Dan Ivascyn: Secular Shifts, Tail Risks, and Portfolio Resilience

Stay tuned after the conclusion of the podcast for additional important information.

GREG HALL: Hey, everybody. Welcome to another episode of Accrued Interest, PIMCOs podcast, dedicated to serving financial advisors and their clients. Really excited to bring to you today a discussion with Dan Ivascyn, Group, CIO of PIMCO. We try to have Dan on at least a couple of times a year.

We do it in January to give us a start on the year and talk about what we're expecting, and we reconnect with Dan around this time, see what's happened, maybe what we got right, what we got wrong and what we're thinking for the balance of the year. Lucky enough to have Dan in New York City here with us today, so we can do this in person. Hey, Dan, welcome! Thanks for joining us!

DAN IVASCYN: Great to be here, Greg, and a lot going on.

GREG HALL: How are you enjoying the city this week? Got a lot going on.

DAN IVASCYN: It’s alright. It's all right. Yeah. As far as personal interest in sports, not exactly what I'd hope for.

GREG HALL: Should we get this out of the way before we move on with it?  Dan is a lifelong Celtics fan. Lifelong.

DAN IVASCYN: Oh, absolutely!

GREG HALL: Massachusetts we've talked about. Okay. And so this is a tough week for you to be in New York City.

DAN IVASCYN: It's a tough week, and it's getting even more challenging, but yes.

GREG HALL: It was looking better until the last seven seconds of the game last night.

DAN IVASCYN: Correct. I went to bed right at the beginning of the fourth quarter, so it wasn't as traumatic as it could have been, but…

GREG HALL: Yeah, at least he…

DAN IVASCYN: It's good fun. It's good fun. I know there are a lot of advisors from New York, so I don't wanna be, we should probably move on to the content.

GREG HALL: I think advisors from New York appreciate your interest in sports, whether or not they necessarily agree with your choice of teams. But anyways, Dan, we,  the other great thing about timing for this week is we just published our secular piece in the last day or so.

And this, for people listening, we've talked about this in the past, but this is something we publish once a year with a goal of not looking out over the next quarter or the next six months, but actually trying to look into the future, five, 10 years, identify structural themes that are gonna influence markets and money making over that time period.

And that piece is called Rupture and Resilience. It's available on the website. And I'm sure those of you who work with us, your account manager will be forwarding a copy. But Dan, it's just such a great opportunity to talk to you about that piece and some of our takeaways. So if it's all right with you, maybe start there and just talk about the forum process and what the debates were this time around and where you guys ended up kind of concluding your key takeaways.

DAN IVASCYN: Yeah, no, I'll do that. And as you know, Greg this has always been a critically important part of our investment process. We were doing it long before I joined the firm in the late nineties. The idea was get away from the noise and all the rapid information flow and be able to step back and look at long-term trends. Markets zig and zag along the way, but if you can get some of those long-term themes right, you end up with good outcomes for clients.

And, I think Bill Gross originally came up with this idea back in the early eighties. Today, now with X and Instagram, and probably information sources I'm not even aware of. That the younger generation focuses on. It's nonstop information hits the market constantly. And the noise can create a little confusion or lead to.

And just getting bounced around in terms of just thoughts on markets and even in thinking about year-to-date market activity early in this year pre-Iran war markets seem to be trading based on longer term themes. And  understandably now with war in Iran across the Middle East as well, this has turned into a significant energy shock. And understandably there's been a massive focus on what's going on with the conflict there. You literally see information hit about Iran and its moving markets. Quite considerably this week. No exception. 

GREG HALL: Today, right? I mean, yeah. And we're recording this, sorry, on, on June 11th for folks following along.

DAN IVASCYN: Yeah. Today’s a good example of that. So I think this year's secular forum was quite important in that we try to not get too distracted by what's, again, important in terms of impacting markets over the short run, important to some degree, too, over the long run.

But, we do think that there's lots of competing forces at work, and a big theme of our secular research piece this year is this idea that there's gonna be more and more disruption, more and more surprises. We've had some large supply shocks in recent years, a global pandemic, obviously being a quite large one. Other shocks around tariff policy and other forms of conflict. We have war going on, and at least a couple of major wars going on in a couple of places around the globe.

And now we have again, this energy shock. You combine that now with considerable geopolitical uncertainty and a point we've made. And we started making this point a couple of years ago. I think we owe it to Gordon Brown who chairs our advisory board. This idea that things have been turned upside down for much of my career.

A lot of the careers of the folks listening to us today, economics drove politics, meaning that you could usually assume, at least in the base case, that there'd be a conventional mindset towards economics. If the economy's strong, it usually leads to good outcomes for politicians. There's this idea of globalization, broad economic efficiency. And again things have changed a lot. Today, political priorities increasingly change or influence the economic agenda.

Tariffs isolating China as an example, trying to bring back supply chains. Finding a way to address critical mineral needs not just from an economic perspective, but try to create resiliency and to try to address these global tensions. US China simplifies things a little bit, but now China's response to US tariffs and restrictions on trade are impacting Europe and so on. We're seeing populous trends, unpredictable politics here within this country, but across the board.

And now you have AI disruption which I'm sure we'll talk about a bit more. It's quite significant and it can have a very different impact on economy wide productivity, while also creating a lot of tension across countries, within countries, within income sectors, across different companies as well.

So I think our main point is that there's gonna be a lot more uncertainty, a lot more surprises from a non-traditional economic or financial analysis perspective. And it's gonna require a slightly different, or even a significantly different playbook in order to drive attractive returns on a go forward basis.

GREG HALL: What did you mean when you said in the earlier part of the year, we were trading more on longer term themes? I obviously, I understand that the Iran conflict is kind of telescope, it's forced everybody to focus on,  kind of the daily oil move, or the tweet about our relationship with Iran, but I am sort of curious as we look back way in the past January, February, how did you see that sort of fitting into our thesis?

