Pimco's Dan Ivascyn on the State of Markets Right Now

be volatile but definitely is in the new environment. And I'm thinking mostly about bonds well, and also, you know, the underlying macro situation is just extremely complicated and contested.

I mean, like there's a debate about whether, you know, the last two quarters considered are characterized as a recession, and there's kind of legit questions about that in you know, setting aside NBA vers two quarters, Like how should you call this environment in which consumer sentiment is really low, growth is down, employment is booming, inflation is still hot, consumption is still high. Like these are just like really difficult,

uh environments understanding part because it is kind of unprecedented. Yeah, and it seems like everyone kind of feels bad, and all the survey based economic measures suggest that sentiment is deteriorating, but at the same time, the hard numbers are really resilient, so actual spending and investment just keep going. And yeah, you're right, it's a really weird environment, particularly if you're

trying to put money to work. And then I would say, over the last two years, like everyone kind of got it wrong at every turn, right, Like everyone said, Okay, COVID hit in early. Here comes a big downturn and a recession, and it's like, actually, we had the shortest recession in history, and then stocks were at all time has a few months later, then you know, fast forward a little bit to people are super positive. Yeah, inflation was ticking up, but he's likely transitory. It's like reopening.

And everyone got that wrong, particularly a lot of investors, judging by the reprist how fast the repricing happened. The FED had to pivot pretty quickly when it realized inflation would persist for longer than expected. Pivot really started in November. So it's like, at no point has it felt like the consensus has been like had a good feel on this cycle. At no point has it felt like anyone really knows what's going on? Correct, is that what you're saying? Yeah? Okay.

On that note, we are going to be speaking with someone about all of these very very big topics. Really the perfect guest we're going to be speaking with Dan Ivson. He is, of course the group Chief Investment Officer and Managing Director over at pimco's Newport Beach. For those that don't know Pimco, I mean you must know Pimco. But PIMCO has something like two trillion dollars worth of assets under management, so making these tough decisions about out the

macro outlook and where to actually invest every day. So Dan, thank you so much for coming on all thoughts. Well, thank you Tracy and Joe. It's very excited to be here today. So you sit on Pimcoe's investment committee, I'm really curious what's top of mind for the people who have to do something with two trillion dollars worth of assets every day? You know, what are you guys talking about and what's what's um on the on the top of the agenda for you at the moment. Sure, well,

you know, inflation is is certainly a topic. As you mentioned this has been an incredibly challenging time from economic forecasting perspective, First the global pandemic, than an unprecedented amount of fiscal stimulus, and now an inflation problem that at least is partially related to those two prior points. So increasingly we're spending a lot of time talking about this inflation dynamic. Of course, um, how policy makers are going to you'll look to look to you know, get inflation

back towards their targets. And now increasingly markets are seeing what has you know, historically been um, a fairly obvious trade off, and that's you know, growth employment, uh, and this inflation problem and how will that be balanced over time? In addition to that, of course, we're not you know, operating in a normal environment. We have war in Europe, lots of uncertainty, and ongoing global tension between the United States,

you know, other Western countries in China. So there's just a lot of uncertainty, UM, a lot of risk, and we're trying to gain sufficiently broad perspectives to see where we may have an edge. And I think it's important in an environment as highly uncertain as this one to realize when you know, at a particular point in time, you don't have an edge and where um your entering markets that represent a lot of risk, a lot of volatility,

and I think there's a risk management piece here as well. Um, there's enough volatility where we should be able to zero in on areas where we do have an edge, where we can't add value while looking to shelter the portfolio from a lot of the unwanted volatility that we're seeing elsewhere in markets. Um So, So that's one key theme. The second, of course, is a lot of real time discussions around this volatility that we witnessed beneath the surface.

A lot of dispersion across equity markets, in fixed INCA markets, a lot of you know, localized overshooting. Given markets aren't super liquid, um, they don't feel distressed, but certainly a type of environment where there's you know, you using a baseball analogy, a lot of singles, um, you know to hit while you gotta be careful, you know, swinging for a home run given this radical uncertainty and the fact that you can get you know, caught off sides pretty

quickly in this type of market. So what do you talk a little bit more about, you know, you said identifying your own sources of edge, like what are they? You know, And I want to get to the actual market environment you're outlook for inflation and bonds and all that. But when you think about, like where sources of edge come from an environment like this, Like what's the answer to that? Well, I think think one lates to UM.

