Episode #360: Erin Browne, PIMCO, “I Combine A Quantitative Approach As A Starting Point…And Then Overlay A Discretionary Point of View”
Guest: Erin Browne is a managing director and portfolio manager for PIMCO, focusing on asset allocation strategies. Prior to joining PIMCO in 2018, Ms. Browne was a managing director and head of asset allocation at UBS Asset Management. Previously, she was head of macro investments at UBS O’Connor, a multi-strategy hedge fund manager, and a global macro portfolio manager at Point72 Asset Management. She has also held roles at Citigroup, Moore Capital Management, Neuberger Berman, and Lehman Brothers.
Date Recorded: 10/6/2021 | Run-Time: 58:24
Summary: In today’s episode, we’re talking all things macro with someone who spent time as a Strategist at Moore Capital, PM at Point72, and most recently Head of Asset Allocation for UBS Asset Management, all of which helped Erin develop a framework for looking at the market through both a quantitative and discretionary approach. Erin applies that lens to the world today and shares what she sees, notably the risk of a continued rise in energy prices. She walks us through how that may impact different asset classes and commodity prices. Next, we look at global equity markets and hear how the U.S. market compares to Europe, China, and emerging markets.
As we wind down, we touch on bonds, interest rates, crypto, and much, much more.
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Links from the Episode:
- 1:10 – Intro
- 2:03 – Welcome to our guest, Erin Browne
- 4:24 – What first led Erin to a career in investing
- 5:37 – Erin’s framework for macro investing
- 11:44 – Thoughts on inflation where it might have the most impact
- 14:36 – Positioning for energy companies, commodities and other asset classes
- 17:33 – Will commodities balance themselves in the near future or is this a new trend?
- 21:35 – What current assets and opportunities investors could be allocating to
- 23:51 – How general equity looks in a post pandemic world in 2021
- 28:01 – When inflation could become a problem in the US and impact multiples
- 29:41 – Can we prepare for inflation and learn to adapt to it?
- 33:34 – Strategic asset allocation
- 36:55 – How out-of-the-box is Erin allowed to get when seeking returns
- 39:19 – Thoughts on the opportunities and landmines in fixed income
- 42:35 – Any plans for Erin to step into crypto in the future?
- 45:03 – Experiences that have shifted Erin’s perspective on macro investing
- 47:53 – What keeps Erin up at night as she looks out to the horizon
- 49:20 – Erin’s favorite charts, indicators, and frameworks for assessing opportunities
- 53:26 – Erin’s favorite places to Scuba dive
- 56:13 – Learn more about Erin; pimco.com
Transcript of Episode 360:
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Meb: What’s up friends? Today another great show. Our guest is a portfolio manager for PIMCO, focusing on asset allocation strategies and last year was named one of the 100 most influential women in the U.S. finance by Barron’s. Today’s show we’re talking about all things macro with someone who spent time as a strategist at Moore Capital, PM at Point72. And most recently, head of asset allocation for UBS asset management, all of which help her develop a framework for looking at the market through both a quantitative and discretionary approach. Our guest applies that lens to the world today and shares what she sees, notably the risk of a continued rise in energy prices. She walks us through how that may impact different asset classes. And then next we look at global equity markets and hear how the U.S. market compares to Europe, China and emerging markets. So we wind down, we touch on bonds, interest rates, crypto, and much more. Please enjoy this episode with PIMCOs Erin Browne. Erin, welcome to the show.
Erin: Thanks for having me. I’m excited to talk to you today and have this conversation.
Meb: I can see you, I’m looking out the window you’re right down the road in Huntington Beach. Where are you, Newport Fashion Island?
Erin: Newport coast so a little bit south of Newport Beach, very grey and hazy day today.
Meb: While we were chatting some telescope economic indicators on the cargo ships, I mean that was a big Barron’s cover story and you said you woke up and they were cleared out and thought, “Wow man, this is going to be an indicator I’m going to have to work into my newsletter.” But there’s a little more play, right?
Erin: The last couple of weeks there’s been six or seven ships parked outside of…and that we could see which is pretty unique like we’ve never… I’ve only lived out here for years, I’ve never seen any cargo ships outside my window. They were cleared out this morning when I looked out and I was optimistic that maybe we were starting to see the Long Beach ports start to clear some of the inventory but unfortunately, I don’t think that’s the case. I think they’re just moving them further north given the oil spill that happened over the weekend. So unfortunately it took an environmental disaster to get the cargo ships to move.
Meb: You may have to put surfing off for a few more days. I’m not sure. I mean, that was one of my biggest adjustments by the way moving to Los Angeles from other towns is often like you walk on the beach or come home and you look down and you say, like what’s that smell? You’ve got a bunch of tar on your feet. That’s never happened to me on the east coast. But they say it’s natural. All right, so you are an East Coast transplant. You have a pretty storied resume. I want to hear the Erin timeline. We got Point72, Moore, Lehman Brothers, Citi, UBS, all in the mix. And now at PIMCO, what was the entree to markets for you?
Erin: So I graduated from Georgetown in 2001. I started off actually at Georgetown as a pre-med student. My dad had me take six years of Latin in high school. So I figured I’d put it to work and become…which is absolutely useless as a foreign language to study. I started off and thought I’d put it to use as a pre-med student. Ended up taking a class, I think my sophomore year at Georgetown and fell in love with economics. And so the rest is history. I sort of blindly went into my summer internship, after my junior year at Lehman Brothers and didn’t really know what I was getting myself into, but really loved it. I just loved the energy, the passion that my co-workers had, and the fact that every day was a different day and like I sort of haven’t looked back since then. A brief three-year stint in an investment banking, which just started my career. Since then, I’ve been really immersed in macro at a number of macro firms that you mentioned. Moore capital, I ran Citi macro trading for a brief while and then moved over to Point72 SAC. Most recently prior to PIMCO, I was at UBS both running a macro fund at UBS O’Connor and then eventually becoming the head of asset allocation at UBS asset management, which led me out west and led me to PIMCO.
