Odd Lots - Pimco's Dan Ivascyn on the State of Markets Right Now

Episode Date: August 11, 2022

Markets have staged an impressive bounce since the middle of June. Stocks are way up. Credit spreads have come in. Mortgage rates have tightened again. And long rates have mellowed out. So is the coast all clear? On this episode of the podcast, we speak with Pimco Group Chief Investment Officer Dan Ivascyn about why this is an environment characterized by a high level of uncertainty. It's not that he's pessimistic or bearish, per se, but rather that there are risks all over the place as the Federal Reserve attempts to tame inflation.See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. And welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, I feel like it's pretty hard to be an investment manager at the moment. Like, I feel like it's hard at the best of times, but at the moment you have this intense volatility. So stuff that is normally volatile, like stocks and commodities, is even more volatile. And then you have stuff that isn't really supposed to be volatile, but definitely is in the new environment.

And I'm thinking mostly about bonds. Well, and also, you know, the underlying macro situation is just extremely complicated and contested. I mean, like, there's a debate about whether, you know, the last two quarters considered are characterized as a recession. And there's kind of legit questions about that in my, you know, setting aside NBR versus two quarters, like, how should you call this environment in which consumer sentiment is really low, growth is down, employment is booming, inflation is still hot, consumption is still high. These are just like really difficult environments to understand, in part because it is kind of unprecedented. Yeah, and it seems like everyone kind of feels bad in all the survey-based economic measures suggest that sentiment is

deteriorating. But at the same time, the hard numbers are really resilient. So actual spending and investment just keep going. And yeah, you're right. It's a really weird environment, particularly if you're trying to put money to work. And then I would say over the last two years, like everyone kind of got it wrong at every turn, right? Like everyone said, okay, COVID hit in early 2020. Here comes a big downturn and a recession. And it's like actually we had the shortest recession in history. And then stocks were at all time highs a few months later. Then, you know, fast forward a little bit to 2021. People were super positive. Yeah, inflation was ticking up, but hey, it's likely transitory. It's like reopening. And almost everyone got that wrong, particularly

a lot of investors, judging by how fast the repricing happened. The Fed had to pivot pretty quickly when it realized inflation would persist for longer than expected pivot really started in November. So it's like at no point has it felt like the consensus has been like had a good feel on this cycle. At no point has it felt like anyone really knows what's going on? Correct. Is that what you're saying? Yeah. Okay.

On that note, we are going to be speaking with someone about all of these very, very big topics, really the perfect guest. We're going to be speaking with Dan Iveson. He is, of course, the group chief investment officer and managing director over at Pimco's Newport Beach. For those that don't know Pimco, I mean, you must know Pimco. But Pimco has something like $2 trillion worth of assets under management. So making these tough decisions about the macro outlook and

where to actually invest every day. So, Dan, thank you so much for coming on all thoughts. Well, thank you, Tracy and Joe. I'm very excited to be here today. So you sit on Pimco's investment committee. I'm really curious what's top of mind for the people who have to do something with $2 trillion worth of assets every day. You know, what are you guys talking about and what's on the top of the agenda for you at the moment? Sure. Well, inflation is certainly a topic. As you mentioned, this has been an incredibly challenging time from an economic forecasting perspective. First, a global pandemic, then an unprecedented amount of fiscal stimulus, and now an inflation problem that at least is partially related to those

two prior points. So, you know, increasingly we're spending a lot of time talking about this inflation dynamic, of course, how policymakers are going to, you'll look to, look to, look to you know, get inflation back towards their targets. And now, increasingly, markets are seeing what has, you know, historically been a fairly obvious tradeoff. And that's, you know, growth, employment and this inflation problem. And how will that be balanced over time? In addition to that, of course, we're not, you know, operating in a normal environment. We have war in Europe, lots of uncertainty and ongoing global tension between the United States, you know, other Western countries and China. So there's just a lot of uncertainty, a lot of risk, and we're trying

to gain sufficiently broad perspectives to see where we may have an edge. And I think it's important in an environment as highly uncertain as this one to realize when, you know, at a particular point in time, you don't have an edge and where you're entering markets that represent a lot of risk, a lot of volatility. And I think there's a risk management piece here as well. There's enough volatility where we should be able to zero in on areas where we do have an edge and where we can add value while looking to shelter the portfolio from a lot of the unwanted volatility that we're seeing elsewhere in markets. So that's one key theme. The second, of course, is a lot of real-time discussions around this volatility that we witnessed. Beneath the surface, a lot of

