Dan Ivascyn, David Fisher
Recorded 3 March 2016
DAVID FISHER: Hi, I'm here today with Group CIO Dan Ivascyn to talk a little bit about some of the major themes that have been driving discussion in ourInvestment Committee, or IC, of late. So Dan, given all the volatility in markets I imagine there's been no shortage of interesting, if you will, topicsfor discussion, so what have been some of the major themes of discussion in IC of late?
DAN IVASCYN: Sure, thanks David. The markets certainly have been keeping us busy; it’s a fairly unique time. In addition to a lot of the discussion aroundthe trajectory of global growth, inflation and other topics more focused on economic themes, we spend as much if not more time on policy. Obviously we'vehad some pretty aggressive policy announcements of late from many of the developed market central banks, including negative interest rate policy, which atleast initially is having an uncertain effect on markets and even an other-than-intended impact on markets. We spent a lot of time talking about policyimplications, both shorter-term and longer-term, with the overriding question as to ultimate or ongoing effectiveness of these policies and their abilityto drive economic and financial market outcomes.
In addition to that we've looked to leverage resources in the commodity space; a key factor impacting markets is the ultimate trajectory of oil and otherimportant commodities. We spend a lot of time talking about those themes, and then finally global trends. And what we've learned over the last few monthsis that, and this has been reinforced, that we truly are in a global marketplace. The Federal Reserve now realizes the impact of their decisions in termsof policy here in the States on other global economies, currencies, markets, even politics and again we're talking a lot about the interdependencies andthe impact on other areas outside the United States.
FISHER: So China I think probably is one of those areas, I would guess, given that that's been a big focus of markets; there's been a growth concern,people thinking that China is slowing very rapidly. Related to that are policy concerns, as you mentioned, the devaluation of the currency, but I thinkplays back into your notion of this interdependency, clearly that's one of the things that's driving policy there. So what are the discussions in the IClately regarding China? Where did where does the IC come down on what China's likely to do from a policy perspective and where growth is likely to go?
IVASCYN: We're absolutely spending a tremendous amount of time talking about China. We had a team at the G-20 meetings last week. Isaac Meng, our regionaleconomist, is here with Luke Spajic who oversees our Asian portfolio management operations. One question again is the growth rate of China. The ability ofChina to navigate a significant economic change over the course of the next few years and we have been on the cautious side of Chinese growth over thecourse of the last few years. We’re a little below consensus, forecasting – at least as of our December economic meetings – a rate close to 6%, and a ratethat likely will trend lower.
But the key question relates to policy. We saw what in retrospect was probably a policy error or at least miscommunication relating to the initialdevaluation of their currencies several months ago, and a lot of uncertainty in the marketplace today in terms of the forward trajectory of that currency.We do think there’ll be ongoing weakness. We've talked about this: We think that it will be an orderly process, however. We think at the end of the dayChinese policymakers have sufficient flexibility on the fiscal side and on the monetary side to be able to navigate this difficult period, but it willcoincide with lower growth. It will coincide with a lot more volatility and it's going to make it difficult for the U.S. Federal Reserve to be asaggressive as they would like in terms of tightening policy given this dynamic. So we do think it's a fragile situation; it's a situation that presentsrisks, but ultimately it's a situation that we think is manageable.
FISHER: Let's talk a little about oil: You mentioned oil earlier, that's obviously been in the news, a lot of volatility in the oil price, a lot of debateabout what's driving that or what it means. You could go back to China and say, does it does it mean less demand in China? Is that why oil prices are wherethey are? Where does the IC come down on this debate over is it supply, is it demand, and what's really driving the oil price?
IVASCYN: Sure, we spend a lot of time on the topic of oil. And it’s a little bit of supply and demand. On the demand side it's also weather. Greg Sharenow,our commodity analyst, reminded me the other day that February again was one of the warmest months in history and if weather had been normal during themonth of February that could've contributed to as much as a five or six dollar higher oil price. That something that’s talked about a little bit less, butis certainly having an impact. We remain constructive on global growth. We brought our forecasts lower but we think that most areas of the developed worldwill see positive growth this year, and based on that growth view and what we're seeing on the supply side in terms of a significant reduction in capacity,we're cautiously optimistic on oil although we're realistic in that uncertainty bands are very wide from a historical perspective. So our team thinks oiltwelve months from now could be back in the $50 range and if it is at $50 we think that a lot of the areas of the market negatively impacted the most oflate can stabilize pretty significantly. So we're cautiously optimistic on the price of oil but also respectful of the fact that that is one of the biggestrisks to the marketplace.