Meb: The land of milk and honey. There’s a couple of funny jumping off points totally unrelated to really anything, which is where this podcast goes. I remember taking as you reference, Latin utility, I took Latin in high school. I was sleeping during one class, and this is when we were doing a Latin play. So the entire thing was in Latin and of course being sleeping got appointed to be the lead in the play, which means you had to memorize the most lines and I didn’t know any of the words, but I just memorize the entire play. I have very painful memories from that. But I would have definitely overlapped with you. I was a Virginia guy but lived in DC 2000, 2001 so probably crossed paths on M Street or elsewhere down by the waterfront. All right, so does part of the macro time at Moore…? Were you there when Bacon bought the ski mountain? Is that considered a macro? Did he buy a townhouse? Am I getting that right?
Erin: A lot of that part of his personal investment. So that was not part of his formal under the more capital umbrella of our investor class.
Meb: It sounds like a pretty good hedge though, inflation and everything else as well. All right, so tell me about like kind of your evolution of framework. You know, macro means a lot of different things to a lot of different people. Some people it means a lot more economic subjectivity. Others, it means a quantitative technical mindset based on prices only, certain others it’s short terms, or in others, it’s multi-years. Some people it’s cross asset classes, some people it’s only in one. Tell us a little bit about kind of how you think about the world and how that’s evolved over the years. And then we’ll start to get into what the world looks like today.
Erin: So I would say yes, and yes to your answers, which is, I think, firstly, my philosophy and my framework has evolved pretty dramatically, I would say over the last 15, 20 years, although it’s been a little bit of a continuum.
Where I am today is I sort of combine both very much a quantitative approach as my starting point, my launch point for how I evaluate markets and opportunities, and then overlay a discretionary point of view on top of that very quantitative approach.
So we start at sort of the bottoms up, which is our long-term strategic asset allocation, which is really where our landing point is, over the next three to five years. What do we think because of supply demand dynamics, because of long-term capital market assumptions? What do we think the sort of strategic landing point for investments are going to be? And that just gives us a valuation anchor, where we think we’ll sort of gravitate to over the secular or the sort of next three-to-five-year horizon.
On top of that, I’ve worked with our analytics team at PIMCO. And I did the same at UBS, O’Connor, to develop a more of a short term tactical asset allocation model, which really looks at different market indicators and economic indicators to really give a sense of where we are in terms of the economic cycle, as well as where we are in terms of the business sentiment and financial conditions to help really frame where I think asset classes are going to go over the next really three to six months. And so this, I think, gives us a much better sort of pulse on where economics are heading. And ultimately, how asset classes shake out on the back of that. And so that really is our sort of starting point for how I think about how to invest over the short to medium term. When I look at investments, I’m always thinking, “How are asset classes going to perform over the next three to six months. I think getting the next one-to-two-week trade is difficult, and it’s much easier to think over a very short cycle, or at least over a macro thematic trade timeframe, which I think typically is inside of a year.
So that’s really the sort of starting point. And then on top of that, I layer on sort of systematic trades, which tend to really look to seek to generate alpha on a systematic basis where I think there’s sort of dislocations in the market. And then on top of that, there’s a discretionary overlay, which is a lot of the relative value trading that I do. I think when I started my career, there was a lot more RV trading.
Meb: Good. Let’s dig in to where all that elusive alpha is hiding today. There’s a lot of current market topics that everyone’s talking about. But as we look around the world, you can kind of pick the starting point for what is the main entry entree into what you’re thinking about or looking at. Maybe is there a particular driving force, whether it’s inflation, whether it’s interest rates, whether it’s valuations, like where should we begin? Here, and we’re recording this in early October 2021, the beginning of fall.
I think the starting point for asset class investing is growth. What is the growth opportunity look like? Where are we in terms of the economic cycle, and ultimately, how does the future look over the next six months or over the next one year?
And I think, starting with growth as our starting point I think that the outlook is still fairly robust. It’s certainly slowing from what we saw over the last year or so in the post-pandemic period. But when you look at corporate balance sheets, household balance sheets, they still look very healthy. And there still is a lot of cash that’s sitting on the side-lines, which makes me optimistic that we still have a lot of runway to go in terms of the growth outlook. There’s certainly been… Because of the port situation that we talked about earlier in this conversation, there certainly is some friction points, which is leading, I think, temporarily to a slower growth outlook. But that also I think, extends the period of growth over a longer timeframe.
That said, we are starting to see inflation start to pick up and start to percolate. And that I think, is one of the biggest risks out there. It certainly has implications with respect to the Fed and interest rate policy, it also potentially could eat into margins at a faster clip than the market’s anticipating right now. Same with household balance sheets, I mean, gas prices at the pump, you’re out here in California, north of $4.5, in most places at least around the coastlines in some areas are as much as $5 a gallon. I mean, you know, we’re up high from where we were, you know, 12 to 18 months ago. I think that that’s starting to eat into household balance sheets at the same time when a lot of the stimulus payments are rolling off. So that to me is the biggest risk factor out there. And certainly people are starting to talk about it. I don’t think that people are talking about it nearly as much as they should be right now.
Meb: What are sort of the indicators, your thoughts on inflation, like to the extent that it is increasing? You know, and you can comment more on that if you want. Where is that going to have the most impact? I mean, I think it’s easy for people to talk about bonds, equities. Do you think it helps or hurts depending on what they are, what they’re doing? What are some of the knock-on effects over the next six months, three years, as you look on the horizon?