You know, markets that are are less liquid than they've been in the past, UM, and and opportunities to take advantage of some overshooting UM. Perhaps a good example is more recently over the last few weeks, or or maybe going back several weeks, where UM equities work quite weak. UM credit spreads were widening and widening fairly significantly, big upticks in the various volatility markets UM, you know volatility. Volatility market could be an agency mortgage, but it could

also be more technical you know volatility markets. And you know, we've seen even over the course of this summer, various UM levered players you know, other other you know, specially type styles get a bit over their skis for risk perspective and part of the stack back that we witnessed over the last several weeks and you know, pretty powerful recovery into what appeared to be you know, bad fundamental news is tied to you know a little bit of

this UM this this positioning that was a bit off sides. So you mentioned how unusual the economic environment has been, and I feel like this is the source of tensions or problems for a lot of investors at the moment. Like we're used to thinking about a normal economic cycle. You know, it starts and then at some point it stops. But it feels like what we've seen post pandemic is is not a normal economic cycle at all. How would you characterize it, Like, how are you thinking about it?

Is this late cycle? Is it early cycle? It seems very confusing at the moment, A cycle outside the cycle? Yeah, is it even a cycle? Who knows? Yeah? I think the multiple cycles or or at least significant cross currents UM.

I think when you look at cycles, I think it's important to make the distinction between a lot of the Western economies and what's going on in China right now, UM get to a lot of us UM COVID is mostly behind us, and where in the midst of a pretty significant COVID related reopening process, very strong demand for travel services shift away in in in many economies from UM COVID related goods consumption towards you know, a more normalized um. You know, focus on areas associated with a

more more traditional and open economy. Over in China now they're dealing with COVID. Other Asian countries are to a lesser degree, and they're in the midst of an environment, you know, where economic growth is slow and slowing uh, and inflation isn't a material problem. And then back to you know, even the US economy very very different or difficult to understand in the sense that we do have

significant momentum and a lot of sectors. Yet we're quickly beginning to see the impact of prior policy tightening on some carry key areas of the economy as well. So you know, the level of complexity is is there. But again, you know, when you have an inflation problem and you have policymakers looking at tighten policy, you're going to get into a situation where it's almost certain that you're gonna

see some economic weakness. And then of course the channel so then becomes, you know, how does this economic weakness impact inflation? UH? Is there a chance of a soft landing or do we have a situation where probabilities are growing and growing fairly rapidly, that we end up in a recessionary environment. Of course, those different scenarios have very different implications on what segments of the opportunities set are going to perform well, both an absolute and relative terms. Well,

let's just get right into that. And of course there's an econ debate. You have folks like Larry Summers and Olivia Blanchard saying like, look, it is, it is unrealistic. It's wishful thinking to say that we can really get inflation back down to any reasonable level without having a meaningful rise, a significant rise in the unemployment rate. Do you buy that or do you think? I mean, because I think this is the multi trillion dollar question right now.

Can the Fed get back to target without a painful recession? Yeah? So, I I think histories on their side. Uh, you don't see a lot of breads Summers and Blanched for sure, But there's certainly a chance that we that we um see what will feel like a somewhat soft landing. Now.

You know, here at PIMCO, we still think core CPI at the end of this year is gonna remain elevated up near that five and a half percent type range even out you know, towards the end of twenty three, and I take that forecast with it with a great assault, given extreme uncertainty, But we don't see inflation getting back below three and a half percent, you know, all the way out to three. So we do think that the likelihood is the FEDS going to need to tighten, and

tighten fairly significantly from here. But we do think there's at least a shot of a somewhat soft landing. We think, you know, officially, you know, we're gonna have a recession. It could be a prolonged but fairly mild recession. But but again, um, one of the bright spots, if if there is a bright spot here, is that you know, over the last few cycles, there appears to be a strong and increasingly strong relationship between the financial economy and

the real economy. And you've already seen in response to moderate tightening thus far, a pretty significant impact on financial conditions. Now they've loosened over the course of the last several weeks, but that transmission mechanism appears to be working and working fairly quickly. So again, we have an economy with very