DAN IVASCYN: Yeah. So you and again, you never know for sure what's moving markets. We talk about it a lot and perhaps, we oversimplify things, but it felt like late last year, earlier this year there was a lot of focus on AI as a technology that was becoming more and more efficient, very, very quickly.

And this idea from a macro perspective, that this could drive broad efficiency lead to increased productivity and through more efficiency, lower costs. It'd be really, really helpful from a top line economic sense. Risk assets doing quite well. while bonds were rallying.

And in fact, we had a very well-behaved market where we started with attractive yields, which again, we're going to talk about later. But also we had a nice well-behaved market where rates were trending lower now embedded in this AI view.

And likely some of the reason why we saw this dynamic at work was this idea that AI can be very, very productivity enhancing, but at the same time can be disruptive and lead to job loss. Anxiety, particularly within the professional middle class as an example, which from a top down macro perspective, could be a good governor to growth, avoid overheating, lead to higher  precautionary savings, less consumption, and given the economic strength from a high level purely financial markets perspective, a pretty good outcome.

Beneath the surface, of course, this could lead to some political uncertainty, political frustration again, that may be a super secular type theme, but at least from a financial market perspective it was a soothing, positive type area of focus.

What we also know was going on at the same time though was the fact that when thinking about AI disruption, it wasn't just about worker displacement, it was about creating disruption down at the corporate level. And this is where issues began to come in around private credit. This idea that, wait a minute, the more efficient and the more productive AI is, the more it's gonna go after old economy business models.

And if you have an old economy business model, you better adapt or be disrupted when you have a lot of debt already, there's a limit to how quickly you can respond to that type of competitive threat. So you began to see concerns in private credit, divergence within the credit sector. The focus was on software, but not just software. AI's gonna disrupt many businesses. You began to develop that type of theme as well.

So the macro didn't matter from a macro perspective, it could be very, very positive. If you own the wrong companies, though, you could lose a lot of money despite the fact that growth is quite elevated. So that's where we started the year.

Then we had the supply side energy shock. And now the focus has shifted very much towards higher inflation risks as opposed to where we started the year with this idea that, you know, wait a minute, over time, this could be quite disinflationary and could be a way where we get back to that central bank target that's been so elusive over the last several years.

GREG HALL: Yeah. So we had a window and it's proven to be elusive, which I think just supports your contention that we're gonna see more surprises. We had a window where fundamentals mattered a lot in the short term. And the macro environment we felt was relatively well understood. And like you said, markets were responding to economic stimuli, and then the Iran conflict throws a wrench into that. And we're reminded about geopolitics and politics playing a huge role in today's investment environment.

DAN IVASCYN: It's a great summary!

GREG HALL: It's, so one of the things that I, this isn't just in the secular piece we put out, but I always admire this about well, you in particular, but the way our investment process works is we always differentiate between predictions, which I think we try not to make all that often. I've seen you ask the question, where's the tenure gonna be in 12 months, and I've seen you refuse to answer that question many, many times.

What I like about our process is we'll proffer a base case, and then we talk about tails. And I think one of the interesting things about the new piece is how we're so explicit about how this new environment, it may not change our base case, but it widens out the tails. Can you just talk about the kind of the distribution of risks in this environment?

DAN IVASCYN: Yeah. And the idea here is that, you know, given the environment I described a lot more uncertainty in both directions, fatter tails, a wider distribution of outcomes. 

GREG HALL: So you take your bell curve and you squash it down. 

DAN IVASCYN: Squash it down. Higher chances of more extreme scenarios occurring within markets. And that means that when you stress test portfolios, when you think about what could happen, you want to be more cautious and more careful. And so many models today will, when we do the fancy stuff from a portfolio allocation perspective, are backward looking.

And I think the challenge, of course, is if the tails are fatter, if there's a higher probability of more extreme outcomes going forward, the backward looking models are  gonna capture that dynamic at least as much as they should. So this is an environment where you need to do a lot of scenario analysis and not just the good old fashioned, well, what does GDP do?

How's the world gonna respond if GDP is 5% versus 4% all the way over to negative 5%, you have to run scenarios involving politics, geopolitics.

Changes in regulation. So, for example, what may slow down all this AI momentum, local governments say, you're not allowed to build data centers. That's not something we learn in business school. When we're doing  discounted cash flow analysis, I think it's being prepared for those types of outcomes. But your first point it's funny, you asked me about the tenure. I chuckled.

That's why I think, on CNBC a little less than some. It's more fun and direct to just say our tenure is gonna be at this number at year end. If I'm honest, and if we're honest, and I think if most people are honest, the right answer is we're really not sure. We don't know. But the second more important point is you don't need to know to generate attractive active returns or returns relative to passive alternatives, because there's so much more to do than having to predict.

So every once in a while we will have a very high conviction view or prediction. The last few years have been very, very good for that type of investing. We've had a great run as has some other macro oriented firms given just how much volatility there's been in rates, shifts in sentiment towards what central banks were gonna do.

But over time, over a decade type period a much easier way to make money are taking advantage of structural inefficiencies, tighter relative value opportunities, more repeatable sources of return, go out there and find someone in the market that has to do something because a regulators telling 'em to do it, or they need a rating agency, rating, and therefore they can only buy that instrument or highly motivated to do that.

Or take the other side of a central bank that's just having a lot of trade flows coming in, and they're just having to buy treasuries or having to buy their own bond market. And then we, of course, can be more flexible and take the other side. So less interesting to talk about, but that's the type of repeatable alpha generating foundation that PIMCO was built on, in which we try to encourage today. And that's, and today it's a very tactical type environment for that type of investing.

