Amid inflationary pressures and an outlook for heightened volatility, investors may want to position defensively while scouring markets for attractive alpha opportunities. Here, Dan Ivascyn and Alfred Murata, who manage PIMCO Income Strategy with Josh Anderson, speak with Esteban Burbano, fixed income strategist. They discuss PIMCO’s economic and market views along with current portfolio positioning.
Q: What is your outlook for the U.S. and global economy over the year ahead? Do you believe inflation pressures will remain?
Ivascyn: We believe the overall global growth recovery will continue. There may be setbacks from COVID-19, but we think that areas of the world most challenged by this terrible pandemic will improve economically as they begin to better contain the virus.
A big challenge in the near term is inflation. Inflationary pressures remain significant but we think they will decline over time. Yet demand for goods and services will likely accelerate as economies open, while the extreme supply bottlenecks across key areas of the economy are going to be tough to resolve quickly.
Our base case view is that a lot of this inflationary pressure will be temporary, but weighing the hedging costs versus the risks, we continue to position defensively against inflation and rising interest rates across the strategy.
Q: What is our outlook for monetary policy and fiscal policy?
Ivascyn: Central banks have remained quite accommodative on a global basis. This month the U.S. Federal Reserve announced it will start paring down its purchase program, but it appears willing to pause the tapering process if incoming economic data becomes concerning. Conversely, the Fed has indicated it can be more aggressive if longer-term inflation expectations become unanchored.
U.S. fiscal policy is more uncertain. We believe we are beyond peak fiscal stimulus. Both pieces of infrastructure legislation may become law by the end of the year, but the combined amount will likely be quite a bit smaller than what the Biden administration initially proposed. And if Republicans take control of the House of Representatives in 2022, as it appears they may, we would have a divided government once again – likely curbing future fiscal stimulus. This could pose a risk for markets in the event of an unanticipated economic shock.
Q: Looking over the next several years, what are the secular trends that could affect portfolios?
Ivascyn: A few key themes inform our broad portfolio positioning over a time horizon of five years or longer. The first is excessive debt. There is probably more debt in the world than can be realistically paid back. This raises the risk of permanent capital impairment through restructuring, and the risk of inflationary monetary policies to repay that debt.
Second, concern over climate change is shifting regulations to encourage investment in green technologies. Higher spending on clean energy is likely to be partly, but not fully, offset by lower investment and capital destruction in traditional energy sectors such as coal and oil, which tend to be debt-heavy.
A third key secular trend is significant technological disruption. Key industries appear to be adopting new technologies faster, with the pandemic seemingly accelerating this trend. It has contributed to recent productivity growth, some of which we believe is sustainable. While good for the economy and inflation, higher productivity could also lead to higher real interest rates, and in turn pressure high quality fixed income securities.
Q: How is the Income Strategy positioned to navigate the challenging balance between generating income while preserving investors’ capital?
Murata: As always, we look to generate an attractive level of income while managing against downside risks. Interest rates are low, while credit spreads are relatively tight – a challenging environment. Fortunately, the Income Strategy has the flexibility to target what we believe are the best ideas in the $120 trillion global fixed income markets. Our team of more than 200 portfolio managers and research analysts around the world seeks to identify attractive opportunities for our portfolio.
Q: What is your outlook on interest rates, and how does it affect portfolio positioning?
Ivascyn: Despite our base case view that inflation will be transitory, we believe that we are not getting paid enough to bet against inflation, so we are positioned defensively. Our interest rate exposure is very low relative to our long-term average. We have a healthy allocation to U.S. Treasury Inflation-Protected Securities (TIPS). These positions have recently benefited from inflation concerns. At current breakeven inflation rates, we believe valuations are reasonable and we are willing to give up a little bit of incremental return to mitigate the risks of upside inflationary scenarios.
If interest rates rise significantly, we would consider adding duration back into the portfolio, but right now, we are more concerned about the risk of rising inflation and interest rates.
Q: What trends are we seeing in the U.S. housing market, and how are we positioned in U.S. non-agency mortgage-backed securities (MBS)?
Murata: We expect growth in U.S. housing prices may decelerate to about 3% per year over the next two years. Yet it is important to note that we focus on legacy non-agency mortgages, which generally have benefited from significant home price appreciation over the last decade. Many of these legacy mortgages have loan-to-value ratios of less than 50%. To negatively affect these mortgages, housing prices would not only have to decline from current levels, but also reverse past gains. So overall, we are modestly optimistic on U.S. home prices, but very optimistic about the significant improvement in mortgage credit over the past decade.
Q: How is the Income Strategy positioned in U.S. agency mortgages?
Ivascyn: The Income Strategy has typically focused on the liquid pass-through segment of the agency market – the same mortgage-backed securities the Fed buys directly. During the volatility in February and March 2020, we significantly increased our agency mortgage positions. So the portfolio has benefited directly from the Fed’s purchase program, and over the course of the last year and a half, agency mortgages have appreciated from very cheap to fair to even a little bit expensive, in our view. We have used the opportunity to reduce our allocation and are now quite defensive on agency mortgages.
Q: What are our views and positions in the corporate debt market?
Ivascyn: Within the corporate credit opportunity set, we are focused on a few key areas. Financials continue to be a core theme in the Income Strategy, although spreads have tightened. Banks tend to be very well capitalized and have benefited from post-global-financial-crisis regulation. Our focus is on senior risk, but we have a modest allocation to bank capital as well, which we see as an attractive high yield alternative.
We also like select COVID recovery themes, areas of the market that have lagged the tightening in broader credit sectors: leisure, hospitality, airlines, and other segments of the marketplace that we expect to benefit from an accelerating reopening process.
In our less liquid corporate credit allocations, we have been taking advantage of relatively abundant liquidity to sell positions. A lot of the off-the-run credit positions we acquired from March into the second quarter of 2020 have performed quite well and we are rotating out of them into more liquid, generic credit, which in turn should give us more flexibility to take advantage of any potential volatility or dislocation going into 2022.
Q: How do we think about the relative value between emerging markets (EM) and other opportunities in the market today?
Ivascyn: Longer term, we believe EM valuations look quite attractive. Our view is somewhat contrarian amid fairly negative market sentiment. We think EM assets are good diversifiers, and our positions should benefit as certain emerging markets catch up to the developed world in containing COVID-19. Our outlook differs dramatically by country and we expect more volatility in emerging markets, so our exposure in the Income portfolio is quite diversified. The vast majority of our EM positions are U.S.-dollar-hedged, although we do have a small diversified allocation in EM currencies.
Q: What should investors expect from fixed income markets and from the Income Strategy in particular going forward?
Ivascyn: We believe there will be a bit more volatility over the next couple of years as monetary and fiscal policymakers diminish support. We also believe that equity and fixed income valuations are a bit high, and that beta returns will be lower than in recent years. But the prospects for alpha look very attractive.
The Income Strategy affords us meaningful flexibility across global bond markets, which we believe will help our team of portfolio managers target attractive opportunities that arise amid regulatory and political frictions, bouts of volatility, and geopolitical conflict. We intend to be patient and defensive, given where we are in the cycle, and look to build up liquidity and flexibility so we can seek to take advantage of inevitable overshooting across markets. This is one of the strengths of PIMCO’s platform.