PIMCO CIO Dan Ivascyn: We’re Very Confident In The Market Environment In Terms Of Finding Value

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PIMCO CIO Dan Ivascyn: We’re Very Confident In The Market Environment In Terms Of Finding Value
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Following is the unofficial transcript of a CNBC interview with PIMCO CIO Dan Ivascyn and CNBC’s Finance & Investing Reporter Leslie Picker live during the CNBC Delivering Alpha conference today, Wednesday, September 28th.

Interview With PIMCO CIO Dan Ivascyn From The Delivering Alpha Conference

LESLIE PICKER: Thank you, Dan, so much for doing this. As we just heard, a lot of pessimism, a lot of concern, a lot of critique about Central Bank policy and how we got here.

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Maybe just to kick things off, can you reflect to some of those comments we heard from your peers and whether you're in agreement with kind of the state of things with regard to inflation and the overall economy?

DAN IVASCYN: Sure. Clearly there's a lot of inflation out there in the world and central banks have significant challenges getting back down towards their targets. We tend to focus a bit more on looking forward and understanding what they're likely to do. I have been hesitant to criticize the Fed and other central banks.

It's been a remarkable and challenging period for them. A global pandemic, $5 trillion of stimulus, uncertainty as to what that reopening process would look like, areas of the world where COVID is still impacting the economy, China as an example. So the degree of difficulty has been significant. In retrospect, the Fed would have liked to have tightened sooner, I think.

I think fiscal agents probably would have liked to reduce the size of the stimulus programs that have created more challenges for central banks. But in some sense that's behind us, and now there are some significant challenges in getting inflation contained.

And at least for the time being we think most central banks are pretty committed to getting inflation back towards target, even if that means the risk of a material slowdown in the economy, and significant weakening in the performance of risk assets in the most economically sensitive areas of the investment opportunity set.

I think several months down the road, as that tradeoff between inflation and employment becomes much more visible, it may be tougher for them to follow through. But for the time being we don't think it makes a lot of sense to bet against the Fed's commitment to getting inflation under control at this point.

LESLIE PICKER: So you said "most central banks." Obviously this morning we had a nice little news peg for this conversation, which of course took place within the Bank of England looking to stabilize its markets by buying U.K. bonds, long duration bonds.

This news obviously has reverberated across all different asset classes today. What do you make of this emergency action and what it says about Central Bank's need to ensure market stability while also this mandate of getting inflation under control?

DAN IVASCYN: Yeah, when I said "most," I think I did it to have the BOE flash in my mind quickly. But there's a challenge there. You know, the fiscal policy produced in the U.K., at least from a textbook perspective, likely adds some interesting and perhaps some positive policy there, particularly some of the supply side reforms.

But it came at a very unfortunate time. The size of the package is quite significant, and it's in the midst of a global inflationary scare. So it's going to create some real challenges for the Bank of England.

What they did today in terms of stepping in to buy an awful lot of gilts -- and the size is quite significant at around 65 billion or so in size -- may be a short-term fix, but it's not necessarily going to help in terms of overall confidence in terms of U.K. policy.

To those that are a bit more cynical, it appears that this could be supporting, or in some sense monetizing, a massive fiscal program there. So, again, I think it's a sign of the nervousness around the globe around inflation, the need for central banks to take this inflationary fight very, very seriously to get back to less volatile financial markets and to get to some form of equilibrium.

So it hasn't been helpful from a global perspective. Also these markets today are highly connected. So we literally saw the response of this volatility in the U.K. impact clients outside the U.S. in their activities in the U.S. risk markets and rate markets.

So we don't necessarily think this is a major global systemic risk, but it's a reminder that markets are quite interrelated and there's a lot of fragility around this inflation question.

LESLIE PICKER: Are you trading it at all?

DAN IVASCYN: Yeah, we've been underway, both the currency and rates, across most portfolios and would be inclined perhaps to reduce some of those expressions. But we haven't done that much thus far.

And our initial instinct, although this news is very, very fresh, is that this isn't that supportive or perhaps, you know, even more negative for the currency intermediate term. So we have a little bit less confidence in the sterling today than we did before this announcement.

LESLIE PICKER: We'll get into some other asset classes shortly. But I want to get your thoughts on inflation broadly.

