With global growth rebounding amid uncertainties over inflation and COVID-19 variants, investors may want to consider a somewhat more cautious and flexible approach when seeking a consistent yield. 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 are PIMCO’s high-level views on markets in 2021, including trends in interest rates, valuations, and liquidity, and what are the key investment implications?
Ivascyn: One major driver in markets in the past few months is the high overall level of liquidity. Given generally low yields around the globe, and tighter spreads in many sectors, we are seeing investors continuing to seek yield by going into more credit-sensitive sectors relative to higher-quality, lower-yielding investments.
The path of the economic recovery across regions is another important story. Recent data suggest that we may see a more moderate and uneven recovery than some market participants expected earlier in the year. We believe several major developed economies may have already reached peak growth. We remain generally constructive on growth and expect the global rebound to give way to a moderation in 2022, though still at an above-trend pace. From an investor’s perspective, when we compare the post-COVID-19 recovery with the years following the global financial crisis, we see much less margin for error. A lot of good news is already embedded in market pricing, in both equity and fixed income markets. Valuations are becoming a concern in some areas.
Over the past few months, we have seen a moderate rally in interest rates. Looking ahead, we could see a fairly volatile period, perhaps with rates rising somewhat off of recent lows. Our view is that compensation for taking interest rate exposure is at relatively low levels.
We believe this is an environment that calls for a bit more caution, some incremental risk reduction, particularly in areas that have rallied a lot. We think investors should be creative in putting together a portfolio, and perhaps be willing to give up some short-term yield for better resiliency going forward. In the PIMCO Income Strategy, we have been looking to increase liquidity and flexibility to potentially take advantage if markets overshoot. We are focused on diversification and implementation as opposed to heavily overweighting any particular sector of the market. And as always, we look across a global opportunity set and leverage the depth and breadth of our investment teams.
Q: Earlier this year, we anticipated an inflation “head fake.” Has our view changed?
Ivascyn: No, our view has not changed much: We are cautiously optimistic on inflation remaining relatively range-bound. Over the next several months, we may see higher inflation – above central bank targets – that could be quite concerning to many investors. We aren’t out of the woods yet. We are seeing an uneven recovery, with significant setbacks such as new COVID variants hindering economies. But overall there is a resurgence in global growth, and we are seeing significant supply constraints and some issues on the demand side. A lot of unspent stimulus funds could hit the economy in the coming quarters. So inflation remains an area where risks are elevated, though our base case remains that inflationary pressures will be transitory.
But when you look at markets, investors aren’t being paid much to bet against inflation. In the Income portfolio, we want to be sufficiently humble in our views and hedge inflation risks appropriately.
Q: Given the inflation situation, what is PIMCO’s outlook for Federal Reserve policy?
Ivascyn: Our base case is that the fairly dovish and data-dependent Fed wants to remain accommodative. This likely means ongoing asset purchases, which may start to taper, likely in early 2022. But if Fed policymakers see more sustained inflation, along with longer-term inflation expectations becoming uncomfortably entrenched at higher levels, then we believe they will take action to fight inflation.
Q: Let’s discuss portfolio positioning. What are our views on duration and the yield curve in the Income Strategy, with rates now slightly lower?
Ivascyn: One important consideration is how interest rate risk interacts with credit risk in the portfolio. Given today’s market concerns over inflationary pressure, having a lot of high quality duration may not be as effective in tempering overall portfolio volatility. From a longer-term perspective, we believe interest rates are on the expensive side, and in the Income portfolio, we remain a bit defensive on interest rate risk.
We are willing to give up a little bit of total return potential, if rates were to rally further from here, because we believe we have enough tools within the overall Income portfolio to seek return in areas where we have higher conviction.
Within a duration allocation, we still like the U.S. market on a relative basis, and some other select developed markets. And we are more neutral on overall yield curve views, focusing mostly on the intermediate portion of the curve.
Q: Turning to the credit portion of the Income portfolio, let’s first discuss mortgages, a sector where we have focused for years. U.S. home prices have risen dramatically recently. What does this mean for the Income Strategy?
Ivascyn: For well over a decade, we have been talking about the resilience and the attractive valuations we see in housing markets, primarily in the U.S., but in some other developed economies as well. After the recent significant rally in U.S. home prices, we are becoming a bit more cautious about certain areas of the country, and about higher-risk segments. We see a little more volatility than we would like in housing markets, driven by abundant liquidity. But the higher-quality investments in that space remain quite attractive, in our view.
Many of the housing-related investments that the Income Strategy targets, particularly in the higher-quality non-agency U.S. mortgage-backed security (MBS) area, remain quite resilient. We stay away from first-loss positions that are exposed to a significant pullback in housing markets, and we favor investments backed by seasoned loans. Many of these loans have benefited from recent home price increases, because borrowers have more equity. We have seen elevated prepayments, which may offer returns in addition to the interest payments investors earn. We believe the Income Strategy’s core allocation to non-agency MBS is a major differentiator.
By contrast, we have changed our view on the U.S. agency MBS sector. In March of last year, agency MBS spreads widened significantly, offering what we believed were almost once-in-a-career opportunities to go overweight a high-quality, government-sponsored spread sector. Today, given the massive quantity of U.S. Federal Reserve purchases, we see agency MBS trading at what we believe are fair, or even expensive, valuations. So we have reduced exposure, and we may reduce exposure a bit more, if they stay expensive.
Q: Let’s discuss the corporate portion of the Income portfolio. What is our outlook for investing in these markets?
Ivascyn: In a sense, the base case for corporate credit appears strong: We are constructive on economic growth, we are constructive on inflation pressures being transitory, and we believe central banks will remain accommodative. Given these fundamentals, we are generally constructive on corporate credit in the short term. However, valuations are becoming a concern. We are also carefully assessing underwriting standards, and watching for froth in some corporate sectors, similar to froth in some equity sectors. We continue to see spreads tighten, driven mainly by excess liquidity and the search for yield, even in companies with low quality earnings, or no earnings at all.
Speaking of liquidity, we have taken the opportunity over the last several months to move up the liquidity spectrum in our corporate credit allocation. Higher liquidity gives us more portfolio flexibility. In the credit allocation within the Income portfolio, we have focused recently on targeted themes in the COVID recovery space: certain segments of the commercial mortgage sector, along with select opportunities in leisure, gaming, and service sectors, for example.
Q: Finally, let’s look at the Income Strategy’s approach to emerging markets (EM) investments. How do we balance return potential versus volatility?
Ivascyn: We haven’t made significant changes in our emerging markets holdings in the Income portfolio. We have some core exposures to select higher-quality external EM sovereign or quasi-sovereign debt, which tends to be the most defensive investment within EM. We also have some tactical exposure to local EM debt; these tend to be smaller, targeted positions with limited overall impact on portfolio volatility. It’s important to manage volatility very carefully, and we work closely with our peers in the EM portfolio management group and also our analytics team to understand how volatility influences our positioning.
We also have exposure to a basket of EM currencies, with each individual currency scaled modestly. We look for local markets that could benefit from a more synchronized global recovery late this year into 2022. These are small percentages within the overall portfolio, given their higher volatility profile. We see these as opportunities that may have lagged the tightening that we have seen elsewhere, and thus offer some global diversification and flexibility, along with prospects for higher yield and total return.