dispersion across equity markets and fixed income markets, a lot of localized overshooting given markets aren't super liquid. They don't feel distressed. but certainly a type of environment where there's, you know, using a baseball analogy, a lot of singles, you know, to hit while you've got to be careful, you know, swing for a home run given this radical uncertainty in the fact that you can get, you know, caught off sides pretty quickly in this type of market. So what do you talk a little bit more about, you know, you said, identifying your own sources of edge.

Like, what are they? You know, and I want to get to the actual market environment and your outlook for inflation and bonds and all that. But when you think about like where sources of edge, you know, you know, we're sources of edge. come from an environment like this? Like, what's the answer to that? Well, I think one relates to, you know, markets that are less liquid than they've been in the past

and opportunities to take advantage of some overshooting. Perhaps a good example is more recently over the last few weeks or maybe going back several weeks where equities were quite weak. Credit spreads were widening and widening fairly significantly. Big upticks. in the various volatility markets. You know, a volatility market could be an agency mortgage, but it could also be, you know, more technical, you know, volatility markets.

And, you know, we've seen even over the course of this summer, various levered players, you know, other, you know, specialty-type styles get a bit over their skis from a risk perspective. And I think part of the snap act that we witnessed over the last several weeks and, you know, a pretty powerful recovery into what appeared to be, you know, bad fundamental news is tied. to, you know, a little bit of this positioning that was a bit off sides. So you mentioned how unusual the economic environment has been. And I feel like this is the source

of tensions or problems for a lot of investors at the moment. Like, we're used to thinking about a normal economic cycle. You know, it starts and then at some point it stops. But it feels like what we've seen post-pandemic is not a normal economic cycle at all. How would you, characterize it? Like, how are you thinking about it? Is this late cycle? Is it early cycle? It seems very confusing at the moment. Is it a cycle outside the cycle? Yeah. Is it even a cycle? Who knows? Yeah, I think there are multiple cycles or at least significant cross currents. I think when you look at cycles, I think it's important to make the distinction between a lot of the Western economies and what's going on in China right now. To a lot of us, COVID is mostly behind us. And we're in the

midst of a pretty significant COVID-related reopening process, a very strong demand for travel services, shift away in many economies from COVID-related goods consumption, towards a more normalized focus on areas associated with a more traditional and open economy. Over in China, now they're dealing with COVID. Other Asian countries are to a lesser degree, and they're in the midst of an environment, you know, where economic growth is slow and slowing, and inflation isn't a material problem. And then back to, you know, even the U.S. economy, very, very different or difficult to understand in the sense that we do have significant momentum in a lot of sectors, yet we're quickly beginning to see the impact of prior policy tightening on some key areas

of the economy as well. So, you know, the level of complexity is there. But again, you know, when you have an inflation problem and you have policymakers looking to tighten policy, you're going to get into a situation where it's almost certain that you're going to see some economic weakness. And then, of course, the challenge then becomes, you know, how does this economic weakness impact inflation? Is there a chance of a soft landing? Or do we have a situation where probabilities are growing and growing fairly rapidly that we end up in a recessionary environment?

Of course, those different scenarios have very different implications on what segments of the, opportunity set are going to perform well, both in absolute and in relative terms. Well, let's just get right into that. And of course, there's an econ debate. You have folks like Larry Summers and Olivia Blanchard saying, like, look, it is unrealistic. It's wishful thinking to say that we can really get inflation back down to any reasonable level without having a meaningful rise, a significant rise in the unemployment rate. Do you buy that? Or do you think, I mean, because I think this is the multi-trillion question right now. Can the Fed get back to Target without a painful recession? Yeah, so I think history is on their side. You don't see a lot of periods. Summers and Blanchard for sure. But there's certainly a chance

that we see what will feel like a somewhat soft landing. Now, here at Pimco, we still think core CPI at the end of this year is going to remain elevated up near that five and a half percent type of range even out, you know, towards the end of 23. And I'd, you know, take that forecast with it with a great assault, given extreme uncertainty. But we don't see inflation getting back below three and a half percent, you know, all the way out to 2023. So we do think that the likelihood is the Fed's going to need to tighten and tighten fairly significantly from here. But we do think there's at least a shot of a somewhat soft landing. We think, you know, officially, you know, we're going to have a recession. It could be a prolonged but fairly mildly.

