Have Governments done enough to prevent a global recession?

Brian Leach - Senior Vice President, Credit Strategy at PIMCO.

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In this episode, Brian Leach, Credit Strategist at PIMCO joins us to discuss the impact of fiscal and monetary measures issued by Governments and central banks and whether enough has been done to avoid a deep global recession. Brian also shares his views on the current performance of the fixed income markets, and what investors can do to positions their portfolios going forward.


Paul O'Connor (POC): Welcome to the The Netwealth Portfolio Construction Podcast series. My name is Paul O'Connor and I'm the head of investment management and research. The investment management and research team manages the investments we make available to you through our super and non-superannuation investment platforms, and also manage the funds and managed accounts that we issue with the responsible entity. Spend a lot of time interacting with the fund managers.

The due diligence that we undertake on funds provides a lot of insights into the differing views on the global economy, financial markets, and investment strategies offered by the managers. Today, we have Brian Leach from Pacific Investment Management Company, or Pimco, who is a fixed interest strategist with a focus on credit and is based in Newport Beach, California.

Good morning, Brian.

Brian Leach: (BL): Good morning.

POC: Pimco are a specialist active bond and credit manager who incorporate a view on the global and domestic economies to understand the impact on fixed interest markets. I think it really well plays to discuss the economic impact of COVID-19 on economies and markets. Pimco have numerous active managed funds available on the Netwealth superannuation and IDPS investment platforms, covering Australian fixed interest, global fixed interest, and alternative strategies.

As Pimco, one of the largest fixed income managers globally, many Australians have an exposure to their strategies. We will be interested in discussing the huge global monetary and fiscal response to COVID-19 and the ultimate impact on long-term bond rates.

Allocating to credit is certainly an interesting topic at the moment. As on one hand, bond rates have fallen to record lows, but the Australian and newest 10-year bond rates sub 1%, which has resulted in a very subdued outlook from traditional bond portfolios and certainly made credit more attractive and the higher yield that is available in credit. However, given the economic slowdown, should we be holding credit exposures in our portfolios?

To start with, Brian, how are you and Pimco... How have you guys adjusted to working from home, and are you back in the office daily now?

BL: Yes. Thanks Paul, and thanks everybody for joining us today. And the short answer is yes. I'm back in the office here in Newport Beach, as are many of our colleagues globally. Our number one priority here, really, is managing money on behalf of our clients, and when we look globally, we have a number of trade floors, including in Australia. But the bulk of our portfolio managers are based here in Newport Beach. For the last couple of months, we've continued to come into the office both here in Newport Beach and then via our business continuity planning, as well. We've actually been employing a secondary trade floor based about 20 minutes away in Irvine, California, as well.

The idea is to have two fully-functioning trade floors, so to the extent that there's an unforeseen surprise, we're able to trade on behalf of our clients. As we start to reintroduce colleagues globally back into our offices, the focus really is on ensuring this trading function remains intact, and then re-introducing ancillary roles, as well, over the coming quarters and years.

POC: I guess it's interesting, Brian. We've all been tested on our business continuity planning, but similar to yourselves, we've tried to make sure key functional teams at Netwealth no longer are operating all together as one team, and that they are separated just in case of any issues to do with COVID-19. I think it's just good governance that your trading teams are separated there.

The impact of COVID-19 on the global economy was fast, and the economic slowdown synchronised. What's Pimco's view on the outlook for global GDP in the current financial year, and can you even get a handle on what a global GDP figure would be for this current year?

BL: Interesting question, Paul. There's a little bit of connectivity there between our business continuity planning and the economy. We've been calling the economy as taking an elevator down- that quick, dramatic decline in economic activity that we saw in March and April- But then taking the stairs back up.

Here in Newport Beach, we've actually been encouraged to take the stairs instead of the elevator, given the situation. It's interesting from an economic perspective. We're envisioning that many trends are in the right direction. You're seeing positive trends globally, many economies slowly reopening. But what that looks like in terms of when are we back to the same levels that we were as when you started the year, I think is the secondary question. Even if we do get, say, positive economic growth in the second half of 2020, we don't think that most economies will reach the same level of economic activity that we began the year with until late 2021 or even 2022, in some cases.

