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

Please stay tuned after the conclusion of the podcast for additional important information. Hey everybody, welcome to another episode of a crude interest. PIMCO's podcast dedicated to serving financial advisors and their clients. Really excited to bring to you today a discussion with Dan Iveson, 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. It's a weird, Greg. A lot going on. Yeah, how are you enjoying the city this week? Got a lot going on. It's all right. It's all right. Yeah. It's our personal interest in sports go. Not exactly what I'd hoped for. Should we get this out of the way before we move on with it? Dan is a lifelong, lifelong Celtics fan. Lifelong. Absolutely. We've talked about. Yeah. Okay. And so this is a tough week for you to be in New York City. It's a tough week. All right. And it's getting even more challenging. Yes. It was looking better until the last seven seconds of the game last night. Correct. I went to bed right at the beginning of the fourth quarter. So it was it is traumatic as it could have been. But yeah, at least it's good fun. It's good fun. I know there are a lot of advisors from New York. So I don't want to be. We should probably move on to the content. I think I think advisors from New York appreciate your 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 in the last day or so. And this for for people listening, we've talked about this in the past. But this is something we published 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 going to 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 you know, the forum process and what the debates were this time around and where you guys ended up kind of concluding your your your key takeaways. 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 90s. 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. Mark and Ziggins Ag along the way. But if you can get some of those long-term themes right, you end up with good good outcomes for clients. And you know, I think Bill Gross originally came up with this idea back in the early 80s. Today now with X and Instagram and probably, you know, information sources I'm not even aware of. The younger generation focuses on it's not stop. Information hits the market constantly. And you know, the noise can create a little confusion or lead to you just just just getting bounced around in terms of, you know, 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, you know, understandably now with war, you know, in Iran, across the least as well. This is turning to 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 it's moving markets quite considerably this week. No exception. Today, right? I mean, we're recording this sorry on June 11th for folks following along. 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 is some degree too over the long run. But, you know, we do think that there's lots of competing forces at work. A big theme of our secular research piece this year is this idea that there's going to 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 in 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 come by in 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 cheers 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 is strong, it usually leads to good outcomes for politicians. There was 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 populist 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 going to be a lot more uncertainty. A lot more surprises from a non-traditional economic or financial analysis perspective. And it's going to require a slightly different or even a significantly different playbook in order to drive attractive returns on a go-forward basis. So what did you mean when you said in the earlier part of the year, we were trading more on longer term themes? I obviously understand that the Iran conflict is kind of telescope. It's forced everybody to focus on 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? Yes, so you, again, you never know for sure what's moving, Mark. Right. We talk about a lot. And perhaps we oversimplify things. 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 were doing quite well while bonds were rallying. 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 just wasn't just about worker displacement. It was about creating disruption down at the corporate level. This is where issues began to come in around private credit. The idea of that, wait a minute, the more efficient and the more productive AI is, the more it's going to go after old economy business models. And if you have an old economy business model, you're back. to adapt or be disrupted. When you have a lot of debt already, there's a limit 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 is going to disrupt many businesses. It 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 can 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. Yeah. 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. Yeah, so we had a window and it's proven to be elusive, which I think just supports your contention that we're going to see more surprises. We had a window where fundamentals mattered a lot in the short term. And the macro environment we felt, you know, 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. Yeah, that's great, great summary. So one of the things that 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, you know, I've seen you ask the question, where's the tenure going to be in 12 months and I've seen you refused to answer that question many, many times. What I like about our processes will profit a base case and then we talk about tales. 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 tales. Can you just talk about kind of the distribution of risks in this environment? Yeah, and the idea here is that, you know, given the environment I describe, a lot more uncertainty in both directions, fatter tales, a wider distribution of outcomes. So you add to your bell curve and you squash it down, so yeah, higher, 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, well, when we do the fancy stuff from a portfolio and allocation perspective, or backward looking, I think the challenge, of course, is if the tales are fatter, if there's a higher probability of more extreme outcomes going forward, the backward looking models are going to 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 going to respond if, you know, GDP is, you know, 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, you know, when we're doing, you know, discounted cash flow analysis. I think it's being prepared for those types of outcomes. But your first point, it's funny, you ask me about the tenure, I chuckle. That's why I'm seeing it be a little less than some. It's more fun and directed, just say, "How the tenure is going to be at this number at year end." If I'm honest, and if we're honest, and I think most people are honest, the right answer is we're really not sure. We don't know, but the second and more important point is you don't need to know to generate attractive active returns or returns relative 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, you know, some other macro-oriented firms, given just how much volatility there's been in rates, shifts in sentiment towards what central banks were going to 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 regulators tell you 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 them by treasuries or having them by 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, you know, alpha-generating foundation that PIMCO was built on in which we try to encourage today. And that's, and today it's a very capital type environment for that type of investing. 