reflex, which tells you that they're still the go-to market in times of stress.

Chris Zand: It's a great perspective to keep in mind. Thanks, Carl. We're getting ready now to head into our audience Q&A, but before we do, any final thoughts from the group?

Carl Kaufman: I'd just like to say that the first quarter was certainly a bit more hectic than we would've liked, and we're hoping for calmer days ahead, but we'll put a low probability on that for the time being. But we believe we are well positioned both in our equity teams and fixed income teams for whatever the world and markets hand us.

Chris Zand: Great. Thanks, Carl. Let's open things up to the audience now. As always, you can ask a question through the Q&A window in the webinar application, or just simply raise your hand. We'll start with a few questions we received by email prior to today's presentation. The first one, Carl, you've touched on this a little bit, but how are we positioned if rates are to stay higher for longer? And also, if rates were to start coming down under Warsh, how would we approach that?

Carl Kaufman: Those are two interesting questions. Clearly, if rates do trend higher, the good news is that when rates go higher, bond prices go lower and we don't have a lot of long-dated bonds that would go down a lot. So we would be fairly stable in that environment and we would be able to buy higher yielding bonds when the move has gotten them down enough where they're an absolute value. On the other question, if Warsh does convince the Fed to start cutting rates into a strong economy, that would mean that at the very short end, we'd be getting less yield. So at that point, we would have to make a decision whether it is one of those times where you should accept the lower yields because of what comes next, or we move out the curve a little bit, maybe two and three, four-year paper rather than six months to one and a half year paper. But I think we're well positioned either way.

Chris Zand: That's great, Carl. Very helpful. Thank you. I'm going to turn to an audience question now. How much is the U.S. insulated from oil price movements due to our relative energy independence?

Carl Kaufman: I'll take a stab at that first now that the equity team maybe comment. I saw a report today that sort of compared the different regions of the world, so to Asia, Europe, and the U.S. So we are much better positioned than the rest of the world by far. Our price of oil, natural gas, diesel, and jet fuel is lower than pretty much anywhere in the world. Our natural gas price, I think, was $256. In Europe, they're paying 43 euros. In Asia, they're paying $16. So that gives you an example. The magnitude isn't as great in other commodities, but jet fuel, we're about 60, 70% of the cost of other regions. And that is because we produce a lot of oil and refine it here. I don't know if the equity team wants to add anything.

Nael Fakhry: I would just add, similar to what I said earlier, just the U.S. consumer is much less dependent on energy. So it's about 3.5% of annual spending, and that was the stat in February before the run up in prices. So that's, again, because of technology changes. And then I'd echo, Carl, what you said. I mean, there have been massive changes in the technology for extracting energy. So think about natural gas, which is not the same type of global market as the oil market is, and that gives us tremendous advantages. And then near term, we still have significant coal deposits and energy is used in utilities still relies on coal. And so major chain differences like that insulate us in a way that, for example, India uses all kinds of fuel oil just for heating and cooking and all kinds of things, and they're seeing the direct impacts today, so they've been much more hurt to take an extreme. At the end of the day, ultimately, you want this to die down, but it does give us runway, I think more so than certainly the rest of the developed world.

Carl Kaufman: Which may also explain why the dollar has stopped going down and it started moving up against a lot of these currencies.

Chris Zand: Great. Thank you both for that perspective. Here's another question from earlier. How concentrated is the portfolio currently and where are our highest conviction positions?

Greg Hermanski: I can take a stab at that. As far as concentration in the portfolio, it's at a normal level. We tend to run around 35 to 40 names. We're there now. As I had mentioned earlier, we added a few defensive positions So we've diversified out the defensive positioning a little bit, but we're within a normal range. As far as high conviction positions, I throw out two, which are in the same industry, commercial aerospace, Boeing and Airbus. We feel are really well positioned. First of all, they don't have the AI risk to them. But also post-Covid, you've seen the average age of a global fleet of airplanes go up fairly dramatically. And as planes get older, they're not just less efficient, but more costly to maintain. And so what we've seen is the backlog of planes grow dramatically for both Airbus and Boeing. And so post-Covid, they've been ramping back up their production, but there's been hiccups as it is pretty normal.

And so the backlog continues to grow. Over the next couple years, we anticipate they're going to get back to stability. Airbus had mentioned on the earnings call yesterday that they expect to get to 75 either at the end of '27 or '28. And then from there, just hold there for several years and basically harvest that backlog. And what will happen is free cash flow and operating margins will go up a lot and the companies should do really, really well through that period of time. So we kind of see a five-to-10-year period for commercial aerospace of growth and increasing profit margins and increasing free cash flow.

Chris Zand: That's great. Thank you, Greg. Very helpful. And we've got one more question. How are you thinking about managing taxes in my portfolio? I'm happy to give this one a stab unless anyone on the core team wants to go first.

Nael Fakhry: I mean, I think just generally speaking, we always tend to try to be long-term and that is inherently tax efficient because of the capital gains rate. So I think that's a major part of it. And then we try to be opportunistic. I'm sure, Chris, you'll touch on this, so I'll let you jump in.

Chris Zand: Yeah, no, I would agree. I think you guys would both agree that over time, our goal is to generate taxes with long-term stories that have worked out really well in the portfolio, and obviously to make room for new ideas as they present themselves. But we do think about managing taxes as a core pillar of wealth management, and it's something that is incorporated into the management of the portfolios. And we do it in a few different ways. First, we look to harvest losses throughout the year when the opportunity presents itself. Second, we think about where we are in terms of realized gains every year, in particular towards the end of the year, such that if there's an opportunity to forego gains into the following year, we will certainly do so. And lastly, we do engage in conversations with clients about managing taxes and understanding what their tax picture may look like outside the portfolio.

Those are considerations we can certainly incorporate when thinking about the management of the portfolio and your long-term goals. Well, that concludes all the questions that came through, and I don't see any further ones in the queue. So at this point, I'd like to thank our panelists for taking the time today and providing this helpful update, and for all of you tuning in to joining us. Wish you a great rest of the day. And if you have any questions, please reach out to the Private Client team and we'll follow up with you. Thank you.