Extra Credit: PIMCO Perspectives with Marc Seidner and Pramol Dhawan

Stay tuned after the conclusion of the podcast for additional important information.

RECORDED EPISODE:

GREG HALL: Hi everybody. Welcome to Accrued Interest PIMCO's podcast dedicated to providing timely and impactful market insights to financial advisors and their clients. Today's pod is a special edition we're going to call Extra Credit. We'll be using today's podcast and future ones like this to tackle topics that are interesting, maybe a little bit more focused, fit into a smaller, smaller of a, of a bite-size relative to our regular monthly edition. And I couldn't be more pleased than to start the first extra credit episode off right where we started the podcast off which is by in inviting Marc Seidner, our CIO for non-traditional strategies to join us on the podcast today. Hey, Marc.

MARC SEIDNER: Hey, Greg. How you doing?

GREG HALL: You are, you are now officially our returning champion. And making his first appearance on the pod is Pramol Dawan, who's a managing director here at PIMCO and manages our emerging markets business. Pramol, welcome to Accrued Interest.

Thanks for having me, Greg.

Alright, so today's topic is a paper that the two of you collaborated on. But before we get into that, that paper is really a number in a sequence that you've been producing for about the past year. The title of that series is PIMCO Perspectives, and I think it launched in February of 24. And Marc, maybe in your own words, do you want to give us a sense of, of where this came from, what you're trying to accomplish with it, why the two of you are working together on it?

MARC SEIDNER: Yeah, sure. Happy to, and, and thanks for asking. I, I think it's fair to say that, that both Pramol and I are quite proud of what PIMCO's Perspectives has become. I think our first published piece was in, was in February of last year. We, we had this sort of aha moment that, you know, we could, we could use even particularly for advisors and others actionable, punchy, perhaps even pithy piece to enhance our normal cadence of cyclical forum write-ups, secular forum write-ups.

And so what we're trying to, what we're trying to accomplish is just exactly that put together a relatively brief, digestible piece built around something that we think is interesting in markets and, and, and an actionable idea that comes out of it that, that folks can, can sort of clinging to and capture. So that's the idea behind it.

GREG HALL: That's great. It, and it, it's obviously that's very consistent with, with what we're trying to do on, on the pod here as well. I think it's, it's such a great fit. I, I, I would anticipate that we'll ask you guys back each time you publish one of these and that's what, about four times a year? Is that the, the frequency you're on?

MARC SEIDNER: Yeah, I mean, it depends a little bit on, on what's happening in markets and, and you know, sort of our sort of collective thoughts and vision about what, what folks should be doing in portfolios. But yeah, I think four to six times a year is probably the right, the right cadence.

GREG HALL: Alright. I heard six times a year signed up for the pod. We'll, we'll, we'll see. We'll see you there. Well let's talk about the, the latest piece. It's available on pimco.com for anybody that wants to check it out. We'll of course link to it in the show notes. But you titled it Where to Look when Equities are Priced for Exceptionalism. And I thought, Marc, maybe we just kick it off with you or stick with you. Can you just walk us through the, the key points of the, of the piece, what you guys observed and, and, and what you concluded?

MARC SEIDNER: Well, I mean, I think we've been writing PIMCO's been writing for quite a while about this, the concept of American exceptionalism, how, how durable it, it is can be or, or, or should be. We've also sort of been writing a lot about the incredible amount of uncertainty that's growing not just in financial markets, but in the macro economy and the world, the world around us.

And when you put the two of them together you know, there, there, there was this pretty meaningful post US election bounce in risk assets, appreciation in equities, tightening of credit spreads, both high yield and investment grade collapsing of in some, in some regards of liquidity premiums. And, and our, our, our main points here would be that, you know, one, valuations are getting quite stretched and that that's not just equities, but it's, as we said, high yield investment grade, high yield credit spreads.

Not there's anything wrong necessarily with high yield from a, from a, from a potential return perspective. But high yield credit spreads are at their zero with percentile. At the end of January, they were their zeroth percentile. I repeat zeroth percentile. I think we all learned in statistics not to give anybody 0% or a hundred percent odds. 'cause they'll always take the other side and they'll almost always win. And here's one of those situations where you're getting 0% odds.