Because we spoke about 11 months ago in Newport Beach for our Delivering Alpha livestream, and you predicted that "inflation will prove to be relatively temporary and will tail off over the course of 12 months or so to the point where it doesn't get embedded into longer term expectations."

Do you believe inflation has already peaked and, if so, how are you thinking about inflation risk over the next 12 months?

DAN IVASCYN: Sure. At least half of that first statement was inaccurate. But on the inflation expectations front, things have remained relatively contained. In looking at inflation, particularly the last CPI print, we're a bit more concerned about inflation lingering at higher levels than central banks would like.

So to answer your specific question, we do think inflation has likely peaked or is close to peaking, at least from a core perspective. We do think inflation will trend lower. So towards the end of this year we see core inflation in that 5.5- to 6-type range.

But the shift in our thinking is that although inflation is highly likely to come down, it's likely to remain sticky at levels above Central Bank targets.

So, at the end of 2023 -- and again, the further you go given the macro uncertainty, you know, you show more and more humility in that forecast, we still see inflation lingering up in that 3.5% range, so comfortably above Central Bank targets. But we do think we've likely achieved or are close to peak inflation, and we will begin to see it trend lower.

LESLIE PICKER: So with a higher terminal rate, perhaps, then, does the Fed need to go further than perhaps the markets are pricing in at this point in time?

DAN IVASCYN: Well, we'll see. We think that they will -- relative to what's priced in the market today, we think there's a chance the Fed needs to do a little bit more relative to what's priced into markets, perhaps get up to a 5%-type level as opposed to around a 4.5%-type level embedded in market pricing today.

And then we think there's a chance that the Fed is willing to pause down the road when they again begin to see the tradeoffs between the inflation mandate and the employment mandate, and perhaps will be willing to accept slightly higher inflation or be a bit more patient in getting inflation back down towards target.

Now, again, given that we think that inflation is going to remain high relative to their targets, you know, we think the fair value for rates needs to be a little bit higher than it had been pre-COVID as an example.

But at the same time, you know, we're beginning to see pretty significant value in fixed income markets, in particular the Treasury market today. So, you know, despite the fact that we think inflation is going to linger, we think a lot of this is embedded in current market pricing.

LESLIE PICKER: So, in terms of value in the treasury market, do you think they've gotten cheap enough to present a buying opportunity? Jeff Gundlach tweeting yesterday that he thinks so.

DAN IVASCYN: We do. And where -- we've been, you know, underweight interest rate exposure, I think we mentioned that when we spoke last.

What was very interesting, you know, a year or two ago, although there was the view that inflation was going to be transitory, rates were so low that you weren't getting paid much to bet against inflation when yields were down in the 1, 1.5 to 2%-type zone.

Today, at current Treasury levels, you know, where you get a 4.25-type yield on the front end of the curve, we think valuations are sufficient where we have been beginning to add back some interest rate exposure.

I know, you know, the fund that I focus on, you know, the most day to day, the income strategies had been quite underweight duration earlier this year, and we are biased to begin thinking about adding back some of that duration underweight. Again, there may be overshooting.

It's going to be very, very hard to time the peak in yields, but pretty good value in the front of the market, and we do think it makes sense for investors to begin to return to the fixed income markets if you've been sitting in cash, or if you're in the more uncertain equity markets, perhaps think about a de-risking trade and shifting a little bit of money from equities into high-quality fixed income.

LESLIE PICKER: What do you make of the signals that the fixed income markets are showing with regard to recession? Because on one hand, of course you have the inverted yield curve.

Credit spreads may not be as indicative that a recession is looming perhaps, and we have yet to see this cascade of defaults or even the potential for a significant amount of downgrades in terms of credit rating. So what does that disconnect tell you about the prospect for a recession?

I know you said on a podcast about a month ago that you still think there's a shot of a soft landing. Is that still the case?

DAN IVASCYN: Yeah. There's definitely a shot. Our current thinking is that the base case is a recession. Our thinking is that it will potentially be a fairly mild recession. One of the reasons why we feel that way is that initial conditions, you know, look pretty good. The consumer balance sheet, quite strong; corporate balance sheets in most areas of the credit markets are quite strong.