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 the desire to be more heroic and make a huge duration call. And I think I've heard you even say that 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. Yeah, I think that's right. Or over a 10-year period, maybe once or twice you get the big trade opportunity. My old colleague Scott Simon used to tell me, you know, tell all of us, you know, he used to run mortgages a year ago. I think he hit his 13th year retired from PIMCO the other day. He sent me a postcard from a place he's vacation to get, but he used to say, "You're probably pretty happy, guy." Happy guy, happy guy. Yeah, we knew Scott he viewed you retired well, but, you know, his point was just, you got to take what the market gives you, right? And 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 going to be a lot more volatility. There's going to 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 additional incremental return to that very, very attractive starting yield within a portfolio. 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, we know that times when we get some things wrong. But of course, 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 6 to 7 percent 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 want to give up some liquidity, within the investment grade space on a targeted basis, you can increase that yield as well. That yields great, at least historically, in an absolute sense. It's really good, even if inflation stays at an elevated level or inflation goes higher. You're still making real returns even within inflation. Absolutely. Three kind of neighborhood. That's correct. And then last but at least quite attractive versus equities. Under most, raise the bowl 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 all on the fixed income. 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 at starting high quality barn yields 1%. So in some sense, it took the horrible environment. We all went through during 2022 in 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. Yeah. The yield really helps you. 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. Yeah. And then the simple bar math too. When you had a little bit of duration, the math and the call, but when you start with a 1% 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 for 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, you know, your return will move around with, you know, what rates do. But that break even math, the simple break even math is very, very favorable. So, you know, again, you could have interest rates 100 basis points higher and still end up with a positive return given starting yields across most bond strategies. It's a great point and it's something that I think hopefully advisors can use with their clients, right? You know, 50 basis point back up in rates or 100 basis point back up 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 that's a really important point. I was I was hoping, because you started to talk about, you know, 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 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 of like what do you think is the base case? And then when we debate and form or when you guys get together and I see 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 and develop market growth or US growth, whichever kind of growth proxy you want to think about, but but what do you think is the base case there? And then where could it go really wrong or or or better than the markets actually expecting? Yeah, so yeah, the situation looks better. You know, the fact that we've, you know, haven't adhered to a full cease fire, but it seems like both sides wanted to escalate from a military perspective. So we'll have to where we were a few weeks ago. We think the the chance of more extreme outcomes is less likely. With that said, you know, our base case or at least modal view the path that's that's most likely to happen will be this idea of gradual deescalation. 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, you know, where we had been. No magic number, but, you know, think about oil somewhere in the $80 barrels 75, you know, a barrel type level. There's a chance, though, of a more protracted situation where we don't get the straight open where there is just ongoing conflict. And that's going to lead to higher energy prices. You could certainly get up into the mid 150s, even in a more extreme scenario. No, it's interesting there is that when you think about those types of periods, yes, it will lead to higher energy prices, but what's typically happened 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. In 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 because you'd begin to see the prices of things that people are buying less end up moderating. Sort of breaks consumption. And does that put us in recession risk? And that's what I was going to get at. 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 giving credit spreads are near all time tights, at least 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. It is. It's constantly befutaling 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 credit spreads maintain tights and equities hit new highs every day. There's more supply coming online. We can talk about this in a minute, but it that it was just in terms of cognitive dissonance. I find that just a strange dynamic going on today. I think it is. And I think I'm sure we'll talk a little bit more of 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 going to impact middle income and certainly lower income cohort groups more. Sure, it's aggressive. Yeah, it absolutely is. That's a shame, of course, but it will flow through to the macro numbers into 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. That's why we've talked a lot about this idea of global diversification. You don't have to own other countries' currencies. You can buy high-quality bonds at a higher yield than what you can 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, we're looking 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. 