Again, just because valuations are stretched doesn't mean that performance can't continue, but the, the, the chips are getting stacked against you for, for certain. Add to that a second point, which is, it is a, we are in a really rare moment in time when the all in yield of a high quality intermediate term bond portfolio is higher than the earnings yield of the S&P 500.

And that's a pretty unique, unique moment from all, and I can both give you all kinds of fixed income portfolios with, again, intermediate term maturities. So call it three, five, seven years with yields of 6.5 to 7.5% for high quality portfolios. And that's, that's, that's, you know, in our minds quite compelling. And, and it looks really good from an asset allocation perspective, then you put points one and two together and one plus two equals diversification.

I mean, sometimes everyone needs a reminder that, that, that the free lunch of investing is, is diversification. And we, you know, if, if, if, and I'm sure Pramol will touch on this, but, but if you can create well diversified portfolios that have a starting point, a pretty attractive yield, you create a pretty resilient opportunity to deliver pretty decent returns to, to clients. So, those are the main points.

GREG HALL: Has that relationship that you just noted between stocks and bonds, has that happened before? I know it's historically rare. How rare is that?

MARC SEIDNER: It's quite rare. It's happened a couple times. In, at least in, in modern history, the.com era would be one of 'em. The brief moment in COVID would be another, but those are periods, Greg, when, when, you know, our forecast for growth for United States for 2025 is 1.8%. It's not exactly, it's not exactly exceptional. Periods where this has occurred before have been periods where growth forecasts have been much, much higher. And yeah, bubbles did ensue, but at least, at least there was some connection between the fundamental growth outlook and the valuation.

GREG HALL: Right, right.

MARC SEIDNER: In this period of time, it stands, you know, quite, quite substantially in contrast.

GREG HALL: So I, I mean, that's interesting. And we obviously, we don't wanna invoke necessarily, you know, the the.com era lightly. But I think you're right to point out it's a growth estimates can be, you know, they can be right or they can be wrong, but at least they were connected to the valuation of the equity markets at the time.

MARC SEIDNER: Yeah. Again, as I said, you know, this is not a moment in time to, you know, light your hair on fire and go run around screaming, sell everything, sell everything, sell everything. Our point is actually isn't sell everything, sell everything, sell everything. It's, it's be very selective. Be very thoughtful. And that last point, you know, points number one, points number two, one plus one equals diversification. And if you can create a diversified portfolio that builds in, you know, some attractive high quality yield from a fixed income market, then you are doing yourself and your clients a favor.

GREG HALL: That's, that's that, that's perfect. So, so Parmol, we've ruled out lighting your hair on fire and running around. What, so put yourself in the position of a, a financial advisor. You've got clients that have had a really good experience owning stocks for a long period of time. Probably have pretty low tax basis in a lot of those holdings.

But you know, more and more we're hearing from people a little bit of concern around the margin of how can this, how can these valuations be sustained? Don't a lot of things have to go right in order for us to continue to feel excited about owning equities at, at this point. How would you then think about constructing a portfolio, implementing some of the conclusions and the observations you guys made in this piece?

PRAMOL DHAWAN: Yeah, thanks. Thanks Greg. I think some of the points that Marc mentioned are, are really, really interesting and important. The point, particularly around America, just not looking that exceptional currently, I think it's, it's something we all have to internalize. We, we had a, an amazing performance of the US economy above trend growth in a post COVID era against a backdrop of, of European malaise, of Chinese malaise in terms of growth. But if we fast forward to where we are today, it's really not looking that exceptional.

Marc's point about 1.8% forecasted growth, where if you take that one step further and you look at composite PMI, the US is at 50.4, the UK is at 50.5, Germany's at 51. They're all sort of in and around the same sort of levels, but they have very different starting levels in terms of equity valuations. And I think much of the market has gotten used to this notion of being long equities, long the nominal assets and, and owning some cash as, as, as optionality. Our point really here is that, that there's not much optionality left in cash and it's, it's still a risk parity construction environment in our, in our minds. But I think you have to--

GREG HALL: What, what, what do you mean by risk parity?

