Markets are anticipating a significant growth recovery, yet interest rates remain relatively low from a historical perspective, and policymakers are providing extensive fiscal and monetary stimulus. Here, Dan Ivascyn, who manages PIMCO Income Strategy with Alfred Murata and Josh Anderson, speaks with Esteban Burbano, fixed income strategist. They discuss PIMCO’s economic and market views along with current portfolio positioning.
Q: What do you believe drove the rise in the U.S. 10-year Treasury yield and overall spread tightening in many fixed income sectors this year?
Ivascyn: The markets are beginning to anticipate a significant growth recovery, and fundamentals are improving. At the same time, policymakers have increased fiscal stimulus, even amid ongoing significant central bank accommodation. These dynamics have led to a repricing of high quality interest rate risk and were likely a key driver in rising interest rates during much of the first quarter.
Q: What are PIMCO’s views on inflation, and how does your positioning in the Income Strategy reflect those views?
Ivascyn: Our base case economic outlook calls for a significant growth recovery in the U.S., accelerating during the second half of this year. (See our recent Cyclical Outlook for details.) Eventually, as vaccines gain traction in other areas of the developing world, we think we’ll see a synchronized global growth recovery well into 2022. We believe this strong growth, in an environment of ongoing COVID-related supply constraints and significant fiscal and monetary stimulus, will likely push inflation higher. But our base case view is that inflation will rise above central bank targets over the short term, and then likely moderate over the course of 2022 and 2023.
Nevertheless, inflation remains a considerable risk to the global economy and to financial markets more broadly. We do not base our investment decisions solely on our base case outlook. We look at the potential impact of different scenarios, including one of higher inflation, and we structure our positioning based on this probabilistic framework. Hedging portfolios against tail scenarios is one reason why we were defensive on interest rate risk going into this year, and continue to have a cautious outlook on duration.
Q: Over the next three to five years, what long-term forces do you think will come into play?
Ivascyn: Inflation is a key area of focus for us. For well over a decade, we have seen powerful disinflationary forces impacting global economies. Technological innovation and aging populations are two dynamics in the global economy that we think will continue to depress global inflation rates. However, we think the response to COVID-19 has changed the policy dynamic, so that future periods of stress will likely see significant fiscal response. In turn, over the long term we have concerns about inflation risks in both directions: secular disinflationary pressures and the potential for deflationary events; and on the flip side, heavy fiscal stimulus – deficit spending that leads to a greater inflationary impulse over time.
Another risk relates to broad fiscal or debt sustainability. Coming out of the COVID-19 crisis, debt levels remain elevated and, across most segments of the global economy, they are much higher than when we entered this crisis.
Q: How are you balancing the Income portfolio’s objective of delivering a consistent income stream for our investors in an environment of low yields and tighter spreads, while at the same time managing the risks of volatility and other uncertainties ahead?
Ivascyn: Longer-term interest rates remain quite depressed, even after the first-quarter sell-off. At the same time, credit-related sectors, particularly within the more generic areas of corporate credit, have significantly recovered and spreads look fair to a bit expensive. A lot of our optimism for global growth is embedded in market pricing.
Fortunately, the Income Strategy’s approach is very flexible, providing the ability to be defensive as we hedge against scenarios that could lead to higher interest rates later this year and into 2022. We’ve been gradually reducing risk in some of the more generic areas of the corporate credit market in favor of select opportunities in sectors likely to benefit more significantly from the recovery.
Our credit holdings include a focus on the financial sector, where we believe fundamentals remain quite strong and should improve as the economy continues to recover. We also like COVID-recovery themes, including certain leisure and travel sectors.
One other area of focus within PIMCO Income Strategy is mortgage-related risk. It is a key differentiator of the Income Strategy versus more corporate-credit-heavy strategies. Our mortgage exposure comes in at least two forms. One is very high quality U.S. government or government-agency-backed exposures, such as pass-throughs from Ginnie Mae, Fannie Mae, and Freddie Mac. Much of this sector has benefitted directly from significant Federal Reserve purchases. These very liquid securities continue to be a ballast of the Income portfolio. However, we have reduced our exposure because they’ve gone from very cheap to slightly expensive, in our view.