recession but again one of the bright spots if there is a bright spot here is that you know over the last few cycles there appears to be a strong and increasingly strong relationship between the financial economy and the real economy and you've already seen in response to you know moderate tightening thus far a pretty significant impact on financial conditions now they've loosened over the course of the last several weeks but that transmission mechanism appears to be working and working fairly quickly. So again, we have an economy with very strong momentum, particularly on the wage of the employment side, and a Fed and other central banks

that have tightened, and it appears that they are having an impact on recent economic activity. So there is a path that I would define as a moderate slowdown and a slowdown that doesn't have a material impact on overall credit fundamentals, it would probably put a 25 or 30 percent type probability to that type of scenario. Again, you know, anytime you have headline inflation up in the 9 percent type range, unprecedented, at least for, you know, several decades, and a lot of geopolitical risk, including war in Europe, which could deteriorate very, very quickly, you have to position yourself for at least a meaningful probability of a more material economic slowdown. And what that means, of course, under that state of the world, you have a lot more

widening to go across most credit sectors. You probably have significant earnings deterioration from this point forward, which will likely lead to weakness in equity markets as well. So, you know, again, you know, our general view is that we have a fairly much, mild but sustained recession. That's why we continue to be fairly cautious regarding the more credit sensitive sectors of the market. But again, that's one of a handful of credible scenarios. And again, you have to prepare for the worst as an investor. And that means, you know, thinking about preserving capital, given the radical uncertainty,

as much as it does, you know, aggressively positioning to, you know, generate total return, particularly in those riskier segments of the market. media and women are looking for more. More out of themselves, their businesses, their elected leaders, and the world are out of them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart. And I'm Catherine Clark. And in this podcast, we interview Canada's most inspiring women.

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But they usually rerun their radio newscasts throughout. the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg News Now. And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. You know, Joe mentioned at the beginning of this conversation that a lot of people got it wrong on inflation. And I'm not just talking about the Fed, of course, which, you know, doubled down on the transitory idea a number of times. But I'm thinking also just of the broader market. You know, you look at break evens and those were continuously expecting inflation to peak within a few months. And that hasn't really come to pass. What do you think people got wrong about the inflation? outlook? What was it that the market seemed to miss? Yeah, I think a lot of participants, you know,

we're looking at an inflationary process in a more traditional sense. I think the pandemic itself was quite confusing. It, of course, had, you know, direct supply side impacts on the global economy. And even more importantly, the policy response on the fiscal side was massive. And massive, sufficiently massive, that again, we haven't had a lot of good case studies in history in dealing with such a significant demand-side boost at a time where you already had significant COVID-related supply constraints. So, you know, it's an unprecedented situation. We talked earlier about, you know, these cross-currents, you know, impacting economies, making it even harder to forecast. And I think, you know, in some sense, you know, we all or

many of us were, you know, using, you know, prior frameworks, at least initially, to think about and to forecast this inflationary process. Now, your point is a good one. Even market pricing didn't envision this level of inflation or how sustained this inflation would be. But at the same time, when you look today at longer-term measures of inflationary risk within markets, they too are fairly complacent.

And if markets prove to be right, then in fact this inflationary event, may prove to be fairly temporary. So it is remarkable if you said, you know, inflation would be, you know, up at 9%. People would be talking about a Fed, you know, well behind the curve, and you would have a 10-year break-even inflation rate below 2.5% or looking at a popular rate we look at, a forward-a-fired rate, like a five-year forward, five-year rate, well below 2.5%. Or yield curve for that matter today, that is fairly flat or, you know, slightly inverted at levels below 3%. So, you know, in some sense, although policymakers and

investors were late, you wouldn't have made a tremendous amount of money through a significant bet on inflation unless you happen to be in some of those commodity markets and particularly the commodity markets that have been impacted as much by the conflict in Ukraine as they were, you know, tied to this inflation rate trend that we've been discussing. So again, markets still may be wrong. There's still plenty of uncertainty around this inflation dynamic. on a go-forward basis. But it is quite interesting that although, you know, people were late, markets are suggesting that perhaps things can be just fine with a bit more policy-tightness. Yeah, some of these medium-term break-even measures are five-year, five-year forward break-evens,