strong momentum, particularly on the wage of the employment side. Uh, and a FED in other central banks that have tightened and it appears that they're having an impact on recent economic activity. Um. So there is a path that I would define as a moderate slowdown, in a slowdown that doesn't have a material impact on overall credit fundamentals and would probably put a twenty or thirty percent type probability

to that type of scenario. Again, UM, you know, anytime you have headline inflation up in the nine percent type range, unprecedented, UM, at least for you know, several decades in a lot of geopolitical risk, including war in Europe, which could deteriorate very very quickly. Uh, you have to position yourself, you know, for at least a meaningful probability of war, material economic slowdown and what that means. Of course, under that state of the world, you have a lot more widening to

go across most credit sectors. You probably have significant earnings UM deterioration from this point forward, which will likely lead to weakness and equity markets as well. So you know again, UM, you know, our general view is that we have a fairly mild but sustained recession. That's why we continue to be fairly cautious regarding the more credited sensitive sectors of the market. But again that's one of a handful of

credible scenarios. And and again you have to prepare for the worst as an investor, um and that means, you know, thinking about preserving capital given the radical uncertainty as much it does, you know, aggressively positioning to you know, generate total return, particularly in those riskier segments of the market. You know, Joe mentioned at the beginning of this conversation that a lot of people got it wrong on inflation.

And I'm not just talking about the FED, of course, um, which you know doubled down on the transitory idea a number of times. But I'm thinking also just of the broader market. You know, you look at break evens and those were continuously expecting inflation to peak within a few months, um and that hasn't really come to pass. What do you think people got wrong about the inflation outlook? What was it that the market seemed to miss? Yeah, I think a lot of participants, you know, we're looking at

an inflationary process and traditional sense. I think the pandemic itself was quite confusing, and of course had direct supply side impacts on the global economy. And UH, even more importantly, UM, the policy response on the fiscal side was massive, UM, and and and and massive, sufficiently massive that again, we haven't had a lot of good case studies in history and dealing what's with such a significant demand side boost at a time where you already had significant COVID related

supply constraints. So you know, it's an unprecedented situation. We talked earlier about you know, these cross currents, you know, impacting economies, making an even harder to forecast. And I think you know, in some sense, you know, we all or many of us were you know, using you know, prior frameworks at least initially to think about it into forecast this inflationary process. Now your points are you know,

a good one. UM. You know, even even you know market pricing UM didn't envision you know, this level of inflation or how sustained this inflation would be. But at the same time, when you look today at longer term measures of inflationary risk within markets, UH, they too are fairly complacent. And if markets proved to be right, UM, then in fact, UM, this inflationary event may prove to

be fairly temporary. So it is remarkable if you said, you know, inflation would be you know up at nine percent, people would be talking about a FED you know, well behind the curve and you would have a ten year break even inflation rate below two and a half percent. Or looking at a popular rate, we look at a forward rate, like a five year forward five year rate, uh, well below two and a half percent, or yield curve for that matter, today that is fairly flat um or

you know, slightly inverted at levels below three percent. So you know, in some sense, um, although policymakers and investors were late, uh, you wouldn't have made a tremendous amount of money through a significant bet on inflation unless you happen to be in some of those commodity markets, and particularly the commodity markets that have been impacted as much by the conflict in Ukraine as they were you know, tied to this inflationary trend that we've been discussing. So again,

markets still may be wrong. There's still plenty of uncertainty around this inflation dynamic on a go forward basis, but it is um, you know, quite interesting that um, although you know, people were late, markets are suggesting that perhaps things can be just fine um with with a bit more policy Titan. Yeah, some of these medium term break even measures or five year five year forward break evens never really got two out of hand and are kind

of a normal range. That Big said. The other phenomenon this year is I don't want to say the FED has been behind the curve per se, because that's a little bit of a cliche and I'm never even totally sure what it means. But I would say that it does seem as though at each meeting they're sort of expressing some hope or optimism that Okay, we think we're getting closer to air, we're uh in a neutral range,

we're not going to go as hard. And then some other data point comes out and it's like, whoop's time to increase, uh, time to go faster again. And so we got that seventy five. Maybe those hope was going to go down another seventy five. Uh Still we're sort of, you know, uh than police believes that policy is close