And the final point I’ll make on oil is an important one. Sustained lower oil prices should have a very positive impact on most economies including theUnited States. To date the tightening of financial conditions associated with lower oil have dominated, but we are cautiously optimistic that if oil pricesstay relatively well contained – and a price of forty to fifty dollars is relatively well contained and, again, low relative to where it was twelve toeighteen months ago – the positive impacts can begin to dominate later this year and that's one of the reasons why we are cautiously optimistic on globalgrowth.
FISHER: So speaking of things that are impacted by the oil price, let's talk a little bit about inflation expectations. I think there's been a lot ofvolatility in terms of inflation expectations. The TIPS market showed the markets at least saying inflation expectations are dropping; they’ve rebounded alittle bit lately but still a lot of pressure; I would say that inflation expectations are quite low over the next several years. Do you think that what'shappening in oil prices justifies that, or how does the IC balance the different considerations as far as inflation?
IVASCYN: We've been talking now for many years about an environment where growth would be well below historical levels and where there'd be considerabledisinflationary or even deflationary pressures that work across global economies. We still think that we're in that general paradigm, but with that said,when you look at the pricing of financial assets we think that more than that cautious view towards inflation is being priced into many markets. Youmentioned Treasury Inflation-Protected Securities as an example: Those breakeven inflation rates or the implied inflation expectations in that segment ofthe market got quite low – at historically low levels. We've seen a significant increase in those breakeven rates the last several weeks and I think that'san example of overshooting or the marketplace worrying too much about the prospects for a global recession, a more significant environment of fallingprices. So we're cautious; our view for the U.S. inflation rate is to get the headline number back a little bit over 2% over the course of the next 12months. A lot of that again is going to depend on what happens with commodities and in general, even in other areas of the world, we still think inflationwill remain positive and we’ll see central banks react to some of the deflationary pressure a bit more aggressively, Europe being an example of that.
So we're cautiously optimistic again on global growth and inflation trends, and across our portfolios we're expressing a reflationary theme. Eitherexplicitly in certain Treasury Inflation-Protected Securities, and other portfolios we're doing it with some high quality additions to segments of ourcredit portfolio, even in more global mandates or diversified mandates we’re doing it via certain currencies that can benefit from a shift in deflationaryconcerns towards more of a reflationary environment.
FISHER: You mentioned optimism on global growth. There’s obviously a lot of talk in the market about the possibility of a U.S. recession. Many peoplesaying the Fed can’t tighten, the economy's much too weak and there's a good likelihood of a recession even this year. What have the discussions in the ICregarding the likelihood of a U.S. recession revolved around lately?
IVASCYN: We're spending a lot of time talking about the U.S. economy and policy, and policy’s impact on the economy as well. We're also looking at some ofthe higher-frequency data that's been quite strong the last few weeks. One thing we do is we try to model the potential risks to recession. We, as youknow, have an Americas Portfolio Committee. They’re one of three regional committees that help support the global Investment Committee. We have that group,chaired by Mohsen Fahmi, and they’ve spent lots of work on recession forecasting. They have a more fundamental-driven model as well as more of a big data,more quantitative approach. We've used that as the starting point for discussions regarding risks to the U.S. economy.
I mentioned earlier that our base case growth forecast is somewhere in the 2% range, which implies a relatively low probability of a recession at leastover the near term. These models that I mentioned have recession probabilities somewhere between the 10% to slightly below 20% type range over the courseof the next 24 months, as an examples. So still relatively low, and certainly low relative to what is implied in certain segments of the credit market, itappears. And this is going to be an ongoing discussion regarding these risks, and an added source of uncertainty of course is the upcoming election in thiscountry. So you do have a unique time period where you have uncertainty around central bank policy for the first time in several years, you have a fairlyuncertain political process associated with this upcoming election, then you combine that with some of this global uncertainty; these are clearly risksthat we want to monitor but where we are, again, is a little bit more optimistic than the market as a whole at the current point in time.