So, long way of saying we're positive, but we think it's going to be an uneven recovery. And one where, as we came into this, what you tend to see in large events like this is some of these long-term secular trends get exacerbated. There will certainly be winners and losers over the coming couple of quarters. If you look at the last few months with Central Banks stepping in, it's been a broad base rally across most sectors, really more of a beta move across the market.

But over the coming quarters and years, we think as that divergence between winners and losers plays out, you'll get more unevenness, more dispersion across different parts of the market across different companies. Cautiously optimistic, but still a long way to go.

POC: Yes, I think it is. It's going to take another year or couple of years, I would have thought, before the global economy can get back to anything that it was doing from a global GDP perspective, pre COVID-19. You referred to the fiscal and monetary responses of governments and Central Banks, which has really been extraordinary. Do you believe enough has been done to avoid a deep global recession?

BL: It's hard to say for sure, but I think shorter answer is, it feels like it right now. If you think of what we saw in March, you had many, many markets pricing in worst-case type scenarios, magnitudes worse than what we experienced in even the 2007-2008 financial crisis. You saw it in Europe, you saw it across most economies, and here in the US, massive fiscal stimulus. Central Banks really learning their lesson from prior crises and stepping into these markets quickly and in a very deliberate fashion to backstop these markets from illiquidity perspective, open up on the fixed interest side new issuance, and using their size to really provide a backstop from a liquidity perspective, with the view that that much of the disruption was more liquidity related, as opposed to true fundamental declines.

That translates to many of these markets opening back up. If you look just at the US investment grade market, you've seen over a trillion dollars in terms of issuance over the last couple of months, because now with Central Banks backing much of the market, there's a feeling that while it may not be a one-way ride upward from an economic perspective, we've at least clipped the left tail, in terms of getting back to spread and valuation levels that we experienced in March, because of how proactive many of the Central Banks have been.

POC: It's interesting. I guess the human impact of COVID-19 has attracted the attention of the mainstream media, and effectively a lot of the extraordinary, mandatory response of governments and Central Banks has gone under the radar a little bit. But it certainly does feel like that the synchronised actions of all of the Central Banks has actually managed to ensure that we avoid a deep recession there.

Historically, when you've had such loose monetary policy, eventually we would start to see a sign of inflation. At the moment, inflation's obviously nowhere to be seen, but does Pimco believe the huge stimulus packages may one day result in inflation? I guess we've seen this debate in this question go back since the financial crisis and and the monetary response back in 2009 and 2010. Is inflation dead for good, or do you think one day we'll see a return of it?

BL: It's hard to say definitively, but I would say that we feel like the potential for inflation to move higher over the long-term is underappreciated right now in the market. Over the long term is under appreciated right now in the market. In terms of the near term, Paul exactly as you mentioned, you have massive disinflationary forces at play globally in the current environment. But over the longer term, you've had significant stimulus, and moreover, you think of the Fed here in the US. The Fed's indicated that it's likely going to be more comfortable in the future with letting inflation perhaps run a bit above target. And so with inflation priced in well under 1% based on the market right now, we feel like there's potential for it to move higher over the long term and well above current estimates, but it'll take some time to play out. And so more of a secular or long-term story, as opposed to one that we expect to play out over the coming couple of years.

POC: And I guess given the importance of inflation will have to managing the huge amount of government debt that's been taken on in recent years, yeah. I would expect that policy makers would err on the side of allowing inflation to eventually run one day. But I agree that I think eventually, it'll be a significant challenge, but I think also it will probably be a nice challenge if we get a bit of inflation back into the system there.Given that there is such a significant amount of quantitative easing programmes being undertaken by central banks and the Australia zone Reserve Bank of Australia has commenced QE, who's actually buying bonds globally that are being issued at a 0% or even a negative yield? And are central banks the major buyer of government bonds?