to neutral. Are we at a place where maybe the FED UH is in a comfortable spot, or do you think, as you said, you think there's going to still be significant tightening from here that once again the FED might have to go a little harder than it hopes in the short term, at least in order to constrain inflation. Yeah, you know, first of all, you know, policy bakers tend to you know, you know, they'll, they'll, they'll, they'll tend

to have an optimistic spin on things. But you know, certainly the price action of late suggests that what central banks have done so far are beginning to have an impact on economic growth. And um, it's not um a you know, a view that hard landings around the corner. Um credit spreads tightened over a hundred basis points, you know, using you know, using high yield as as a proxy. We've seen a significant you know, bouncing in equity valuations in the midst of moderate deterioration and a lot of

the forward economic indicators. So relative to where we were several weeks ago, the FET has to be reasonably pleased with the impact of their policy decisions thus far. And I think although Powell may have um, you know, slipped up a touch in suggesting, you know, with a high degree of confidence that we're we're implied degree of confidence that we're in your neutral right now, I think the key point was that, UM, we can begin to focus

a bit more on the data. UM, you have seen the beginning of some you know, material signs of economic slowing in a world with massive uncertainty of geopolitical variety or traditional economic variety. So I think they're they're they're they're comfortable in the sense that they've have gotten to a point where they seem to have calm markets over

the short term. This could change very very quickly. And when we look at you know, nine percent headline inflation rate, which is likely at least the near term peak, they have a lot of work to do UM, and we do think that they likely will need to tighten a bit more than what's currently embedded in the front end of yield curves. We don't think they were wildly far away.

We still have thought that you know, three and a half or four percent type funds rate combined with material balance sheet reduction will likely be enough UM to UM slow the economy and get inflation back towards their target. Another hundred and fifty basis points of tightening more or less is what you see that would be right, Yeah, one fifty, But you know, again, even under that base

case scenario. You know, we're not back to core CPI levels UM that you know, UM within most central bank target zones until you know, probably out into and there can be a lot of shocks of the interim, some that may be helpful, UM you take to getting inflation back down towards target, several events that may not be helpful. And again I think humility has got to be the key point here. But we think about inflation, when we think about inflations impact on the developed markets, UM, you

have to be a meteorologist as well. UM. You know you're going to go into a period UM in Europe in particular, temperatures get cold, with massive uncertainty around energy supplies and with Russia UM holding the cards at least for the time being. So there there are a lot of events that can derail UM the more positive scenarios

that we've described and have been embedded in market pricing. Again, one of the reasons when we add up all of these sources of uncertainty, we see, you know, the type of rally that we've gotten across financial markets over the last several weeks, and we're inclined, you know, to take a few chips off the table um get get get away, or reduce exposure to the economically sensitive areas of the market. Not because our base case view UM is so dire.

It's just that this extreme uncertainty is such um that that investors should just be careful in some of those more credit sensitive investments where you know, essentially there are forms of of of of a short volatility type trade, and given that extreme uncertainty, we just don't think, you know, you're getting paid enough just yet at these levels to be overly aggressive in the those more economically sensitive areas are higher yielding areas of the opportunity set. It's a generalization.

There's there's a certainly you know, things you can do, you know, on the margin, but that's our general thinking. You know, given where we are today, can you talk a little bit more about how you see the credit market at the moment, because I feel like, obviously, whenever there's concern about a recession, a lot of those worries are going to seep into corporate bonds um, which are

economically sensitive, as you mentioned. But then secondly, even before the pandemic, I think there was quite a lot of concern about froth in various portions of the credit market things being overvalued and potentially a liquid when the time came to sell. So how are you viewing that space at the moment? Where are their opportunities and what's most vulnerable? Sure, so, you know, just just at a very high level, and I think there's a lot, a lot of interesting things

going on, you know, within the credit markets. Um, you know, we were adding some credit um you know, back you know several weeks ago, when you know, how yal corporate bond spreads you know, had gotten out to the north of six hundred basis points. We thought they're you know, looking at historical analysis and and thinking about embedded our recession probabilities and those spreads the credit markets were, um, you know, forecasting a very high probability of at least

