«There Will Be More Rude Awakenings»

Dan Ivascyn, Group Chief Investment Officer at Pimco, expects more market turmoil in 2019 and hints how investors can protect their portfolio.

Dan Ivascyn may not be known very well to the public. Yet, the Group Chief Investment Officer of Pimco is one of the most powerful investors in the world. The bond firm from Southern California manages around 1.7 trillion dollars of client money and ranks among the ten largest asset managers in the world. Ivascyn who rarely speaks to the media expects another turbulent year for the financial markets. Because of the fragile state of the global economy and political risks investors may have to cope with even more turmoil than in 2018, says the down-to-earth American in an exclusive interview. That’s why he argues for caution when it comes to equities and corporate credit. According to his view, there are better opportunities in US government bonds and in housing related investments.

Mr. Ivascyn, most investors won’t keep 2018 in good memory. What is awaiting the financial markets in the new year?
We think 2019 is going to be another volatile year, potentially even more volatile than 2018. Our biggest concern is this extreme political uncertainty which is increasing rapidly. It’s almost guaranteed that there will be a lot more uncertainty in US politics. But the more impactful uncertainties are probably outside the United States with the situation in Great Britain, in Italy and now even in France. There are significant divisions across societies and this leads to this ongoing political friction which can rear its ugly head very quickly and unpredictably. There will be more rude awakenings and more political surprises like what we’ve seen in France recently. These types of issues can pop up with greater frequency and they can also feed on themselves. That’s why we think volatility in 2019 is likely going to be even higher than what people anticipate today.

In the US and around the world, stocks have suffered a severe setback. What’s your view on the equity market from the perspective of a fixed income investor?
US equities have performed well over the last several years. Until this recent correction, equites in general looked fully valued from a historical perspective. We don’t believe they were at bubble type valuations. But they were fully valued, and when you have markets that are fully valued, it takes less negative news to create higher degrees of volatility. Now, the recent weakness has taken valuations to more reasonable levels. But our equity outlook for this year remains cautious.

What should equity investors watch out for?
A lot of these macro sources of uncertainty can impact equities in both, in a positive or in a negative fashion. But from a value perspective, our earnings outlook is lower than consensus. This makes us a little bit cautious for equities in general. What’s more, over the last few years, there has been a flight to quality into the United States given the divergence in growth and the perception that the US is insulated from some of these more extreme sources of uncertainty outside the United States. So, if you end up with more negative scenarios, you could actually see a little bit of US equity underperformance this year.

How does the turmoil in equites affect the bond market?
The recent equity weakness has begun to filter into credit spreads. Remember, we had a big volatility event in equites already earlier in 2018. Especially in some segments of the commodity complex, we have seen a tremendous amount of volatility. But it really hasn’t been since early 2016 when we have seen volatility in credit. And, it’s been many years since we have seen a real default cycle. As a result, there is a lot of complacency and more risk of negative scenarios within the corporate credit market. So, if you ended up having less economic growth than the market anticipates, this is an area where investors could begin to fear the risk of real defaults and real capital impairments. Against this background, investors should be careful in non-financial corporate credit.

Which sectors are most at risk?
Pimco’s view is that oil will trend higher over the next year. But if oil happens to go lower, it will create challenges for the energy sector again. Since energy prices dropped the last go-around, many of the companies most sensitive to the price of oil have rebuilt their balance sheet. Therefore, these sensitivities are lower than they once were. Then again, given low oil prices today, a lot of corporations which have been resilient thus far are at a point where, if oil were to fall further from here, you would begin to see stress re-enter the market. Therefore, investors shouldn’t be complacent in terms of the relative resilience thus far.

Where else would you advise for caution in the corporate space?
There are sectors continuing to face strain. A lot of this strain is due to rapid shifts in technology because of disruption from certain key players like Amazon (AMZN 3'488.98 -0.85%). Retail is one example. There are ongoing major shifts in that sector which will be a source of concern. Another source of concern are trade relations. Although we expect to see a near-term compromise between the US and China, trade issues in general aren’t going away. So, more extreme trade policy can quickly create winners and losers, specifically when it comes to manufacturing and exporting companies.

Another source of uncertainty is monetary policy. How will major central banks like the Federal Reserve impact markets this year?
The Federal Reserve is getting closer to a neutral policy position. As a result, there is going to be a lot of uncertainty and confusion around economic signals along the way. In our base case, the Fed will probably hike interest rates again in 2019. Outside the US, central banks are going to be very measured in tightening policies. In Europe, any meaningful movement in rates won’t happen until late 2019. That’s far away and there are a lot of things that could make it difficult for the ECB to remove monetary accommodation. The same goes for the Bank of Japan. Therefore, it’s far too premature to declare that central banks outside the US are going to be able to meaningfully normalize rates. We’re still in a world where central banks have to remain vigilant and, in some cases, have to remain active.

There is also growing concern about the global economy. How real is the threat of a recession?
We see a synchronized global slowdown in 2019. We think that US growth this year will be somewhere in the low 2%-range. For Europe, we expect a pace of around 1.5%, and for Japan something between 1% to 1.5%. Of course, there is a lot of uncertainty around these numbers and our models suggest an increased risk of recession in 2020. But a lot of times, recessions occur because of unanticipated shocks which are hard for models to capture. So, there is a chance that you could have shocks that lead to a recession sooner. On the other hand, you also could see – through careful central bank policy decisions or a near-term reduction in political uncertainty – this expansion last a lot longer.

How do you cope with all these risks as a bond investor?
Since recessions are extremely hard to predict, we focus at valuations in the market and try to insulate our portfolios from the risk of an economic slowdown. In terms of portfolio strategy, we have already started to reduce risk. That process began about a year ago and is gradual. We try to use every tool at our disposal around the globe to come up with creative ways in our fixed income complex to generate yield without exposing investors to the negative impacts.  As a result of recent de-risking, we stand poised to provide liquidity to markets in response to anticipated volatility.

