Fractured Markets, Strong Bonds

We Believe

  • History suggests the lagged economic effects of tighter central bank policy are arriving on schedule, but any eventual normalizing or even easing of policy will still likely require inflation to decline further.
  • Volatility in the banking sector has raised the prospect of a significant tightening of credit conditions, particularly in the U.S., and therefore the risk of a sooner and deeper recession.
  • At current yield levels, bonds can provide an attractive balance between income generation and cushion against downside economic risks, while market dislocations are creating pockets of value.

For investors, times of uncertainty can underscore the importance of a cautious approach.

Central banks’ efforts to fight inflation by sharply raising interest rates have contributed to recent volatility across the financial sector, as the effects of tighter monetary policy filter into markets and the economy with a lag. Peak policy rates are now likely to be lower than markets previously were pricing. But normalizing monetary policy, and then eventually easing, will take more time and need inflation to decline closer to target levels. In the meantime, unemployment is likely to rise.

We discussed the latest opportunities and risks across the economic and investment landscape at PIMCO’s Cyclical Forum in March in Newport Beach (for more on our forums, please visit PIMCO’s Investment Process webpage). We also spoke about how geopolitical risks could affect our outlook with PIMCO Global Advisory Board member Michèle Flournoy, an expert in U.S. defense policy and national security issues. We have continued our conversations amid the unfolding challenges in the banking sector and arrived at three main economic themes for our six- to 12-month horizon, which we review in the next section.

The recent U.S. bank failures set off a wave of deposit outflows and a response from regulators to stem the contagion. In Europe, the stress led to the demise of Credit Suisse and a seismic shock to the broader European banking system. These shocks are likely to slow credit growth by making banks less eager to lend, pull forward any recession, and raise the risk of a somewhat deeper downturn.