Thriving in a world of low and flat: An interview with Douglas Hodge

The head of the world’s largest fixed-income manager discusses the industry’s past, present, and future.

Douglas Hodge is PIMCO’s CEO and a managing director of the firm. He has more than 30 years of investment experience. In June 2014, McKinsey’s Martin Huber spoke with Mr. Hodge about the industry and where it is headed.

McKinsey on Investing: You’ve referred to today’s environment as a “world of low and flat.” What does this mean for asset managers?

Douglas Hodge: By low and flat, I mean a world in which the Fed funds rate is just over 0 percent, real rates are at –2 percent, and the yield curve is not steep. By comparison, we think the “new neutral” rate, in which GDP, employment, and inflation are stable, is about 2 percent nominal and 0 percent real. Rates below neutral, like we have today, produce an economy that finds it hard to grow out of its debt overhang, that is not favored by aging demographics, and that is vulnerable to geopolitical instability. Low and flat compresses risk premiums in fixed income and other financial assets, which makes prospective returns more difficult. For asset managers, that means you’ve got to be able to exploit opportunities either across a broader universe than you have traditionally operated in or in a deeper and more selective way.

Importantly, and paradoxically, it also means you’ve got to be prepared for volatility. Volatility right now is priced quite low. The new neutral we see suggests that volatility is going to stay low. But we also know, courtesy of Hyman Minsky, that low volatility can be a stage just before the top blows off. You’ve got to be ready, especially in the heavily traded fixed-income instruments.

McKinsey on Investing: Can you say more about where asset managers need to look for opportunities?

Douglas Hodge: This might mean markets that either are in emerging economies or in different parts of the capital structure. We might even need to go outside and push the limits even further into things that aren’t securitized, where banks have historically operated, and get into primary debt origination. In this new neutral, if you’re simply trying to jockey back and forth between heavily traded fixed-income instruments, risk premiums are so tight that it’s going to be hard to earn consistent excess return.

I would say the same goes for stocks. If you look at the valuations of equities, say, in the US market, we’re at levels now that do not offer much upside, unless you postulate higher growth. Growth would solve the riddle, but in our view growth is going to be modest. That’s the real challenge, and there are just so many impediments. We see pockets of growth in the energy sector and even the housing sector. But income growth is hardly moving, labor participation is low, and then there is this whole demographic wave. Having lived in Japan for seven years, I have experienced the problem in which, as economies age, they hit a soft wall as they try to create above-trend growth.

McKinsey on Investing: Is that “soft wall” what’s happening in Europe, in your view?

Douglas Hodge: I think so. Of course, the European Central Bank is doing everything in its power to avoid it, but Europe’s political leaders are more afraid of unemployment than they are of the long-term consequences of slow or no growth. That said, I do think that the Brussels mind-set, if I can call it that, is beginning to soften a bit. Coming out of the crisis, the mission was to rewrite prudential regulation and rethink how markets work. Now political leaders are beginning to realize there’s another dynamic to consider: growth. In my view, good regulation without growth leads to collapse, and growth without good regulation leads to crisis. Neither is acceptable. We need to strike a balance, and I think the regulatory community is beginning to soften just a bit on this.

McKinsey on Investing: What about emerging markets? What do you make of the dynamics of growth there?

Douglas Hodge: What’s interesting to me about emerging markets is that while growth is lower but still strong, it is largely inaccessible to foreign institutions. Take three markets: Brazil, China, and India. These are very big, populous countries whose growth trajectories have been very strong—Brazil and China in particular—but the regulatory environment simply has not been friendly to financial institutions seeking to enter these markets. All three of them still have some version of capital controls. Not only does that make it difficult for asset managers to enter the market, but it also limits the ability of residents to invest in markets outside their home country. About ten years ago, China opened up its market a bit by allowing foreign asset managers to participate in joint ventures with Chinese firms. Now one after another of the Western banks and asset managers is pulling out. It seems odd to some people who say, “Aren’t we right at the threshold of a new opportunity in China?” Clearly some people who have been there a long time are taking a different view.

McKinsey on Investing: Some people are also expecting to see big emerging-market banks become global powers in asset management. Do you see potential there?

Douglas Hodge: That’s certainly a possibility. Given the valuation of some large financial institutions, they certainly have the currency to acquire. They haven’t as yet, and perhaps they are mindful of the history here. The Chinese joint-venture experience is the most recent, but if you look back further, many of the acquisitions Japanese institutions made in the 1980s and 1990s ended in tears. There’s example after example of failure rather than success, which I think tempers everybody’s expectations from both sides of this equation.

