Paul Britton, CEO of $9.5 billion derivatives firm, says the market hasn’t seen the worst of it

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The market has seen tremendous price swings this year – whether it comes to equities, fixed income, currencies, or commodities — but volatility expert Paul Britton doesn’t think it ends there. 

Britton is the founder and CEO of the $9.5 billion derivatives firm, Capstone Investment Advisors. He sat down with CNBC’s Leslie Picker to explain why he thinks investors should expect an uptick in the amount of concerning headlines, contagion worries, and volatility in the second half of the year. 

(The below has been edited for length and clarity. See above for full video.)

Leslie Picker: Let’s start out — if you could just give us a read on how all of this market volatility is factoring into the real economy. Because it seems like there is somewhat of a difference right now.

Paul Britton: I think you’re absolutely right. I think the first half of this year has really been a story of the market trying to reprice growth and understand what it means to have a 3.25, 3.5 handle on the Fed funds rate. So really, it’s been a math exercise of the market determining what it’s willing to pay for and a future cash flow position once you input a 3.5 handle when to stock valuations. So, it’s been kind of a story, what we say is of two halves. The first half has been the market determining the multiples. And it hasn’t really been an enormous amount of panic or fear within the market, obviously, outside of the events that we see in Ukraine. 

Picker: There really hasn’t been this kind of cataclysmic fallout this year, so far. Do you expect to see one as the Fed continues to raise interest rates?

Britton: If we’d had this interview at the beginning of the year, remember, when we last spoke? If you’d said to me, “Well, Paul, where would you predict the volatility markets to be based upon the broader base markets being down 15%, 17%, as much as 20%-25%?’ I would have given you a much higher level as to where they currently stand right now. So, I think that’s an interesting dynamic that’s occurred. And there’s a whole variety of reasons which are way too boring to go into great detail. But ultimately, it’s really been an exercise for the market to determine and get the equilibrium as to what it’s willing to pay, based around this extraordinary move and interest rates. And now what the market is willing to pay from a future cash flow standpoint. I think the second half of the year is a lot more interesting. I think the second half of the year is ultimately – comes to roost around balance sheets trying to determine and factor in a real, extraordinary move in interest rates. And what does that do to balance sheets? So, Capstone, we believe that that means that CFOs and ultimately, corporate balance sheets are going to determine how they’re going to fare based around a certainly a new level of interest rates that we haven’t seen for the last 10 years. And most importantly, we haven’t seen the speed of these rising interest rates for the last 40 years. 

So, I struggle — and I’ve been doing this for so long now — I struggle to believe that that’s not going to catch out certain operators that haven’t turned out their balance sheet, that haven’t turned out the debt. And so, whether that’s in a levered loan space, whether that’s in high yield, I don’t think it’s going to impact the large, multi-cap, IG credit companies. I think that you’ll see some surprises, and that’s what we’re getting ready for. That’s what we’re preparing for because I think that’s phase two. Phase two could see a credit cycle, where you get these idiosyncratic moves and these idiosyncratic events, that for the likes of CNBC and the viewers of CNBC, perhaps will be surprised by some of these surprises, and that could cause a change of behavior, at least from the volatility market standpoint.

Picker: And that’s what I was referring to when I said we haven’t really seen a cataclysmic event. We’ve seen volatility for sure, but we haven’t seen massive amounts of stress in the banking system. We haven’t seen waves of bankruptcies, we haven’t seen a full blown recession — some debate the definition of a recession. Are those things coming? Or is just this time fundamentally different?