Erin: So firstly, I think as Americans we’re in a little bit of a privileged position with regards to sort of what I see as a looming energy crisis on a global basis. If you look at Europe, I mean, natural gas prices, they’re skyrocketing, they were up almost 30% I think overnight. And same thing with yesterday. Yeah, pretty explosive, natural gas price appreciation. You’re starting to see that filter through into Asia as well, which are much more sensitive to energy costs than certainly we are in the U.S. right now, just given the fact that the U.S. energy prices haven’t accelerated nearly at the same clip, as we’ve seen across Europe and Asia.
What you’re seeing on the back of that is you’re starting to see some companies actually have to curtail or shut down their production lines. And so China is now making decisions in terms of what regions or what businesses can continue to produce, and which ones have to shut down temporarily. You’re also starting to see a number of utility providers in Europe, I think there were five or six in the last month or so in the UK, which have gone out of business. And you’re also starting to see decisions being made, even here in the U.S. in terms of what plants to plant, I guess is the right word. The decision in terms of the trade-off between corn versus soy, corn is a more fertilizer intensive crop to plant versus soy and wheat which are lower fertilizer intensive, and if fertilizer prices continue to rise, you may start to see farmers making those type of economic decisions in terms of which plants to plant the season.
So we are starting to see inflation really start to influence business decisions. We’re really at the starting point of that right now because we’re only a month or so into this explosion in energy prices that we’re seeing. I don’t think that the equity market has fully woken up to that fact, when you look at earnings expectations and the expectations for margins. There’s been a lot of talk about supply chain shortages, there’s been a lot of talk about interest rates potentially rising and the impact that that’s going to have on the balance sheets and corporates. But you haven’t seen yet a lot of talk about the margin impact that rising energy prices could potentially have to different pockets of business. And so I think that that’s really the next conversation to be played out within equity markets.
Meb: As we take that thesis to the next step, I look back over the last couple of years. It’s been kind of bananas we were talking about on the podcast last year. Talking about the energy sector as the equity sector and just saying how crazy it’s been over history where at one point, it was like a third of the S&P almost and then it got as low as what, 2% or 3% I think at the bottom? And then not surprisingly, it’s having an absolute ripper of a year this year. What’s the sort of positioning when you think of this? Is it, “Hey, look, you want to be long energy companies? Is it actually you want to be long commodities? Have they moved too far too fast? And when you say commodities, obviously, it’s not one general asset class, there’s a lot of granularity, you know, precious metals have been doing poorly, and this is personal to me, because I manage a farm in Kansas that I managed to sell all of our wheat about a week before it ripped up. So my timing is always atrocious on this, by the way, listeners. But what are sort of the implications do you think? Because most investors I talk to are rarely, if ever, unless they’re Canadian, allocated to energy and commodities in general. What’s your sort of general thoughts?
Erin: Looking over the secular horizon, I think you want to be invested in those commodities that are going to play well into the adoption of ESG. So I think whether that’s copper, because there’s going to be a much higher copper content and ESG friendly build out of infrastructure than what you see today. I mean, I think that that’s a good long-term secular play. But if we’re just talking about the here and now and what’s going to do well over the next three to six months, I do think that as we get into winter, I think natural gas prices and U.S. energy prices, in particular which have lagged the rest of the world, will continue to do well, particularly if we go into a colder winter season this sort of upcoming winter.
So do think that energy likely does well. But then you also have to think like what are the substitution, sort of commodities that are going to be tightened because of the tightness that we’re seeing in the energy markets play out, whether it’s coal, whether it’s steel, aluminum, because they have to close down factories, because they don’t have enough energy to keep the same supply factories open in China, in the U.S. Now, I do think that you’re going to start to see some real decision making happening, that is going to have a much broader impact across commodities than just the energy sector as in and of itself. And so I think those materials and those raw commodities that need energy as a higher input are going to be the ones that are likely going to see tighten supply into the winter months. And that’s probably the right places to be long right now. So I think industrial metals, as well as energy use for commodities are likely to continue to do well over the next you know, sort of three-to-six-month horizon.
Meb: Commodities tend to have…and this is just kind of like econ 101, a way of bouncing out over time horizons, you know, low prices get cured by companies shutting down in production and high prices, vice versa. I look to this. I mean, we’ve seen the craziness with lumber, and we’ve seen a natural gas in Europe, do you think is something that this kind of cures itself in the next year? Is this going to be something we’re going to be dealing with for the next 3, 5, 10 years? Is this just like the craziness all pandemic just flush of all the systems getting jacked up over the past year? Or is this actually like, something that you foresee could be the sustainable reality?
Erin: This is a really good question, because there’s a supply and demand element to this conversation. I think on the demand side, yes, you’ve seen greater usage or greater need for goods at this post-pandemic…as we exited the post pandemic-period, we’ve seen a much more physical rebound in terms of physical goods, this time, as opposed to past recessionary periods, or the exit of past recessionary periods where it was much more of a service driven or service led recovery. This has been much more of a physical goods recovery, which is very distinct from past periods of rebounds that we’ve seen out of recessions, at least relative to recent history.
So there is definitely a demand side that’s fuelling, I think, a lot of the appreciation that we’ve seen in the energy sector, as well as in the metals and materials sector over the last few months. But I think this is also largely being driven by supply. And I think this is a much bigger factor that’s led to the current climate that we’re in right now. There are a couple of different threads that are driving this. The first is ESG adoption. So you have seen an under investment in new supply across energy over the last couple of years because of the sort of ESG adoption, because financing to the energy sector has gotten more expensive. And I think that that has curtailed the investment in either new mines in the industrial side, or new exploration on the energy side. And so that sort of materially under investment has led us to potential…the supply place story where we are right now, in here today.