GREG HALL: Yeah. It doesn't yield. Sorry for the pun, ‘yield’. But it doesn't get you the easy headline, but we grind it out, right. We hit singles and doubles, and it's very rare that I've seen you express a desire to be more heroic and make a huge duration call. And 'cause and I think I've heard you even say that, like, a lot of times those calls just don't work out, it's a little bit more about ego than it is about generating real risk adjusted returns.

DAN IVASCYN: Yeah. I think that's right. Or, you know, over a 10 year period, maybe once or twice you get the big trade opportunity. My old colleague, Scott Simon used to tell me, tell all of us, he used to run mortgages years ago. I think he hit his 13th year, retired from PIMCO the other day.

He sent me a postcard from a place he's vacationing at. But he used to say, you gotta take what the market gives you. You can't force things. And I think that's a very, very important lesson. And again it's something that we try to embed in the PIMCO process.

But before I forget, the other most important point about the secular, we did talk a little bit about credit though, is that there's gonna be a lot more volatility. There's gonna be a lot more uncertainty about inflation, about growth, about these other factors. But again, for the patient investor, the value proposition in global high quality fixed income hasn't been this good in a long time.

So in some sense, it matters a lot less than people think. If you get the tactical right, you can add a lot of a additional incremental return to that very, very attractive starting yield within a portfolio. And in fact, last year was a great example of a lot of our flexible active strategies that started with a pretty good yield ended up generating much more return relative to that starting yield.

Now, there'll be times where we get some things wrong, but that was our other theme, is that when you look at fixed income today, high quality bonds US or even better, a diversified global opportunity set, it's attractive, in a simple sense you can put together a portfolio in the liquid space with a yield of six to 7% without having to add a lot of really economically sensitive risk.

If you want to add that type of risk to the portfolio, now you're in the even higher single digits. If you wanna give up some liquidity within the investment grade space on a targeted basis, you can increase that yield as well. That yield's great, at least historically in an absolute sense. It's really good, even if inflation stays at an elevated level or inflation goes higher.

GREG HALL: You're still making real returns even with inflation in the three kind of neighborhood

DAN IVASCYN: That's correct. And then last but not least quite attractive versus equities under most reasonable, longer term fair value models. They don't have to converge, or they're not necessarily a predictor of returns over six months, but they tend to be, again, pretty good predictors of return over a one year period. So that's the other point, and again, everyone's, oh, well, the fixed income, you know, CIO says this.

Again, I think it's important to look at the data. You could not credibly make these points back in late 2021. When you had starting high quality bond yields, 1%. So in some sense, it took the horrible environment we all went through during 2022.

And a little bit of additional volatility since then to get to the point where we finally have initial conditions that are attractive enough to warrant an allocation and allow you to be patient and still let income drive a good portion of those returns.

GREG HALL: Yeah. The yield really helps you, I mean, I hate to say it this way, but you can be wrong about timing. You can be wrong a little bit here and there about some of your investment decisions, but that yield is very forgiving. It helps you whether, your own decisions as well as the macro situation working itself out.

DAN IVASCYN: Yeah. And then the simple bond math too. When you had a little bit of duration with the math and the call, but when you start with a one or 2% yield, it doesn't take much in terms of sell off in order to get you into a negative return position. This year, rates from the most part have gone higher, yet most strategies are somewhat in the positive territory.

And again, you give it a little bit more time, and then that coupon allows you to catch up. So, your return will move around with what rates do, but that break even math, the simple break even math is very, very favorable. So, again, you could have interest rates a hundred basis points higher and still end up with a positive return given starting yields across most bond strategies.

GREG HALL: It's a great point, and it's something that I think hopefully advisors can use with their clients, right. A 50 basis point backup in rates or a hundred basis point backup in rates when your starting point is four, four and a half is just not as big of a deal. I'm not saying it doesn't matter, but it's not as big of a deal as it was when rates were zero, or 1%, and you're talking about a doubling in that environment, right.

So that's, no, it's a really important point. I was hoping because you started to talk about the kind of the growth outlook, and we got into the duration topic a little bit. And I wanted to see if we could use that framework of the base case and the fatter tails to talk about a few different, kind of macro items or maybe not quite as macro items, and just get your sense, like, what do you think is the base case?

And then when we debate in a forum, or when you guys get together in IC, what do we talk about as the tails that we want to be prepared for, even if we don't think they're the likely outcome? And maybe I'll start with the conflict in Iran, inflation and develop market growth or US growth, whichever kind of growth proxy you want to think about. But what do you think is the base case there, and then where could it go really wrong or better than the market's actually expecting?

DAN IVASCYN: Yeah. So, the situation looks better, the fact that we've, now  having it adhere to a full ceasefire, but it seems like both sides want to deescalate from a military perspective. So relative to where we were a few weeks ago we think that the chance of more extreme outcomes is less likely. With that said, our base case or at least modal view that the path that's most likely to happen will be this idea of gradual de-escalation.

We think that it's mostly what's priced into markets at the moment. And what that would mean would be a period where the current oil price gradually drops over the course of the next few quarters, but remains elevated versus, where we had been no magic number.

But think about oils somewhere in the $80 barrel, 75, a barrel type level. There's a chance though of a more protracted situation where we don't get the Strait open where there is just ongoing conflict. And that's gonna lead to higher energy prices. You could certainly get up into the mid one fifties, even in a more extreme scenario.

Now, what's interesting there is that when you think about those types of periods, yes it will lead to higher energy prices, but what typically happens in those types of environments is you begin to see demand destruction. People that are seeing this flow through to higher gas prices now are at a point where they're not spending money on other things to be able to handle those higher prices, and almost every energy shock you've had in the past when you start getting to these points in time where we had a re-acceleration in the price of energy related assets or their derivatives.

You've begun to see that type of demand destruction. So under those scenarios, you likely would have higher rates higher inflation temporarily, but over time, probably less overall inflation than you would tend to think, 'cause you'd begin to see the prices of things that people are buying less end up moderating,

GREG HALL: Sort of breaks consumption and does that put us in recession risk?