a moderate recession. After the rally. Now, over the course of the last several weeks, um spreads look less interesting to us. Uh, the embedded probability and in credit spreads currently of a more moderate recession is dropped, you know, down towards you know somewhere in that you know type areas. So a little bit less interesting today. But back in terms of thinking about the credit market and the structure

of the credit market. You know, a few thoughts here, UM One, Since the Global Financial Crisis, you've had massive regulation impacting the real estate areas of the credit markets, asset back markets, UM, the market. The financial sector, as we know, is heavily regulated today. UH not coincidentally, these are all the areas that caused all the problems during

the GFC. UH. Non financial corporate credit growth in terms of issuance has been significant, both public and private markets, and that's where you know, even you know, before COVID, we did see a meaningful deterioration in underwriting standards, more corporate leverage, more aggressive rating agency framework around UM, you know, putting their ratings on certain types of risk, far fewer covenants,

and when there were covenants, not particularly strong covenants. We also saw a significant build out our growth in the private markets, which are inherently lower quality lending markets. So this is where we think there's the weak link this time. If we were to get into a broad economic slowdown. UH. Public markets have repriced, and they've repriced quite significantly in certain sectors and segments of the market. Private credit markets, that always move a lot more slowly, have lagged and

lagged considerably. That dynamic is true within the real estate credit markets as well. If you look at what type of spread you can obtain for like risk in a public CMBs security versus you know where lending is going on currently in the private space. So I think point number one, um, it's the corporate credit sectors where there's the most excess. It's nowhere near the type of excess we saw uh in the mortgage credit markets leading up

to the global financial crisis. So don't want to set over the alarming, but this is probably the weakest link in the credit chain and where there will be some interesting opportunities for fresh balance sheets, fresh band dates to take advantage of what will likely be a moderate default

cycle over the course of the next few years. And then again, if you have you know, a public band date that's repriced quite significantly versus other private markets, it makes sense to take advantage of those opportunities because over time there's going to need to be convergence. It can

converge with public markets recovering. More likely it will converge by gradual deterioration in marks in a widening of spread levels in the private sector as well, and then the last point, I'll make all those areas I mentioned earlier that have been heavily regulated since the global financial crisis, we think present tremendous opportunity for investors. People still get nervous today about housing related risk. Banks continue to trade

in a very volatile fashion. Um. They are well capitalized, and the mortgage credit market is near pristine um in terms of you know, the borrower qualifications necessary to get a loan over you know, the last decade or so. So and those are some high level thoughts, um. And again consistent with the way we're positioned across portfolios. Of course, UM, you know there's a difference you know, and where when we're operating in mutual fund space versus your longer locked

up alternative vehicles. But those say general principles are the principles we're adhering to at this stage in the economic cycle. So my next question is completely out of self interest, but I I bought a house in in February of

this year. Did I top tick the market? And then secondly, secondly, you know, you mentioned taking on some housing exposure or real estate exposure, and I'm curious what the opportunity is there exactly because We have seen a lot of people worry about the fact that house prices shot up post pandemic, secondly the fact that mortgage rates have shot up. And then thirdly there's been some sort of market structure weirdness within the arena of mortgage backed securities um where things.

You know, for a while it looked like the market was sort of like creaking a little bit at the edges as rates went up very very quickly. So how are you balancing that? Can you just dig into housing a little bit more for us? Sure? So you may have top ticked the market if you set all the details to our Our mortgage team you know, will run some numbers and let you know just how much you're top ticked by. But that's a good actually offering that

service to that's a really nice service. Trace you gotta take them up of that. Ye tell me how wrong I was. Yeah, it is a little frightening how much mortgage data of a highly granular fashion is out there nowadays. But um but now in terms of housing, um so, so you know, we do think housing is going to slow and slow significantly. We think on a national basis, housing is likely to decline in real terms or inflation adjusted terms over the worse of the next few years.