I think in addition to that, you have seen China also making I think decisions to under invest, particularly in some of their infrastructure that really curtail, particularly in the northern region investment because of ESG. So it’s not just the U.S. and European sort of conundrum that we’re facing, but you’re seeing it across China as well. And with respect to China, the trade deal or the trade tensions that they’ve had with Australia has also curtailed their imports of coal from Australia into China. So have been sort of under supplied with respect to coal, because that was one of the largest imports prior to the trade tensions that emerged over the last 18 months or so. In addition to that, there’s been a number of natural disasters and weather impacts that have shut down production, both in terms of the energy sector as well as in the industrial sector, over the last few months or so. And that’s also curtailed supply.
So I think there are a number of factors that have led to the current environment that we’re in, some of them potentially could clear quickly. But I think some of them particularly when you talk about the under-investment is a longer-term sort of structural challenge that we face right now. And it’s likely not going to be cleared over the next sort of three to six months. Even if you were to start to build out new capacity, it’s going to take time for that capacity to be built out. And so I think that that is going to lead to a little bit of a longer sort of leeway in terms of the challenges that we face. And I don’t think that we’re going to see this necessarily ameliorated in the very short term unless we see a very, very mild winter, which could probably clear a lot of these problems in the shorter-term timeframe.
Meb: I’m looking for some snow out west, so it can be mild, but snowy. Talk a little bit about investing implications, are there any pockets of opportunity on either time horizon you’re looking at? And we can stay in sort of the thought space of commodities, but also equities and rates. I feel like a lot of people have struggled when I talk to them about why precious metals have kind of done so poorly, relative to a lot of the other commodity complex, but any general thoughts like where should people be putting their money on this trade? Is there an opportunity? Or is it more just like, “Hey, you should have a set allocation and set path?
Erin: So there’s been a lot of talk about rates moving higher, and I struggle to see how real rates are going to move materially higher, A with a very gradual fed that doesn’t seem like they’re willing to really rock the boat too quickly, too fast. And then secondarily, with the fact that you’re seeing commodity prices rise at the clip that they are, which obviously, feeds into breakeven yields, and that I think, is going to keep real yields quite low. So that actually, when you think about it isn’t necessarily a bad environment for equity investors. But I do think that you have to move away from some of the more defensive sectors, some of the more secular growth players that have done well over the last couple of years and think about moving into some of the later cycle investments which tend to be more of the cyclical sectors in the economy.
So whether it’s industrials, metals, mining, sort of select energy players, I think that those are likely the ones that are going to outperform. You’ve also just seen because of the pandemic, some pretty significant dislocations in equity assets as well. Real estate, I think is one of the big ones, the travel and leisure sector. So sort of absent this whole energy discussion that we’ve been having, I still think that there are laggards from the pandemic that likely will continue to do well as we continue to normalize, we see people go back to work, resume travel, go back to more of their daily lives. And so I still like the hotel leisure hospitality sector, which I think will likely do well, particularly as we move past the next couple of months.
Meb: What do you think about U.S. stocks in general? We’ve had a monster run, not just since the pandemic, but really this entire cycle post-financial crisis, particularly relative to the rest of the world. Talk to us, we can start with the U.S. in general, and then we can move around the world as you see fit. What role did valuations play? You said you used to talk a little bit still do about relative valuations. But what’s the world look like here end of 2021? I almost said 2020. How do things look there on the general equity side?
I think … if you’re thinking about valuations over a short timeframe, you’re likely going to be disappointed in using them as a benchmark for how asset classes should perform.
I think, you know, valuations tend to work well over a 5-to-10-year timeframe. And they really only tend to work well when you’re seeing valuation well in excess, or well under what their sort of long-term strategic value should be. So if you see equity center two standard deviations above the long-term sort of fair value, that’s probably a good time to sell equities over the next 10 years. But as an investor that cares about the daily mark to market or at least the monthly and quarterly mark to market that probably isn’t going to be that helpful. But I think evaluations can be useful, but you have to understand when they’re useful and the timeframe that you’re thinking about.
On a relative valuation basis, the U.S. always commands a relative premium to the rest of the world. And I think it’s justified. I think that structurally, the U.S. has advantages. It’s a more business friendly climate, the innovation and productivity tends to be higher than the rest of the world, at least the rest of the developed market economies. In addition to that, just the way that we are…the S&P 500 is sort of structured with a much higher weighting towards technology than what you see certainly out of Europe, also is a structural advantage, because you’re investing in higher productivity, higher growth companies just because of the way that the S&P 500 was designed.
So I think that U.S. equities, in most market environments, will tend to outperform unless you’re at very significant extremes, or unless you’re at a point where another region is at an inflection point with respect to growth that’s going to materially outpace the U.S. And I don’t think that we’re there right now. I think that Europe has had a good run over the last six months or so, it’s performed relatively in lockstep with the U.S. But the energy crisis is going to hit Europe a lot harder than it’s going to hit the U.S. over the next three to six months. And so they’re at a pretty pivotal point right now, where I think you’re going to start to see under-performance. With respect to China, I think China has become largely a very…I don’t want to say investable place, but a very difficult-to-invest place.
Meb: You can say whatever you want.
Erin: It’s really difficult as an institutional investor right now to invest in China, given the fact that there’s just not clarity about what the regulatory regime is going to look like over the next sort of year or so or five years. They continue to take a very sort of autocratic approach to the way that they’re shutting down different businesses, or different business lines, making it difficult to continue doing business as usual, whether it’s the education sector, whether it’s the healthcare sector, the gaming sector, video, game sector, internet, as well. And so you don’t know what’s the next shoe to drop. And so as a result of that, as an investor, it’s very difficult to put money to work there. And so while valuations have gotten really cheap, and there’s a lot of good companies in China, you don’t know if they’re going to be able to do business as usual, they’re going to be able to grow in the same way over the next five years.