DAN IVASCYN: And that puts you, and that's what I was gonna get at, is that that would put you into recession risk or at least would result in a meaningful slowdown in the economy. Equity markets probably don't like that. Credit probably doesn't like that. So even though that's not a great scenario for bonds, it could be even worse scenario for credit spreads or inequities. Especially given credit spreads are near all-time tights.

Equities are near all time wides, and you do have this yield cushion or yield advantage in high quality bonds, but that's a scenario that looks a little bit less likely at the moment. But it's something that's certainly within the realm of possibility. 

GREG HALL: It is constantly befuddling to me. And again, I'm a little biased too, of course working at PIMCO, but the fact that I understand, it's not our base case, but it's a very real possibility. And yet still credit spreads maintain, tights and equities hit new highs every day, there's more supply coming online. We, I mean, we can talk about this in a minute, but that was like, just in terms of cognitive dissonance, I find that just a strange dynamic going on today.

DAN IVASCYN: Yeah. I think it is. And I think, I'm sure we'll talk about it a little bit more. This AI thing matters. Just the raw investment alone in AI is driving the economy forward. The rise in AI related stocks are creating a wealth effect that's leading to support on the consumption side.

Now it's concentrated in upper income cohort groups, which is a concern. It's not that nice, well distributed growth that you'd like to see. The impact of higher energy prices is unfortunately gonna impact middle income and certainly lower income cohort groups more

GREG HALL: Sure. It's regressive, yeah. 

DAN IVASCYN: It absolutely is. And that's a shame of course. But it will flow through to the macro numbers to the extent that we see these prices higher for longer or even higher for longer. Then the other piece is that of course if you get into that situation like that, you very well will see more central banks increase policy rates.

Now, the other point I'll make real quickly is that what we described in terms of that type of scenario is far worse for countries outside the US. It's far worse for countries that have to import a lot of their energy. It's far worse for countries that have to import a good portion of their energy and don't have companies that are leading in AI related innovation.  So that's why we've talked a lot about this idea of global diversification.

And you don't have to own other countries’ currencies. You can buy high quality bonds at a higher yield than what you could get in the US market,  hedge back to the US dollar in economies that would likely see more economic weakening even under what would be a traditional high inflation scenario than the US.

So we could have a situation where yes, this sounds horrible for the US given our setup relative to many other parts of the world, but we can take advantage of other parts of the world where you could actually see a bond rally in that scenario where the weak growth begins to overwhelm the inflation shock. So it can get complicated in terms of implementation. But the basic idea is just that there's such an exciting global opportunity set.

You have the different impact of a shock like Iran on different areas of the market. It allows you to find investments that will respond better than what you would have in a more narrow or more importantly in a passive strategy in order to generate return or to insulate portfolios from that outcome. I always start negative, so lemme get to the positive.

GREG HALL: I was gonna ask if there's a right tail, but I just on that last point  I just wanna make sure that I understand it. And maybe by trying to articulate it, some of the advisors hopefully listening, this will help crystallize it for them too. But it sounds, your point being that oil shock bad for us, and we have this offsetting jolt to the economy from AI, but other countries where they're very, very, they're dependent on external energy sources.

So they could have an, even bigger growth hit to their economy, more demand destruction without that offsetting technological investment to push their economies forward. And so there you can think about taking on rate risk, taking on duration and what you might have executed in the United States thematically in the absence of that AI boom, you can actually generate returns elsewhere in the world, which is a really nifty way, I think, of translating an investment thesis to the domain where it's gonna work, right, and sprinkling that into portfolios.

DAN IVASCYN: Yeah. I agree. And I think, and the way I sometimes describe it is, bond markets like low growth bond markets, usually like recessions, at least high quality bond markets. And if you end up having a shock like a war and that leads to lower growth somewhere in the world where you already have a starting yield, that's quite attractive.

That's usually a good environment. And in some sense, the US market now, because of all of the great technological innovation it's  hard to slow our economy down, which is of course a great thing for our economy. But it creates great diversifying opportunities in the active area of fixed income management and with liquidity versus giving up liquidity.

We could change our mind when, as the situation evolves we can target different high quality investments to help generate return above and beyond the already attractive yield.

GREG HALL: Alright. Well, let's talk about the rights though. What could go better with Iran? And then we'll move on to another topic.

DAN IVASCYN: Yeah. I'll be real quick there. Look, the Trump administration likely wants a more, a quicker, and a better defined ceasefire type agreement. A priority of the administration has been to get yields lower, I assume or we assume a priority of the administration is to attempt to main control of Congress. Selection coming up and you look at the polling, inflation is a considerable factor, if not the major factor.

There's a chance that we get a solid deal relatively quickly. You see how markets react even today. To the latest rumor of us getting close to a deal, you very well could get a deal that could get you back into a mindset very similar to the mindset we had earlier in the year, where people begin focusing on a Fed, being able to reduce the funds rate quicker and more substantially. 

Powell has already been dovishly inclined. And has stated time and time again, had like to do that. Warsh too has talked about this idea that given the current economy, how productive this economy is that you very well could withstand a lower funds rate. That would be again, a great environment. It's an environment where inflation would come down.

You'd get back to a mindset towards this longer term cost reduction associated with AI efficiency. And more importantly, you could get a central bank that's back from being on hold to potentially cutting interest rates. And that has implications both on bonds in terms of that high yield going lower, and you, in addition to getting great income, getting price performance, as implication though, if you're in cash if you, and it's understandable that you get a little bit concerned about this environment, and you've moved from bonds back into cash, or you're in cash waiting for something to happen under that type of scenario, that cash yield starts going lower.