Tremendous economic momentum, tremendous amounts of job openings, add a very low unemployment rate, a banking system that's quite well capitalized, all areas that tend to be weak links in recessionary environments that have pretty strong fundamentals, also, still a decent amount of that stimulus of a couple years ago that's been saved.

So when you look at the yield curve, the yield curve is suggesting an elevated risk of recession. Credit spreads, when you look at high-yield spreads, you know, up now in the high 500-, 600-type level, are suggesting elevated risk of recession, but also pointing to the type of economic slowdown that may not be catastrophic for certain segments of the credit opportunity set.

And I think one other, you know, really important point here which is making it challenging for policymakers is that there's a really good chance that the policy -- there are always policy lags, but there's a really good chance that this cycle, those lags are longer than they typically would be.

One of the reasons for that is that we had this remarkable period coming out of COVID where we had incredibly low interest rates, the ability for corporations and households to lock in fixed rate financing for very extended periods of time.

So, you know, Central Bank policy has always operated with a lag, but this time we have a situation, for example, with the U.S. homeowner where about half of the mortgages were refinanced during that post-COVID period at rates of around 3%.

Those mortgages are trading in the market today at 80 cents on the dollar. Home prices in real terms are up 20, 25% since COVID while the market value, if you're going to mark the market, the loan on those properties is down 20%.

So just an example of some of the structural resiliency in this market to Fed rate policy and why, although the economy is slowing, there's different signs of slowing, we likely will end up in an outright recession, albeit perhaps a mild one.

Those lags may be greater and, therefore, of course that poses challenges for market participants trying to understand whether it's enough policy or even too much policy at this point in time.

LESLIE PICKER: That's a great point. How long are you thinking with regard to this lag? And how does that compare with what is typical, you know, when you do see more hawkish policy and more tightening out there?

DAN IVASCYN: We just think that you're going to see continued economic momentum throughout year-end. Any type of material slowing will likely be a 2023 phenomenon, and the economy may surprise with -- over our resiliency in this market.

It doesn't mean that it's not going to weaken eventually, but that you could end up seeing some stickiness that could create again more volatility, more uncertainty.

LESLIE PICKER: Yeah. And you mentioned this that, you know, because it's more of a Fed-orchestrated slowdown of sorts, we're not seeing certain sectors experiencing particular distress. It's kind of the full tide is going up and down together.

Is that a good thing for bond selection? Is that a good thing for Delivering Alpha? Does it make it harder to really find ways to outperform in the current environment?

DAN IVASCYN: Well, I think since central banks have been very, very active in these markets, volatility of course has gone up tremendously. We're very, very confident in the market environment in terms of finding value, even getting long fixed-income assets.

So you've got a situation to date where not only have the more economically sensitive assets -- lower-rated high-yields, senior secured bank loans -- drop in price, you've always seen widening in high quality areas of the opportunity set as well.

Very high quality investment-grade risk is at spread levels that look attractive from an historical perspective, particularly adjusting for on the strength of these balance sheets.

Higher quality high-yield bonds have widened despite the fact that many of those companies used the post-COVID period to term out their debt at very, very attractive levels and shore up their balance sheet for many years to come in many instances.

Agency mortgage-backed securities that have a direct government guarantee are trading at almost a 2% yield premium to treasuries. So you look at a 4.25% front-end yield, you tack 2% on, now you're looking at a 6.25-type return in a default remote asset.

So we think that there's a tremendous amount of opportunity in markets today, given our economic outlook, given the extreme uncertainty we have. And we didn't talk about geopolitical uncertainty yet. We think it's premature to be too aggressive in the most economically sensitive areas of the opportunity set, namely lower-rated high-yield.

Senior secured bank loans, we are especially cautious about and may want to talk about that further. But seeing enough value in the higher quality segments of the market where we think, after the recent selloff in rates and widening of spreads, that there's a real good opportunity for investors to return to these markets.

LESLIE PICKER: And given the geopolitical situation, which we will get into further, are you investing more domestically as a result of that, or are you still pursuing opportunities outside the U.S.?

DAN IVASCYN: So we have a preference for U.S. assets, particularly credit assets. We continue to be underweight, as I mentioned. Exposure, you know, over in the U.K, over in Japan. Our views in emerging markets are more nuanced.