BL: Yeah. It's a great question. It feels like what's old is new again. I think the first point is negative rates is a question that's come up for years, but is certainly not new. We've had this dynamic at play for a number of years and I think it's gone to the sideline a little bit as you've had the US and selectively other central banks globally raising rates. But if you look back to where we are now, you're looking at about 25% of global government debt trading negative. That's actually a similar level to what we had in early 2016. And so from that standpoint, it's new versus say last year, but it's actually a similar dynamic as we've been facing over the last number of years.

And then I think the second main point, and it gets specifically to your question, is it's important to remember that about half of all buyers in the fixed income markets globally are non-economic actors. So entities like central banks who aren't buying say to generate a yield or to generate a return, but our regulated entities often have other considerations. And I think the point around the role of say part of a portfolio that yields close to zero comes back to the role of fixed income in general. Many clients that are economic actors, say non central banks, are buying it to be a diversifier to equities, to be a yield driver.

And so I think what this means in terms of a punchline for us is that even if yields are low, on a relative basis, there's going to be demand for spread, demand for yield. And so perhaps that continues the shift that we've seen over the last couple of years, in terms of more interests, more buying in parts of the spread and credit markets globally, versus what might have been the case 10 or 20 years ago.

POC: It's interesting, the whole dynamic of the bond market, but I think it also, as you were talking there Brian, it raises in my mind the real need and the use of credit in an investor's portfolio. And that's given the government bonds are so low yielding. To get some type of yield, we've got to look at having a diversified credit exposure I think in our portfolios. We've certainly seen in recent months rising geopolitical risks and tensions. And obviously, there's been a growing divide between the US and China. And particularly also we've seen increasing friction between Australia's and China's relationship. So in terms of the impact of this growing divide there, how do you think this will play out, given the China is such a large investor in US bonds?

BL: It's a great question and one that seems to have captured perhaps less attention as the COVID-19 situation has developed. But if we think back to recent years, part of the reasons the markets had rallied to the degree that they did say throughout 2019 was perceived progress between US and China, Australia and China, other developed markets relationships with China, because it appeared as you had things like the phase one trade deal between the US and China, that the country was willing to be a bit more accommodative. And we've always been of the view that it's in China's long-term best interest to be a partner to the Australia's, the US economies of the world. And so that there might be negotiating, there's always going to be jawboning in terms of what's in the headlines, there's going to be some of those near term negotiating points, but that ultimately, there will be progress over the long-term because it is in China's interest.

And so I think our base case would be that you're going to continue to see that push and pull, the tug of war in terms of some positive, some negative headlines, depending on the time period. I'd say we're in the unique situation here in the US where you have an election, a presidential election coming up later this fall. And so that may play a role in terms of the posturing that the administration here in the US plays versus China, because it may be perceived to be an advantage to be hawkish on China from their perspective.

As it relates to the US treasury piece, I'd note that again, it's probably not in China's best interest to let US treasury rates move significantly higher by selling securities. And the other point would be that when we think about the risk sentiment right now, you still have a lot of caution globally. So to the extent that entities or individuals are looking for high quality, risk-free type assets, even US treasuries sub 1% versus other alternatives actually seem like a reasonable trade, especially if we get market volatility picking up again.

Yeah. I think there's a couple of lessons, but the one that's really stuck out to us has been trying to determine assets or asset classes that experienced price declines purely from a liquidity perspective, versus those that have a bit more cashflow and certainty. And so to give you a few examples, when we think of areas like US government guaranteed mortgages, or high quality US denominated front-end debt that sold off significantly in March. From our standpoint, these were purely liquidity induced price declines, where we felt like the value of those underlying assets really did not deteriorate. That, to us, was really a buying opportunity and that's where we've tended to be most constructive in terms of adding securities across portfolios or some of those assets within portfolios that we felt like sold off purely from a liquidity standpoint.

And then on the other side are those that we think there is true cashflow uncertainty. So if we think back to that March, April time period, areas like the energy market, areas like retailers, those exposed to the recession more directly, we've tended to be quite cautious on those names. And so what you've seen over the last couple of months is the market started to discern where the parts of the market purely sold off from a liquidity standpoint, versus those that perhaps have a bit more cashflow in uncertainty.