How attractive are US government bonds against this backdrop?
We’re in the latter part of the economic cycle. Unemployment is low, and you may very well see a further uptick in inflation over the coming months. But central banks will be able to relatively easily contain this late cycle inflation. That’s why we think rates will remain relatively range bound over the next few years. In our portfolios, we prefer the US versus other global bond markets. Our highest conviction is that the best place to buy high quality bonds is somewhere in the five to ten-year maturity spectrum where the yield curve is steeper.

There are two main reasons why we like this trade: First, if the economy deteriorates further from here, not only will the market price out remaining policy tightenings by the Fed. But we may very well face an environment where equities are going down further, and credit spreads are widening. In this case, it’s very likely that the market could even start pricing in future drops in the Federal Funds Rate.

And what’s the other main reason?
We also have real questions about long term debt sustainability in the US and elsewhere, which also contributes to our preference to avoid longer end maturities. The US obviously has added to the deficit with the tax package. Globally, you’re seeing situations where policy makers are finding it difficult to get the budget situation in order. In Italy, you have a new government that is explicitly trying to take deficits higher. In France, the government was looking to raise revenues. But after a few weeks of very unfortunate situations on the ground, we’re talking again about pushing up against deficit limits. Across many economies, significant segments of the population have been left out of this multi-year recovery. As a result, there is pressure on governments to spend more money. From that perspective, we have become a bit more concern about owning a lot of longer-term bonds. Because at some point, people may worry about the ability of governments to pay back these bonds. This is also contributing to our view that whatever government exposure you’re taking should be in shorter maturities.

Today, the yield on ten-year treasuries hoovers around 2,6%. Where will it be at the end of 2019?
We’ve had a pretty significant rally in treasuries over the last couple of months. If we see some near-term positive news relating to trade, the Brexit situation or the Italian budget uncertainty, there is a good chance that you could see a recovery in risk assets and treasury yields moving back at higher levels. You could see a break-out of the ten year yield up into the 3-3.5%-range. But we would be surprised if it goes meaningfully higher than 3.5%.

It’s been almost two and a half years since the yield on ten-year treasuries hit an all-time low. Are we now in the process of a secular bear market in bonds?
It will take a lot of pain to retest those lows from a couple of years ago. But we believe it’s far too premature to declare that we’re in a long-term bear market in bonds. When we look back at economic cycles since the mid-eighties, each trough of the cycle has been accompanied by lower and lower terminal policy rates around the globe. The last economic slowdown was unique in that central banks didn’t stop at near zero. They went negative and in addition to that, they expanded their balance sheets by several trillion dollars. We have been talking about the «new normal» for many years. Many of these factors are still in play. So, when the economy slows meaningfully from here, we think that rates are going to go lower than they are now, at least out the curve.

So where do you see the most attractive opportunities for fixed income investors today?
One of Pimco’s highest conviction views across all our portfolios is to look for housing related investments. We think that investments tied to the US housing market will offer resilience. Whether its government guaranteed mortgage backed securities or other bonds backed by loans to homeowners or the homes themselves. We think they are going to perform very well across many different economic scenarios. They can be resilient if rates go higher. And, if we are going into a recession, these bonds will materially outperform their corporate counterparts.

What’s the bull case for housing related investments?
People remember the last crisis when weakness in home prices drove economic weakness globally. But if you go back to the long-term history, there tends to be very little relationship between economic growth and home prices. In fact, home prices in prior recessions proved to be quite resilient. What’s more, there is very little leverage at the household level. We’re looking back at a decade of a highly regulated environment with very little excess in terms of lending. So, credit metrics remain strong and we think this sector is very defensive.

Then again, in the past few months, the housing market was often cited as one of the weak spots of the US economy.
We agree that the pace of home price increases likely will slow. But for the investments I’m talking about to work out, you don’t need home prices to go up. You don’t even need them to stay flat. They just can’t go down a lot. And, if rates go higher, we think this sector will be very resilient given valuations, price-to-growth, price-to-income, price-to-rent and other affordability metrics. So, we think this is a great way to provide clients with attractive yields in very defensive assets at a time where credit metrics in the corporate market have gone in the complete opposite direction: leverage metrics deteriorating, less covenants and less ability to control outcomes as investors, at least in the public space.

Where else do you spot opportunities?
There are some higher risk segments of the market that have overshot to some degree. One area is the banking sector. There, risks are much higher than in other segments of the credit market. But you can reduce your overall exposure to the credit markets and make some targeted investments in financial institutions that have record capital positions after a decade of very strong regulation and de-risking. Of course, such investments are going to be very volatile if they are tied to what’s going on in the UK, France or Italy. But they offer good relative value.

But what about the risk of another systemic event like in the fall of 2008? Deutsche Bank’s stock chart for example looks quite concerning.
We have record levels of debt. Worldwide, the total is close to $250 trillion. As bond investor, any time you have very high debt levels and relatively low economic growth potential, you need to be a little bit nervous and careful. That’s because you never know for sure when this dynamic reveals its ugly head and creates a lot of uncertainty. Nevertheless, banks are in a pretty strong capital position. But in Europe, their earnings model is strained. So, we don’t see a major capital issue but there are issues with the earnings model. Of course, there is risk in these investments and they will continue to be volatile. But unlike in other segments of the credit market, we don’t think there is a lot of complacency. When you look at the news flow and at the volatility of the stock prices in the banking sector, people are at least aware of these risks. As long as you size these investments appropriately, you’re getting reasonably paid to take that risk.