And so we’re taking a little bit of a wait and see approach to the way that we’re thinking about investing in Chinese equities right now. Outside of that, emerging markets also are at a difficult point, if you have slowing growth and tightening monetary policy, like emerging markets typically don’t do well in that environment. So I’d rather stick with the U.S. for now as my overweight, wait and see for the rest of the world and wait for valuations to get a lot more attractive and things to stabilize before I step back in.
Meb: At what point do you think that inflation becomes a problem in the U.S. where it starts to affect multiples, or what people are willing to pay or like, do you see that as something, as a big concern, minor concern, no concern at all?
Erin: I think you’re going to have winners and losers. Typically, if you just think of it on a very macro basis, when inflation gets above three to three and a half percent, that’s when we start to see it impact multiples. And that would be sort of sustained over a longer time frame. You have started to see inflation expectations on the longer-term rise, but they’re still fairly muted over a very long sort of time horizon. And so while people are buying into short term inflation, arising because of these supply constraints, because the sort of temporary factors, I don’t think that people have really bought into yet that the long-term inflation expectations are going to be materially higher. I mean, most people, most economists, most outsider analysts still expect that inflation is going to move back down throughout 2022. And sort of settle in the mid 2% range at the end of next year.
If we were to start to see longer term inflation expectations rise and sort of sustain that higher level, I think that that would definitely into sort of margins and into the expectation for multiples. We’re not there yet. I do think though, people are being a little bit overly optimistic when they sort of price out what their expectations are for margins next year. I think you’re going to see a lot more disappointment on the margin side than what people are estimating. It’s probably not going to hit the third quarter. It may not even hit the fourth quarter, but I do think it’s going to hit 2022.
Meb: I’ve spent a lot of time thinking about, when you think about certain markets, one idea that sits in my brain is an environment where the current cohort, portfolio managers, analysts and everything else, haven’t experienced it in the U.S. I mean, most managers haven’t really experienced like an inflationary type environment, right? You got to go back quite a ways to the ’80s. And you and I were playing Nintendo at that point probably versus the ’70s and prior. I mean, this reminds me of 2008, which was sort of a crisis that really didn’t have some similar analogues probably more similar to the Prussian sort of bust than others. And think about other things like extrapolating to talking to friends in Japan who have lived there for the past 20, 30 years, most have experienced, a very distinct world that is different than what it was prior to boom time.
So I wonder how much like, the mindset of theoretically, if there is inflation, is it something that people even know how to adapt to? And what sort of effects that has? I don’t know, I spend time noodling a lot of these things it doesn’t really affect anything I do. But I think about it, it’s more of a happy hour discussion.
Erin: No, I think that’s a really good point. I remember listening to a speech by Abe, when he first took over as the leadership position in Japan. And he said something to the effect that he was going to break through the bedrock of sort of inflation expectations of the Japanese sort of psyche with respect to inflation. He tried really hard with his, you know, sort of Abenomics and his three arrows of Abenomics. In order to do so, put a lot of sort of might and muscle behind it, and yet still, inflation expectations in Japan barely budged. I mean, I think they budged for a couple of quarters and that was about it. And I think you’re right, it’s really hard to break that mentality. Just as an example, my mum was born in 1937. So she’s approaching 84. She’s pretty seasoned. And she grew up in the depression. I mean, she would tell me stories about growing up and she grew up in not a wealthy household, it was a pretty poor household. Her father, my grandfather was an electrician and worked three jobs and was barely home because one of his jobs was in Philadelphia, and he lived in Brooklyn. So he was commuting back and forth on the train to Philadelphia for his engineering jobs. And so my mum would chew gum, and then she would actually save the gum under her dresser or under her bedside table so that she could chew it the next day.
And they would make tomato soup by buying ketchup packets and mixing it with water and that’s sometimes what they’d eat at night for dinner. To this day, my mum who has done very well, and my dad has done very well in their careers and have saved up but a pretty nice nest egg… To this day, my mum still has that exact same mentality, she’s always worried about how she’s going to pay the next bill, even though they have plenty of assets to pay the bill well beyond what their sort of natural lifespan is going to be. I remember growing up, we were clipping coupons every weekend, and my mum was only buying brand list cereal, or flour, or whatever it was, it’s still that mentality. My parents still shop at Costco and refuse to buy anything outside of Costco, including clothes, like they think that that is like the end all, be all for shopping. It’s really hard to break that mentality and I think that what you grow up in is largely how the lens that you see the world and largely how you see the world.
So I think that you’re right, like the current generation of investors haven’t lived through an inflation scare, likely don’t know how to sort of position for that. And certainly, we can all study and look at what assets perform well during inflation environments. But without having that experience, it makes it very difficult, I think to properly factor that into your investment framework.
Meb: I had so many thoughts as you were talking about that. I mean, I definitely had a lot of fun that’s talking to my father and grandparents when they were alive about those times. And there is a great book called “The Great Depression: A Diary.” Listeners if you want to read a little bit about that period, in particular, but there to give you some perspective. And the second lesson is if you go over to Erin’s house, parents, whatever you do, don’t put your hands under the breakfast room table, because it’ll just be covered in gum reserves for the pandemic, part two. How does this sort of fit together? I feel like us macro folk could sit and chat for 10 hours on these topics. But part of what we talk about on the show and elsewhere is like you have the diagnosis and then like what’s the prescription? Meaning, how does this actually impact what you end up doing in the portfolio? And so do you start from like a target allocation and then move away? Is it a situation where you start with a blank page, and then add things from the recipe book, how does the chef put it together?
