Manny Roman: ‘there will be a tidal wave of money coming’

Good morning. This is the last edition of Unhedged for 2023. We will have more to say about both the year that is ending and the year to come in January, but for now, let me just note how much fun Ethan and I have had writing the newsletter this year, and how much we have learned from our readers’ comments and emails. We hope you have had some fun reading it, and maybe acquired an idea or two as well. Happy holidays!

Ideas for what we should write about next year? Email us: robert.armstrong@ft.com and ethan.wu@ft.com.   

Thursday interview: Manny Roman

Manny Roman has been chief executive of Pimco, the California-based asset manager, since 2016. In that capacity, he is responsible for $1.7tn in investor assets, in just about every form of fixed income, from municipal bonds to private credit. Below he talks to Unhedged about why the soft landing consensus is a bit too optimistic; why a little stress in markets is good for business; the advantages of scale in fixed income; the promise of artificial intelligence; and the “tidal wave of money” that is about to crash. This interview has been edited for clarity and brevity. 

Unhedged: Consensus says we have pulled off a soft landing, that we’ve achieved immaculate disinflation. Does Pimco have a house view that contrasts with that consensus?

Manny Roman: We put a higher probability on a recession. There are a number of data points which show weaknesses, and it is quite unlikely that the Fed can cut rates and cut rates quickly. And so there’s probably a 40 per cent chance that you get a mild recession. The difference between a soft landing and a mild recession is not going to be humongous, because it’s really in the details. But some of the Covid aid is running out, and so the consumer is going to be weaker, student loans need to be repaid, credit card bills are going up. What surprised us the most is how tight the labour market is, and I think that you won’t have a recession without [unemployment] at four and a half per cent [the unemployment rate is now at 3.7 per cent]. 

Unhedged: Acknowledging that the difference between a soft landing and a mild recession is small, how does your view that consensus is too optimistic express itself in portfolio management?

Roman: We’re more cautious about credit than some. I think we find a lot of value in mortgages. Broadly speaking, we think the opportunity to take risk is quite good. There’s a lot to do, which is not always the case. And if we arrived [at a point where there is] more fallen angels and companies who face more difficult challenges, that provides an incredible opportunity for performance. Broadly speaking, when you remember the years like 2006 and 2005, those are the years that tend to be difficult for us because everything is going up, and the chances to distinguish yourself are not there. But this could prove to be a very good time for active management. 

Unhedged: A little bit of disruption is good for you?

Roman: Yes. You want 2001 and 2002, which was quite exciting — anaemic growth but a lot of volatility and a lot of things to do. If you have a 2008, it could either be great, or you’re dead. It’s like Schrödinger’s cat . . . and for us, 2008 turned out to be great.

Unhedged: This summer, you described the market as a “target rich environment”. Things have changed a lot in the past six months, though. Is it still true?

Roman: What people sometimes miss is that a lot of what we do is supply and demand. The SVB situation [Silicon Valley Bank, which failed in March] has led to the regulator being much tougher on banks in terms of capital requirements. And what that has translated into is banks selling portfolios of assets. And size is a competitive edge when banks sell large pools of assets . . . it’s giving us a chance to buy large pools of assets cheaply. We bought GreenSky from Goldman Sachs, and I never thought we would get a good deal from Goldman Sachs, but we did. They needed to get out.

Unhedged: When capital requirements for banks change, and assets leave the balance sheets of banks and land on Pimco’s balance sheet, from the point of view of systemic risk, what has just happened?

Roman: You have a stronger bank, and if we know what we are doing, you have higher expected returns for many people who have money in a pension plan, or a mutual fund, or for an insurance company. It’s a pure transfer, the bid/offer basically benefits the saver. When you think of it as a prudential measure, it does make some sense.

Unhedged: I suppose there’s a worry on the part of the bank leadership where they say, well, we’ve got to make money too, and our return on assets is declining.

Roman: Yes, but it’s at the margin. They don’t get rid of the whole portfolio. It’s a transaction which gets them to the level [of assets ] where they need to be. They keep on lending, they keep on being very active. And the banking system, the big banks and the regional banks in the US, is in great shape. It’s really the banks that have problems, like you saw in March, or it’s banks where if they don’t do something, they may get in trouble. I mean, there are 4,000 banks in the US.

Unhedged: On the day the Fed starts to loosen policy, what changes? What is Pimco’s strategy in anticipation of that day?

Roman: Well, the first thing is, of course, we will own more duration. Right now we are duration neutral. And I think there will be a tidal wave of money coming. Right now you have $5tn in short-term cash in the US, rolling Treasury bills, that can extend in duration and take more risk. It is very hard to predict when, because it’s animal spirits, and predicting animal spirits is not an easy game. But the moment this happens, you will see an enormous amount of money, and it will come in many different ways: in fixed income, in mortgages, in munis, some will go into equities. It will make risky assets of all types appreciate. You will see some coming in anticipation [of cuts], but it’s very hard to figure out when it will come exactly. I think the analogy of a slow big wave is the best one. Once it starts, it starts, and it’s big. I think it’s true across the globe, because remember, Asian investors and European investors have not been much invested in US fixed income because of the cost of hedging [which is increased by high US interest rates]. When that changes, we will also see a lot of money coming back into the US. Our house view, remember, is that we feel better about the US economy than we feel about the UK and Europe.

