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

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The market has seen huge price swings this year – whether in equities, fixed income, currencies or commodities – but volatility expert Paul Britton doesn’t think that’s right. ‘stop her.

Britton is the founder and CEO of the $9.5 billion derivatives firm, Capstone Investment Advisors. He spoke to CNBC’s Leslie Picker to explain why he thinks investors should expect an increase in worrying headlines, contagion worries and volatility in the second half.

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

Leslie Picker: Let’s start — if you could just tell us how all this market volatility is factored into the real economy. Because there seems to be some difference right now.

Paul Breton: I think you are absolutely right. I think the first half of this year has really been a story of the market trying to reassess growth and figuring out what it means to have a 3.25, 3.5 grip on the fed funds rate. So really, it’s been a mathematical exercise of the market to determine what it’s willing to pay and a future cash flow position once you enter a 3.5 handle when valuing the stock. So it’s been kind of a story, what we’re saying is in two halves. The first half was the multiple determining market. And there hasn’t really been a huge amount of panic or fear in the market, obviously, outside of the events that we’re seeing in Ukraine.

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

Brittany: If we had this interview at the beginning of the year, do you remember when we spoke for the last time? If you had said to me, “Well, Paul, where would you predict volatility markets would be based on broader base markets down 15%, 17%, down 20%-25%? “I would have given you a much higher level on their current situation. So I think that’s an interesting dynamic that’s happened. And there are a whole variety of reasons that are far too boring to go into detail. But ultimately, it’s really been an exercise for the market to figure out and get the balance on what it’s willing to pay, based on this extraordinary movement and interest rates. And now what the market is willing to pay from a future cash flow perspective. I think the second half of the year is much more interesting. I think the second half of the year is finally – roosting around balance sheets trying to determine and factor in a real and extraordinary movement in interest rates. And what does that do to balance So, Capstone, we think that means CFOs and ultimately corporate balance sheets are going to determine how they fare based on a level certainly new interest rates that we haven’t seen since the last time. t 10 years. Most importantly, we haven’t seen the speed of these interest rates increase in the last 40 years.

So I find it hard — and I’ve been doing this for so long now — I find it hard to believe that it’s not going to catch up with some operators who haven’t turned over their balance sheet, who haven’t turned over the debt. And so whether it’s in a leveraged lending space, whether it’s high yield, I don’t think it’s going to have an impact on the large multi-cap IG lending companies. I think you’re going to see some surprises, and that’s what we’re preparing for. That’s what we’re preparing for because I think it’s phase two. The second phase could see a credit cycle, where you get these idiosyncratic moves and these idiosyncratic events, which for the likes of CNBC and CNBC viewers, may be surprised by some of these surprises, and that could cause a shift behaviour, at least from a market volatility point of view.

Picker: And that’s what I was referring to when I said we haven’t really seen a cataclysmic event. We certainly saw volatility, but we did not see massive strains in the banking system. We haven’t seen waves of bankruptcies, we haven’t seen a full-fledged recession – some debate the definition of a recession. Do these things happen? Or is it just this time fundamentally different?

Brittany: At the end of the day, I don’t think we’ll see – when the dust settles, and when we meet, and you talk two years from now – I don’t think we’ll see a remarkable increase in the amount of bankruptcies and defaults payment, etc. What I think you’ll see, every cycle, you’ll see the headlines on CNBC and so on, it will make the investor wonder if there’s contagion within the system. This means that if a company releases something that really scares investors, whether it’s its inability to raise funds, incur debt, or the possibility of having cash flow problems, then investors like me, and then you’re gonna say, “Well, wait a second. If they’re having issues, does that mean other people within that sector, space, industry have similar problems? And should I readjust my position, my portfolio to ensure that there is no contagion?” So at the end of the day, I don’t think you’ll see a huge increase in defects once the dust settles. What I think is that you’re going to see a period of time where you’ll start to see a lot of headlines, just because it’s an extraordinary movement in interest rates. And I find it hard to see how this won’t impact every person, every CFO, every American company. And I don’t buy into the idea that every American company and every global company has a balance sheet in such perfect shape that it can handle an interest rate hike that we have [been] experience right now.

Picker: What does the Fed have in terms of recourse here? If the scenario you’ve described comes to pass, does the Fed currently have tools in its toolbox to be able to get the economy back on track?

Brittany: I think that’s an incredibly difficult task they’re facing right now. They have made it very clear that they are prepared to sacrifice growth for the detriment of ensuring that they want to put out the flames of inflation. So it’s a very big plane they’re running and from our point of view it’s a very narrow, very short strip of runway. So to be able to do that successfully is definitely a possibility. We just think it’s [an] unlikely possibility that they nail the landing perfectly, where they can mitigate inflation, ensure they get supply chain criteria and dynamics back on track without ultimately creating too much demand destruction . What I find most interesting – at least what we are debating internally at Capstone – is what does this mean from a future perspective of what the Fed is going to do in the medium to long term? From our point of view the market has now changed its behavior and that from our point of view makes a structural change… I don’t think their intervention is going to be as aggressive as it has been for the past 10, 12 years after the GFC. And the most important thing for us is that we look at it and say, “What is the real size of their response?”

So a lot of investors, a lot of institutional investors, talk about the Fed put option, and they’ve been very reassured over the years, that if the market is facing a catalyst that needs to be calmed down, it needs stability injected into the market. I’m going to argue that I don’t think that bet was – which is described as obviously the Fed bet – I think it’s a lot further from the money and more importantly I think the size of this intervention – so in essence the size of the Fed’s put – will be significantly smaller than it has been historically, just because I don’t think any central banker wants to end up in this situation with undoubtedly galloping inflation. So that means, I believe this cycle of boom and bust that we’ve had for the last 12-13 years, I think ultimately that behavior has changed, and central banks will be much better able to let the markets determine their equilibrium and the markets will eventually be freer.

Picker: And so, given all of this context – and I appreciate you laying out a possible scenario that we could see – how should investors position their portfolio? Because there are a lot of factors involved, a lot of uncertainty too.

Brittany: This is a question we ask ourselves at Capstone. We manage a large, complex portfolio of many different strategies and when we look at the analysis and determine what we think are possible outcomes, we all come to the same conclusion that if the Fed doesn’t move as quickly as once that she used to. And if the intervention and the size of these programs are going to be smaller than they were historically, then you can draw some conclusions, which ultimately tell you that, if we get an event and we get a catalyst, then the the level of volatility to which you are going to be exposed is simply going to be higher, because that said, an intervention is going to be further away. This therefore means that you are going to have to maintain the volatility for longer. And at the end of the day, we fear that when you get the intervention, it will be lower than the market expected, which will also lead to more volatility.

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 View I’m looking at ways to try to incorporate downside protection – options, strategies, volatility strategies – into my portfolio. And ultimately, if you don’t have access to those types of strategies, consider running your scenarios to determine: “If we get a sell, and we get a higher level of volatility than what we can -be experienced before, how can I position my portfolio?” Whether it’s using strategies like minimum volatility or more defensive stocks within your portfolio, I think these are all good options. But the most important thing is to do the work to be able to ensure that when you manage your portfolio through different types of cycles and scenarios, you are comfortable with the end result.

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

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