FISHER: You mention policy; I think that is an area where PIMCO is a little more optimistic about the Fed's likelihood that they will be raising rates thisyear or even in 2017, where the markets have really pulled back their expectations for Fed policy. So what is it that you see in Investment Committee thatmakes you confident that the market has really got it wrong here, in thinking that the Fed’s not going to be hiking rates at all, effectively?
IVASCYN: So to be clear, this is an area where there is significant uncertainty. We agree with most market participants that the Federal Reserve is goingto be extremely measured in any tightening process. The reason why we're a bit more optimistic than what is implied in the market currently is that we arefairly constructive, as I mentioned, on growth. We're beginning to see some tightness in the labor markets, some early signs of additional wage pressurethat historically has caused central bankers some concern. So even under a backdrop of fragile global growth, China that is at least somewhat reliant onthe U.S. remaining accommodative, we do think there is the potential that we’ll see some gradual increase in the fed funds rate, and we're talking about onthe order of one to two times this year relative to a market that until very recently was pricing in no tightening; not only this this year but into andeven through 2017 as well.
FISHER: So let's get back to investments. Obviously the Investment Committee is trying to take all of these inputs and decide what the best investments arearound the world. So given that there have been a fair number of dislocations recently, markets may be mispricing things, where would you say are some ofthe best opportunities where PIMCO might be able to take advantage of some of those dislocations or mispricings in markets?
IVASCYN: I think that's an important point and we try to remind us of this all the time in the Investment Committee that you can’t invest in GDP, at leastexplicitly, you can't even directly invest in policy. I guess there are certain areas where you can bet on the outcome of elections but you can't really doa whole lot of size. So the point there is that we have to translate this into implementable investment ideas. So a few points I'll make: One, given thecurrent interest rate structure and the fact that we do think that we could end up with slightly better growth than the market expects, we think thatexposure to higher-quality interest rate markets warrants caution. In much of the developed world, rates are negative well out the yield curve. So we'redefensive regarding higher-quality interest rate exposure.
In terms of good ideas in areas to go on the offense a little bit, we have seen over the course of the last few months very high quality assets widensignificantly in spread: high quality investment grade companies with no direct exposure to the energy markets; high quality financial institutions thathave built significant capital cushions and have regulatory regimes that make it very difficult for them to take aggressive risks; high quality trueTriple-A – and by that I mean our own internal analysis of credit risk – commercial mortgage-backed securities investments that have widened considerablydespite most commercial real estate fundamentals or most markets in the United States remaining very solid from a fundamental perspective; U.S.housing-related investments where the U.S. housing market has actually benefited from a lot of this global weakness in the form of lower gas prices forhomeowners, lower mortgage rates than would be the case otherwise, which has helped them in terms of debt burden and refinancing opportunities, job growthin this country which has been relatively strong and because of very low regulation there has been limited building of new homes. So fundamentals remainvery strong for the housing market in housing-related investments, and we're not calling for significant increases in prices from here, just a relativelystable market. In all these areas, which I’d categorize as high quality very safe spread, we do see attractive opportunities and we have been adding aroundthe margin.
Also I mentioned earlier that we’re becoming more constructive on energy prices. This is not a time, given the uncertainty, to dive into energy-relatedinvestments. You need to be very discriminating and very bottom-up focused in your analysis, but we do see interesting opportunities across a wide range ofassets to position portfolios to benefit from the ultimate stabilization in commodities, oil primarily, even in some of the emerging market areas that areoversold. Higher-quality segments we think are beginning to look interesting as well.
FISHER: So a basic summary would be volatility tends to create opportunity for active managers.
IVASCYN: It does, and one other key topic for us has been the outlook for volatility. And the good news for active managers is that we think we're in asustained period where there's going to be high local volatility. These are going to be markets that are prone to overshooting, that the liquidity dynamic,the regulatory regime in place is leading to this type of overshooting. So if you're patient, if you have a long-term focus, if you have sufficientliquidity at your disposal to take advantage of periods of volatility like we've been in, we think it's a tremendous time to add value. So these are topicsas well that are outside some of the macro discussions that we have at the Investment Committee level but are more about portfolio positioning, riskmanagement and the tactical use of the liquidity that our clients trust us with to drive returns through active ongoing tactical decision-making.
FISHER: Thanks very much for the update; that was very helpful and thanks to you for joining us today.
IVASCYN: Thanks, David.