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. Let me get to the positive. If there's a right tale, but I just, on that last one, I just want to make sure that I understand it and maybe by trying to articulate it, some of the advisors, hopefully listening, this will help crystalize it for them too, but it's not your point being that oil shock bad for us and when we have this offsetting spur to the, sorry, I said spur that Freudian slip, but we have this offsetting jolt to the economy from AI, but other countries where they're very, very dependent on external energy sources so they could have an even 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 investment thesis to domain where it's going to work and sprinkling that into portfolios. Yeah, I agree. And the way I sometimes describe it is, you know, bond markets like low growth, bond markets usually like recessions, at least high quality bond markets. And you know, if you end up having a shock like a war and that leads to lower growth somewhere in the world where you're already have a starting yield that's quite attractive. That's usually a good, good environment. In some sense, the US market now because of all of the great technological innovation, the hardest, the hardest lower economy down, which is of course, it's 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, you know, as the situation evolves, you know, we can target different high quality investments to help generate return above and beyond the already attractive yield. All right. Well, let's let's talk about the right toe. What could go better with Iran? And then we'll move on to another topic. - Yeah, I'll be real quick there. Look, 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. There's election coming up and you look at 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. - Even today. - 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 dubbishly inclined. In a state of time and time again, he'd like to do that. War's too has talked about this idea that given, that 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 get back to a mindset towards this longer term, cost reduction associated with AI efficiency. And more importantly, you get a central bank that's back from being on hold to potentially cutting interest rates. And that is 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, - Yeah, sure. - In certain about this environment and you move from bonds back into cash or you're in cash waiting for something to happen, under that type of scenario, that current cash yield starts going lower. You don't get to lock in that cash yield. The way you lock in a 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 a 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 talk about at our secular. - We talked about it 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 in the tails, framework, how do you think about just the long term, kind of creditworthiness of the US? - Yeah, I'll be quicker there. Look at where 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 we all call it, 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, any use to follow up, I say, we sure give it a go to try to really use that advantage that we have. But more importantly, 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. - Yeah. - Because with a 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 out of 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 '90s, 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 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 that it's disposal to address it. But again, not many people are talking about it. And we think that the concern will be that these debt levels continue to build. Yeah, last point I'll make, which we're talking about. The solutions and the tough choices that we need to make in order to kind of, I got you. 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 want to suddenly complacent, you can diversify into countries that have a much better fiscal picture. Australia as an example, 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 in 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 aware of the mindset that, yeah, the higher deficit levels have caused U.S. rates to go higher, it's one of the reasons why we can lend to the U.S. 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 exit one basket, so to speak. Just in case fiscal becomes a bigger concern globally, let's owe it a little bit of this country that has a much better fiscal picture. And you extend that to all 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 passable 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 and this environment of greater uncertainty. - Lots of countries out there to lend to. And we always, obviously, as U.S. investors, we have a home bias. And then I think 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 monolithic and it just rates and just rates in the U.S., or 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, we're having, we don't talk about as often, but have been talking a lot about recently. But the capex super cycle, 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 countries 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're 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? - Yeah, well, to start with the technology itself, it feels like this is different. But sometimes, it 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, I think it's going to be exciting. - 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 CAPX piece. It's massive. And it's having a incredibly positive [BLANK_AUDIO] 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. We've got with K-shape's, usually it's, you know, upper income versus lower income, but you can extend it to countries. Countries that have this, 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, we're tight by the credit spreads are still quite tight in the 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 could look at a lot of things. You don't have to do very many of them. You could pick the assets that you like and you could get very attractive spreads versus other areas of the market. And you can do so when underwritten properly with very attractive terms or documentation that protects you as an investor. And we've talked for years about covenant light or low dock or the inability of companies to not even have to respect the fact that you're senior in a capital structure because they can gain the docs. 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. Right. And we saw that with the internet. Yeah. And 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 merchant model. It won't get too technical in terms of how you price risk. And the simple point is that extreme uncertainty and volatility is really good for equities, because it means that there are scenarios where your asset will go up a lot. And then there are scenarios where they'll go down a lot. So if you buy 10 AI companies, equity, it can go out of business and two can go to the moon and you end up making a ton of money. And 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 got to 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 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. They don't only play the lottery, start pulling money together with our co-workers 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 going to necessarily maximize their expected return or put more simplistically. They know they're going to 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 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 U.S. 