And so as we look out over the coming quarters, we're going to continue to focus on that dynamic, which is you're going to have potentially inflammatory headlines. You're going to see many sectors under pressure, but if we can continue to delineate parts of the market that we think from a cashflow and from a fundamental perspective are impacted versus those that are simply impacted from a liquidity perspective like we saw a couple of months ago, we'd imagine a bit more caution on those that are experiencing cashflow uncertainty, a bit more optimism on those where we feel like it was more of just a liquidity issue.

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Yeah, yeah, yeah. I think a key point that you've made there Brian is the fact that in any down market, there's always good assets that are indiscriminately sold off, and to a good quality active manager, that really creates buying opportunity for the long-term investor, so a perfect time to buy into some of these better quality assets. And the key point you made that they have not been [inaudible 00:19:50] in terms of their income and their earnings, but just indiscriminately sold. So yeah, I think that that very much resonates the opportunities that these types of dislocations can provide to the patient- These types of dislocations can provide to the patient longterm investor. The delineation between public and private markets has become very blurred over the last 10 years. Why has this become blurred and what are some of the crucial areas for investors such as PIMCO in identifying opportunities in the private markets? And perhaps you could even just for some of the listeners, give a short just explanation of the difference between public and private bond markets.

BL: Yeah. And maybe I'll start with that last point is, think of public credit as securities that trade with a CUSIP or an identifier on them, and price on a daily basis. So those would be traded broadly by a variety of global players. On the private side, what you'd see is assets that aren't traded quite as broadly, aren't heavily marketed and they're underwritten by similar types of entities, but are typically much less liquid, much less traded, and don't have the same type of daily valuation. And to your point, Paul, this has been one of the key trends over the last 10 or 12 years that's really stood out to us, is this delineation between public and private credit has really broke down. And if you think about the source of that, it's been a little bit of a story of distorted incentives.

If you think of the environment that we've just come from, you had record inflows into credit. If you looked at public credit, it's about $20 trillion in size globally, and that's going to encompass areas like high yield bonds, leveraged loans, investment-grade bonds, mortgages. And then just to give you a sense for some of the growth on the private side, specifically the middle market lending space, in 2009, that was an area that was about $40 billion in size. As of this year, it's grown to about $900 billion in size. And so think of that as coming during a period where we've had less liquidity overall in the market. Dealers, so think investment banks, have reduced their footprint, post financial crisis in making markets particular on the public side. And then you have areas like high yield and leverage loans that have grown in terms of the types of vehicles.

You see a lot more retail holders of these types of assets. And if you look at the private markets specifically, yes, some parts of the market might experience a bit less volatility, but it comes back to that pricing. On the public side, assets are priced every day. On the private side, it can be much less. But you've also seen on the private side, as demand for many of these assets has grown is, returns have compressed on the private side as well. And so it's not really a matter of either or in terms of what should I be buying, it's not one is good, one is bad, but it really comes back to making sure that you're buying either type of asset in a vehicle that makes sense. And we think over the upcoming quarters and years, having a lot of flexibility to traffic across both public and private assets.

If you look at how we've built our platform here at PIMCO, we're not separated between, say, a private only team and a public only team. In fact, many of the best opportunities that we've uncovered over the prior couple of years have straddled that middle ground in terms of trying to identify some of the areas of the market, independent of a public versus private delineation, where we find value.

POC: Like equities, credit, valuations have recovered since their lows in late March. Which parts of the global credit markets do you see the best value presently?

BL: Yeah. It's a timely question because it was pretty obvious a couple of months ago that given where spreads were, if we got support or recovery in the economy, that the credit markets offered a really unique opportunity. And so if you looked at what the markets were pricing in, take investment-grade, for example, they were pricing in a 10X, the worst case scenario that we've ever seen. So there was a clear price appreciation play there, where if you were adding credit assets in March and April, spreads have tightened, which means prices of those underlying bonds have gone up, but we still feel like there's a lot of opportunity, especially for longterm buyers in credit. Yes, returns on a forward looking basis probably won't be as attractive as the last couple of months, valuations are more like median, but there's still a lot of things to like.

