How PIMCO is Preparing for the Next Capital Loss Cycle with Dan Ivascyn

18:09Yeah. But it's very, very important. And then we're trying to get a bit more of a, you know, a bearish or cautionary message. You know, when you're lending against AI investments and at best you get par back, hopefully. Yeah. Unlike, you know, some of these private AI companies where you're talking about, you know, five, ten times multiples, tripling money.

18:27Downtown Josh Brown:It's a different conversation. You guys are worried about return of capital as much as you're worried about return on capital. Correct. And, of course, there are huge macro implications here. But even if you get the macro right and you make a few mistakes in a bond portfolio, you know, they're like grenades going off. You can quickly lose half a percent here, half a percent there. And you work hard to generate that incremental return. So we're going to talk about that secular theme and what the implications might be for fixed income. But in this particular outlook, well, last year the outlook was the fragmentation era.

19:07Downtown Josh Brown:This year it's called rupture and resilience. I like that you saved us with the resilience part after the rupture part. But it is a meaningful escalation in language from fragmentation to rupture. So why don't you talk us through what's changed between last year and this year as far as that outlook and what you mean when you say rupture and resilience? Sure. And we've talked about this for the last few years. And the general thought, at least when you look at the geopolitical stuff, is that for a while, it was safe to assume you're a politician, you generate good economic outcomes, everything's fine.

19:44You get reelected. And most policy was based on global economic efficiency, the whole globalization trend. And then we had the COVID shock. And now we have a series of shocks. Populism within politics. The realization that significant parts of the economy, middle-income, lower-income households, haven't done so well the last few decades. China sort of snuck up on the world, quite large, quite impactful, both in terms of trying to grow its own economy, but creating disruption all around the globe by exporting cheap products. AI-related uncertainty. We're just at a point where something did change a few years ago.

20:27politics began in some sense dominating traditional economic decisions like tariffs as an example tariffs aren't there just out of you know purely economic fairness or efficiency there as trump

20:40Downtown Josh Brown:has said you know the textbooks say tariffs are bad we're doing them anyway because there's a political reason to do them correct maybe not necessarily a purely economic reason absolutely right and there's a lot of that going around absolutely right so that was the that sort of set the stage in something we've talked about. But when you look at the last 12 months in particular, you have outright armed conflict now. Still in the Ukraine with a risk of escalation. Actual war in the Middle East alongside the type of direct trade tensions, geopolitical tensions, extreme political uncertainty within this country.

21:18You look over at the UK, similar dynamic. You look at elections all around the world now that you tend to have candidates from extreme perspectives, typically battling out for control of countries. There is very little true middle nowadays. So, you know, our point with the piece is that, you know, you're starting with financial market valuations that are high. You've had, you know, pretty good performance the last few years, yet you're dealing with a type of uncertainty now that most investors haven't had to deal with to the same degree. So be real careful about being surprised. And some of the surprises can be very good ones.

21:58AI, again, incredible investment in this technology. People are making these investments because, you know, they think that by making those investments, things will change. So even just the tech trends alone, you know, the almost$10 trillion of anticipated investment are creating just massive uncertainty. And I think that's great. You know, as an active asset manager, it's better to have this type of uncertainty, these types of frictions in markets to generate returns relative to passive alternatives. But anytime things move around a lot, you can lose money too if you're on the wrong side of the trade.

22:34Downtown Josh Brown:So by rupture, you mean like a rupture of the existing world order and some of the, I guess, people have talked about this like in terms of NATO and like just some of the things that we've come to believe are like part of the bedrock of the global order, all of a sudden there seem to be bigger shifts than we're accustomed to. And then that has implications further on down until you get to like financial instruments, currencies. Okay. Yeah, and that's the macro point. And then, you know, and that's usually enough to create a lot of uncertainty. Yet you have now with this, you know, highly innovative new technology that just arrived on the scene, massive potential disruption to old economy business models, the way that we conduct work.

23:22You know, we used to go out to get an accountant to do our taxes. I'm learning. You know, the young kids are teaching me how to do this in the organization. But I actually think that with a little training, you know, that's something you can do with a few clicks of the button and you can go on through different areas, you know, where we have gotten used to things happening a certain way where all of a sudden, a few years from now, it could be completely different. So yeah, it's, You know, geopolitics, while also seeing these trends that we haven't seen in a very, very long time. I guess the internet in the late 90s, early 2000s comes close.

23:53But even there, you know, it feels like the disruptive aspects of this new technology can be, you know, quite impactful for markets. So, yeah, geopolitics, traditional monetary policy uncertainties, high debt levels, you know, all these are going to be sources of volatility. then despite all that we still have this other source of uncertainty that again it's moving fast and it's and it's going to matter we just don't quite know exactly how it's going to matter

24:20Downtown Josh Brown:just staying on geopolitics you quoted mark carney who very memorably i guess that was a few months ago at the un perhaps he was addressing the world and um talking about the rupture itself and a transition away from the post-World War II rules-based regime. I wanted to ask, do you actually believe that we're at the point of no return on globalization and that things can never go back to the way they were? Or do you think that maybe some of this is cyclical and not secular? Well, we think many of these themes and trends will be hard to reverse anytime soon. Now, politics in our country, of course, at least the You know, the president changes every four years.