PRAMOL DHAWAN: Well, meaning that, that you have to stay invested in, broadly speaking, a 60-40 portfolio where you have some risk assets, but the need to balance those risk assets with assets that will be inversely correlated to those risk assets. Right. Should, should times get harder, should the lighting of the hair moment actually come to fruition. The cash won't immunize you from, from, from, from those, those issues. And, and that's why you need duration on the portfolios.

And that's why that this sort of duration call or call to action is, is, is more of a call to add insurance in a portfolio as a ballast to the portfolio than it is of one to, to sell risk assets. Now, even though the risk assets are, are very well priced, and we would sort of argue that that never has there been a case where, where, where valuations have been so stretched and, and uncertainty both economic and, and geopolitical have been this high that, that really forces you into thinking about how to construct the portfolio such that you can be immunized in most states of the world.

And I think that, that right now you're just in a very fortunate time where you've got high quality starting yields within a government bond portfolio outpacing that of, of, of an equity market that sort of pays you to, to, to put that insurance on the portfolio.

GREG HALL: Lemme, lemme see if I'm, if I'm following along here. So one, I think, I think we all agree that, that not, not a moment to be frightened of but to apply due care to portfolio construction. We feel like equities are certainly in a zone where I think maybe I was joking, but a lot of things do need to go right in order for us to feel good about those valuations.

Fixed income and taking some duration could arguably be seen as a way of feeling a little bit more comfortable holding onto some of that equity risk, right? 'cause you're layering in what you, what you said Pramol, the inverse correlation, the, the notion that bonds go up when equities go down. If we see an economic weakening if we see some monetary policy unfold in response to that economic weakening, all things, a bond allocation in your portfolio can, can help you know, to, to ride through and then cash.

It's important. 'cause cash, you, you guys may look at these numbers, I look at them pretty closely. Cash by a factor of, depending on what you look at, one and a half, 3X is the most popular allocation. It just even in the beginning of this year. Cash or floating rate, cash alternatives, right? Zero duration assets. So I think, I think a lot of our clients, a lot of advisors are willing to step out gingerly on the yield curve, but still doing it very, very, very close to zero rate exposure. And, and the point that you're making, of course, is that in the event of something happening that doesn't offer them any protection.

PRAMOL DHAWAN: Yeah, and…

GREG HALL: Or, or more mitigated protection.

PRAMOL DHAWAN: More mitigated protection. Exactly. And cash prices won't move higher and won't be inversely correlated to, to, to equities. You have to also sort of think, you know, with, with these levels of starting yields, Greg, the, the, the two percent-ish growth that Marc talked about in, in real terms, two point half percent inflation, which Rich Clarida talked about. Your last podcast. So you're at a 4.5%, call it 5% nominal return in, of growth in, in, in the US assuming no multiple expansion.

Marc and I feel very confident that you can get better yields than that. And high quality, safe assets with substantially reduced volatility, substantially reduced tail risk in, in investment grade, in, in mortgage backed securities and high quality fixed income assets. So really, let's put it another way, the burden of proof has to be on the equity side to, to prove its valuations. It does not need to be on the fixed income side to prove its starting yields.

GREG HALL: Let me, the last, the last question I wanted to, to ask the two of you it, none of us have a crystal ball. We tend, I think, to think of the world in terms of scenarios that might play out. Maybe just talk to us about the economic scenarios we talk about internally, whether it's a hard landing, a soft landing, stagflation, these things that could happen, whatever our baseline view might be.

And then the, the conclusions of your piece as you think they would unfold in different states of the world, help advisors listening kind of begin to understand what they would expect from a portfolio that followed your prescription depending on what happens in the world.