On the investment-grade side, which is the area we're probably most constructive, so think higher quality corporate credit, we've tended to like this space because we feel many of these companies are resilient and can continue paying their debt, even if the macro economic recovery is slower than anticipated. We've also liked the structured credit markets. So think areas of the market where we're able to take exposure to mortgages. That's an area where even when we look globally at a lot of the volatility, we think US housing in particular is on pretty sound footing, and you've seen that over the last couple of months. We're still cautiously constructive within the high yield segment. We anticipate about six to 9% levels of defaults from that space, mainly from the energy segment, which is about what the market is pricing in.

So we're still cautious there, but there's specific names that we like. In terms of underlying themes, and there's been a couple that have stood out more from a bottom up perspective, I mentioned earlier, you've seen about a trillion dollars of new issuance. So newly issued bonds coming to the market, we've partaken in those particularly in some of the non-cyclical names. So those that are a little bit more resilient to the macro environment. We selectively added some higher quality, high yield names that we've liked. Specifically in that space, you've seen many high yield companies come with better collateral. So something that's actually providing some security behind the bond. So coming in the form of, say, a cruise ship or underlying real estate. And so those have been some of the trends that we've been taking advantage of.

POC: So in terms of these opportunities, are there any industry or sector themes, or is it really just very company specific? And you've got to look at each individual company, and I guess thinking behind the question there, in my mind, there are certain industries that have been benefited out of the recent economic dislocation and a lot of the IT companies managing and working with online functionality, as opposed to an industry like the airline industry that's almost completely shut down at this stage. So yeah, is it more idiosyncratic per company or yeah, are there any industry themes that you can provide some comment on, Brian?

BL: Yeah. That's a great question and I'd say, this is a point I'd say that the bond market tends to be very different than the equity market from this perspective, because it's not just about the sector or the company coming to market, but it's about what does that structure look like? Where do you want to be positioned? And there's more options if you look at the fixed income markets. And so there's a couple of different themes that I would highlight. The first is investment-grade. You've seen about a trillion dollars issued in that space. That's the area where we have been finding the most opportunities. We've participated in many of the names that have come to market. Specifically, we've liked, as you referenced, some of these less impacted more non-cyclical sectors. So think healthcare, telecom, media type companies.

What was really interesting about that space a couple of months ago is many of these companies, because they were so aggressive in terms of coming to market at a time when there wasn't a lot of appetite, they were actually paying what's called a new issue premium. So an extra percentage or extra set of yield that you're getting for coming to market versus your outstanding bonds trading. So to some extent, we felt like companies were paying up to come to the market and so we were happy to participate in that. The second theme has really been many companies are coming with better terms. So you're seeing even in some of these challenged sector some opportunities because, say, a cruise ship operator is coming, but actually putting up their cruise ships as collateral with still really elevated levels of yield. And similarly, retailers are coming to the market, say offering the real estate backing their brick and mortar stores.

And so it's not as if just because a headline sector is challenged, means it's a good or a bad investment, it depends what it looks like. And I'd say selectively, we are finding some opportunities in some of these more challenged sectors, but it does come up back to understanding the structure in that bottom up view. And then the other area, the third one where we have been seeing a lot of positive trends is on the reverse inquiry side. So think of this as a company. If you think of PIMCO broadly, we manage about $400 billion in credit. So we build relationships with many of these companies over years and years and decades in some cases. And so what they'll do is they'll call PIMCO and they'll say-And so what they'll do is they'll call PIMCO, and they'll say, "We'd like to issue these bonds at these levels and these maturities. What's your feedback? Are you willing to participate?" And so what we're able to do is it's still a publicly issued security. There are other participants in terms of buyers, but we're able to drive terms in some of the companies that we like because we have that direct relationship with them.

POC: I guess it's interesting there, Brian, that being one of the largest bond managers in the world, you would have many different entities that would come to you with different ideas about raising credit and trying to get your view and opinion. Are there any other themes or interesting sort of ideas coming out of your engagement with corporates at the moment?