never really got too out of hand and are kind of a normal range. That being said, the other phenomenon this year is, I don't want to say the Fed's been behind the current. per se because that's a little bit of a cliche and I'm never even totally sure what it means. But I would say that it does seem as though at each meeting, they're sort of expressing some hope or optimism that, okay, we think we're getting closer to where we're in a neutral range. We're not going to go as hard. And then some other data point comes out and it's like, whoops, time to increase, time to go faster again.

And so we got that 75. Maybe there was hope was going to go down. another 75, still were sort of, you know, then Paul believes that policy is close to neutral. Are we at a place where maybe the Fed is in a comfortable spot? Or do you think, as you said, you think there's going to still be significant tightening from here, that once again the Fed might have to go a little harder than it hopes in the short term, at least, in order to constrain inflation? Yeah, you know, first of all, you know, policy makers tend to, you know,

They'll tend to have an optimistic spin on things. But certainly the price action of late suggests that what central banks have done so far are beginning to have an impact on economic growth. And it's not a view that a hard landings around the corner. Credit spreads tightened over 100 basis points, you know, using high yield as a proxy. We've seen a significant, you know, bounce in equity valuations. in the midst of moderate deterioration and a lot of the forward economic indicators. So relative to where we were several weeks ago, the Fed has to be reasonably pleased

with the impact of their policy decisions thus far. And I think although Powell may have slipped up a touch in suggesting, you know, with a high degree of confidence that we're, or an implied degree of confidence that we're near neutral right now, I think the key point was that we can begin to focus a bit more on the data. You have seen the beginning of some, you know, material signs of economic slowing in a world with massive uncertainty of a geopolitical variety or a traditional economic variety. So I think they're comfortable in the sense that they've gotten to a point where they seem to have calmed markets over the short term. This can change very, very quickly. And when we look

at, you know, a 9% headline inflation rate, which is likely at least the near term peak, They have a lot of work to do. And we do think that they likely will need to tighten a bit more than what's currently embedded in the front end of yield curves. We don't think they were wildly far away. We still, you know, have thought that, you know, a three and a half were a four percent type funds rate combined with material balance sheet reduction will likely be enough to slow the economy and get inflation back towards their target. And we're at 250 now. So another 150 basis points of tightening more or less is what you're. That would be right, yeah, 125, 150. But, you know, again, even under that base case scenario,

you know, we're not back to core CPI levels that, you know, within most central bank target zones until, you know, probably out into 2024. And there can be a lot of shocks in the interim, some that may be helpful, you know, to getting inflation back down towards target, several events that may not be helpful. And again, I think humility's got to be the key point here. When we think about inflation, when we think about inflation's impact on the developed markets, you have to be a meteorologist as well. You know, you're going to go into a period in Europe in particular. Temperatures get cold with massive uncertainty around energy supplies and with Russia, holding the cards, at least for the time being. So there are a lot of events

that can derail the more positive scenarios that we've described and have been in better. in market pricing. Again, one of the reasons when we add up all of these sources of uncertainty, we see the type of rally that we've gotten across financial markets over the last several weeks. And we're inclined to take a few chips off the table, get away or reduce exposure to the most economically sensitive areas of the market. Not because our base case view is so dire. It's just that this extreme uncertainty is such that investors should just be careful in some of those more credit-sensitive investments where, you know, essentially they're forms of, of a short volatility-type trade. And given that extreme uncertainty, we just don't think,

you know, you're getting paid enough just yet at these levels to be, you know, overly aggressive in those more economically sensitive areas or higher-yielding areas of the opportunity set. It's a generalization. There's certainly, you know, things you can do, you know, on the margin, but that's our general thinking, you know, given where we are today. Can you talk a little bit more about how you see the credit market at the moment? Because I feel like obviously whenever there's concern about a recession, a lot of those worries are going to seep into corporate bonds, which are economically sensitive, as you mentioned. But then secondly, even before the pandemic, I think there was quite a lot of concern about froth in various portions of the credit market, things being overvalued and potentially illiquid when the time came to sell. So how are you viewing that space at the moment? Where are there opportunities and what's most vulnerable? Sure.