You don't get to lock in that cash yield. The way you lock in high cash yield essentially is to go out there and buy bonds with a slightly longer duration. So that would be an environment that would be bad for the cash rate over time. Real, real good for bonds. That's not an inconceivable scenario at all. And then there's everything in the middle.

And I think if you end up with these outcomes in the meat of the distribution, you're earning your coupon, even if you have delayed clarity in the Middle Eastern situation still pretty good fundamentals to drive returns over the three to five year horizon, which we talked about our secular,

GREG HALL: We talked about at secular, also looking out much further in terms of US fiscal policy, the sustainability of deficits and the risk that if we're more dovish on the front end, the bond market may step in and force us into a situation we don't really enjoy way out at the 30-year. Again, using that kind of base case and the tails framework, how do you think about just the long term kind of credit worthiness of the US? 

DAN IVASCYN: Yeah. I'll be quicker there. Look at, we’re the global reserve currency. We have one of the strongest militaries in the world. We have the largest and most dynamic capital market in the world. As my old colleague, Paul McCulley, I used to say, that gives us the chance to be much more irresponsible in the fiscal side than nearly any other country in the world.

And he used to follow up by saying, we sure give it a go to try to really use that advantage that we have. But more important, I think the key point is we may not have it forever, but we probably have it for the foreseeable future. A few facts about the US, we tax our population much less than other countries in the world.

Because we're the global reserve currency, because of our influence from a geopolitical perspective many, many other countries own our assets and feel almost obligated to own our assets. When you look at our debt picture or how much we have to pay to maintain our debt over a multi-year period and compare us to other countries coming outta World War I, World War II, other periods of elevated inflation, it would appear that it's manageable for several years to come, but at some point it needs to be addressed.

It's very unique for us to be running six-ish percent deficits, give or take during a period of such strong economic growth. If we ended up having a recession, that number would automatically go up to 10%. The positive side though, is that if AI ends up becoming incredibly productive, it could continue to drive, very, very strong growth like we saw in the nineties, that's gonna help us solve the situation if that happens and if we have disinflation and we could bring interest rates lower combined with higher productivity, that could improve the fiscal situation and it could improve it fairly substantially.

So, there's some positive scenarios there. There's some not so positive scenarios. I think the key point is that if and when it becomes a political priority, the US when you look at other situations of high debt has a lot of tools at its disposal to address it, but again, no one's, not many people are talking about it. And we think that the concern will be that these debt levels continue to build. Last point I'll make, which is …

GREG HALL: Not talking about the solutions and the tough choices that we need to make in order to kind of. I got you. Yeah.

DAN IVASCYN: We're not, so we're not there yet. But I think the most important thing I could say about that issue is back to this idea of diversification. If you're concerned about debt in this country, and you should be to some degree, I don't wanna sound overly complacent. You can diversify into countries that have a much better fiscal picture.

Australia as an example, the UK has its own unique challenges but from a narrow perspective of their approach to debt more recently, more fiscally responsible. And again, that's what's exciting. Those two countries I mentioned have higher yields than the United States. You can hedge back that currency so you don't have the volatility associated with just buying another country's currency, and that's what we're doing. 

Even though we're of the mindset that yeah, the higher deficit levels have caused US rates to go higher, it's one of the reasons why we can lend to the US government now and pick up some of the highest yields we've had in many, many years. But we don't have to put all of our eggs in one basket, so to speak, just in case fiscal becomes a bigger concern globally.

Let's owe a little bit of this country that has a much better fiscal picture. And you extend that to all of the areas of the opportunity set. Now you have a nice robust portfolio where if fiscal concerns begin to dominate, you own some things, again relative to passive alternatives that you've chosen, because they actually have a much better fiscal picture. So that's part of the mindset today, here's the risk. What's our assessment of the risk? If we're wrong, what could end up happening?

And then based on those risks relative to our outlook, what can we own to end up with a much better portfolio? Sometimes with an even higher yield? That's what's cool about the current environment. That's sort of the mindset around portfolio construction in this environment of greater uncertainty.

GREG HALL: There's lots of countries out there to lend to. And we always  obviously as US investors, we have a home bias. And then I think there's,  we're all guilty sometimes of thinking about the bond market. Maybe not you, but those of us, and I think some advisors as well, you can think about it as kind of monolithic and it just rates and just rates in the US or even even just the tenure.

And you do have a lot of tools to work with, whether it's curve shape or other countries that we could look at. This will be a little more, this will be a little bit different. This is a little bit of a different topic. And one that we don't, or haven't, you know, we don't talk about as often, but have been talking a lot about recently, but the CapEx supercycle.

It's featured in the piece. We introduced the topic, I think by just identifying the amount of money that we think is going to need to be borrowed because of AI and data centers and compute build out, but also defense rebuilding in Europe, the global reshoring, moving supply chains into, in country so that you don't have to rely on another country to give you the things that you need for your critical industries.

And the numbers get really, really big really, really quickly. And I'm just curious how you are thinking about the impact of that on growth, the impact of that on the demand for and supply of credit. And then   maybe a little bit more of a nitty gritty basis behaviorally. Is that leading? Is there a little bit of a boom mentality that's beginning to infect structures and other things?

DAN IVASCYN: Yeah. Well, to start with, the technology itself, it feels like this is different, but sometimes, always tends to feel a little bit like it's different, but  this very well could be the most exciting and you have sort of positive or sort of negative excitement. Most impactful technology that we've experienced in our lifetime.

And it can lead to incredible productivity improvement, increased efficiency, but it also can displace a lot of workers, create a lot of tension, create a lot of uncertainty in some sense. The more productive it is, the more disruptive it will be to other business models. But you have the technology first, and we'll start with the CapEx piece. It's massive and it's having an  incredibly positive contribution to economic growth through that specific channel.