BL: Well, I'd say it relates to that point from a few minutes ago, which is what's really unique right now is we mentioned this idea of less delineation between public and private assets, and one of the unique parts of our platform is we have a large presence on the alternative side. We also have a large presence on the public side, and we're trafficking in the middle as well, specifically via some of the new structures and strategies that we've been focused on over the last couple of years. And so the benefit we've found is being a capital partner independent of where the company is looking to issue debt, we feel like we have resources and capabilities across the spectrum, so can traffic, not only in really any geography, but any part of the capital structure, public or private. We feel like that's really an advantage, especially during periods like we've just gone through where the bias towards trying to issue debt or trying to ensure access to the capital markets is really robust. And so we found that a lot of the companies that we work with have really valued that.

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So given interest rates are at such historic lows at the moment, are corporates taking advantage of those low rates and borrowing, or are they sort of practising  more austerity to try and defend their balance sheets?

BL: They've been pretty opportunistic in terms of borrowing. But what I would say, Paul, is it is not a new trend. If you think of the last couple of years, and I'll use the US as an example, rates have been extremely low. There's been robust demand for credit. And so if you were, say, a large tech company holding a large amount of cash on balance sheet, you probably didn't need to go issue in the debt markets. But what you did see over the last couple of years is many entities like that came to market simply because getting access to the debt markets was so cheap.

What we've seen over the last couple of months is an interesting mix of incentives where as soon the Fed here in the US stepped in to backstop the markets via its facilities, you've seen, as I mentioned, about a trillion dollars in terms of investment grade issuance, but what was interesting is every company that could come to market effectively did. There was actually a stigma if a company was not able to come to the market. The view might have been that maybe there's something that their management team knows that we don't or other investors know that we don't, and so really every company that could come to market over the last couple of months has partially from that incentive perspective, but also with a desire to ensure they have a robust balance sheet if, for example, the economic contraction is longer than anticipated.

POC: Yeah. Well, it certainly appears rational in my mind that, yeah, no, you would take advantage of the low interest rates if you do need to raise some debt to expand your product line up or whatever you need the [inaudible 00:34:06] there. Brian, we usually finish our podcasts with asking our guests for any personal investing tips that you've applied through life and really might be central to your own personal investment philosophy. So do you have one or two tips you can share with our listeners?

BL: Of course, and it's really pertinent now because it feels like we just went through a period where some of these tips can be really valuable. And I found this one specifically helpful during that March timeframe, which is really helping yourself via the structure of vehicles. What I mean by that is I was susceptible just like everybody out there in terms of looking at my computer screen when the markets were down, stocks were down, and wanting to hit sell at the bottom, which especially given the rally over the last couple of months would not have served me well. And so one of the strategies I've employed is trying to introduce structures to my portfolio via liquidity, via investments, where I'm not able to sell, say, at the bottom. And so the idea behind this is to overcome some of the behavioural bias to not selling at the worst time.

And I think that's something that, even as somebody who's in this every day, my knee jerk reaction is similar to probably what many of you feel, which is during those periods of volatility you want to sell, but in fact it probably isn't an ideal time. And then the second, which has really been key more on the saving and retirement front is really relying on default options. So putting money away without making a decision to do so. So that's going to come in the form of retirement options, et cetera, but then also the automatic rebalancing, things that you can do with your portfolio to take the decisions out of your hands because you make it seamless. I found that things that are automatic or things that are default option have really helped me personally in my own portfolios. 

POC: Yeah, very valid comments there, Brian. I certainly agree there with you that human emotion can get in the way of longterm investing, and it can cloud, I guess, our longterm investment objective. And we all have that fear in significant market downturns that we should sell or what have you, but at the end of the day, none of us can tell what is the low point, when markets are going to recover, so we are better off having a systemized structure in the way we save and the way we dividend reinvest and those types of rules, I guess, and strategies that you can put in place in your portfolio. So, Brian, thank you very much for joining us today. Your insights have been really valuable, and I'm sure our listeners have got a lot out of your comments there. To the listener, thank you again for joining us in the Net Wealth Portfolio Construction Podcast. I hope you have a great week, and we look forward to joining you on our next podcast. Thank you again, Brian. You have a great day.

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