Q&A with Dan Ivascyn, Group CIO of PIMCO

It’s been a brutal few months for stocks and bonds alike, as markets have been confronted with risks posed by inflation, tightening monetary policy, and the war in Ukraine. Can you walk us through what’s happening and how markets have reacted?
Sure, so you’re exactly right. It’s been an incredibly volatile period for markets. We anticipated significant volatility this year based on the global economic reopening process as well as this uncertainty around inflation. And now you’ve added the situation on the ground in Europe with actual war in Ukraine. So this is a world where there are tremendous amounts of cross-currents that need to be analyzed. That’s leading to a lot of uncertainty, even a little bit of fear in certain pockets of the market.

So given everything you just outlined, how should investors be looking at the current market environment and in particular bonds?
Sure, so just to start on bond valuations, we’ve had a significant selloff. And as we approach yields in this country, the United States, of around 3% now, you’re beginning to see levels that represent at least reasonable long term value.
If, as we anticipate, inflation comes down, it will remain frustratingly high, but comes down over the course of the next couple years.
So for the first time in a long time, bonds are beginning to look reasonably attractive from a longer term perspective.  
So with volatility comes opportunity. Doesn’t feel great for investors participating in these markets, but we’re seeing a much more target rich environment to use and leverage the full team here at PIMCO to extract value through more of a relative value trading mindset.

So Dan, given all the volatility in the market, where are you starting to see value today?
Well, first of all, we think it’s critical that investors take a value oriented approach in the current market environment. You need to be patient and focus on longer term value.  And in fact, there are sectors of the market based on the recent selloff we’ve seen across most areas of the financial market opportunity set that are beginning to look attractive. You’ll never time things perfectly, and you very well may be adding risk that continues to widen in spread over the short term.  But the key is that relative to the last several years, we haven’t seen these types of valuations for quite some time.
We’ve seen some key segments of the market widen in spread to the point where valuations are beginning to look quite attractive, and that’s what we’re really trying to do, is to step back and look at areas of the market that have widened in a world of fairly extreme uncertainty that represent good intermediate to long term value for the end client.  One example, agency mortgage backed securities. These are investments that were heavily purchased by central banks, the Federal Reserve.  Now they’ve expressed an intent to reduce balance sheet in these instruments that benefit from a direct government guarantee or a strong agency of the government guarantee have widened out to levels that look quite attractive from a historical perspective.  This is a sector that’s very high quality, very liquid, represents good value in an area where we’ve begun to return in more significant size as we see much more attractive absolute and relative valuations.
The financial sector is a sector that we continue to like. Certainly in a world where recession risk is higher than it was previously, banks going to suffer from a spread perspective. But these institutions since the global financial crisis are incredibly well capitalized.  Based on post crisis regulation, they’re taking very few risks as platforms, at least from a longer term historical perspective. And based on recent spread widening valuations are beginning to look quite attractive as well.
There are a whole slew of COVID related recovery themes that we think are still attractive today. Although recessionary risk is elevated, there are sectors and segments of the market that are going to directly benefit from this very powerful reopening process we’re seeing in the U.S. and Europe and some other key regions of the world.  The lodging, hospitality sector, airline sector, where you get access to secured exposure all make sense to us from a relative value perspective as well.
Collateralized investments, whether you’re talking about asset backed risk, commercial mortgage backed, or even residential mortgage risk of a more seasoned variety also look quite attractive.
These are instruments that have benefitted significantly from the big rise in asset values that we’ve seen over the last several years. These are sectors of the market that tend to be resilient during more reflationary type periods like we’re in today.

So in investment committee today, how are we sizing recession risk?
So we see recession risk over the next 12 to 18 months to be as high as about 30%. We have several different types of models that approaches recession probabilities from different perspectives, but that’s our general thinking.  One of the key reasons for that is the Fed and other central banks appear dead set on getting inflation under control.  They’re at least talking in that manner. The choices will become more difficult over time as people begin to see the tradeoffs between growth and inflation, but we do believe they’re serious and really looking to get in front of this inflation problem.
But the tails of the distribution have certainly gone up. War in Europe is a very unique, challenging situation, far from being under control.  But then you see even out in Asia, Covid still is having significant effects on the global economy as well.  So again, we think it’s a time where investors should begin to look at some interesting areas of the spread sectors but stay in the higher quality end of the overall risk spectrum.

Now on the topic of inflation risk, you mentioned the Fed will be front footed. What can we expect in terms of their inflation response?
Yeah, we think they’re going to be very aggressive in both words and initial actions.  They’ll continue to be very focused on the data, though even if they begin to see some key components of core inflation trend lower, to the extent these absolute levels remain well outside their target, we think they’re inclined to go fairly forcefully over the course of the next few meetings.  And in an environment like that one, not only can you expect a volatility within the fixed income markets but as rates go higher, particularly real rates, we would expect to begin to see some downside volatility in equities, in the more sensitive areas of the credit markets as well.

How do you view the dynamics between public and private credit?
Well, we think that in this environment of relatively stretched valuations still, that having a broad opportunity set is better than a more narrow opportunity set.  So wherever clients can afford to give us flexibility, we would strongly encourage looking at the full range of opportunities across the public and the private space.  Now, within the public and the private markets, there’s significant leads and lags.  So for example, when there’s a lot of volatility like we’ve seen year to date, the public markets tend to widen in spread while many of the private opportunities become much more sticky from a pricing perspective.  So at the moment, our teams are working very closely together, looking to carefully assess value between the public and the private opportunity set. And for the time being, we’ve seen some interesting opportunities to be liquidity providers to those looking to sell public investments.