So just at a very high level. And I think there's a lot of interesting things going on within the credit markets. You know, we were adding some credit, you know, back, you know, several weeks ago when, you know, high-yield corporate bond spreads, you know, had gotten out to north of, you know, 600 basis points. We thought there, you know, looking at historical analysis and thinking about embedded our recession probabilities in the, you know, spreads the credit markets were you know forecasting a very high probability of at least a moderate recession after the rally now over the course of the last several weeks spreads look less interesting to us the embedded probability and in credit spreads currently of a of a more moderate recession is dropped you know

down towards you know somewhere in that 20 25 percent you know type area so a little bit less interesting today but Back in terms of thinking about the credit market and the structure of the credit market, a few thoughts here. One, since the global financial crisis, you've had massive regulation impacting the real estate areas of the credit markets, asset-backed markets, the financial sector, as we know, is heavily regulated today. Not coincidentally, these are all the areas that caused all the problems during the GFC. non-financial corporate credit growth in terms of issuance has been significant, both public and private markets.

And that's where, you know, even before COVID, we did see a meaningful deterioration in underwriting standards. More corporate leverage, more aggressive rating agency, frameworks around, you know, putting their ratings on certain types of risk, far fewer covenants and when there were covenants, not particularly strong covenants. We also saw a significant build-out or growth in the private markets, which are inherently lower-quality lending markets. So this is where we think there's the weak link this time if we were to get into a broad economic slowdown. Public markets have repriced and they've repriced quite significantly in certain sectors and segments of the market. Private credit markets that always move a lot more slowly have lagged and lagged considerably. That dynamic is true within the real estate credit

markets as well if you look at what type of spread you can obtain for like risk in a public CNBS security versus where lending is going on currently in the private space. So I think point number one, it's the corporate credit sector is where there's the most excess. It's nowhere near the type of excess we saw in the mortgage credit markets leading up to the global financial crisis. so don't want to sound overly alarming. But this is probably the weakest link in the credit chain and where there will be some interesting opportunities for fresh balance sheets, fresh mandates

to take advantage of what will likely be a moderate default cycle over the course of the next few years. And then again, if you have a public mandate that's repriced quite significantly versus other private markets, it makes sense to take advantage of those opportunities because over time there's going to need to be convergence. It can converge with, public markets recovering. More likely it will converge by gradual deterioration in marks,

I mean, a widening of spread levels in the private sector as well. And then the last point I'll make, all those areas I mentioned earlier that have been heavily regulated since the global financial crisis, we think present tremendous opportunity for investors. People still get nervous today about housing-related risk. Banks continue to trade in a very volatile fashion, but they are well capitalized, and the mortgage credit market is near pristine in terms of, you know, the borrower qualifications necessary to get a loan over, you know, the last decade or so. So, and those are some high-level thoughts, and again, consistent with the way we're positioned across portfolios. Of course, you know, there's a difference, you know, when we're operating in mutual fund space

versus, you know, longer locked up alternative vehicles. But those same general principles are the principles we're adhering to at this stage in the economic cycle. So my next question is completely out of self-interest, but I bought a house in February of this year. Did I top tick the market? And then secondly, you mentioned taking on some housing exposure or real estate exposure. And I'm curious what the opportunity is there exactly because we have seen a lot of people worry about the fact that house prices shot up post-pendemic. Secondly, the fact that mortgage rates have shot up. And then thirdly, there's been some sort of market structure weirdness within the arena of mortgage-backed securities where things, you know, for a while, it looked like the market was sort of like creaking a little bit at the edges as rates went up very, very quickly.

So how are you balancing that? Can you just dig into housing a little bit more for us? Sure. So you may have top-dick the market. If you set all the details to our mortgage team, we'll run some numbers and let you know just how much your top ticket by. That's a good service. You're offering that service. It's a really nice service, Tracy.