25:07We've already seen. So far. So far. So far. Good point. So we've already seen now. This is the second term of Trump with Biden in between. When Biden got elected, there was a partial reversal in some of the Trump trends. And we have an election coming up in a little over a couple of years. And you very well could see if you had a Democratic, more traditional administration, embracing certain global institutions and looking to reverse some of which has been done. It's the nature of our politics. But with that said, you know, we think it may be bumpy. You may see a situation where different administrations or depending on who controls Congress may move in a different direction or look to try to, you know, get back to where we were a few years ago.

25:53but all in the midst of very, very powerful and accelerating secular themes that are going to be very, very hard to reverse. Probably a good example would be tariffs. You know, Trump put tariffs on during his first administration. The Democrats weren't super supportive of that. Many Republicans weren't super supportive of that. He left. The tariffs didn't get reversed.

26:15Downtown Josh Brown:Yeah. I think just an example of how, from a political perspective today, people realize that trade isn't helping all segments of the economy. And that tariff policy, and if it's not tariffs, some type of more aggressive industrial policy or policy towards our adversaries is warranted. So it may take a slightly different form, but this idea of dealing with conflict, addressing the China problem, trying to come up with some creative ways to ensure that those that have been left behind by globalization, you know, see a shot for their incomes to go up. Some of these are themes that are, again, going to be hard to reverse and are unpredictable in nature.

26:53They can be orderly or at times represent more disorderly change like we've seen all of a sudden in the Middle East this year. Tensions had existed there for quite some time. In the absence of armed conflict, the economy and market performance this year would likely have been quite different. So you're not sure when these things are going to erupt. You just know that they're likely to erupt with more frequency than what we remember from the old days.

27:18Michael Batnick:So, Dan, the more you zoom out and take a big picture view, the scarier things get at the global level. People are always fighting. There's always uncertainty. And the more you zoom in, the more the picture gets a little bit less horrific. So how do you think about the juxtaposition between global uncertainty, what's going on with the straight, and the juxtaposition of that between our economy, which has proven to be remarkably resilient, and the consumer that powers the economy, despite the tariffs and the inflation and the AI uncertainty and everything that has been thrown at us, our economy just continues to chug along.

27:59Michael Batnick:And when you're making investment decisions, there's this push and pull between the fears and whatever might or might not happen versus what is happening today. And what is happening today has been a continued remarkable push through all of these dangers. Absolutely. And I look back at some of PIMCO's views. We may talk about this later. Back in the mid-2000s, aggressive underwriting concerns, developing the banking system. We were worried. We thought, wait a minute, if this continues, we're going to have a recession. And we began to get really, really concerned and really, really defensive. You flip forward today, and yeah, there may be some excesses in certain areas.

28:40And yes, there's uncertainty, but our economy has been incredibly strong. We have a real, real strong, at least middle and upper income consumer. Home prices have gone up for many, many years. Most people or close to half the people in this country own homes. The consumer balance sheet, solid, you know, many years of, you know, real, you know, good labor market performance for middle and upper income cohort groups. And now this technology through capital investment through and the productivity numbers are noisy. But we get the sense that you're already beginning to see the positive effect of productivity on the U.S.

29:20economy. So despite uncertainty, despite Trump tariffs that in a narrow sense could lead to some additional frictions in the markets, we're fairly optimistic. And that does change the way you think about investing. When you're really pessimistic about growth, when you see lots of problems that just for the passage of time are eventually going to lead to a slowdown, you have a very different approach. So the bottom line today is that you want to be cognizant of the uncertainty, but also optimistic. about growth. As a fixed income investor, that means you're probably not optimizing portfolios if you're getting wildly defensive and just hunkered down in the absolute safest stuff.

30:02Downtown Josh Brown:Now is not the time for wildly defensive. No, not in our opinion. I think it's time for resilience. And it's a great word in every industry who disagrees with resilience. But I think the idea is be up in quality or take advantage of this exciting global opportunity set of higher quality risks that can actually generate similar returns to the real risky stuff if we continue to grow like we expect, but will provide some downside protection if you end up having a recession. Let's talk about these. Dan, give me chart four, please. This is from your presentation. You're talking about, I don't know if you're calling these like the four drivers, but I'll say these are like the four biggest drivers, I guess, of global GDP growth or spending.

30:46Downtown Josh Brown:So you're highlighting AI infrastructure is$7.6 trillion over the next five years. And you say that is the GDP equivalent of the economies of Japan and France. Then you've got energy and grid, I guess, modernization or reinvestment, $2.6 trillion, about the size of Italy's economy. You've got defense spending, NATO plus whatever else, 2.4 trillion, which is about the size of Canada's economy. And then finally, reshoring and supply chain, I guess like less manufacturing overseas, more here. Okay. 1.4 trillion about the size of the Netherlands. So add those four things up. It obviously does seem like along with the rupture of the way things used to be, there's a ton of opportunity given how much money is going to go pouring into these things.