Erin: That’s actually where we use that strategic asset allocation. That starting point is, that is our long-term sort of allocation of how we should think about where our landing point should be over the next three to five years. And so that’s our starting point. And then we’ll move away from there based on what we think the near-term horizon and the near-term investment landscape is likely to bear for us. So as that starting point, for us actually, most of the funds that I manage are 60/40 funds or target date funds that have a sort of defined glide path for investing over a longer timeframe. And then for 60/40 funds, we’ll use that as their starting point and then move away from it based on how much we think 60/40 is likely to dominate over the next couple of years.
I also do run some absolute return strategies where it’s a little bit more of a blank slate. And so we’ll build up rather than use a benchmark as our starting point. But for all of them, I think that the philosophy and the way that we sort of manage the funds is pretty similar in terms of really overlaying those shorter-term views in terms of how we think assets are likely to perform over the next year or so. So right now, I think we’re probably somewhere in the mid to…moving into the later cycle environment. And so as a result of that, I want to be more invested in commodities, more invested in sort of asset classes that are going to be positively convex to inflation rising and sustaining a higher level, and being a little bit away from investments that I think are going to fare poorly in that, either because inflation is going to be higher than what the market’s anticipating, or because they run with high leverage. And if you start to see either growth flow or inflation higher than expected, input costs higher than expected, they’re going to run into real problems.
And I think right now, we’ve been in an environment over the last couple of years where liquidity has been flush, where assets that maybe shouldn’t have been in existence or shouldn’t have been funded at the levels that they have been funded. We’re ripe with liquidity and we’re able to keep the lights on because of that. And so I do think that there’s real opportunity to pick your spots to be short in the market right now that probably aren’t going to fare well in either a higher inflation, lower growth or less liquid environment.
Meb: How much latitude is there? Like, how weird are you guys willing to get? Is it like, do you have the mandate where they’re like, “You know what Erin, you can straight up go 100% cash and bonds if the world’s ending.”? I assume that’s not the case. What’s the sort of tolerance bands? Or is there ability to…could you move the portfolio short? Could you say, “You know what, I’m just going to go relative value China versus U.S. and that’s that.” How much sort of weirdness do they allow you to do over there?
Erin: It really depends on the fund. And because I like sort of run a pretty wide range of funds, it really is product by product specific. What I think was the most interesting and that PIMCO does the best, and this is across my funds and across other funds as well, is that because of our size, our scale and our balance sheet, we’re able to actually invest in like pretty weird assets that we think are really attractive convexity profile in terms of the pay-outs that other funds probably won’t touch, or wouldn’t do, or just don’t get the look on. So whether that’s account receivable financing, whether that’s some of the private deals that we participate in, the fun and sort of interesting sort of weird stuff is more about the asset classes that we play in, and what we invest in, rather than risks that we’re taking. We tend to be somewhat conservative in terms of the risks that we are taking or properly conservative in terms of the risks that we’re taking, we’re willing to sort of traffic in asset classes that I think a lot of people don’t even get the looks on just because of sort of who we are and what we’re able to do because of our balance sheet size.
Meb: And when you say that, does that mostly mean in fixed income space? Are you talking catastrophe bonds? Are you talking about swaps on crypto, what does that mean?
Erin: Yeah, I mean, so catastrophe bonds, absolutely. You talked about sort of like just account receivable financing for different companies, different corporates will do stuff in the emerging market space, where…on the corporate side, which I think is particularly complex. And then a lot of deals are brought over the wall by the issuer in order to help sort of structure on the private side deals that meet their needs, but also meet our investor needs. That I think is where we really do use sort of financial engineering and structuring in order to create really attractive opportunities. So I think that that’s what’s the most unique thing about PIMCO where we do things that some of our traditional sort of competitors are like not equipped to really traffic in.
Meb: This answer may differ a little between you guys and then kind of what you would say to an individual but PIMCO, long story history, fixed income manager, what does the fixed income part look like? Is it all treasuries’ tips? Is it a worldwide blend of sovereigns? How do you think about the fixed income space? Are there any particular landmines? Any particular opportunities today?
Erin: Yeah, so what I think is really interesting because I run 60/40 funds, basically when you look at our competitors, they’re all running the 60. They’re not really running the 40. The 40 is they’re basically investing in Barclays Ag and letting it do what it does, but all the tracking, or all the risks that they’re taking is on the equity side. And it makes sense, right? Like equities are fun. A lot of times the people who approach 60/40 funds come from an equities background, it’s higher octane, you can get more volatility more return. And people think that within fixed income investing, it’s largely pull to par and sort of the more boring aspect of multi-asset investing. But what we actually do, which I think sets us apart, is we are actively investing and driving alpha on the 40 portion of the book as well. And that is by diversifying pretty meaningfully, the fixed income portion of our portfolio away from just sort of a Barclays AG or sort of a boring Treasury portfolio, investing in emerging market bonds, and investing in high yield corporates, in corporates globally, not just in the U.S., investing in munis, investing in a real rates as well as normal investing in a, you know, much wider swathe of in terms of opportunities than what you see in sort of traditional multi-asset funds.
So this is not hard. It’s just that people don’t do it. I think that right now, there’s really ripe opportunities within fixed income, just given the fact that the way that most of the market is set up, it’s just not set to take advantage of those opportunities.
Meb: We’ve managed to do an entire macro conversation without any reference at all to crypto. What’s PIMCO doing? What do you guys think about that in any capacity at all?
