Amid rising volatility and near-term inflationary pressures, we favor a defensive approach while positioning for attractive opportunities. Here, Dan Ivascyn, who manages PIMCO Income Strategy with Alfred Murata and Josh Anderson, speaks with Esteban Burbano, fixed income strategist. He discusses PIMCO’s economic and market views along with current portfolio positioning.
Q: What is PIMCO’s high-level economic outlook? And do we believe inflationary pressures will persist this year?
Ivascyn: We are cautiously optimistic about the outlook for economic growth over the next couple of years. But this is a fast-moving cycle characterized by uncertainty, both economic and geopolitical. Inflation has lingered much longer than most market participants anticipated, and the near-term inflation outlook remains uncertain. Our base case calls for inflation to trend lower during the second half of 2022, but the risks that it will prove sticky are elevated. COVID-19 variants also create uncertainty over the recovery’s timeline. And if the omicron variant creates additional supply bottlenecks, it could push inflation even higher.
Q: What is our view on central bank policy around the world?
Ivascyn: Central banks appear prepared to act decisively if necessary to contain near-term inflationary pressures; in some emerging markets we’ve already seen fairly aggressive policy responses. Our base case calls for the U.S. Federal Reserve to raise interest rates over the next few months, and potentially reduce its balance sheet. The Bank of England is continuing to tighten policy, while the European Central Bank is likely to remain more cautious.
The market has grown accustomed to significant central bank accommodation. Real rates across most of the developed world are deeply negative. As a result, as central banks tighten, we anticipate greater volatility and uncertainty.
Q: What is our longer-term secular outlook?
Ivascyn: We expect heightened volatility and uncertainty over the next five years, as transformative trends disrupt the global economy. One of these powerful trends is the transition to green energy. While positive for the planet and the global economy over time, we believe it could lead to near-term bottlenecks, creating volatility.
Another broad disruptive trend – turbocharged by the pandemic – is the sharply accelerating adoption of new technologies, such as digitalization and automation. While they have improved prospects for better productivity growth over the coming years, it could also pressure real interest rates higher. Companies innovating the disruptive technologies tend to be asset-light, carrying very little debt, while those in disrupted industries often hold a lot of debt, sometimes even more than they did pre-pandemic. For investors, this warrants increased caution. In the corporate credit markets in particular, we are very careful to invest in areas that we believe have very limited risk of downgrade or default, areas that should be able to withstand disruption.
Q: How do you balance the need to generate income with the potential for periods of market stress?
Ivascyn: We are increasing portfolio flexibility, moving toward a higher-quality bias, and adopting a broadly defensive posture with regard to interest rate exposure. We have gradually reduced some of our credit exposure over the last few months and shifted into more liquid segments of the market. In this environment of generally subpar liquidity, we expect the markets to overshoot fundamentals further into 2022 – and we may use the opportunity to go on offense, as the flexibility embedded in the Income portfolio should help us target attractive opportunities to add value amid market volatility.
Q: How is the strategy positioned to manage upside inflationary risks, as well as rising interest rates?
Ivascyn: In our base case, we believe inflation will trend lower later this year. But we continue to position defensively with respect to inflation across the strategy given that interest rates remain low and the costs of hedging inflation are also relatively inexpensive.
We have an allocation to U.S. Treasury Inflation-Protected Securities (TIPS). Breakeven inflation rates embedded in the TIPS market look fair, in our view, while the risks are biased toward higher rather than lower inflation.
We are very defensive on interest rate exposure, with overall portfolio duration of roughly one and a half years over the last few quarters. Our duration exposure is diversified with the bulk of it in the U.S. market, including about a third in TIPS. We are also positioned defensively in floating-rate instruments.
Our interest rate exposure emphasizes the intermediate portion of the yield curve, with less exposure in longer maturities. We base our positioning on several factors, namely the Federal Reserve’s outlook, our long-term concerns around debt sustainability more broadly, and our desire to be defensive.
Q: How is the Income Strategy positioned in the U.S. mortgage market, in both non-agency and agency securities?
Ivascyn: Our non-agency mortgage-backed securities (MBS) allocation remains concentrated on legacy positions that have benefited from rising home prices over many years, and now have low loan-to-value ratios that mitigate the risk of home prices falling.
We reduced our allocation to agency MBS last year when valuations became expensive, largely as a result of the Fed’s bond-buying program (which is likely to end in March). Recently, amid Fed tapering and interest rate volatility, we’ve found agency mortgages have cheapened – both in absolute terms and relative to other high quality alternatives – and are beginning to look attractive again. If we continue seeing these relative spread levels, we expect to take a closer look at the agency MBS sector, which historically has been a focus for us in the Income portfolio. Agency MBS represent an attractive and liquid alternative to traditional credit assets to provide incremental return potential with meaningful downside risk mitigation.
Q: What areas of the credit market, outside of residential mortgages, do we find attractive?
Ivascyn: We continue to favor areas of the asset-backed markets, including allocations to senior tranches within commercial mortgage-backed securities and other asset-backed instruments in the U.S., Europe, and elsewhere. We particularly like COVID recovery themes, areas of the market that have lagged the tightening in broader, more generic credit sectors: lodging, office, multi-family, and other segments that we expect to benefit from the ongoing reopening process.
Within the unsecured corporate credit opportunity set, we are focused on a few key areas. Financials are a core overweight in the Income portfolio. Many banks globally have historically high capital levels and are taking relatively low risks – a result of post-global-financial-crisis regulation. Our focus is on senior risk, but we have a modest allocation to subordinated debt, which we see as an attractive high yield alternative.
We also like investing in senior secured debt in select companies where the company itself may be overly leveraged, but where we would expect the senior secured bonds to be well protected even in the event that the company were to default. These cross a wide range of sectors.
Q: How are we positioned in emerging markets (EM) assets given the volatility we expect over the coming quarters?
Ivascyn: Emerging markets valuations in general look quite attractive, despite the uncertainty that pervades specific countries. We believe some EM regions that have been aggressively taming inflationary pressures should provide attractive total return potential if we see a synchronized global growth recovery later this year. We think EM assets are prudent diversifiers, but we also acknowledge the significant risks to the asset class, including the possibility of ongoing U.S. dollar strength, greater-than-expected Fed tightening, or worsening U.S.–China tensions, among other idiosyncratic risks. So we hold small, diversified allocations focused on high quality sovereigns or quasi-sovereigns, with little exposure to EM corporates, which are less liquid and represent more downside risk. The vast majority of our EM positions are U.S.-dollar-hedged, although we do have a small diversified allocation in higher-yielding EM currencies.
Q: What should investors expect from fixed income markets and from the Income Strategy in particular going forward?
Ivascyn: Significant uncertainty surrounds the economy, inflation, and geopolitics. We expect the bouts of heightened volatility we have seen recently to continue throughout 2022 as monetary policymakers around the world remove support, possibly driving slight to moderate increases in interest rates. But if our forecast for above-trend global growth this year comes to fruition, we believe the credit-related assets we are targeting have the potential to perform well, both on an absolute and relative basis.
The Income Strategy affords us meaningful flexibility across global bond markets. And on a historical basis, the portfolio is positioned quite defensively. As such, volatility very well may be our friend this year, potentially increasing prospects to generate alpha.
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