31:41Downtown Josh Brown:So talk a little bit about why that's important for PIMCO and for your investors. Yeah. So it's important just from a macroeconomic perspective, as long as that type of capital investment can be maintained, it's going to create a lot of positive momentum for economies making those investments. It's got to be bullish. I mean, to have that much investment. It's a lot of stimulant. It is. It is. And by the way, that bears watching as well. Over the short term, all of these investments can be great for the economy. It could lead to better productivity, lower inflation. But there very well could be a timing mismatch.

32:17And that's why, again, I think it's important to note that although our base case is that inflation, if we get the situation in Iran stabilized, inflation probably stays at this level and trends lower. There's some uncertainty. just given the massive amount of materials you got to go find to make these investments. But generally speaking, positive. And then from a fixed income opportunity perspective, people need to raise money. For a while, these large hyperscalers, these big tech firms were generating so much cash flow, they never had to come to the bond market. NVIDIA. NVIDIA came today. They don't even need the money and they're coming today, which again is a pretty strong forward indicator that even nvidia generating the most cash flow of all is still um looking to lock in i i saw it today 30 30 billion this is this is a key part of the story as you mentioned

33:08Michael Batnick:all of these hyperscalers were producing more money they didn't know what to do with it just sitting on hundreds of billions of dollars buying back stock so it's that's no longer the case google did an equity offering for the first time i think since 2001 recently they raised 10 billion dollars oracle announced earlier in the year in the last call that they were going to do $20 billion of equity, another$20 billion of debt. NVIDIA, to your point, first time since 2021, they're raising$20 billion. You guys actually were a big part of the financing Meta's Hyperion data center, right? Is that in Louisiana?

33:40Michael Batnick:You guys work. So was that with Blue Owl? Blue Owl was in the equity on that trade, correct. Okay. So you obviously have a great lens into what's happening with the buildout and where this is going for the next 10 years. So what is your view on the data center buildout? Yeah. Yeah, so look at the build-out's going to continue, and it's going to accelerate. It's going to accelerate from here. From here. Now, again, you're going to get a – you're seeing, even over the course of the last few months, in a signal like we're seeing from NVIDIA today that capital investment targets have just gone higher, and we would expect them to remain higher, even going a bit higher from here.

34:21Frictions are going to increase. You're even seeing it at the local political level. some pushback, and that bears watching as well. So it may be bumpy in terms of actual implementation, but the bottom line to keep it simple, for a long time, there was very little issuance. During COVID, lots of companies were able to term out their debt. So everyone's been, well, why are high-yield spreads and IG spreads so tight? Well, there hasn't been a tremendous growth of issuance.

34:46Downtown Josh Brown:No new product. No new product until recently, and this is concentrated within the tech space. That's great for an active manager in that for the first time in a long time, you know, there's all this froth in private credit. People falling all over themselves to do deals. You know, those that were borrowing didn't have to give on terms because there are plenty of people out there raising money to give them. Oh, this is competition for private credit investors. Well, it's so big now that the capital needs are so large relative to the amount of money we all have. So everybody can eat. Everyone can eat and we can go out there and actually drive terms.

35:23Now, that doesn't mean you like every deal because, again, this dynamic that if I'm a bond investor, at best I get my coupon and I get par back. And these companies, although they're doing great things, they're going to lead to better productivity, all of them haven't figured out how to make money yet. So it's a great opportunity because for the first time, we can look at 10, 15, 20 deals. And that's probably what we have in our pipeline today, some of which are on the order of$20,$30,$40 billion in size. Those are great deals where you can come in, you can do very precise underwriting, you can look to create structures that insulate our shareholders from some of those longer-term AI-related risks and end up with the spread on the deals we like at a significant pickup to your typical investment-grade bond or your typical lower-quality, below-investment-grade type bond.

36:15Now, you've got to be careful, and sometimes it may say IG on it. We don't quite believe the rating agencies in that it's investment grade. But you get enough spread cushion where you can compare it to some type of lower-quality bank loan where you don't get good protective terms in the deal. All this stuff, you know, we read about all the time where, wait a minute, I thought I was senior, and then I ended up because I had bad docs. You know, someone was able to, you know, lend and take away my collateral. Here you have a lot of ability to negotiate and find value.

36:44Michael Batnick:I think Munger or Buffett, I can't remember which one said this, you would make the price, I'll set the terms. And it sounds like you would rather be on the term-setting side than the pricing side. Or both. Well, ideally. Yeah, ideally. But I think in this environment, the terms matter a lot, just given the uncertainty, given the complexity. So we think that if we have a chance to help drive terms, that we're a large enough firm. We have perspectives from our real estate group on the risks of developing a data center. We have folks on the infrastructure team or the old asset-back lending team that understand the nature of those types of contracts and how, in theory, it may sound like you have good collateral, but you better make sure you have the ability to go get it and realize on it.

37:23And then when you have to go get it, the price is a lot lower on that collateral than you tend to think. So that's an environment where we should be able to add good value for investors. But one, we don't want to be wildly overweight this risk. It's a sector where we want to generate attractive return, not own too much of it.