Our other mortgage-related focus is the non-government-backed segment. Although U.S. housing prices have gone up over the last 12 months, valuation metrics, including price-to-book, price-to-rent, and price-to-income, look relatively well-contained in a historical context. This rally has not had the same degree of lending excess we saw prior to the housing crash in 2008, either in absolute terms or relative to what we are seeing in segments of the corporate credit market.
Q: As the Fed continues buying agency mortgage-backed securities (MBS), valuations are tightening to pre-pandemic levels; do you anticipate that you will continue reducing the position?
Ivascyn: The Fed will likely continue to support the agency MBS market through ongoing purchases into the end of this year, and we believe any tapering activity as it relates to mortgage or Treasury investments will be quite gradual and highly telegraphed to the market. But this liquid segment of our opportunity set has rallied a lot, and we may gradually reduce those positions further over the coming quarters as we find other high quality alternatives to rotate into. We plan to maintain exposure to that sector, however, given its attractive liquidity and the extra yield pickup we get for its greater complexity versus more traditional government debt.
Q: In the corporate credit market, how are you thinking about balancing the level of potential richness in this sector versus the opportunities that might arise in a very strong global economic recovery?
Ivascyn: Corporate credit looks fair to a little bit expensive on a historical basis, but technicals remain quite favorable as investors – including those offshore – search for yield, and fundamentals remain strong. Following tremendous market dislocation during the first quarter of 2020, we shifted away from more liquid, more generic, index-type credit exposure to temporarily target risk in sectors that we believed would rally as the market dislocation resolved. Now that the stabilization period is behind us, we are looking for opportunities to rotate back into more liquid forms of corporate credit, favoring certain sectors that have greater cyclical sensitivity, more attractive overall fundamentals, or are backed by hard assets.
Q: What are our views on emerging markets?
Ivascyn: Valuations in emerging markets look reasonably attractive from a historical perspective, both in absolute and relative terms, although this sector will likely be one of more volatile segments of the Income Strategy’s portfolio. We think it is an area that could serve as a key differentiator within this flexible strategy.
Overall emerging markets exposure within the Income Strategy remains nominally low. We do not have a lot of outright interest rate risk, but we do have local currency exposure and external, or dollar-denominated exposure, primarily across the higher-quality segments of the emerging markets. Emerging markets face unique challenges from the pandemic, including geopolitical uncertainty, and, in some cases, local politics. The pandemic has hit many areas of the emerging world very hard, with tragic consequences. But we expect many of these countries will begin to control the virus, and therefore we remain cautiously optimistic on their growth outlook, and believe this sector stands to benefit from the anticipated synchronized recovery later this year and into 2022.
Q: What are our views on environmental, social, and governance (ESG) investing, particularly with regard to income-focused strategies?
Ivascyn: ESG is critically important to PIMCO because it is critically important to our clients. We are committed to be leaders within the ESG space in fixed income and to provide our clients with customized solutions. We have a series of ESG-related strategies, including an income-focused ESG strategy. Our goal is not to mimic our regular Income portfolios, but instead to target an ESG-oriented opportunity set to generate consistent dividend income, with an important secondary objective of capital preservation or total return.
Q: What should investors expect going forward for fixed income markets and for the Income portfolio in general?
Ivascyn: As always, we are looking to generate consistent, responsible dividend income while keeping an eye toward capital preservation and ultimately total return. The recent increase in yields has created a bit more flexibility, and we’ll adjust our thinking as needed in response to changing market conditions as well as the economic and policy environment.
The flexible nature of the Income Strategy is critically important amid macro uncertainties and generally low yields. It is not focused on a benchmark. We take a broad fixed income asset allocation approach and use scenario analysis to optimize our positions. To be sure, flexibility is a key differentiator of the strategy, and we intend on using that flexibility in a responsible fashion, integrating the best ideas from across our portfolio management and analyst teams.