The global financial crisis is several years in the rearview mirror, yet global debt is at an all-time high in dollar terms, and even larger as a share of global GDP than before the crisis. The overhang of leverage is an integral reason why PIMCO sees a New Neutral of abnormally low monetary policy rates that will persist over the secular horizon of three to five years. In the following interview, Daniel Ivascyn, Deputy Chief Investment Officer for income and alternative strategies, discusses the status of financial regulation and shares PIMCO’s long-term outlook on lending institutions and related capital markets. He also highlights opportunities for investors with patient capital.
Q: Reregulation of the international financial system has been a theme of the post-financial-crisis era. Now that the global economy is healing and converging toward slower but increasingly stable growth, will policymakers ease up?
Ivascyn: Over our three- to five-year secular horizon, we expect a modest relaxation in financial regulations. Nevertheless, we expect the regulatory environment to remain significantly more restrictive than what we have observed in the past, which will impede the loosening of credit standards in both mortgages and other forms of consumer credit. Given this backdrop, we have not seen, nor do we expect to see, a material loosening in credit standards, which was typical in prior economic recoveries. As long as credit growth remains muted, this will be a headwind for economic growth.
Many of these financial regulations are highly complex, and in some cases these financial regulations have not yet been finalized. Given the uncertainty in both the regulations themselves, and the implications of these regulations, many market and industry participants have constricted lending standards until there is more clarity. Consequently, the lending that is taking place is at higher rates or to a smaller subset of borrowers than under prior regulatory regimes. This is particularly true across the regulated banking sector.
As for the U.S. housing market, we think that governmental agencies such as Fannie Mae and Freddie Mac will continue to be the primary providers of mortgage credit, only gradually loosening their underwriting guidelines. Nevertheless, significant market frictions will remain.
Q: What is the outlook for global banks over the secular horizon?
Ivascyn: Overall, banks have made a lot of progress in repairing their balance sheets, and we expect this trend to continue. Nevertheless, there are still some banks that will have to be restructured, and we see some concerning trends developing in China.
In general, we believe U.S. banks are among the healthiest. Not only are bank leverage ratios lower than before the crisis, we have seen stabilization in U.S. housing prices, and expect U.S. national housing prices to increase by another 3%–4% a year over the next two years, which should be positive for bank credit quality.
In Europe, while we have seen significant progress in terms of bank balance sheet repair, European banks entered the financial crisis with materially more leverage than U.S. banks, and economic growth in Europe has lagged the U.S. Consequently, European banks have a lot further to go in deleveraging their balance sheets. Over the next few years we expect to see European banks continue their strategy of asset dispositions and capital raises to deleverage their balance sheets.
As for banks outside the developed world, they are generally in good health, but they still face challenges. For example, Chinese banks are confronted with issues and pressures related to rapid credit expansion that are spreading to other developing economies and sectors that rely on Chinese economic growth.
Q: How do these trends create opportunities?
Ivascyn: These trends are shifting the opportunity set in favor of certain sectors and strategies.
As financial institutions deleverage and sell non-core assets, for instance, we are looking to capitalize on potential dislocations that may result in investment solutions for our clients. These distressed sales have the potential to generate attractive risk-adjusted returns. In Europe, we expect banks will dispose of some $1 trillion in non-core assets, including residential and commercial real estate as well as corporate securities.
This is slightly less than what the market had predicted as banks recently have been successful at raising additional capital in the marketplace. Relative to the capital dedicated to those opportunities, it remains a quite large and significant investment opportunity.
Moreover, the prolonged and significant dislocation in some legacy structured products will continue to result in investment opportunities. Compared with the pre-crisis environment, the number of assets getting securitized and then rated by ratings agencies has fallen sharply, which has led to significant opportunities for investors that are not constrained by ratings.
As markets heal, we anticipate there will be ways to exploit the return of market liquidity via securitizations. To make the most of these opportunities, however, investors will likely need the strengths of firms that have the capacity, diligence and experience to conduct deep analysis, offer and manage comprehensive solutions, and optimize eventual exits.
Another attractive opportunity is to provide capital in areas where banks are no longer participating. In the past, particularly pre-crisis, financial institutions and Wall Street broker-dealers committed a lot of capital to arbitrage away market mispricings and localized market volatility. Now these institutions are much less involved due to regulation as well as some bad experiences during the 2007–2008 period. As a result, these pricing displacements tend to linger a bit longer than previously. This is true across volatility markets, interest rate markets and credit markets, and provides opportunities to investors with longer-term investment horizons.
Q: What are the implications of The New Neutral for interest rates, and for income opportunities in fixed income strategies?
Ivascyn: Central banks are likely to remain accommodative and keep policy rates abnormally low for an extended period of time: longer, in fact, than most market participants seem to expect. In the U.S., for example, we view the Federal Reserve as moving slowly to a neutral policy rate of roughly 2% nominal in the years ahead (0% after adjusting for inflation – what we call The New Neutral rate).
Why the low policy rates? There remains excess capacity across global economies and labor markets, and shifting demographics, which will contribute to lower growth and reduce inflationary pressure. In addition, policymakers are likely to feel constrained by the overhang of global leverage, which remains at peak levels.
Given that the intermediate portion of the yield curve will benefit from the stability of policy rates, we find that portion of the yield curve to be attractive. In contrast, the long end of the interest rate curve is subject to significant mark-to-market volatility, and we do not believe that the current level of rates is sufficient to compensate for these risks.
In general, credit spreads are tight, but having the resources to scour the global opportunity set allows us to concentrate our capital in select opportunities that are attractive, such as in U.S. non-agency MBS, higher-quality emerging market opportunities and select senior secured corporate exposures.