37:40Michael Batnick:And your investors own equities too. Correct. And they're already probably all in. Yeah, and that's a great point. And then I was going to mention the correlation piece. So when you looked at that chart over there, you saw, okay, well, there's AI investment, and then there's energy investment. Well, they're related because you've got to figure a way to keep the data centers or the manufacturing facilities on. So when you start looking at portfolios, it's pretty important to think about how that risk they move together and realize that you're not going to quite know for sure, which gets back to this idea that anytime you got to raise$10 trillion in a market, yeah, there's great opportunity.

38:17There's also a lot of risk, especially if you own.

38:19Downtown Josh Brown:So I want to ask you from the perspective of an end investor. So not you guys as the portfolio manager, but your clients. I understand the benefits of investing in AI infrastructure on the equity side. I might invest in something at$10 million valuation that turns into core weave. I totally understand that part. What's the pitch to invest in digital infrastructure or AI cloud data centers from a fixed income investor's standpoint? Why is that attractive? Are the yields so much higher or is the risk mispriced in some way where it's way less risky than people assume? Or what would be your answer to that question?

38:59You know, I'll give, I'll, I'll bring it into two, two, two reasons. I mean, we could, we could talk a lot about all the nuance in the market, but the first would be that you can structure safe risk, true investment grade type risk. That's my favorite type of risk. Yeah. It's, it's a, it's easier one. Safe risk is great. Safe risk, you know, but, but, but lower yielding again, you're in the investment grade space nowadays. Still have to give or take. Yeah, you're looking at 6%, 7%, 8 % type returns in an asset that, if structured properly, at the end of the day, have credit risk that looks a lot like Meta.

39:35And Meta, again, is a much better tech firm than others in this space because they're more diversified. They're generating more cash flow. They're in popular indices. So you can take advantage of owning MetaRisk, a company that we do think is solid investment grade.

39:50Downtown Josh Brown:Generates tons of cash flow, very sticky business model, probably going to be around for a long time. Right, exactly. And you can do that at a spread pickup to their underlying credit of two percentage points, as an example. So now you're talking about getting the same type of yield you'd get on typically a very high-risk investment for something that's a bit more complex. It happens to be quite liquid as well. So if investors change their mind, they can sell out of it very, very quickly. In fact, that bond in question is one of the most liquid bonds out there in the market. What's that, the meta data setter bond?

40:22That'd be the Beignet deal, that data setter deal. Just given its size and given the sponsorship out there, that's a very, very liquid instrument. So that would be one, a high-quality way to generate much higher incremental returns. So instead of only a high-yield bond fund, I can own this type of risk that's investment-grade, get the same type of spread. The other bucket, and there is this entire other part of the ecosystem, which is risky lending within this space. There, we think investors, and we'll look at that risk as an equity alternative. So we'll compare it to a NASDAQ stock or we'll compare it to a dividend-producing equity investment and say, yeah, it doesn't have the same type of safeguards.

41:08We still got to be careful about concentrations, but we can go out there and target deals that are well-structured. but lower quality. And now we're looking at 9%, 10%, 11%, 12%, 13%, 14%, 15 % type returns. So you compare that to historical risky stock returns, it looks pretty good. I think it's very, very important though for investors within PIMCO and elsewhere to put it in the risky bucket though. I think the problem is when you have a lot of AI euphoria going on, when you've had a period where we haven't had a loss cycle in a long time, you can create the illusion of safety just because those types of assets haven't moved around a lot in the past.

41:51Downtown Josh Brown:Nothing bad has happened yet, therefore. It's all okay. Yeah, and of course you do get the current coupon. So again, unlike an AI stock or VC stock or some of the names that are out there that are doing real well, there you buy it and then you hope you can sell it to someone at a higher price in the future. On some of the riskier areas of this market, a lot of times you are getting a 10 % yield or 12 % coupon, that creates some stability. Because once I get that coupon, you can't take it away from me either. So we do think that as a form of maybe equity replacement or as an alternative to equities at these very high valuations, you can carefully move into some of these areas of the market in the higher yield and riskier space and generate good value.

42:37Downtown Josh Brown:Let's stay on that equity high valuations. Dan, can I have chart six? The equity risk premium in the US is basically zero. That's by your own data. Yeah. But you're not calling for any kind of like imminent equity correction or bear market. But sort of like, is that implied when you think about today? How much do you care about equity risk premium would be the way I would phrase that question. Yeah. So first of all, we picked a chart. As you know, there's 10 different ways we could have essentially communicated the same thing. What are we looking at here? I don't even know which one this is here.

43:12This is probably a Shiller PE that's just being graphed here.

43:19Downtown Josh Brown:Showing forward returns below the 0 % line. Yeah, basically what this says is if you smooth earnings or if you adjust earnings and then compare what you have to pay for stocks based on this assumption, They're very, very expensive and near the most expensive they've been relative to bonds in many, many years. Now, again, you can look back at the last time this stuff got real expensive and you'll notice it's expensive today. It can get a little bit more expensive. Those were the years leading up to the internet bubble bursting. So I say this and it'll sound more alarmist than I intend. But one way you poke hole in these charts is you say, OK, well, yes, under these types of longer term valuation metrics, equities look expensive.