Erin: So right now, we’re doing a number of workstreams that are really focused on, “How do we approach crypto, and how do we do it in a way that’s appropriate for our clients?” And we’ve spent a lot of time over the last couple of years, studying it, researching it. I sit on a work stream, on our investment committee at PIMCO. And every month or so we’re having a crypto conversation, in terms of like how we’re thinking about it as a business. The volatility of the asset class right now is such that we don’t think it’s appropriate for the average investor, just given the fact that it is highly volatile. And it’s also not a good hedge within client portfolios, given the fact that it tends to be somewhat correlated to overall market risk and risk sentiment.
And so I think initially, people were thinking crypto was a great hedged asset for the rest of their portfolio. But what we found in practice, particularly over the last 18 months or so is that it actually has just added fuel to the fire of your risk in your portfolio, particularly during down periods of risk aversion in the market, which is really not what you want. It doesn’t perform like gold, you know, as an example. I think that when you’re thinking about investing in crypto, you have to realize you’re taking a very highly speculative bet. It’s a bet it’s really not an investment for sort of a long term unless you’re willing to sort of put it in a side pocket and check on it you know, every couple of years and take that sort of longer term bet on it.
Meb: You know, how many people on the planet do you think could own some crypto and check on it every couple of years? Not even crypto, any investment on the planet. That’s a good idea for an app or brokerage, where it’s like a lockbox, you put it in and like you are not allowed to touch this for 1, 3, 5 ,10 years. If you look, it’s like a penalty. That’d be the only way to get around it. All my crypto friends check crypto, I would say hourly.
Erin: That’s led to sort of this high-octane volatility environment for the asset. And so I think that there’s probably a lot more maturing that needs to occur in the asset class before we’ll really feel comfortable putting dollars behind it. That’s not to say that we won’t, but right now, if you think about the added benefit that it brings to multi-asset portfolios over the short term, it’s really hard to model that in any type of real system that would make us feel comfortable allocating capital to it.
Meb: You’ve been in some pretty storied shops over the years, how is your macro perspective changed? Is there any, as you grow more experienced, and through different cycles…? I mean, we’ve been through a couple interesting ones, we both graduated sort of right after the internet bubble, which feels like there’s a couple rhymes with today, with some things going on. Anything that you’ve like, really changed your opinion on or that surprise you, or you spend a lot of time scratching your head about here?
Erin: I’ve had a number of life lessons over the last 15 years or so in terms of understanding correlated risks within the portfolio. And I’ve gotten burned a couple of times in terms of not understanding how the portfolio would perform, particularly in significant sort of risk off periods where the risks become highly correlated. You can model the risks as well as you want in normal environments, but when you hit these pockets of risk aversion, your correlation goes to one and everything trades, sort of in line with one another. So I think understanding that has probably been the biggest sort of lesson that I’ve learned and learned painfully along the way in terms of managing risks in the portfolio. And it’s really hard then to think about how different asset classes are going to perform when they perform 99% of the time in one fashion. But then they perform completely different when everything sort of hits the skids. And everything goes to a one correlation and perform very, very differently in that environment.
And so sort of being able to manage a portfolio that does provide enough potential upside in good times, but also isn’t going to really crack in the downside has been sort of, I think, the biggest challenge and the biggest thing that I’ve worked on in terms of portfolio construction. And we saw that really play out in terms of the last sort of 18 months with the pandemic, where growth was slowing coming into 2020. And there’s sort of an expectation that, as long as you were long defensive assets that we’re going to do well. We came into a crisis that was unlike anything that we’d seen before and markets sort of cratered very quickly. Being able to have the fortitude to sort of first shed risk in an environment where things were rapidly falling, and being able to sort of get liquid fast, but then also being confident enough when you hit bottom to start to put risk back on and the portfolio. I think is what certainly saved us last year, it was also saved a lot of investors. And so being able to be nimble, be quick and not be overly stubborn in terms of how you manage risk in your portfolio has been, I think the biggest thing that I’ve worked on and hopefully learned over the last 20 years.
Meb: As we look out to the horizon. So it’s the end coming down to the end of 2021. Anything on your brain that you’re particularly worried about, you’re particularly excited about, particularly confused about, you’re scratching your head about, is there anything that’s keeping you up at night?
Erin: Well, I think inflation is one of the things keeping me up at night. I’m not really so worried about the Fed tapering. There’s a lot of ink spilled in terms of discussing Fed tapering. And I think we’ve learned over the last 10 years that these market gyrations that may be caused by the Fed tapering or removing accommodation largely can be…if you look over a longer time horizon usually tend to heal themselves, that the Fed doesn’t want to disrupt financial markets too much. You know, I also think, though, that as we look out over the next three to five years, how ESG adoption is going to infiltrate into finance. I think there’s going to be pretty significant winners and losers from that. And maybe it’s a longer super secular discussion for ESG adoption. But I do think as a result, you’re going to look to see orphaned assets and dislocated assets, and right now are trading at decent multiples. But I think if you look out over the next five to 10 years, you’re going to see very different market receptivity to financing those assets. And so that’s something that I think the market needs to wake up to as well.
Meb: So I take away your terminal, I take away your desktop, and I say “Erin, you’re only allowed a couple of your favorite charts, indicators, pieces of information.” What do you rely on? What are some that you say, “Look, this is one that I’m…if given no other information, these are some of my favorite frameworks to assess what is going on in the world.” Anything come to mind?
Erin: I think there are three things that you need to focus on maybe four. One is business sentiment. So having a reliable indicator for business sentiment, I think is key. Second is financial conditions or liquidity. And then third is inflation, and fourth is growth. And so those are the four things that you want to have your eye on. Everyone has the sort of different favorite indicators for each of them. I think for inflation, you want to look at sort of longer-term inflation expectations, what the market sort of is pricing in. So looking at 10-year break-evens, I think is a good starting point, at least, if I could only choose one indicator for inflation.