Any time you have an inflationary problem and central banks tightening aggressively, you need to be cautious particularly of some of the weaker segments of the emerging market opportunity set. But valuations look real interesting, both in equities and fixed-income assets.

Emerging market central banks were well ahead of developed market central banks in fighting or combating inflation. Brazil is an area that's worth noting. They were very, very aggressive from a policy perspective. Brazil understands the dangers of unanchored inflation expectations real well.

And you have a situation where in Brazil you've seen some very positive inflation prints the last few months. You have very, very high real interest rates, you have a quite consequential election coming up, but where there does look to be some interesting value in terms of the currency as well as the local rate market.

So we do think for higher-risk-type strategies there are going to be opportunities within the emerging markets. Same idea, given extreme macro and geopolitical uncertainty, we don't think it makes sense to be too aggressive in lower-rated risk, frontier market risk.

But in the higher-quality emerging markets, you know, we do see some value. We do have some positions. We've added a little bit to those positions on a selective basis as well. I haven't mentioned China yet. Not doing much there. People say it's uninvestable.

We wouldn't go that far. It's definitely challenging to invest in an economy, in a financial market that hasn't been tested from a restructuring perspective. If you're looking at credit markets, obviously China is going through some growth challenges there as well.

So we haven't been doing a lot in China more recently, but from a 5- or 10-year outlook perspective, the China economy is going to continue to grow at a strong level in absolute and relative terms. And the Asian area is an area that should be a focus of investors over the long term. But again, for the time being, relative to other areas of the opportunity set, we haven't been super, super involved.

LESLIE PICKER: Does the situation in Russia that we saw earlier this year give you pause in China?

DAN IVASCYN: It does. I think the situation in Russia was a reminder that with elevated geopolitical attentions in the world, you need to think about diversification differently. It's not just geographic industry.

You have to increasingly think about the politics and what sides are various countries on. So it's going to be a tail risk in China, other areas of the world where you don't have as strong of an alignment with the West around future sanctions-type activity.

I think they're all tail risks, but tail risks need to be accounted for in your fair evaluation analysis. So all else equal, we are a bit more skeptical investing within China today because of some of those tail concerns than we would have just a few years ago.

But that doesn't mean avoid; it just means attempt to size that risk in your analysis and be careful in terms of prudent diversification across portfolios, given that Russia shock is a good reminder of how politics can certainly matter.

LESLIE PICKER: And how quickly things can turn.

DAN IVASCYN: And they can change quickly, for sure.

LESLIE PICKER: I want to ask you about the dollar, because when we spoke last week in preparation for today's conversation, you told me that the dollar looks expensive. It's now at about a two-decade high last time I looked, but you can't pull the trigger in any significant size to sell at this point in time.

Of course, a lot has happened in the FX market since we spoke even a week ago. I am curious if you're starting to get more comfortable around the idea of selling, or what really puts you over the edge in terms of the ability to pull that trigger?

DAN IVASCYN: Yeah, so we've been, you know, a little bit underweight, the dollar, in certain strategies. Within some of the commodity exporting EM countries, it's performed surprisingly well this year. It's been quite painful, you know, within the developed market opportunity set.

This is one of those themes, and we've talked about it for a few years, I know there's other market participants that talk about their best trade that they're not ready to put on yet will be at some point going short the dollar. That's our general view.

The dollar screens quite expensive from a valuation perspective, even from a real carry perspective, there are other currencies that look interesting, but the dollar still remains a flight-to-quality-type asset.

This tremendous momentum in terms of dollar strength and what sounds good in theory is very, very hard to implement in size and practice, so we're holding off on major negative dollar expressions. It's in the toolkit, it's something that we're monitoring.

If you asked me to put on a trade and have me come back to this conference five years ago, maybe ten years ago, I would likely have more conviction in that dollar short, but you have to respect dollar strength and momentum.

So we're keeping our footings low at the moment, but it's a very, very interesting theme for a very long-term investor to at least begin that process of shifting towards the dollar underweight.

LESLIE PICKER: We spoke a little bit about the real estate market, given just that the -- you know, where mortgage-backed securities are trading and how people refinanced.

Do you think that's a good opportunity right now, given that it has shown some resilience in terms of pricing, regardless of interest rates? Or do you think eventually that will actually turn, given that lag that you described earlier?