44:04But if these tech companies are leading equity markets and their earnings growth is double digits for the next few years, you can justify these valuations.

44:14Downtown Josh Brown:You have to adjust by the earnings growth. And as it comes in, it makes the multiple look more reasonable in hindsight.

44:19Michael Batnick:We were talking about the Shiller-Cape ratio. Screaming about it literally in 2015. People were getting alarmed. So I'm not making a prediction on fall returns. But by traditional metrics, valuations have looked stretched forever. and these tech giants have just continued to rewrite. And margins just keep growing. What we thought was possible. Correct. And that's why these types of relationships aren't great as a trading signal to say, okay, all of a sudden short the market. And then they also get into concentration type risks where for the average investor, you're getting a point now where because the tech stuff's gone up so much, you need to go out there and find diversification.

44:54And you can shift around these metrics depending on what equities you're looking at. But I think the bottom line is, When you look at these starting valuations and then you look at subsequent returns over a five or a 10-year period and you go all the way back to the late 1800s. Not great. Not great. And in fact, quite negative relative to the starting point for yields. But again, this time could be different. It does feel a little bit different. But I think the point is that it's been a bad period for bonds. They've generated almost no return after inflation for 15 years. Stocks have just steadily gone higher.

45:32And in theory, you get to a point where, and we strongly believe that, valuations have shifted to a point where the next five to 10 years are probably going to be different. And on the fixed income side, you earn your yield. You don't know what it is after inflation. You don't know what it is if it's in a different currency. But in high-quality bonds, it's fairly simple in that you start with a yield, a boring index. I say it respectfully, but it's not super exciting. the Bloomberg aggregate index, and you're at near a 5 % type return, you buy a bunch of other high quality paper, give up some liquidity, you're at a 7 or 8 % yield.

46:0995-ish percent correlation between starting yield and five-year forward returns.

46:13Downtown Josh Brown:You could almost set your watch by it. Set your watch by it. So let's explain that for the audience. So the correlation between the starting yield and what you end up returning over a given period of time. So if the starting yield of a portfolio is 7%, you should not be expecting 11 % returns or 3 % returns. It's going to look, hopefully if things go well, closer to that seven on an average annual basis. That's right. Then it could go up or down based on trading strategies along the way. Right, right. Hopefully it's a little bit higher than that. But simplistically, if you don't want to give any benefit to the active piece, that's what you earn.

46:49So going back a few years ago when yields on that index were 2%. Right. What did you expect? And we ended up with, you know, 22 is back. It can all happen at once, just like stocks. People show me that chart. Well, what does it mean? Well, it could mean that equities just disappoint slowly. Yeah. Or they reprice massively and then they look cheap again. You know, that we don't know. And bonds bounce around as well. But, you know, what I do for a living, I say it time and time again when our clients come in, I'm glad I don't do the VC stuff. It's just not the way that myself and others at PIMCO are wired to the same degree in that we like the cash flow piece.

47:25We like to forecast based on cash flows. They create a predictability to what we do. You guys talking about, again, the AI investments and where someone's going to pay for something that's not going to have a dividend maybe ever. That's tough. It's unpredictable.

47:41Downtown Josh Brown:It's a whole different mentality on the part of the PM. Can we talk about fixed income? You say the credit loss cycle is upon us. Define what you mean by that. Are you talking about like a wave of defaults? Or are you talking about sort of a slow grind of maturity extensions, payment in kind negotiations? Like is it – it's a blow up or it's just sort of a return to normal and it's glacial and nothing to be alarmed about? How do you see it? Yeah, so I think the return to normal parts, yes. And this does require a little bit of nuance. But coming out of the global financial crisis, it's been a very, very unique period in that you've typically, and investors have grown used to, earning almost your entire yield when you invest in risky credit, below investment grade credit.

48:40Downtown Josh Brown:No recessions. No recessions. And then COVID came. They papered it over. There were no losses in COVID. Papered it over. So you look at the stats, and you can see that if you look at the same type of risky credit. By the way, mid-market direct lending is risky lending. It is? It's performed very well, but it's risky. Not recently. Not irresponsible. Bank loans, broadly syndicated bank loans, risky lending. Performed exceptionally well. Back in the 80s, the 90s, and the 2000s, you'd earn a lot of yield. Then you'd have some type of loss cycle. You'd give a lot of it back. Then you'd earn money for a few years.

49:12You'd give it back. It's been one way.

49:14Michael Batnick:But Dan, sorry to cut you off, but I think one of the problems or one of the things that lulled investors recently into complacency is those bonds performed in 2022 because there was no recession and they're plain vanilla bonds. And they don't, investors in general don't really understand that it was all interest rate risk. And so as interest rates went up, their government bonds got destroyed. And these risky corporate loans to middle market companies returned nine to 11%. And so it further made those coupons much more enticing. Absolutely right. And then the market convention is different if they were the private version of those investments.

49:48So you even had less volatility than what you had, at least briefly, in the tradable high-yield bond market. So all true. And what we're getting at here is – so we don't expect a wave because we expect economic growth to hold up. I said this the other day. I don't want to offset it. A steady stream. But a couple of points. One, given how much money was pouring into the lower quality credit markets, it was easy for a while to just kick the can forward. Pick interest where a company was struggling to make their coupon.