Our base case view is that home prices UM stabilized near zero growth or you know, very very low single digit type growth rates, but it would not be surprising and it wouldn't necessarily have to be overly alarming if you saw, if you see home prices decline on a national basis now similar to the comments I earlier, you know, on on on the complicated you know, economic environment. Housing

markets are complicated as well. UM. As we know, there's been a massive shift in preferences since the COVID pandemic, desire to live further from the office. Certain vacation and resort communities UM have gone up in price quite significantly. In some areas there's more land scarcity than others. So they are gonna be pockets UM where you saw a big increase in demand, where they're gonna be outright price declines. UM. You're gonna hear over the course of the next several

months more headlines around price reductions, price declineings. UM. A lot of stories in that regard, And I think if you're underwriting a new pool of mortgages, particularly higher risk type investments, you have to be very very granular and very very careful in how you under write that risk. But from a macro perspective, there's still too few homes in this country and other Western nations relative to the number of households that have been formed over the last

several years. UM, So again that supplied demand dynamic is important. Rents remain elevated, so when you think about the buy to rent decision, although the cost to own a home has gone up, UM, rental rates are going up as well,

so that switch is less obvious. And then when you step back and look at price to incomes, priced to rents, the amount of borrower equity that exists, and again you have a tremendous about borrower equity today after um several years of significant home price growth, and I mentioned earlier a near pristine mortgage market. From a credit quality perspective, we just don't see a major risk of significant declines

in housing on a national level. UM. We do expect though, and you're already seeing this a rise in inventories, a reduction and housing related activity, which is the transmission mechanism or one of the transmission mechanisms that's going to help slow the economy and eventually bring inflation back down towards

towards more reasonable levels. The last, but not least, from an investment perspective, in housing related areas of the market, UM, those investments in many cases aren't tied to um what goes on in home prices from here because they've delivered so much. So the typical housing related investment you can buy today is backed by pools of mortgages that were

issued again ten or fifteen years ago. UH embedded loan of value ratios in those types of investments today have fallen from a dent back during the global financial crisis down to in most cases today, borrow with sixty points of equity and their property even you know, facing moderate declines in their current home price are not a big default risk. And even if they are, that's the type

of load where you anticipate a full recovery. So a lot of what we like in the market today is season type risk that benefits from the multi years of home price appreciation and therefor is much less sensitive to what goes on from this point forward. Let me go to the other side of things. I mean, just trying to think of your overall view, it seems like not

particularly pessimistic. Your outlook isn't particularly dire, but clearly risks abound and opportunities to derail or return to a soft landing, all kinds of risks out there. I'm curious, though, like what is your view right now on if and what role treasury should have in people's portfolio, because and I've

asked versions of this question too many people. It's like, for years it was just such a great trade to own a slug of tenure treasuries, and they went up in the principle appreciated in value, they were a great diversifier to risk assets. They usually went up when the stock market went down in the short term. And now those conditions are obviously changing to some extent. Sixty forty type portfolios got club that coupon that you're getting each

year is getting swallowed up big time by inflation. Is there a role for what is the role for treasury ownership? Yeah, that that's a great question. And uh, of course, you know what you're getting out is a correlation argument. Um, you know, are we gonna have are we are we

gonna get back? Can we get back? Then you'll uh to to a degree and I think you're you're you're witnessing this um now with the recent rally that we've seen in government bond markets, elevated geopolitical risk um, you know, both both in Europe and in the China cityation signs of deteriorating economy and elevated risks of recession, and now government bonds are beginning to rally, um, you know on

that type of news. Now, you know, we think you get better protection, you know, up when a ten year treasury is at three and a half percent versus you closer to two and a half percent. But we do still think high quality bonds at these higher yield levels will provide some insurance benefit now locally and by locally, I mean you know, during you know, small moves and markets. We don't think you know, you're gonna you know, we we we think correlation is going to be much lower

than they've been in the past. I think that's gonna be the case as long as inflation remains a key risk facing financial markets. But if inflation begins to trend lower towards central bank ranges, so again, exiting this this post COVID period of elevated inflation, we do think you can revert back to more traditional correlations and high quality bond can you know, provide stronger protections or stronger diversifying

benefits for UM a multi asset type portfolio. But for the time being, and by the time being, I mean the next several quarters, those correlation is going to be highly unstable. We think an extreme flight to quality situations signs of a major hard landing in in the global economy, signs of you know, UM deteriorating um UM, a deteriorating situation with the war in Europe, or heightened conflict you know with China as another example. We think those are

scenarios that likely lead to lower treasury yields. So the bottom line is we wouldn't give up on bonds here. I think investors just need to understand that UM, those traditional relationships that were fairly strong have weakened and there's just more in certainty, at least over the short term. In terms of these overall trading relationships. How are you

hedging volatility nowadays? And who is selling it? Because it feels like everyone wants vlatility protection And I can remember, you know, once upon a time, not so long ago, PIMCO is a big seller of fall protection. But I'm assuming you guys aren't doing much of that now. Well, we sell a little bit of we sell a little bit of volatility explicitly, Um, we didn't talk about agency mortgages. Um. You know, these these are are are are interesting investments.