You've got to take them up about that. Yeah, I might too. Tell me how wrong I was, yeah. It is a little frightening how much mortgage data of a highly granular fashion is out there nowadays. But no, in terms of housing, so we do think housing is going to slow and slow significantly. we think on a national basis housing is likely to decline in real terms or inflation-adjusted terms over the course of the next few years. Our base case view is that home prices stabilized near zero growth or very, very low single-digit type growth rates. But it would not be

surprising and it wouldn't necessarily have to be overly alarming if you see home prices decline on a national basis. Now, similar to the comments I made earlier, you know, know, on the complicated, you know, economic environment, housing markets are complicated as well. As we know, there's been a massive shift in preferences since the COVID pandemic, desire to live further from the office, certain vacation and resort communities have gone up in price quite significantly. In some areas, there's more land scarcity than others. So there are going to be pockets where you saw a big increase in demand, where they're going to be outright price declines. You're going to hear over the course of the next several months, you know, more headlines

around price reductions, price declines, a lot of stories in that regard. And I think if you're underwriting a new pool of mortgages, particularly higher risk type investments, you have to be very, very granular and very careful in how you underwrite that risk. But from a macro perspective, there's still too few homes in this country and other Western nations relative to the number of households that have been formed over the last several years. So again, that supply demand dynamic is important. Rents remain elevated. So when you think about the buy-to-rent decision, although the cost to own a home has gone up, rental rates are going up as well. So that switch is less obvious. And then when you step back and look at price to incomes, price to rents, the amount of

borrower equity that exists. And again, you have a tremendous amount of borrower equity today after several years of significant home price growth. And I mentioned earlier, a near-prosdine mortgage market from a credit quality perspective, we just don't see a major risk of significant declines in housing on a national level. We do expect, though, and you're already seeing this, a rise in inventories, a reduction in housing-related activity, which is the transmission mechanism or one of the transmission mechanisms that's going to help slow the economy and eventually bring inflation back down towards more reasonable levels. The last but not least, from an investment perspective in housing-related areas of the market, those investments in many cases aren't tied to

what goes on in home prices from here because they've delivered so much. So the typical housing-related investment you can buy today is backed by pools of mortgage. that were issued again 10 or 15 years ago. Embedded loan to value ratios in those types of investments today have fallen from 120% back during the global financial crisis down to 40% in most cases today. A borrower with 60 points of equity in their property, even facing moderate declines in their current home price, are not a big default risk. And even if they are, that's the type of loan where you're to anticipate a full recovery. So a lot of what we like in the market today is season-type risk that benefits from the multi-years of home price appreciation

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I'm curious, though, like, what is your view right now on if and what role treasury should have in people's portfolio? Because I've asked versions of this question to many people. It's like, for years, it was just such a great trade to own a slug of 10-year treasuries. And they went up in the principal appreciated in value. They were a great diversifier to risk assets. They usually went up when the stock market went down in the short term. And now those conditions are obviously changing to some extent, 60-40 type. portfolio's got clubbed, that coupon that you're getting each year is getting swallowed up,

big time by inflation. Is there a role for, what is the role for treasury ownership? Yeah, that's a great question. And of course, you know, what you're getting at is, is a correlation argument. You know, are we going to have, are we, are we going to get back to, can we get back there? You know, to a degree. And I think you're, you're witnessing this now with the recent rally that we've seen in government bond markets, elevated geopolitical risk. you know, both both in Europe and in the China situation, signs of a deteriorating economy and elevated risks of recession, and now government bonds are beginning to rally, you know, on that type of news. Now, you know, we think you get better protection, you know, up when a 10-year

Treasury is at 3.5% versus, you know, closer to 2.5%. But we do still think high-quality bonds at these higher yield levels will provide some insurance benefit. Now, locally, and by locally, I mean, you know, during, you know, small moves in markets, we don't think, you know, you're going to, you know, we think correlation is going to be much lower than they've been in the past. I think that's going to be the case as long as inflation remains a key risk facing financial markets. But if inflation begins to trend lower towards central bank ranges, so again, exiting this post-COVID period of elevated inflation, we do think you can revert back to more traditional correlations and high-quality bonds can, you know, provide stronger protections or stronger diversifying benefits for a multi-asset type portfolio.