50:24Downtown Josh Brown:We can't pay you back, but we'll give you more bonds. We'll give you an IOU. We'll pay you later when we can. Or we'll extend the maturity. So when you have inflows coming in as a portfolio manager, you're feeling more generous to allow a company to do something like that versus take them to court and try to take blood from a stone. Correct. And when you have a more traditional, predictable economy where work as we know it isn't being disrupted. So you had the liquidity piece, money pouring in, easy to extend. Private equity, we can't realize on the investment, we can wait. We'll extend our debt.

50:58Someone will give us an extension or they won't make us pay our interest for a while. That dynamic has existed over the last few years. Now, actual losses have steadily gone higher. But the prediction in terms of future losses, and usually when you're allowing a company or when a company can't meet their current interest payment, that's a good or bad signal in terms of their ability to afford that over the long run. So that's one piece. The piece we wanted to highlight this year, though, that has been the real change is that AI disruptions here. All this AI investment is looking to feast on old economy businesses, businesses that had the so-called boats.

51:40They had attractive current cash flows. They did so much of what we're used to them doing. We're saying software.

51:48Downtown Josh Brown:Lawyers. Financial services. Financial services, software, all of these areas of the market that are likely to be disrupted and disrupted with increasing frequency. And I think the point we want to make is that that time has arrived. You're going to see higher realized losses that we've seen in quite some time. And those losses are going to be somewhat independent of the strength of the economy. You have this very, very unique situation where the more productive AI is at the economic economy level, the more disruptive it's going to be. It's almost necessary. It's a plutology. It almost has to be that way.

52:26So that's what you're going to have. And then I want to be careful, too, because it always comes across as overly alarmist if left there. We think it's a steady stream of losses now, not a wave. If you combine this AI disruption with a negative growth shock to the economy, especially if it's stagflationary or put more simplistically, this is a risky macro setup in that almost all of that debt that we talked about that did so well in 2022 is floating rate. If you don't get that short rate down or if that short interest rate or the policy rate has to go higher, now you have companies that are facing AI disruption.

53:03They already have a lot of debt.

53:04Michael Batnick:And higher costs. And higher costs to service that debt. So any type of growth shock with inflation remaining elevated would be a far worse scenario for credit. We're not forecasting that. So the point we are simply trying to make here is that what used to be an unlevered 8 % return with very few realized losses, especially given how aggressive lending got coming out of the COVID period. Those were really bad vintages where spreads were super tight. And because of this battle for market share, you just weren't getting good protective terms on your debt. So those types of segments of the economy that were used to having losses close to zero are likely going to have a period where those losses end up migrating up to the mid single digits.

53:51So that old 8 % type return that you were getting back when high quality bonds were returning one or two is probably going to be 4 % or 5 % for a while. Probably with 4 % or 5 % today is, I can buy an Australian government bond. I get that too, but I could buy, finally I could buy a treasury bond at 4.5%.

54:07Michael Batnick:Yeah. Well, your piece, we started the show with the rupture. What was the other side of the rupture? Something better? Resilience. Oh, resilience. So one area of rupture, we have a new Fed share. Pretty unconventional by traditional standards. And one of the reasons why fixed income has been so challenging is all of the government intervention in the fixed income market, some of it needed, some of it, you know, you could argue was very excessive. There was an article in the journal this morning, Kevin Warsh, Nick DiMario said he wants the Fed to stop explaining everything. For decades, the central bank believed talking openly.

54:43Michael Batnick:All right, we understand. Are you a fan of the overwhelming amount of transparency, the fact that these Fed officials, these governors have been basically on a podcast tour for the last decade or so? Do you like that level of transparency? What's your thoughts on policy today? That's great. So I like to differentiate when I'm reflecting a PIMCO view versus a personal view. So this is an area where we have a little bit of difference of opinion. Of course, we have Rich Clarence, the former vice chair of the Fed. He's done his share of speeches and things. Great speeches. Let me just say this. No, I don't.

55:18Look, I think I don't care, I guess would be the first point in the sense that Wait, wait, wait.

55:24Downtown Josh Brown:Don't care about whether they speak or not? As a market practitioner, I think that a lot of the speaking that's gone on is interesting, but not essential for the markets to have a good sense of what the Fed's thinking is. The crowd loves what you're saying. You wanted to shut up. Because I'm from the old school. I liked Greenspan. He would come out once a year and speak in riddles like the Caterpillar from Alice in Wonderland. Nobody had any idea what he said. It was by design. He said, if you understood what I said, I made a mistake. And we were somehow able to manage capital markets, no problem.

56:03Downtown Josh Brown:I understood the hard pivot toward over-communication in the Bernanke years. It's already four Fed chairs ago. Why are we still doing press conferences like they just won the NBA finals? Every time they go up or down or nothing. It makes no sense to me. Well, Warsh is speaking on Wednesday, so. Well, they're long. And then even dots and things are the individual views, which, again, views usually tend to be pretty good around policy when you're looking forward a month or two. But when you're looking forward several quarters and you have it in the ages. They're always – we're data dependent, but here's our 12-month outlook.