They benefit from a direct government guarantee or a strong agency guarantee, which is always nice. You know, given heightened risk of a more material economic slowdown, and they've widen and spread a lot. Um they're not quite as cheap as they were in the first quarter of but they are quite attractive on an option adjusted spread basis relative to where they've been historically. So we have been adding back some agency mortgage backed securities. In an agency mortgage

backed security represents a form of a volatility sale. We've also on a targeted basis, have have have taken advantage of some volatility sales in the option markets. That's one of the areas I mentioned earlier where you know, a lot of the hedge funds other specialist managers have been caught offside given the significant moves and realize volatility, and there has been a few opportunities to provide liquidity UM and and and and take on some of that risk

at what we think are attractive levels. But the way that we're we're dealing with volatility uncertainty now is is really staying up in quality in terms of our investments.

And you know, I mentioned that we've been reluctant to aggressively add to the weaker areas of the credit markets where your short volatility from a more implicit perspective um so across a lot of our portfolios today, we've been taking advantage of the widening in areas of the market that represents spread risk, not material risk of permanent capital impairment. And I mentioned agency mortgages in that category. I mentioned

the non agency of the non government guaranteed mortgages. I mentioned the banks where we have high degree of conviction that although those spreads will remain volatile, most banks, particularly US banks a bit more isolated from the European uncertainty, are tremendously well capitalized and not taking um significant risks at the moment. And then there's a whole slew of other triple A and double A type risk high quality municipal bonds, other areas of the acid back sectors. We

have a lot of hard collateral and additional subordination. These are all areas that should be resilient in a period of heightened volatility and which in some cases of widening sympathy with these other markets that are much more sensitive the credit fundamentals. Where are the areas that you see are particularly sensitive to credit fundamentals that you want to avoid because you don't want to deal with actual impairment.

I mentioned the private markets, um, you know, and I again you need to differentiate there what we're referring to there would be more traditional direct lending mid market companies that tend to struggle in a recessionary environment, you know,

more so than larger cap names. The other issues within the private markets which have which have significantly lagged public markets or the senior secured bank loan market as an example, is that you have floating great debt, so borrowers within that space are seeing a direct impact from FED policy in the form of higher debt service costs. Now, some of those companies will hedge in the cap markets, but

typically it's a partial hedge. Several companies won't hedge, and it's not easy to tell which companies are hedging and which ones aren't. So you know, that's an area of the market that's going to be more sensitive to rate policy from here. In fact, we anticipate that if the FED had to tighten policy materially more than a terminal funds rate of three and a half percent, you know, you'll begin to see a decent amount of stress on

that segment of the market. If that higher rate policy coincides with EBA dot or earnings deterioration, you can even see, you know, more problems from a downgrade perspective in that segment of the market. So again, I don't want to sound, you know, overly alarmist here, but in terms of looking for weaker links in the marketplace, that's where we would focus, and that's where we're being most defensive right now in

terms of overall credit position. So I think you've outlined a pretty um sort of cautiously optimistic approach here, or maybe cautiously opportunistic where you're sort of selecting quality credits and things like that. What would make you feel comfortable about taking on either more credit or more interest rate risk in general? Like, is there a particular thing if you saw that happen in economic data point or something in the market where you would just jump right in. Yea.

So so you know from where we top down perspective better valuations as a start, you know, you know, stating stating the obvious, Um, you know, if we got up to a point where you saw some of these riskier segments of the market embed a much higher probability of an outright recession, you know we would we would get more comfortable. Now you know that that's likely up at levels you know, you know, around seven d basis points.