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 bus 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, you know, ten times higher than the original price, it can go down that quickly as well. So that's going to be a risk associated with this environment of rapid and uncertain technological change. It's going to 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. Yeah. And I really like your point. I mean, as fixing 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 clawed and coding. And it's super exciting. It doesn't mean that we can make more than par plus interest in lending to some of these projects or these businesses. I think that's right. I think in an environment like that where 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. There's 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 have 10, 15, 20, 25, 30, 35, 40 percent software concentration. But we think that resulted in this mindset that this is where people want to borrow money, money's coming in. We're lending to those types of companies. And I think that in this environment, concentrated risks, two 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 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 anyone thing. I think in retrospect, what happened in the last few years in this very, very bullish environment for credit, concentrations 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. 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 that we think that the credit default cycle has begun, which you're alluding to software issues and 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. Yeah, no, it's good. People are very focused on credit. Even some of the media uptick was a little bit more dramatic. Then we'd like a PIMCO expects a wave of losses. And I said earlier today, not a wave, 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 steady stream of losses. you know what? 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 advertising that risk. 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 Warren Iran, these state stack flationary 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. It's been a good period of even moderate credit losses. What we're describing is an environment that looks a lot like the '80s, '90s, 2000s. 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 have a big spike. Other times you'd have periods where it would happen within one sector or a segment of the market, the economy would be weasably strong. But the reality is that you 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'd 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 are just 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, well 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 out of the little 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. - Another, I'm sorry, go ahead. - No, that's it. That was because of course, if you were to have a negative economic shock, then you could take a steady stream of credit losses and you can get into much more. - But that way is that they were talking about. - The way that they were talking about. - Yeah, yeah. 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, I know 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 it's 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. - Yeah, I know this is what 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. In 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, and 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 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 going to date myself here too, myself and a few of my colleagues, you begin in these markets in the mid 1990s. In the mid 1990s was really the first wave of innovation within the asset back markets. The David Bowie music receivables. Remember that? Wait, wait, wait, wait back when securitizing other more esoteric forms of collateral, airplanes, heavy equipment, shipping receivables. Sure. It got really popular in the mid 90s. There was this wave of financial engineering. Very, very low quality mortgages, first go around. Second lean lending, up to 125 to 80. 20, yeah, that's where I remember these things. 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 market. It's entering that bubble and, you know, NRAWN and the telecoms. And then in the mid 2000s, 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, you know, different fund investments, multiple fund investments into structures and getting more investment grade risk. So you could literally look at the situation where you took high risk load, dropped into a series of structures, funds, pulled it together, and ended up turning this very aggressive loan into like 97% AAA or high investment rate at the beginning. So the math broke down given-- That's a bad asset quality. Structured into something that's labeled AAA. That's right. We became almost impossible to figure out with all sorts of liquidity mismatches and so on. We're not anywhere near that point. It feels to me like, 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, when we started this, the 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 want to say addicted-- but there's an element of that, right? And then 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. 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 a little bit of world very much regulated based on ratings. So 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 we 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 pull and create something investment grade off it. It doesn't mean you want to 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 and checked 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 regular-crisis 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 them kitchen sinks. Not just risky instruments turn into investment grade things, but risky instruments turn into investment grade things that are then 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 it bears watching. And I think the key point is that just because a radio agency says something's investment grade doesn't mean it does. Especially if it's only one radio 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 want to set 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 to give in rating. If you have a flexible bond strategy within the opportunistic space, private space, or public space, you're explicitly need the rating. And 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 going to drive a lot of relative value. And again, active returns are going on going 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 harkens back to what I saw personally in the mid '90s, which we saw in the mid 2000s period. But it's early going. And I just, it's worthy of comment in it bears watching. It's really the only point we try to make. - 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 sizable books, it's very common you've got advisors in their 50s and 60s. But 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 meteor 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, we're interested, wanna go deeper. We would very much encourage you to visit us at pymco.com in the US or your website in any other country that you happen to be listening to this too. If you identify yourself as a financial advisor, you will be taken to advisor forum. That's our one-stop shop for you to get what you need from pymco 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 this 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 to beechless and for those of you who are in the Northeast and join the nice weather. Thanks so much. (upbeat music) The discussion and content provided within this podcast is intended for informational purposes only and may not be appropriate for all investors. 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