MARC SEIDNER: Well, why don't I start by just painting what I would, I think Pramol and I would both suggest might be the, the baseline that's priced into markets then, and then, and then Pramol can, can get a little bit more granular on, on our views and, and scenarios. But, you know, for all this talk of hard landing, soft landing, no landing, I mean, it certainly feels as if, again, given the starting points of valuations that markets are pricing in a re-acceleration of exceptionalism.

So it's, it's not even, the landing isn't even envisioned. It's, you know, plane keeps humming along and probably, you know, takes [UNCLEAR] gains altitude. You know maybe hits an air pocket, but, but it ultimately ends up gaining altitude. And, and the way I, I suppose as a bond investor, I'd look at that is, is, is that the, the, the path of short-term interest rates.

I mean, the market is basically never telling you that short-term interest rates are never going below 4%. Never. And again, all I know is that, that that, if, if, if that's the starting point and we think inflation's gonna be 2.5%, that's one point a half percent real return on cash, plus a little extra yield on a fixed income portfolio, that's giving you zero probability. Again, here we go with zero probabilities, zero probability of any sort of landing whatsoever. And that again, I think is the, the cornerstone of what we're identifying as this opportunity.

Again credit spreads have narrowed since the election equity prices have gone up since the election. Valuations have narrowed for equity since the election and bond yields have gone up in immediate term bond yields have gone up. And to us, that's, that's sort of the opportunity that, that's presenting itself because the market's basically telling you that exceptionalism, exceptionalism is a right, it's not an opportunity, it's a right. And that there is no landing and vision. In fact, as you said there is a, there, the, the, the plane's gaining altitude. And, and that's what I think is priced into markets. And that's again, sort of the cornerstone of the opportunity.

PRAMOL DHAWAN: If you, if you play golf like I do, Greg, you, you're far, far more concerned with the rough..

GREG HALL: Golf, I doubt I play like you do.

PRAMOL DHAWAN: You're far more concerned with the rough than you are with the fairway. And, and it's just another way of saying that, that the market's perfectly priced for the base case. It's not at all priced for the tails, and it's the tail risks that you really wanna focus on right now.

Take a look at the S&P 500 this year. We're, we're recording on a Monday. We're up a few percent this year. With, with, we're a huge degree of volatility. Take a look at Euro stock performance, up 12% Chinese equities up 17, 18% year to date. You, you have for the first time in a long period of time, a really heterogeneous backdrop for global developed market economies and emerging market economies.

And, you know, from an asset active asset management perspective, I, I have to say it's a super interesting time to, to try and pick winners and, and losers and try and find and create value for our clients and portfolios.

So Marc and I are, are sort of laser focused on, on trying to find those right stories, those right assets and not being sort of tied or wedded to very, very dogmatic views around, around markets. Because many things can change. And as I, as we said before, there's a really, really fine margin, a really fine needle to, to, to be able to thread here.

GREG HALL: Yeah. I think by extension, and, and maybe we'll close with this, I think a really exciting time to be a financial advisor as well. Just a ton of options to look at relative to maybe the last, you know, 10 years of, of really strong performance in the US equity market. I hope everybody listening took full advantage of that and did a great job on behalf of their clients.

And I think the argument you all are making is you know, kind of keep your heads up looking around for opportunities in case that is not the next 10 years. What are some things that you can do in the fixed income markets, maybe internationally to make sure that your clients keep participating to the greatest extent possible in the best risk adjusted market returns. And with that, I think we'll close it down for today.

I wanna encourage everybody listening, please go check out the piece that Marc and Pramol published. It's on pimco.com. We'll link to it in the show notes, as I said we will hopefully see them back here for another edition of Extra Credit featuring PIMCO Perspectives at their next publishing date. And in the meantime please do join us in March. We will be focusing on short-term markets and on cash alternatives with Jerome Schneider, our head of short-term here at PIMCO. Look forward to having that conversation and sharing it with you.

As always, please visit pimco.com if you identify yourself as a financial advisor. You'll be taken to Advisor Forum, which is your home@pimco.com, with curated collection of information and documents, research pieces that we think are most helpful to you and your clients. And of course, the full panoply of what's available at PIMCO. All there at your fingertips.