You know, you know, within the high yield space. Now again, you think about high yield in a full blown recession and you can get to a thousand basis point type spreads quite easily. But as as you approach that level um and you embed you know, you know, more risk

of harder landings. You know, we would begin to add to that space a bit more aggressively in terms of the fundamental picture, um, you know, really focusing on this inflation every process we think headline is is hard to forecast and is I'm certainly going to come down based on what we're seeing commodity prices today, but other areas represented in course cp I are going to bear watching as well. One is housing or owner's equivalent rent, it's

been quite elevated. Another is wages that have been running, you know, at levels that are that are making central banks uncomfortable. Even related to labor, focus on the labor for and seeing you know, what percent of the labor force returns to the market, providing some cushion and increasing the probabilities that the FED can bring job openings lower without a meaningful hit to unemployment. So it's it's really the details embedded in a lot of these higher frequency

economic indicators that we're monitoring more closely. Of course, on on the geopolitical side, any type of sign of UM a stalemate or an improvement UM in the relationship between Russia and Europe, the situation on the ground in Ukraine, it would take a considerable risk off the table as well. So I just a lot of focus on the higher

frequency type numbers. But again, even if we don't get resolution there, we are going to respond to, you know, better valuations, you know, like we did a did a bit you know, several weeks ago, you know, at at higher yields and materially wider spreads all right down, We're going to have to leave it there. Thank you so much for coming on Odd Lots. Really great to have

you on the show. And I'll be sending over my my mortgage data to your department so you can tell me exactly how bad my timing was on on real estate purchases. Well, yeah, well we'll do that. They have some pretty pictures too, yeah, they they look real good.

So Joe, I've really enjoyed that conversation. There were, I mean a number of things that stick out, um number one to call on real estate, but secondly, when he was talking about floating rate loans and the idea of some of those companies who had borrowed money in floating rate increments like actually becoming a credit risk as interest

rates go up. That's interesting to me because you'll remember that floating rate loans were supposed to be the big hedge for higher interest rates, right, Like, those were the things you were supposed to buy if inflation was going to go up and rates were going to go up. And now it's like, well they've gone up too much

and it might actually be a risk. Right, So if you're an owner of those notes, yes you get higher monthly coupons, which is nice in a period of higher inflation, but the cohort of companies that may have issued that the company might go bankrupt are not necessarily the more the most credit worthy ones, which raises the risk that if we actually get like a real recession, that your inflation hedge suddenly you start to worry about loss of loss of principle exactly, you know, just in general, I

thought it was interesting, sort of and basically to the point that you just made. You know, we we tend to think very broadly about like rate and credit, but it was interesting hearing him, you know, sort of speaking from the perspective of a of a fixed income investor. That's like, you know, credit is just way too broad

a category, and so you mentioned floating rate it. But also some of his point about like highly seasoned reads was interesting, this idea that, again, how do you avoid credit risk, How do you get some of the how do you get some of the upside but avoid the credit risk and a downturn. Well, one answer might be reads in which the owners are the payers of those mortgages have built up significant equities such that you're not

likely to experience significant defaults. These are all just sort of things that are like a little more in depth and insightful than sort of a typical like headline credit conversation. Yeah, I totally agree, And it sounds like PIMCO. I mean, you would assume PIMCO would be very good at doing this, but it sounds like PIMCO is sort of they're not They're cautious in the market, they're not adding a ton of risk, but they are sort of tweaking their portfolio

for the uncertainties that we just discussed well. And I think also, you know, it's is a this is an environment with lots of lots of I don't know, land mines out there, so to speak, in which you know it would be easy to or you know, stepping on a rake right and hitting your face, And so this idea that like you can be sort of optimistic. You think maybe the FED it's possible that it's turned the corner or getting ready to make a pivot, that maybe

we're going to soon see lower CPI readings. We'll have some confidence that the line is going down. But there's just so many little things that could go wrong. There's politics, there's geopolitics, Uh, there's the virus. There's other aspects of the supply chain that like it all sort of keeps you guessing. Actually recording these interns and outros kind of makes me nervous nowadays, because there's so much that could happen between the time that we record and when we release. Yeah,

all right, shall we leave it there? Let's leave it there alright. This has been another episode of the All Thoughts podcast. I'm Tracy Allowhite. You can follow me on Twitter at Tracy Allowhite and I'm Joey Isn't All. You can follow me on Twitter at the Stalwart, follow our producer Kerman Rodriguez at Carmen Armand, and check out all of our podcasts Bloomberg under the handle at podcasts. Thanks for listening