Britton: Ultimately, I don’t think that we’re going to see — when the dust settles, and when we meet, and you are talking in two years’ time – I don’t think that we’ll see a remarkable uptick in the amount of bankruptcies and defaults etc. What I think that you will see, in every cycle, that you will see headlines hit on CNBC, etc, that will cause the investor to question whether there’s contagion within the system. Meaning that if one company’s releases something which, really spooks investors, whether that’s the inability to be able to raise finance, raise debt, or whether it’s the ability that they’re having some issues with cash, then investors like me, and you are going to then say, “Well hang on a second. If they’re having problems, then does that mean that other people within that sector, that space, that industry is having similar problems? And should I readjust my position, my portfolio to make sure that there isn’t a contagion?” So, ultimately, I don’t think you’re going to see a huge uptick in the amount of defaults, when the dust has settled. What I do think is that you’re going to see a period of time where you start to see numerous amounts of headlines, just simply because it’s an extraordinary move in interest rates. And I struggle to see how that’s not going to impact every person, every CFO, every U.S. corporate. And I don’t buy this notion that every U.S. corporate and every global corporate has got their balance sheet in such perfect condition that they can sustain an interest rate hike that we’ve [been] experiencing right now.

Picker: What does the Fed have in terms of a recourse here? If the scenario you outlined does play out, does the Fed have tools in its tool kit right now to be able to get the economy back on track?

Britton: I think it’s an incredibly difficult job that they’re faced with right now. They’ve made it very clear that they’re willing to sacrifice growth at the expense to ensure that they want to extinguish the flames of inflation. So, it’s a very large aircraft that they’re managing and from our standpoint, it is a very narrow and very short runway strip. So, to be able to do that successfully, that is definitely a possibility. We just think that it’s [an] unlikely possibility that they nail the landing perfectly, where they can dampen inflation, make sure that they get the supply chain criteria and dynamics back on track without ultimately creating too much demand destruction. What I find more interesting – at least that we debate internally at Capstone – is what does this mean from a future standpoint of what the Fed is going to be doing from a medium-term and a long-term standpoint? From our standpoint, the market has now changed its behavior and that from our standpoint makes a structural change…I don’t think that their intervention is going to be as aggressive as it once was these past 10, 12 years post-GFC. And most importantly for us is that we look at it and say, “What is the actual size of their response?” 

So, many investors, many institutional investors, talk about the Fed put, and they’ve had a great deal of comfort over the years, that if the market is faced with a catalyst that needs calming, needs stability injected into the market. I will make a strong case that I don’t think that that put was – what’s described as obviously the Fed put — I think it’s a lot further out of the money and more importantly, I think the size of that intervention — so, in essence, the size of the Fed put — is going to be significantly smaller than what it has been historically, just simply because I don’t think any central banker wants to be back in this situation with arguably runaway inflation. So, that means, I believe that this boom bust cycle that we’ve been in these past 12-13 years, I think that ultimately that behavior has changed, and the central banks are going to be much more in a position to let markets determine their equilibrium and markets ultimately be more freer.

Picker: And so, given this whole backdrop — and I appreciate you laying out a possible scenario that we could see — how should investors be positioning their portfolio? Because there’s a lot of factors at play, a lot of uncertainty as well.

Britton: It’s a question that we ask ourselves at Capstone. We run a large complex portfolio of many different strategies and when we look at the analysis and we determine what we think some possible outcomes are, we all draw the same conclusion that if the Fed isn’t going to intervene as quickly as once they used to. And if the intervention and size of those programs are going to be smaller than what they were historically, then you can draw a couple of conclusions, which ultimately tells you that, if we do get an event and we do get a catalyst, then the level of volatility that you’re going to be exposed to is just simply going to be higher, because that put, an intervention is going to be further away. So, that means that you’re going to have to sustain volatility for longer. And ultimately, we worry that when you do get the intervention, it will be smaller than what the market was hoping for, and so that will cause a greater degree of volatility as well. 

So, what can investors do about it? Obviously, I’m biased. I’m an options trader, I’m a derivatives trader, and I’m a volatility expert. So [from] my standpoint I look at ways to try and build in downside protection – options, strategies, volatility strategies – within my portfolio. And ultimately, if you don’t have access to those types of strategies, then it’s thinking about running your scenarios to determine, “If we do get a sell off, and we do get a higher level of volatility than perhaps what we’ve experienced before, how can I position my portfolio?” Whether that is with using strategies such as minimum volatility, or more defensive stocks within your portfolio, I think they’re all good options. But the most important thing is to do the work to be able to ensure that when you’re running your portfolio through different types of cycles and scenarios, that you’re comfortable with the end result.