But for the time being, and by the time being, I mean the next several quarters, those correlations are going to be highly unstable. We think in extreme fight-to-quality situations, signs of a major hard landing in the global economy, signs of, you know, deteriorating, a deteriorating situation with the war in Europe or a heightened conflict, you know, with China as another example. We think those are scenarios that likely lead to lower treasury yields. So the bottom line is we wouldn't give up on bonds here. I think investors just need to understand that those traditional relationships that were fairly strong have weakened. And there's just more uncertainty, at least over the short term, in terms of these overall trading.

relationships. How are you hedging volatility nowadays? And who is selling it? Because it feels like everyone wants volatility protection. And I can remember, you know, once upon a time, not so long ago, PIMCO was a big seller of Vol protection. But I'm assuming you guys aren't doing much of that now. We sell a little bit of, we sell a little bit of volatility explicitly. We didn't talk about agency mortgages. You know, these are interesting investments. They benefit from a direct government guarantee or a strong agency guarantee, which is always nice, given heightened risk of a more material economic slowdown. And they've widened and spread a lot.

They're not quite as cheap as they were in the first quarter of 2020, but they are quite attractive on an option-adjusted spread basis relative to where they've been historically. So we have been adding back some agency mortgage-backed securities. And an agency mortgage-backed security represents a form of, of a volatility sale. We've also on a targeted basis have taken advantage of some volatility sales in the option markets. That's one of the areas I mentioned earlier

where a lot of the hedge funds, other specialist managers, have been caught offside given the significant moves and realized volatility. And there has been a few opportunities to provide liquidity and take on some of that risk at what we think are attractive levels. But the way that we're dealing with volatility, or uncertainty now is really staying up in quality in terms of our investments. And I mentioned that

we've been reluctant to aggressively add to the weaker areas of the credit markets, where your short volatility from a more implicit perspective. So across a lot of our portfolios today, we've been taking advantage of the widening in areas of the market that represent spread risk, not material risk of of permanent capital impairment. And I mentioned agency mortgages in that category. I mentioned the non-agency or the non-government guaranteed mortgages. I mentioned the banks where we have a high degree of conviction that although those spreads will remain volatile, most banks, particularly U.S. banks, a bit more isolated from the European uncertainty, are tremendously well capitalized and not taking significant risks at the moment. And then there's a whole slew of other AAA and double A type risk,

high-quality municipal bonds, other areas of the asset-back sectors where you have a lot of hard collateral and additional subordination. These are all areas that should be resilient in a period of heightened volatility, and which in some cases have widened in sympathy with these other markets that are much more sensitive to credit fundamentals. Where are the areas that you see are particularly sensitive to credit fundamentals that you want to avoid because you don't want to deal with actual impairment? I mentioned the private markets. And again, you need to differentiate there. What we're referring to there would be more traditional direct lending, mid-market companies that tend to struggle in a recessionary environment, you know, more so than

larger cap names. The other issues within the private markets, which have significantly lagged public markets, or the senior secured bank loan market as an example is that you have floating rate debt. So borrowers within that space are seeing a direct impact from Fed policy in the form of higher debt service costs. Now, some of those companies will hedge in the cap markets, but typically it's a partial hedge. Several companies won't hedge, and it's not easy to tell which companies are hedging

and which ones aren't. So that's an area of the market that's going to be more sensitive to rate policy from here. In fact, we anticipate that if the Fed had to tighten policy materially more than a terminal funds rate of 3.5%, you'll begin to see a decent amount of stress on that segment of the market. If that higher rate policy coincides with EBITDA or earnings deterioration, you can even see more problems from a downgrade perspective in that segment of the market.

So again, I don't want to sound overly alarmist here, but in terms of looking for weaker links in the marketplace, that's where we would focus, and that's where we're being most defensive right now in terms of, overall credit positioning. So I think you've outlined a pretty sort of cautiously optimistic approach here, or maybe cautiously opportunistic where you're sort of selecting quality credits and things like that. What would make you feel comfortable about taking on either more credit or more interest rate risk in general? Like, is there a particular thing if you saw that

happen, an economic data point or something in the market where you would just jump right in? Yeah, so, so, you know, from more of a top-down perspective, better valuations as a start, you know, you know, stating the obvious, you know, if we got up to a point where you saw some of these riskier segments of the market embed a much higher probability of an outright recession, you know, we would get more comfortable. Now, you know, that's likely up at levels, you know, around 700 basis points, you know, you know, within the high yield space. Now again, you think about high yield in a full-blown recession and you get to a thousand basis point type spreads quite easily. But as you approach that level and you embed, you know, more risk of