You see it in the US, you see it in other parts of the world that have the type of companies in demand to help supply that infrastructure. Incredible moves. And we talk about K shapes, usually it's upper income versus lower income, but you can extend it to countries.

Countries that have these companies are seeing massive investment and that's positive at least in a more narrow sense for economic growth. For active fixed income managers, it's super exciting as well, because now we have massive supply that has to come to market.

And unlike the past several years where there was massive money pouring into credit, and where there was massive battle for market share across the industry, spreads were tight, by the way, credit spreads are still quite tight from historical perspective, but you couldn't drive terms.

And it's still hard to do that in the more generic areas of the market. But because of these capital needs and the sectors that you mentioned, it's great because you can look at a lot of things, you don't have to do very many of them. You can pick the assets that you like and you can get very attractive spreads versus other areas of the market.

And you can do so when underwritten properly with very, very attractive protective terms or documentation that protects you as an investor. And we've talked for years about covenant light or low dock or the inability and the ability of companies to not even have to respect the fact that you're senior in a capital structure because they can game the docks. It's very, very hard to do that in some of these better underwritten transactions.

So it's exciting from that perspective. But the cautionary point that's very, very important to make. And you hinted at this. I think in your question is that there's a lot of uncertainty still where we're headed in terms of AI. It's one thing to be productive in certain areas of the economy that's different in terms of how you make money off of it, and we saw that with the internet.

Internet ended up being an incredible innovation, but the companies that were leaders early on in the development of the internet, many of them didn't end up making money. It took a lot of adjusting from a market's perspective to figure out who ultimately made money.

Second point is that, anytime you have this incredible uncertainty across an industry, there's a model, it won't get too technical in terms of how you price risk, but the simple point is that, extreme uncertainty and volatility is really good for equities, 'cause it means that there's scenarios where your asset will go up a lot. And then there's scenarios where they'll go down a lot. So if you buy 10 AI companies, equity, eight can go outta business and two can go to the moon, and you end up making a ton of money.

In fixed income, you lend your money, you get back your interest rate, and you hope you get your principal back. So it's a very, very different dynamic, which means you gotta be very, very careful owning too much of that risk. And then the related point from a macro perspective is that there tends to be this lottery mentality. And it's been discussed in the academic research, and I think we all can relate to this. Lotteries are usually, at least in the United States, they are managed by the states.

And they are to bring in revenues. So you have a lottery, people buy tickets. Most people don't make money. And that's the whole point because it's to bring in government funding to support schools and other programs. So all of us sort of know that, you know, going out there and buying a lottery ticket is a negative expected return, you're expected to lose money.

But as the jackpots go higher and higher, and we see the potential for a really, really big payout, we eventually, those of us, I'll throw myself in that camp, don't normally play the lottery, start pooling money together with our coworkers and going out there with the family and we buy lottery tickets, because we see the potential for a very big payoff.

So it means that more people end up investing trying to get the big win, even though they know rationally it's not gonna necessarily maximize their expected return or put more simplistically, they know they're gonna lose in most scenarios.

That dynamic tends to exist when you have these exciting technologies, people pile in and they pile in with the hopes of a big payoff. And then of course, a few years down the road, like we've seen with the internet, and you can go all the way back to other manias throughout many, many decades, even centuries of economic history and see that dynamic.

That dynamic probably will play out the same way it always does, and at some point in the future it could be tomorrow, it could be five years from now. There will be disappointment and there will be a lot of downside volatility in equity markets. And typically given the tight relationship of the US economy to the financial markets, you'll probably see an economic slowdown or even a recession associated with it. 

Hard to predict. This technology may be different, and it may take a long time to happen, but you have to have it in the back of your mind as an investor. And those types of, sort of boom bust type scenarios when they happened tend to be pretty good again for high quality bonds. So, and not very good for credit, of course. So I think that's not something that we fixate on.

It's just something that you see throughout history. You have to have a healthy respect for that type of uncertainty. When something can go up, 10 times higher than the original price, it can go down that quickly as well. So that's gonna be a risk associated with this environment of rapid and uncertain technological change.

It's gonna lead to more winners and losers, and it can lead to a sudden unpredictable growth shock in the future. Again we don't manage to that scenario, but it's something that investors should at least think about in the back of their mind.

GREG HALL: Yeah. And I really like your point. I mean, as fixed income investors, just keeping our heads about us, the most we can make is par, at plus interest at the end of the day. And so, however, and many of us are incredibly enthusiastic.

I mean, you and I have talked about it using AI tools at work, using AI tools at home and messing around with Claude and coding, and it's super exciting. It doesn't mean that we can make more than power plus interest in lending to some of these projects or these businesses.

DAN IVASCYN: I think that's right. And I think in an environment like that where you have, you already have extreme uncertainty and you have those types of risks, you combine that with base case disruption. And, we do think, and this is a point in our piece that investors should seek diversification. Because what's great about diversification is that even if you're wrong, even if these surprises occur, you may lose money in a portion of your portfolio, but it doesn't impact the overall strategy's ability to generate return.

And when you look at what's happened over the last few years, software is probably a great example of that. Everyone's focused on software today. Software is a sector that is highly prone to AI related disruption through a series of events where   more and more money poured into segments of the credit markets.

People lent more and more to software related companies, not surprising,  software related companies over the past several years until recently had performed extremely well. They generated a lot of stable cash flow. But it is somewhat unusual to have strategies that have10, 15, 20, 25, 30, 35, 40% software concentration.

But we think that resulted in this mindset that this is where people wanna borrow money, money's coming in, we're lending to those types of companies. And I think that in this environment, concentrated risks, too big, a set of bets can be dangerous. Because I think you just have to have the appropriate humility that it's a complicated world, you're gonna get a few things wrong, and you have these great areas to be able to diversify portfolios.

