by Dan J. Ivascyn, PIMCO
- The global economy remains in a multiyear period of global deleveraging; it will be an uncertain and, at times, volatile process.
- The substantial uncertainty and volatility affecting interrelationships across different markets are providing relative-value opportunities.
- Alternative strategies can be enticing, but the decision to use them needs to be fully informed and weighed against all the options.
Market volatility can be unsettling, but it can also signal opportunity. So is there more volatility – and opportunity – ahead?
In the following interview, portfolio manager Dan Ivascyn assesses global financial markets and discusses alternative approaches to seeking compelling returns.
Q: How have financial markets evolved since the financial crisis of 2008 – where are the strengths and weaknesses?
Ivascyn: Economic and financial conditions have improved since 2008, especially in the corporate sector, but the global economy remains in a multiyear period of global deleveraging. The nature of the problem has shifted from subprime loans and excess consumer credit in the U.S. to sovereign debt in Europe, but it is still the same general illness of too much leverage. In the U.S., for example, we have seen leverage shift from private to public balance sheets.
To be sure, central banks have injected considerable liquidity into the global financial system, but that does not mean that it always ends up in the places where it is most needed. Also, the critical issue has shifted from liquidity to solvency. There are concerns about the viability of the euro and of the financial apparatus in peripheral Europe, and there have been some outflows from banks in Greece and Spain. Although we assign a relatively low probability to a major bank run that causes a global financial shock, it remains a possibility and shows that the global financial system is not quite out of the woods yet.
Elsewhere, and as noted by my colleagues, significant new regulations are scheduled for enactment over the next few years, and as financial managers adjust we are likely to see more market volatility.
Q: Presumably these and other events are producing relative-value opportunities, too. Would you give us some insights into where those opportunities may be, both asset classes and geographically?
Ivascyn: All the things we have discussed – volatility, regulation, liquidity, solvency – are leading to what we believe is a tremendous amount of opportunities for alternative or unconstrained strategies. It is perhaps the most “target-rich” environment I have seen in the 20-plus years I have been involved with markets.
In the more liquid macro-orientated space, for example, there are a variety of financial instruments that can be used to express views on how the environment may change. Whether it is government yield curves, financial-sector debt instruments or something else, in our view, the substantial uncertainty and volatility affecting interrelationships across these different markets are providing relative-value opportunities.
One reason for this is that proprietary trading desks across Wall Street, London and other locations appear to have significantly reduced their activities and may be forced to reduce their activities further in response to regulation, including the Volcker rule. By our estimation, we are seeing material mispricings remain in the marketplace much longer than they have in the past because of a lack of capital coming in and arbitraging away the opportunities.
Also, think about deep credit strategies and the substantial complexities associated with deleveraging. Many assets originated in 2006 or 2007 that were once seen as very reliable instruments have been severely impacted by the weakness in economies, financial markets and housing since 2008. And many financial institutions still have too much risk on their balance sheets, some of which they will likely have to sell at attractive prices. These are fairly complex, illiquid instruments. But if you have the expertise and depth of resources to do the analysis as well as a longer investment horizon, they can provide interesting relative-value and directional opportunities, potentially offering very attractive yields in an environment where interest rates are very low.
Q: Expand on that: What are the attributes an investor needs to be able to identify to potentially capture these opportunities in this environment?
Ivascyn: Nowadays, even the most bottom-up credit decisions have a macro element. For example, it is not enough to understand a company in a particular jurisdiction. It is increasingly important to understand the health of that local economy and any uncertainty about the fiscal situation of that country. Amid all the global uncertainty discussed earlier, we believe informed macro insights are critical to investing.
Also, the multiyear global deleveraging process will at times be very unpredictable. Balance sheets need to be reduced, but it can be difficult to predict the form of risk that will be transferred or the jurisdiction where the transfer will occur. We see tremendous benefit to having a deep global platform that allows investors to look at opportunities across markets, geographic regions and capital structures, as well as be highly responsive and tactical.
Similarly, it can be advantageous to have the resources to look at increasingly complex investment opportunities, such as mortgage-related instruments where you are modeling at the loan level, and at the zip code level. The modeling and dealing with operational and other issues require several types of expertise, but putting those experts together can add value to investment activities.
Finally, in the more illiquid strategies, sourcing is important. In many ways this is a relationship business, and we believe it is essential to leverage multiyear relationships with financial institutions and others in these markets.
Q: How can investors deploy alternative strategies in their portfolios?
Ivascyn: Alternative strategies can be enticing, but the decision to use them needs to be fully informed and weighed against all the options. In our view, investors should do careful cost-benefit analyses when considering such approaches and check to see whether they are getting access to a risk-return profile that is both additive and diversifying to the portfolio. Of course, how much investors should allocate to such strategies is a function of their overall risk tolerances and return targets.
As mentioned earlier, some strategies are more liquid, while others sacrifice some element of liquidity in order to target segments of the market that are attractive because of global deleveraging. These strategies range from those designed to take advantage of macro uncertainty or institutional and regulatory frictions, to strategies that provide access to very unique assets that are part of this deleveraging process. We believe these are the alternative strategies that are best positioned to potentially generate attractive risk-adjusted returns during the remainder of this secular period.
A final note of caution is that although there is tremendous deleveraging pressure and there will likely continue to be opportunities in credit-related segments of the marketplace, certain sectors or geographical regions can get crowded. At times, too much capital is chasing too few opportunities. In our view, an example was FDIC bank dispositions during some of the 2009-2010 period. And that could happen with Europe, as it is popular to raise alternative assets to target European opportunities.
At PIMCO, we are highly confident in our secular view that the deleveraging process is going to continue. We are also confident that this is going to be an uncertain and, at times, volatile process. But the specific nature of opportunities could shift in unpredictable ways, and we believe investors should consider broad, flexible mandates with managers having deep global resources and capabilities.
Past performance is not a guarantee or a reliable indicator of future results. All investments carry risk and may lose value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