harder landings, we would begin to add to that space a bit more aggressively. In terms of the fundamental picture, you know, really focusing on this inflationary process. We think headline is hard to forecast and is, I'm certainly going to come down based on what we're seeing in commodity prices today. But other areas represent. and core CPI are going to bear watching as well. One is housing or owners equivalent rent. It's been quite elevated. Another is wages that have been running at levels that are making central banks uncomfortable. Even related to labor, a focus on the labor force and seeing, you know, what percent of the labor force returns to the market, providing some cushion and, you know,

increasing the probabilities that the Fed can bring job openings lower. without a meaningful hit to unemployment. So it's really the details embedded in a lot of these higher frequency economic indicators that we're monitoring more closely. Of course, on the geopolitical side, any type of sign of a stalemate or an improvement in the relationship between Russia and Europe, the situation on the ground in Ukraine, it would take a considerable risk off the table as well. So just a lot of focus on the higher free.

type numbers. But again, even if we don't get resolution there, we are going to respond to, you know, better evaluations, you know, like we did a bit, you know, several weeks ago, you know, at higher yields and materially wider spreads. All right, Dan, we're going to have to leave it there. But thank you so much for coming on All Lots. Really great to have you on the show. And I'll be sending over my mortgage data to your department so you can tell me exactly how bad my timing was on real estate purchases. Well, we'll do that. Yeah, we'll do that. They have some pretty pictures too. They look real good. So, Joe, I've really enjoyed that conversation. There were, I mean,

a number of things that stick out. Number one, the call on real estate. But secondly, when he was talking about floating rate loans and the idea of some of those companies who had borrowed money in floating rate increments, like actually becoming a credit risk as interesting. interest rates go up. That's interesting to me because you'll remember that floating rate loans were supposed to be the big hedge for higher interest rates, right? Like, those were the things you were supposed to buy if inflation was going to go up and rates were going to go up. And now it's like, well, they've gone up too much and it might actually be at risk. Right. So if you're an owner of those notes, yes, you get higher monthly coupons, which is nice in a period of higher inflation. But the

cohort of companies that may have issued those loans are not necessarily the most creditworthy ones, which raises the risk that if we actually get like a real recession, that your inflation hedge suddenly start to worry about loss of a loss of principle. Exactly. You know, just in general, I thought it was interesting sort of, and basically to the point that you just made, you know, we tend to think very broadly about like rates and credit, but it was interesting hearing him, you know, sort of speaking from the perspective of a fixed income investor that's like, you know, credit is just way too broad a category. And so you mentioned

floating rate debt, but also some of his point about like highly seasoned reits was interesting. Yeah. This idea that, again, how do you avoid credit risk? How do you get some of the, how do you get some of the upside, but avoid the credit risk in a downturn? Well, one answer might be reads in which the owners or the payers of those mortgages have built up significant equities such that you're not likely to experience significant defaults. These are all just sort of things that are like a little more in-depth and insightful than sort of a typical like headline credit conversation. Yeah, I totally agree. And it sounds like PIMCO, I mean, you would assume PIMCO would be very good at doing this, but it sounds like PIMCO is sort of, they're not,

they're cautious in the market. They're not adding a ton of risk. But they are sort of, of tweaking their portfolio for the uncertainties that we just discussed. Well, and I think also, you know, this is a, this is an environment with lots of, lots of, I don't know, landmines out there, so to speak, in which, you know, it'd be easy to, or, you know, stepping on a rake, right, and hitting your face. And so this idea that, like, you can be sort of optimistic. You think maybe the Fed is possible that it's turned the corner or getting ready to make a pivot that maybe we're going to soon see. lower CPI readings will have some confidence that the line is going down, but there are just so many

little things that could go wrong. There's politics, there's geopolitics, there's the virus, there's other aspects of the supply chain that like it all sort of keeps you guessing. Actually, recording these intros and outos kind of makes me nervous nowadays because there's so much that could happen between the time that we record and when we release. Yeah. All right. Shall we leave it there? Let's leave it there. All right, this has been another episode of the All Thoughts podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Allo. And I'm Joe Wisenthal. You can follow me on Twitter at The Stallwork. Follow our producer, Carmen Rodriguez, at Carmen Armin. And check out all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.