So I think that's another important feature of the current environment. But also a lesson I've learned throughout my career is that  when you have a lot of things to do, don't do too much of any one, any one thing. And I think in retrospect, when you look at what happened in the last few years in this, in a very, very bullish environment for credit, concentration's built up and now you're beginning to see still in a fairly stable economy, the risks of that concentration. And again, in this world going forward we think investors need to be especially cautious from that perspective, 

GREG HALL: You make a couple of points in the recent piece that I think are a little bit newer to our commentary on where things are. So, one for what you were just saying, a fairly definitive statement from us that we think the credit default cycle has begun which you're alluding to software issues and in private credit, but maybe you could elaborate on that a little bit. I know it wasn't meant to be an alarmist statement, but I think it's an interesting take on where we are, especially in the midst of a really robust and growing economy.

DAN IVASCYN: Yeah, no, it's good. I, people are very focused on credit, but, even some of the media uptick was a little bit more dramatic. Than would like, because today I saw that PIMCO expects a wave of losses.

And I said, earlier today, not a wave, you know, a wave of losses would happen if the economy slows a lot. And you have a lot of AI disruption. So, probably a better term would be a stream, a steady stream of losses. And what's happened over the last few years, as we know you had aggressive underwriting.

You had a lot of deals get done with aggressive terms in the private equity space. And you had weaker investment or investor protections than you've had in the past. But there's been a willingness given just how much money is poured into these lower quality areas of the credit market to just kick the can forward, extend maturities.

If companies couldn't pay interest, then you would create what's known as pick interest. Basically say, ‘hey, look, you don't have to pay that full coupon today, pay it at maturity’.  And then of course, maturities have been extending, so that's a form of sort of soft default or loss, maybe…

GREG HALL: Advertising that risk. Yeah.

DAN IVASCYN: So maybe you could recoup it, but given just how much liquidity there was in the market, how much stability there was in the credit space, stocks going up, economy strong, that mindset existed. Well now,  with war in Iran, these stagflationary issues in the economy, meaning growth potentially slowing with inflation staying high, some of the weaker underwriting or capitulation from the private equity community saying, ‘Hey, look, I'm not willing to put more money into these businesses’.

And again, all this disruption that's coming you've begun to see and you're gonna see now less of a willingness to kick the can, and you're gonna begin to see a more steady stream of losses. Not catastrophic, not systemic, and why it feels worse than maybe it should is that it's been a long time, since we've had a period of even moderate credit losses. What we're describing is an environment that looks a lot like the eighties, nineties, two thousands.

During that three decade period, it was very, very common to have periods where you'd have losses from time to time. Sometimes there'd be violent associated with a recession and you'd have a big spike. Other times you'd have periods where it would happen within one sector or segment of the market, the economy would be reasonably strong.

But the reality is that you're gonna have some disappointment because the losses are gonna be elevated. We're not talking about theoretical losses now. We're at the point where you're gonna expect to see more dispersion within credit markets, more loss realization.

And that means returns are going lower in areas of the market that have had near perfect periods of overall credit performance. And that's where we also said that the playbook investors need to use to maximize in this new environment is gonna be a little bit different.

They're gonna involve, we think more flexible strategies, a sense for diversification and higher quality segments of the market, much more caution about concentrations within their portfolios, and given still relatively tight spread levels across much of the credit markets, creative ways of going up in quality while maintaining attractive returns and some skepticism around allocating too much to lower quality, more leverage credits in this environment of extreme uncertainty.

And again, that used to be the norm. What's so unique is that we had this multi-year period coming outta the global financial crisis with lots of government spending, lots of monetary policy accommodation, very low rates, very low inflation. People needed to go out there and be more aggressive in order to maintain the type of yields that they had grown to expect

And I was gonna say, of course if you were to have a negative economic shock, then you could take a steady stream of credit losses you can get into much more dire scenarios for…

GREG HALL: That the wave…

DAN IVASCYN: The wave.

GREG HALL: The, I was gonna say another symptom of a couple of decades here, nearly of uninterrupted financial prosperity has been, and you point this out in the report, is sort of the resurgence of the financial engineer, and again, not, I know you weren't you're not trying to be chicken little about this, but I do think it's always interesting for me when you point out some of the things we're seeing in markets today that rhyme with some of the things we saw leading up to the financial crisis.

Maybe to lesser extent, maybe certainly not with all of those excesses and not centered on the banking system the way that it was back then. But maybe as kind of our last topic here, we could sort of talk about what you're seeing, what gets you a little uncomfortable and where you think advisors ought to just be asking some questions and making sure they stay alert to some of this stuff.

DAN IVASCYN: Yeah, no, this is when we think about a lot. We chose to mention it for the first time, since the years leading up to the GFC this year,  now. To be clear, there's nothing wrong with financial engineering. In fact, people know I'm a financial engineer. And that my background is in structured credit. So many people at PIMCO's backgrounds are in structured credit. We've been massive players in the mortgage markets, the ABS markets.

And Bill Gross deserves the bulk of the credit where the years leading up to the financial crisis, the GFC, where we began to see concerns here. And then the ability to pivot and go on the long side coming out of the global financial crisis, and be able to generate incredibly attractive returns over that period versus peers versus passive alternatives.

So there's nothing wrong with financial engineering. It is a tool that we use within capital markets to create types of risk that are easier for many investors to hold. But today we're in an environment where many, many participants hadn't begun investing in credit since post global financial crisis. And when you look back, and I'm gonna date myself, here too, myself and a few of my colleagues began in these markets in the mid 1990s.

And the mid 1990s was really the first wave of innovation within the asset backed markets. The David Bowie music receivables, way back when securitizing other more esoteric forms of collateral airplanes, heavy equipment, shipping receivables.  It got really popular in the mid-nineties. There was this wave of financial engineering. Very, very low quality mortgages, first go around. Second lien lending lending up to 125%,

And it didn't go, it ended fairly badly, during the 1998 market shakeout. And then people stopped doing it for a little while, and then some of the excess migrated into the corporate credit markets, the internet bubble, and Enron and the telecoms. And then in the mid two thousands the financial engineering began again. We’re well aware of that, subprime lending.