McKinsey on Investing: What do the competitive dynamics we’ve been discussing mean for customers’ product preferences? Do you see significant opportunities in the retrenchment of banks and insurance companies from some of the businesses in which they traditionally have been active?

Douglas Hodge: Banks and insurance companies have a different operating model from investment organizations. They use their balance sheet to underwrite liabilities: banks make loans, insurers make a promise, and they place them on their balance sheet. They then hypothecate their balance sheets, and that’s how they make money. An asset-management firm essentially does not have a balance sheet but acts as an intermediary or agent. Our clients give us a portion of their balance sheets to invest in the capital markets. That’s a fundamental difference in operating models; what we’ve seen so far is only limited demand for a combination of the two. Yes, we’ve had variable annuities and things of that nature, but they didn’t perform well in the crisis; on the balance-sheet side, they weren’t priced properly.

Will demand for a marriage of the two increase? It might. We’ve seen the demand for investment products become far more differentiated. The equity market has always had a differentiated product set—small capital, large capital, international growth, and emerging. But fixed income has been, for all intents and purposes, largely generic. One thing that PIMCO did was to differentiate bonds. Twenty-five years ago, one bond looked much the same as any other bond. We coined the term “total return”; now everybody has a total-return fund. As the industry shifts to include individual investors, products are becoming further differentiated. There are income-oriented products, long-duration products, and lots of variations on equity and emerging markets. Over the past year, we’ve introduced more than 100 new products. Some are regional variations, but most have a unique element.

That’s partially driven by the low-and-flat world; why would I lend you money for a longer period of time when I can get the same rate of interest for a shorter period of time? There has to be something different from simply the duration of the loan, the duration of the investment strategy, and that has created myriad responses from bond managers everywhere.

McKinsey on Investing: So some of these products are things that a bank or insurer could underwrite against the balance sheet of clients or investors. But wouldn’t this introduce a whole new set of risks, creating an imbalance that might be conducive to another bubble?

Douglas Hodge: Probably. One area where this kind of imbalance has gotten a lot of attention is the money-market industry in the United States, where there is an implicit promise to reset the net asset value to $1 per share every day, without any real backstop. Asset managers are operating in capital markets, but with a balance-sheet expectation from investors. Regulators are considering ideas such as floating net asset values to address the problem,1 but they too look through the lens of the balance sheet and apply the balance-sheet mind-set to the asset-management industry. It just doesn’t map very well.

McKinsey on Investing: Another topic that is at the center of industry debate now is digital. What’s your view on how digital is affecting asset managers in the short term, and will that change over the long run?

Douglas Hodge: This is one of the biggest question marks for our industry. The people we serve are mostly in their 50s, 60s, and 70s. The next generation of wealth accumulators is going to be far more digitally aware than the current generation. No one has really figured out how to respond to that. Everyone understands now that, regardless of age, people are far more comfortable taking information through a digital portal. But when it comes time to transact, they want to do it with an individual. They want somebody at the end of the line. Asset managers can make information readily available through digital portals—websites, Facebook, other social media. And to a degree, that push can also pull people into your product set.

McKinsey on Investing: Do you see asset managers working harder to communicate their value to customers, or are they more or less happy with the status quo?

Douglas Hodge: No, there is constant pressure on fees in our industry. I don’t know if it is any more intense now than it has been in the past, but I do think it is going to continue to be intense. But the best asset managers can justify their fees. I continue to believe that there is a degree of inefficiency in capital markets. True, inefficiencies are harder to find, and how you think about investing in these opportunities has to change, because the dynamics of the capital markets are changing. Nevertheless, some of those things are going to create more inefficiency. And that’s what active management is all about.

McKinsey on Investing: One of those dynamics is that the balance sheets of the banks are getting smaller. Does that make your market more or less efficient?

Douglas Hodge: It creates inefficiency. If you look across derivatives at the trading volumes of the banks, they’ve come down, while total volumes have actually gone up. What that tells me is that markets and market makers, including asset managers, are clever and creative and will continue to find opportunities.

McKinsey on Investing: If I understand you correctly, you wouldn’t be too unhappy about seeing more passive investing in the market because this provides you with more opportunities to trade on.

Douglas Hodge: Passive is a mixed bag. It contributes to the compression of returns in a world of low and flat, but I also believe it creates more volatility. That volatility is an expression of inefficiency, and there are ways to take advantage of that. If everybody is buying the index, then the assets that are not in the index will be cheaper. Part of this is being driven by regulators, so it’s not just the marketplace that’s deciding. Some people are always going to choose the index; they think it’s a more efficient way to invest their capital, and they’re going to get a better risk-adjusted return.

About the author(s)

Martin Huber is a director in McKinsey’s Cologne office.