56:39Downtown Josh Brown:What are we doing? Yeah. So I think it's a lot of noise. And I think the markets will be just fine with more standard and targeted communication. The other point is, you know, when we hear about Feds behind curves, ahead of curves, with just a few words, you can control market expectations. And sometimes you don't need any words at all. For example, we started this year, January and February, we had bonds rallying. There was this mindset. I think over the long run, it's a reasonable mindset that all this AI technology is going to put downward pressure on prices. Disinflationary. And then you had the war break out in Iran.

57:16It didn't take a single Fed speech to get the front end of the yield curve to go higher because now people knew inflation was higher in that it was less likely that you're going to cut rates.

57:26Downtown Josh Brown:You stopped talking about insurance cuts when the bombs started dropping in and around the Strait of Hormuz. Correct. We all understood it immediately. We didn't need a speech. Correct. And then you see it with stocks. Trump administration, Trump himself tweets about the potential for a deal. Stocks rally. News comes out that a deal is not going to get done. They sell off. By the way, bonds were moving in the same direction more recently. So we do think also that a Fed has the ability to influence market expectations if they feel it's necessary with just a few targeted words. And that by the time you're beyond the occasional speech or the occasional comment into massive discussions, we just think there's just rapidly diminishing.

58:12Downtown Josh Brown:Warsh is seen as an anti-activist, like a do less. I think that's like, it's not, he's a hawk, he's a dove. It's not about that. It's, I don't think the Fed needs to be doing all that. Like the Fed might be doing too many things all the time.

58:25Michael Batnick:Well, this is a quote that he gave last year at a State Street conference. He said, if you're not very good at something, you should do less of it. These forecasts have been abysmal. And he said, my dots wouldn't be perfect either. So I just wouldn't give them. Yeah, so we, and we talked about this in our recent piece. We think, you know, a Warsh Fed will be sufficiently independent in the areas that matter to the markets, which are funds policy and balance sheet. There's still some uncertainty. We think in a perfect world, a Warsh Fed would like to get the balance sheet down quite a bit. But I think that this is a Fed that, again, it's a committee, not a chair decision.

58:59And I think there is the appreciation that with inflation elevated, with the balance sheet down to a manageable level, that it probably makes sense in the base case just to wait and see, don't rock the boat too much. That's our best sense of this Fed. Even the Powell Fed has been dovishly inclined, looking to get rates down ahead of inflation starting the year with at least the hope of getting that funds rate down further. So we do think that this is a Fed that would like to have the opportunity to get rates lower even before inflation makes meaningful progress towards their target. But we don't think that's super different than Powell other than your point in that we do think the Warshman from a philosophical perspective wants to be a bit more rules-based, a bit clearer or more straightforward in their communication.

59:55Michael Batnick:He's going to come at our Wednesday and say, no change. See you later. Yeah, yeah, yeah. It'll be interesting.

1:00:00Downtown Josh Brown:I think something tells me the financial media would be able to even take that sentence and do three hours of content about it. So which syllable did he emphasize most? All right, putting that aside, here's where I want to end. You talked about AI being this massive opportunity. You're forecasting trillions more in spending on data centers. You actually think it accelerates. You guys are funding these deals. I think our audience would love to hear from you, your perspective on the way in which this can end up being disinflationary and what impact you think it might have on not just the overall economy, but the people that are in the economy.

1:00:42Downtown Josh Brown:Are you glass half full? Are you glass half empty? Like just what's your perspective on where all this is headed? And you can tell us your personal one as well as your professional one if you want to. Well, yeah, and it depends on market practitioner. Nobody's listening. Yeah, no, but I mean, I think there's a market's view. And all too often, I think this is that, you know, what's good for markets is not so good for segments of the economy. And those tend to be the lower income cohort groups, which is a challenge. We saw it with globalization. On paper, it made a lot of sense. It probably did lead to higher global growth, but it also created instability for those that have the least economic flexibility.

1:01:20And we're still dealing with this today. So, you know, our general view, despite the uncertainty, is that, you know, AI could lead to, you know, some inflationary noise the next few years as you go out there to find materials to build this stuff and to power this stuff. Over the next several years, though, we do think that AI could be a game changer on the productivity side, bring the costs for providing goods and services down and down quite considerably. Those costs are people's salaries. And unfortunately, I was going to get to that. So, again, from the standpoint of where the inflation rate may go, it's probably positive.

1:01:55It could even be positive for our debt picture. We didn't spend much time talking about it. We talked about all the corporate investment, but we're still spending way too much money at the government level. I don't see that changing this year. We'll find more. Next time we'll come back, we'll cover that. We'll cover that. But we do think, you know, unfortunately, we do think it's going to lead to some displacement of workers that, particularly the middle-income professional cohort group, could see more uncertainty than they've experienced in quite some time. White-collar unemployment. Agree. And that could lead to higher precautionary savings, a little bit less consumption, which can have a moderating impact on inflation and be good for the markets as a whole, both stocks and bonds.

