Is the Era of Volatility-Suppressing Policies Possibly Over?

On this episode of The Long View, Morningstar’s Jeff Ptak interviewed Dan Ivascyn, Pimco’s global CIO, in a taped video shown at the Morningstar Investment Conference, All-Digital Day, in Sydney, Australia. Ivascyn discussed his macro outlook, how investors can make sense of the rate cycle, Australia and China’s markets, asset allocation, and more.

Here are a few excerpts from Ivascyn and Ptak’s conversation.

Is the Era of Volatility-Suppressing Policies Possibly Over?

Jeff Ptak: I wanted to start at a very high level, which is your secular outlook. You published the most recent version around this time last year. And in it, you stated with the era of volatility-suppressing policies possibly over, you expected heightened volatility and risk to global growth. And we’ve seen continued volatility in global rate markets, as well as unsynchronized disinflation patterns across economies. I’m curious to get an update on how your views might have evolved since you published that outlook.

Dan Ivascyn: I think the timing is pretty good in that we just had our secular forum a couple of weeks ago, where again, we brought in some outside experts, got the whole group together, mostly here in Newport Beach but also using that VC [video conferencing] technology we all figured out during the unfortunate covid period, and we talked about the outlook for economies and markets over the next five years. We’re in the process now of doing smaller breakouts. Even today at the investment committee, we’re talking about some of those conclusions. So, maybe I’ll share a few.

We talked about a covid aftershock global economy, meaning that covid shock was so significant that the economy would be dealing with some of these issues for many, many years to come. And looking at the world today, I think that still is the case. Inflation is above central bank targets. We’ve made a lot of progress getting inflation back down toward targets, but even over the last few months, in certain parts of the world, including the United States, inflation has remained stubbornly high.

An exciting time for active asset management. You are seeing much less synchronized growth cycles around the world. The United States is an economy growing quite quickly, maybe even overheating a little bit. Inflation is still a challenge. We’re a market where monetary transmission is taking a lot longer to influence the economy and slow it down to a healthier long-term rate. China, not dealing with the inflation problem but dealing with the growth challenge, dealing with some disruption and uncertainty across the private sector. And then over in Europe—the UK, Europe, even Australia, Canada—a more mixed picture. I think those economies that I just talked about arguably have more sensitivity to front-end policy rates. Mortgage markets, consumer credit markets that are more floating rate, in contrast to the United States, which is a 30-year fixed market, almost in its entirety since the global financial crisis. So, more of a mixed growth picture there with a lot more fragility over in Europe.

And when you get to the policy area, a lot of uncertainty there, too, but the likelihood for less synchronized policy decisions. Other parts of the world may be able to lower interest rates ahead of the United States, creating more total-return potential for those bond markets. The fiscal picture is very different around the globe with the United States having the most significant fiscal response during covid, now running some of the largest deficits in the developed world, with other countries being more fiscally responsible with deficits in the low single digits or even balanced budgets in some cases.

So, in a less global world, a lot of geopolitical uncertainty, a lot of geopolitical tension. We unfortunately think that this is going to be with us for the next several years and leading to a focus on resiliency, bringing supply chains home, less globalization, which probably leads to more symmetric inflationary risks on an ongoing basis. Before covid, we were mostly worried about disinflationary risk, central banks are trying to figure out a way to get inflation up toward target.

So, I think it’s a more uncomfortable world, a more uncertain world, but I think there are a couple of positives as well. One, there’s value back in global fixed-income markets. For a while, the US was the only game in town, and it wasn’t much of a game with 10-year Treasury rates at 1.0%, 1.5%, and rates negative in other parts of the world. Now we look and there’s value back in markets where there was none for a very long period of time. Less influence from central banks, so markets are forced to go it alone, move based on the confidence level of the private sector, the good old-fashioned bond vigilantes. That will create some risks that will likely lead to more sustained volatility, but again, great opportunity to take advantage of a global opportunity set.

One theme coming out of our secular forum this year will be a lot of near-term uncertainty on inflation, near-term uncertainty on policy, but bonds look pretty good. After a few years of very rough performance, while stocks continued to go up across most parts of the world, you have really attractive longer-term valuations. I think that will be a key theme. The second key theme will be, again, a very, very different environment than before covid. You truly have a global opportunity set to take advantage of today. Higher-quality areas of the market look attractive and there is still, although a lot of optimism in regard to the US economy, a lot of uncertainty, and that uncertainty can be both positive in terms of the potential for significant increases in productivity tied to tech innovation, but any type of tech cycle or innovation cycle can lead to a lot of disruption as well. Unfortunately, with war in key parts of the world and ongoing tension with China in the West, there are some downside surprises potentially ahead as well. So, again, bumpier than we would like, but opportunity from the standpoint of a fixed-income-oriented investor or an alternatives-focused investor is pretty encouraging, at least relative to where we came from.

How Can Investors Prepare for an Uncertain and Risky Future?

Ptak: Considering the recent trends back toward tightening credit spreads and increasing stability in some of the larger economies, including the US, how should an investor think about reconciling that with some of the notes that you sounded in your most recent secular outlook, which talked about an emphasis on resilience and preparedness for an uncertain, risky future? How should investors tie those two things together?

Ivascyn: Let’s start with fundamentals. The economic data has been quite encouraging, especially in the United States, but generally encouraging in other parts of the world as well. Many forecasters, including Pimco, would have thought you would have needed to see more economic weakness after the significant tightening in policy rates around the globe to address very, very high inflation levels. But we’re here today. Inflation has come down a lot. We’re not quite at the central bank target across most developed markets, including the Australian local market. We’ve made tremendous progress with a decent amount of economic resiliency. That’s the good news.

The bad news is as an investor you have to look at what’s embedded in market pricing relative to your own fundamental views. So, although the fundamental growth picture and inflation picture have been quite constructive, it’s been accompanied by rallying equity markets and tightening credit spreads around the world.

So, when we look at where we are today, we do think that there’s a little bit of complacency embedded in these very, very high levels of equity prices. We look at the most economically sensitive areas of the credit opportunity set, particularly floating-rate credit, that would be senior secured loans, segments of the direct private lending area. Those borrowers are facing the full brunt of central bank policy. Most of them are not perfectly hedged. In some cases, not hedged much at all in regard to interest rates. And there, higher-for-longer scenarios, reaccelerating inflation, the need for central banks to do more could be quite detrimental to overall returns.

So again, I think it’s important to acknowledge that the data has been quite strong. The data has held up, certainly in the US market. But I think a lot of that’s already reflected in current valuations. We still think, given pretty elevated equity markets, pretty tight credit markets, that investors still should look for resiliency. They still should look for areas of the market with a little bit less economic sensitivity, given a lot of optimism in the market, combined with the decent amount of ongoing uncertainty. And the great news is that there are a lot of high-quality segments of the bond market that look really, really attractive.

Finally, there are alternatives to simply going down in credit quality to try to pick up the income that you’re looking to target as an end investor. And now you can do so in a diversified global opportunity set that’s up in quality. And I think, again, given the uncertainty and elevated valuations, that’s the focus for now. Over a five-year period, we do think there are going to be opportunities to go on offense, take advantage of portfolio flexibility and liquidity to target some of those riskier segments of the market. Right now, we think, stay up in quality. Don’t try to be a hero. Don’t try to make it more complicated than it needs to be. Focus on the higher-quality areas of the opportunity set. Be active, but don’t max out on risk here.