Unhedged: Pimco is a shop that prides itself on going after alpha — on earning excess return. There’s a lot of talk about how the pandemic was an inflection point, and that maybe we’re in a different kind of rates regime or a different kind of economic regime. Pre-pandemic versus post-pandemic, has the way you think about going after excess return in fixed income changed?

Roman: I think there has been [a regime change] because essentially remember that pre-pandemic you had, I can’t remember offhand, $10tn of negative yield? For us, the worst business situation is Japan 2019, when rates hover between zero and minus a quarter. There isn’t much to do, and adding value for investors is not easy. So, the bad news is we got a real repricing of rates. Rates went much higher than any one of us expected, and we had to adjust to that. The good news is that now we have a lot of business which is super attractive. Japan is incredibly interesting all of a sudden. The UK is incredibly interesting for all sorts of reasons. The US is interesting. Emerging markets are interesting. The transition wasn’t fun. We clearly lost assets because of the arithmetic of the duration adjustment. But it’s quite exciting right now.

Unhedged: What’s exciting to Pimco about Japan? 

Roman: The fact that there may be a change in monetary policy, and the fact that given the demographic constraint of Japan and the truly extraordinary amount of money on the sidelines. A push towards more risky investment may be incredibly beneficial to return.

Unhedged: In previous interviews, you’ve used the term “biodiversity” to describe fixed income. Different issuers, durations, structures. But I wonder if you can see something like what has happened to equity funds happening to fixed income funds, as technology becomes more sophisticated. More passive strategies, more automated strategies, pressure on fees, and so on?

Roman: Of course it’s possible. But what is happening in practice is the reverse. The world needs to borrow more and it borrows in all sorts of ways — government, corporate, asset-backed, municipal, private, public. One assumes that all these things should trade on an efficient frontier, but they don’t. Sometimes the private debt market is pretty attractive, sometimes it’s not. Sometimes the student loan market is really attractive, sometimes it’s not. We have biodiversity, in terms of where it is possible to invest, which is incredible. And I think people from the outside sometimes don’t realise that our job is much easier, in a way, than the stock picker’s. If you want to own AI, and you manage a big portfolio of stocks, chances are you have to own Nvidia, whether you like it or not, whether it’s expensive or not. We don’t have this problem.

Unhedged: Pimco has a private credit business alongside its huge public credit business. How has the increase in assets flowing into private equity affected the public bond markets? Is there a tension between the two?

Roman: The reality is the banks, for a variety of reasons, can’t quite lend enough for the private equity market. It’s a very big industry, we could have a long conversation about the returns, but the reality is they need to issue debt, and the question is, is the debt that private equity sponsors are issuing cheap or expensive? Do they have better terms than the [bond] market? And can one truly be agnostic about where value is? And the private debt issued by sponsors really needs to be held to maturity. There’s no liquidity, so you should harvest a liquidity premium. And the liquidity premium should be one and a half to 2 per cent. To make matters more complicated, the structure of the notes, the covenants, the rights you have under the debt are rarely the same. You’re not necessarily comparing apples [to apples]. Right now, the public market looks quite attractive. And at some point in time, these things compress themselves: if the public market looks too good, more people put money into the public market, and all of a sudden private becomes attractive.

Unhedged: It is probably more true in private equity than in private credit, but there is a view of private markets that, so far from offering an illiquidity premium, investors like the illiquidity and will pay more for it. They want an asset that doesn’t get marked to market, whatever the underlying volatility of the asset is.

Roman: I very much agree with you on private equity. I think there is still a situation where it’s hard to believe that every single pension fund [private equity allocation], as we speak right now, is marked to market. There’s probably another shoe to drop in terms of catching up. And I think the difference in valuation could be quite big. The thing about debt is . . . as long you don’t have a real downturn in the business cycle, you will not see much of this mismatch [between public and private valuation]. You will see some in real estate and some in certain industries which are more challenged, but you need a downturn. The moment you have a downturn you have a rise in the default rate and all of a sudden you see a big difference in marks. And the marks will not go from 100 to 99. They will go from 100 to 60 or whatever the right level is.

Unhedged: Well, you’ve given us half an hour of your time, which is all that I can ask for.

Roman: Can I add one thing? Artificial intelligence is very real. Because essentially, the way this industry used to work is we would have data, the data would be parcelled and organised, the human brain would look at the data, and one human brain would make better decisions than another. And it would be a zero-sum game, with a generic outcome. What AI is going to do is it’s going to go and fish for data, in many different places, in places we’re not used to or that we’re not good at, it’s going to do part of the thinking. And it’s going to be a real tool to make better decisions.

Unhedged: You envision a tool that will present recommendations, that will say, have you thought about this or that?

Roman: I’ll give you one example. We have data on the mortgages of every single US homeowner. And we would have a payment model in the old days where, when rates go down, people would pre-pay. And at first it was non-linear regression. Then we would use machine learning to get a better pre-payment model, understanding who is going to pre-pay and who is not going to pre-pay. I think the next thing is we will have incredibly deep learning algorithm that we look at all of the mortgages in the US and every possible other information that the machine can get its hands on, at mortgage level, jobs, migration. It’s easy to get excited about the prospects. What the result will be, we will find out. I think it’s powerful and I think we have to invest quite a bit, and I think we need to embrace it. 

One good read

Glynn Simmons, free for Christmas after 48 years.