Everyone knows the story there, but it started with aggressive lending against the home. And then those aggressive bonds ended up going into CDOs and then CDOs of CDOs. And then other vehicles that became complex where you started dropping different fund investments, multiple fund investments into structures and getting more investment grade risks.

So you could literally look at a situation where you took a high risk loan, dropped it into a series of structures, funds, pulled it together, and ended up turning this very aggressive loan into like 90 something percent triple-A or high investment grade type instruments. So the math broke down, given…

GREG HALL: It's like, it's bad asset quality structured into something that's labeled triple-A.

DAN IVASCYN: That's right. That became almost impossible to figure out with all sorts of liquidity mismatches and so on. We're not anywhere near that point. 

GREG HALL: It feels to me like, and maybe this too philosophical a point, but like something happens when the buyers of this stuff, they cease to be impartial judges of value, and they become enamored of the structure or the profile because it works.

Like you said it when we started this, if financial engineering is often about figuring out a way for an asset to fit into a portfolio of somebody who needs it to look a certain way, and when you hit that just right, the buyers become, I don't wanna say addicted, but there's an element of that, right? And they demand that the market create more of this risk for them, and that seems to be kind of like a little bit of a tipping point.

DAN IVASCYN: Well that's right. And typically what will drive this, at least a good portion of this will be the fact that it's ratings based. And so much of the world is still regulated based on ratings. So despite the fact that within the global financial crisis, so much investment grade risk ended up turning out to generate outright losses, even catastrophic losses, we still live in a world very much regulated based on rating.

So, you know, if you are an entity regulated based on rating, you have the incentive to maximize yield per unit of capital, which usually means per rating. And that's where you get into a situation where what can start out as being quite reasonable can become unreasonable because as we've said for years you've heard me say it, you can almost always take a collateral pool and create something investment grade off it doesn't mean you wanna own it.

But you can usually create it. And now there's even more rating agencies and there's rating shopping and incentives, in order to put a rating on certain things. And what held the market in check this time is that the global financial crisis was so significant that people remembered it.

People were quite skeptical of aggressive financial engineering. The rating agencies were very, very skeptical and very, very careful especially given the regulatory scrutiny of being too aggressive here. But the global financial crisis is a long time ago.

And we're beginning to see a lot of that old technology get dusted off, where you're now seeing, we used to call 'em kitchen sinks not just risky instruments turn into investment grade things, but risk instruments turn into investment grade things that then are put into funds where there's additional leverage that are turned into investment grade things that are then put into a structure to create another investment grade thing.

This is so early. This is nothing like 2005 when we were screaming from the rooftops, there's major problems here, but all we're saying is that bear is watching. And I think the key point is that just because a rating agency says something's investment grade doesn't mean it does.

Especially if it's only one rating agency, because sometimes you can assume that you asked the others and they came back with an answer that you didn't like. Don't wanna sound alarmist. And what's so exciting about this environment is that with a lot of this going on, you can do your own credit work. You can differentiate from a solid sound investment versus an investment that's less sound. And you can take advantage of the fact that there's lots of entities in the market that need spread at a given rating.

If you have a flexible bond strategy within the opportunistic space, private space, or public space, and you don't explicitly need the rating, and some, in our most flexible mandates, you can issue that rated note to someone that has to buy it and hold the stuff that ends up being more attractive. Or you can just do good old fashioned credit work.

And given the tight starting spread levels, given the amount of risk that needs to come to market, which will be used in order to create the perception of higher credit quality or actual credit quality, you can determine how much is perception versus reality. And it's gonna drive a lot of relative value, and again, active returns on an ongoing basis.

From a systemic perspective, we just think it bears watching. There's no natural governor to this in the current market environment. So the pace has been accelerating. There's more and more we're seeing that just hearkens back to what I saw personally in the mid-nineties, which we saw in the mid two thousands period. But it's early going and just it's worthy of comment and a bear's watching is really the only point we're trying to make here.

GREG HALL: One of the things that's great about financial advisors in the US is, and sometimes it's cited as a weakness of the industry, is that most financial advisors have a few decades of experience underneath their belt, by the time they've built up their client base and they're running sizeable books. It's very common.

You've got advisors in their fifties and sixties, but one of the, I think one of the key benefits of that is the experience, the history, the pattern recognition. They've seen this movie before. So I was really pleased when we put that into this year's publication because it does bear watching and it's good to just remind people that in previous episodes when things have looked a little too good to be true, they have been.

And it's good to be cautious. Well, Dan, thank you for joining us. You've been so generous with your time. This is fantastic as always to have this midyear chat with you. We will catch up with you again in January, if not before. For those of you listening today who enjoyed what you heard, were interested, want to go deeper, we would very much encourage you to visit us at pimco.com in the US or your website in any other country that you happen to be listening to this.

If you identify yourself as a financial advisor, you'll be taken to Advisor Forum. That's our one-stop shop for you to get what you need from PIMCO as quickly and as efficiently as possible so that you can be smart, well informed and spend more time focusing on your clients.

Please don't forget to like and subscribe. Let us know you're out there so that we can devote more time and attention to this podcast and bring more conversations like this one with Dan to you and hang out and spend time with us over the summer. We've got a lot of great programming planned. We're gonna talk a lot more about credit.

We're gonna talk a lot more about the global markets and bring a few of our practitioners in, from around the world to talk about some of these global themes that Dan brought up today. We're gonna have some practice management episodes. We're gonna talk about behavioral finance. It should be a really interesting summer and great beach listen, for those of you who are in the northeast enjoying the nice weather. Thanks so much.