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PIMCO: Don't Get Complacent About Inflation Risks

Though their base case is for muted inflation, PIMCO's Dan Ivascyn says that with high debt levels worldwide, he and his team are on the lookout for deflation as well as inflation.

Eric Jacobson: Hi, I'm Eric Jacobson with Morningstar. I'm here today at the Morningstar Conference with Dan Ivascyn, who heads up the bond operation at PIMCO for the investment side.

Dan, thank you so much for coming to chat with us today.

Dan Ivascyn: Thanks Eric, excited to be here. 

Jacobson: So, the topic that's always first and foremost for everyone is inflation. So, if you could give us a sense of where you guys stand right now on your expectations. And one thing I'd really be curious to be know is, so, let's say that either you're wrong or the Fed's wrong, you know, the market turns out to be wrong. What are the consequences for investors, especially in terms of magnitude if things don't go as expected?

Ivascyn: Sure. So, a few important points there. In terms of our base-case forecast we still think that inflation will remain relatively contained. In fact, across most areas of the developed world we could even see inflation tail off a little bit later this year. So, we think that the inflation rates will remain at central bank targets, even be a little bit below targets across key regions of the world. Now with that said, investors can't be complacent and there are couple of reasons for that. One is probably a long-term theme and that is that there is too much debt in the world. Debt levels are at the highest in history, higher than they were at the beginning of the financial crisis and any time you have an environment where debt levels are very high, nominal growth rates are very low, you have to worry about how policymakers are going to deal with that.

Large piles of debt can be dealt with through write-downs. You can grow your way out of those challenges, or you can choose policy that may lead to some surprise inflation as well. That's always a risk for bondholders.

In the United States in particular, we are at a late-cycle stage in our economy. We are beginning to see some signs of wage pressure. Some signs of capacity issues in the labor force. This is occurring at a time when the new administration is proposing pretty aggressive stimulus. In that type of environment, the risks of overheating of inflation here in this country go up pretty significantly. It's not our base case, but it is a risk that we're focusing on. It's a risk that we're following and it's a risk that we are trying to protect our clients from as best we can in the context of the fixed-income strategies that we manage. 

Jacobson: So, it's interesting because some of the things that you described sound like risks that are deflationary in the global sense, and tell me if you think I am missing that in terms of the debt situation and so forth. But some obviously risks on the upside is that--do you look at that as being differentiated across economies and what are the risks to the U.S. if things don't go well elsewhere?

Ivascyn: We do think risks are somewhat symmetrical, where we are still in a world as you pointed out with lots of debt and there are certainly scenarios that could lead to disinflationary or even outright deflation pressure. That's something that we also want to be concerned about. In terms of inflation risks themselves, at least in the near term, it's more of a U.S. focus. Given that we are an economy that is growing above potential, productivity growth is still relatively low, and where we have the prospects for a cyclical outbreak in inflation. When we look at levels or activity outside the United States you have a situation where China is slowing. The Japanese economy is struggling. And in Europe there is tremendous amount of uncertainty.

So, there are certainly scenarios where if you had issues in any of those regions you would see pressure on the U.S. Now that could actually lead to a little bit more flexibility or a little bit less pressure on the inflation side. But too much pressure outside the United States can lead to much lower economic growth. So, we still live in a highly interconnected world. You can't look at any one region without understanding what's going on in other regions. Which is one of the reasons why our team and our group has expanded in terms of our focus over the course of the last several years, to make sure we are taking into account activities outside of this country that could have an impact on inflation and fixed-income valuation.