1:02:40but it can also lead to more political uncertainty, the risk of regulatory backlash, and a lot of tension. So we do think that it's hard to accomplish all of this in a neat and clean way where you can retrain folks fast enough to not create some frictions, some unpredictability, and perhaps even a pretty big reaction against what is perceived to be a technology and companies that are creating this disruption. So it's likely to be bumpy. So high-level macro and financial market impact, we're fairly constructive while realizing that we got a lot of uncertainty. And again, when I take my investment hat off and look at the potential disruption that, yeah, on a textbook basis, ultimately, it's probably fine.

1:03:27You end up retraining folks. It's good for the economy as a whole. We just worry that there are going to be real timing issues here.

1:03:34Downtown Josh Brown:So the CEO of Google giving the commencement remarks at Stanford this weekend, and they showed video on social media of hundreds of students walking out. And I said, oh, this is probably about like AI. They don't want to hear the AI CEO-in-chief talk about. Turns out it wasn't. It was about like Google's contracts with the government and all the causes.

1:04:02Michael Batnick:Eric Schmidt got booed out a couple of weeks ago.

1:04:03Downtown Josh Brown:Yes, but so I was wrong with that assumption, but I do think the general direction of this stuff, I think it's going to be an issue in the midterms, especially in states where there's a lot of data center construction happening. But putting that part of it aside, we had 150 ,000 layoffs in tech this year, which is not big enough to have shifted like the national employment numbers, but – and 40 ,000 of those were last month. so the pace of layoffs within tech is actually rising in the biggest bull market for the nasdaq in 30 years i thought i thought that was interesting um a lot of people are saying this is ai including the companies themselves look how efficient we're becoming thanks to the roi from our ai investments the venture capitalists who were backing more ai investments are saying no this is just ceos with bloated um workforces using ai as an excuse to do something they would have already done.

1:05:01Downtown Josh Brown:You guys have a strong point of view about whether or not we're going to see that accelerating in the second half of this year. And will it spill over from tech into some more Main Street industries? Yes, our biggest concern for the remainder of the year was the Iranian situation. That's a bigger, that's a much bigger deal. Classic energy shock in that if we didn't get that addressed, you know, you start seeing more, more, more, more imbalances on the physical side, that that would really be the negative for the economy. We think if you get the Iranian situation under control, defined as not perfect clarity, but just more oil flowing through the strait, less uncertainty there, we're pretty bullish on the economy going into year end.

1:05:47What you're describing absolutely, we think, will be a key theme the next several quarters, certainly the next few years. we think it probably won't have as big of a direct economic impact, but it's going to be an ongoing theme. When we look at our business and we look to plan ahead three, four, five years, it's not so much that we're looking to make major changes in the workforce. It's just the acknowledgement that the type of skill set that's optimal is going to evolve. So where you may have had 200 new folks coming in with more traditional finance backgrounds.

1:06:23Downtown Josh Brown:Like spreadsheet, discounted cash flow analysis people. You probably need less of them. Absolutely right. And then you're going to end up with folks in the tech groups looking to leverage the folks that have those skills. So we don't know what the ratio will be necessarily, but it's that type of dynamic. And again, what's important is empowering the younger generations that understand this tech the best. So there's even just a shift in mindset in terms of seniority in who you surround yourselves with, realizing that that optimal mix is likely to be different than what folks like myself that have been doing it for a long time would naturally think is the case.

1:07:03But we do think it will move. It's moving fast by typical economic standards. But we definitely think this is going to be a multi-year theme. He sounds bullish on balance. He sounds like constructive, right?

1:07:16Michael Batnick:Yeah, most Bond guys are not that as constructive as yours. It's refreshing. Yeah, and I'm not accused of being optimistic. You don't sound Pollyanna. Especially, I'm sure I'm someone with a Knicks hat on, too. As a lifelong Celtic fan, I should be down right now.

1:07:30Downtown Josh Brown:Oh, you have your share.

1:07:31Michael Batnick:Stop it.

1:07:32Downtown Josh Brown:Is there anything you'd like to say positively about Jalen Brunson before we let you go? Yeah, he's a Villanova guy. I used to like him. He's a great player. He's a great player. He's a great player. Impossible not to love this guy. He's a great player. Yeah. And he plays the right way. So it's been exciting. It's funny. Saturday night I sent around a, I congratulated, I think it was Georgia for a win in the NCAA baseball tournament. And then I mentioned that Hartford Whalers won the cup this weekend. Anything you can do except the Knicks. Anything other than the Knicks. But it's all good. I think we'll let some folks out early for the break.

1:08:08Downtown Josh Brown:Daniel Iverson, this has been such a pleasure for us. We're huge fans and admirers of yours and of Pimpos' as well. And I wanted to let people know where, Agnes, where can people go for more insights from PIMCO and the team? PIMCO.com? Okay. And is Dan going to start a podcast anytime soon? No. Probably not. All right. Well, you guys do it incredibly well. Really an honor to be here with you guys today. It was a lot of fun. Thank you. All right. In hour two. No, I'm just kidding. All right. Dan Iverson, ladies and gentlemen, thank you so much for joining us. Guys, thank you for watching. Thank you for listening.

1:08:42Downtown Josh Brown:We'll talk to you soon.

1:08:47Thank you.