DAN IVASCYN: Yeah, I should probably have mentioned housing. And then, you know, when we talked about credit earlier, I should be clear where we see weak links. Any type of economic slowdown, there are weaker links in the financial markets.

Our view on housing, I mentioned earlier, housing prices have gone up a lot, you know 20, 25% in real terms over the course of the last few years. Some of these increases were tied to shifts in COVID preferences towards certain real estate markets.

Home prices in real terms are going to come down. They very likely will come down on a nominal basis as well. They could come down fairly significantly under more negative economic scenarios. That, however, doesn't have to be catastrophic for mortgage credit assets.

It doesn't have to lead to major problems across households, because the credit quality within the mortgage finance space is the best it's been in several decades.

People have built up a tremendous amount of equity in their homes, there's been a big shift towards fixed-rate mortgages where many of these borrowers have locked in very, very low rates for the next 30 years, and there's been very, very little extension of affordability product or very credit-sensitive product in this marketplace.

So, you know, people that need to sell their homes will likely have to drop price, but we don't think housing is going to be the major driver of problems in this cycle. Therefore, mortgage-related assets, we think look quite interesting, especially if you begin to see significant weakening in prices on fears of some impending doom on the credit side.

So we like that space. We like the banks I talked about earlier as well. Back to that credit discussion where, you know, since the global financial crisis, it's been very hard for banks to take risk. They've been forced to hold a tremendous amount of capital relative to what they've held in the past.

Even under a pretty significant economic weakening cycle, you know, we think banks will hold up well from a capital perspective. Very interesting from a fixed income investment side to invest in either senior banks or even bank capital if you're looking for more risky in higher-yielding areas of the opportunity set.

LESLIE PICKER: And this is U.S. banks?

DAN IVASCYN: Well, global banks. But, you know, you've obviously got a little more risk over in Europe now, given, you know, more significant risks, economic risks tied to energy, tied to the situation in Ukraine.

Where we see the weak links, you know, this process, they're going to be in the senior secured bank loan space and in segments of the direct lending or the private credit space. I think it's important to note all of those investments, or the vast majority of those investments, are floating-rate investments.

Sometimes I hear what I think is a misconception that, well, it's good for investors because you don't have duration risk, your coupon goes up, you know, with Fed policy. Well, that's one way of looking at it. Another way of looking at it is that these are weaker, lower-rated, more levered entities where the company's going to have to come up with more debt service as the Fed increases rates.

So that transmission mechanism from the Fed to these companies is very, very direct. Not too dissimilar to what it used to look like when we had a lot of adjustable-rate mortgages in the United States in terms of Fed policy's impact on the households.

So if the Fed has to keep taking up rates, you're going to begin to see some strain across that segment of the corporate universe. That's where there's been more excess on the underwriting side and where there's the most fragility.

So I think that's the area where investors should expect more disappointment. It's going to happen on a lag basis. Some companies are, of course, are hedged to front-end rates, but our suspicion is that they're much less hedged than they probably should have been in retrospect.

So the bottom line is, housing is going to get a lot of the headlines over the course of the next few months. That was, of course, the problem during the GFC. It won't likely be the driver of most problems this time.

We think the problem is going to be in that segment of the nonfinancial credit space. Those risks have laid mostly dormant thus far but will likely be a negative theme for markets, you know, as we get into the 2023 period.

LESLIE PICKER: So keep an eye on private credit as the Fed raises interest rates. That's a good takeaway to conclude our conversation today. So wide-ranging. Thank you so much, Dan, for providing your perspective. Really appreciate it.

DAN IVASCYN: Thank you.

Jacob Wolinsky is the founder of ValueWalk.com, a popular value investing and hedge fund focused investment website. Jacob worked as an equity analyst first at a micro-cap focused private equity firm, followed by a stint at a smid cap focused research shop. Jacob lives with his wife and four kids in Passaic NJ. - Email: jacob(at)www.valuewalk.com - Twitter username: JacobWolinsky - Full Disclosure: I do not purchase any equities anymore to avoid even the appearance of a conflict of interest and because at times I may receive grey areas of insider information. I have a few existing holdings from years ago, but I have sold off most of the equities and now only purchase mutual funds and some ETFs. I also own a few grams of Gold and Silver
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