For business sentiment, you know, I think that the U.S. tends to have the best business sentiment indicators. So while you’re sort of ignoring the rest of the world, I think, looking at business sentiment indicators, whether it’s…ISM probably would be the best indicator for that. For growth for me, I think looking just at consumer confidence as a sentiment indicator but looking at that as a leading indicator for growth is probably the one sort of indicator, I’d want to be focused on. Lastly, looking at financial conditions, I’d probably look at bank lending surveys to give me some type of profile for what lending conditions are doing as a financial indicator. So I guess if I had to narrow it down to sort of those four indicators, that’s what I’d be looking at.
Meb: Any comments generally on what does the sentiment feel like today? And so I’m not sure if you’re talking specifically towards CFOs, or CEOs, or business owners, if you’re talking about retail investors, or professional investors, like when you talk about sentiment, like what are you kind of referencing?
Erin: For business owners, I think the sentiment right now has been quite robust. But it’s starting to become a little bit more worrisome just because of the supply chain shortages. And you see that in the comments of the ISM surveys. There’s a pretty bifurcated world right now, between large caps, and small caps, or small caps are having a much more difficult time. If you look at SMEs in terms of obtaining materials, obtaining goods, dealing with the labor challenges that are afflicting them right now and seeing their margins compressed versus larger caps, which have better visibility into what their margins are likely to be because they have more control in terms of their supply chains, albeit they’re being somewhat tested right now as well.
Retail sentiment, I think, is still pretty good, although I think it’s starting to reflect as well. I mean, the retail investor has been doing really well in the stock market over the last year, they’ve been buying every dip and that’s worked out well for them. In general, they’ve, you know, been the beneficiary of a pretty significant fiscal stimulus transfer to sort of a household balance sheet. And up until recently, you know, inflation has been pretty muted. So from their perspective, they’re sitting on a lot of cash that they’ve been investing in that’s done well for them. But I think that that is starting to slow. From the professional investor side, they’ve been a little bit more reluctant, particularly in the last couple of months, you’ve seen…you could look at a number of different risk sentiment indicators in the market or even just looking at call skew in the market that tells you that sentiment is starting to ebb in terms of professional investor sentiment.
So I think we’re at this really critical juncture right now where we’ve sort of picked the easy pickings over the last sort of 12 months in terms of market returns and it’s going to get a lot choppier, a lot more uncertain over the next couple of months.
Meb: I see you’re a scuba diver even out to Catalina Channel Islands. Where do you go? Or are you only a warm water diver.
Erin: I’ve done both warm and cold. I certainly prefer warm water diving. My favorite places to dive are probably in Indonesia, Raja Ampat, Komodo. I’ve been to Raja Ampat a couple of times, and it’s pretty hard to beat the manta rays there and the schooling sharks, but I did do a dive off of Cabo a year ago and went to dive with the hammerhead sharks. And because they have hundreds, thousands of schools of hammerheads off the coast of Southern Cabo, and was diving with hammerheads, sort of immersed in them. And all of a sudden that probably about 10 to 15 feet from me, from my left comes a humpback whale just like cruising right by and it literally blew my mind. I totally forgot about the sharks, couldn’t care less about them. It was the most spectacular diving moment I’ve ever had in my life. I had a similar experience, which wasn’t quite as amazing but close, when I was diving off of Alor in southern Indonesia and had a whale shark come like cruising right by me. But I sort of had anticipated that because I knew there were whale sharks in that region. I had no idea that…I’ve never seen a whale diving before, so that was like one of the most spectacular moments of my life. Having a son during the pandemic was definitely another spectacular moment of my life, but they’re both pretty much up there. So it was pretty cool.
Meb: Was the hammerhead diving towards the like Sea of Cortez like Cabo Pulmo?
Erin: Yeah, it was a little bit south of Cabo Pulmo but yeah, it was in the Sea of Cortez.
Meb: I remember it being really cold there I went with my brother many years ago we were kind of baha-ing around the peninsula and I remember I was like ice cream headache the whole time in that part of the world. But sounds that whole Sea of Cortez is an absolute gem, treasure of a place. Whaleshark sounds like a pretty special experience as well as the humpback just cruising on by.
Erin: I love shark diving. It’s sort of my passion. So the more sharks I can see… I’ve done shark diving off of Florida where we just like dove with bull sharks like it’s something that really excites me. So it’s the one thing that can clear my head for markets, so I try to do it you know, particularly when I need a break from markets for a couple of hours.
Meb: I’ll take the other side of that trade so that’s what makes the market. I can do without seeing the sharks. I’m a fairly terrible surfer and I go here locally in Manhattan Beach, but they talk to the lifeguards, and they say, “Yeah, most days people say they see a baby great white shark.” And I say, “I’m happy not to know.” I know they’re there. But if I never see them, it’s fine with me. But I’ve always wanted to go out to the Channel Islands and Catalina but it’s just a little kelpie that’s a little great white sharky for me, I don’t know.
Erin, this has been a great romp around the world. If people want to find out more what you’re doing, what you’re up to, what’s the best place to go to, PIMCO? Where can they track your ongoings?
Erin: Yeah, so if you go to PIMCO, and just like search my name Erin Browne, you’ll see all the funds that I manage, all the content that I put out, everything that I write. You’ll see my picture, my bio, all of that fun information. So that’s probably the best place.
Meb: And in some ocean in Indonesia. Erin it was a blast. Thanks so much for joining us today.
Erin: Thanks for having me. I really appreciate the time and the conversation.
Meb: Podcast listeners, we’ll post show notes to today’s conversation at mebfaber.com/podcast. If you love the show, if you hate it, shoot us firstname.lastname@example.org, we love to read the reviews please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening friends and good investing.