Investment implications of a fast-moving cycle
You can see from our economic outlook that multiple issues have the potential to influence the investment outlook, in particular the speed, depth, and evolution of the nascent efforts by central banks to reduce their extraordinary monetary accommodation.
We plan to focus on the volatility that can result from the rapid pace at which the economic cycle is moving toward late-cycle dynamics, a time when, like today, inflation tends to quicken and may prompt a tightening in monetary policy, unnerving many investors.
Markets nonetheless appear priced for a blue sky scenario where central banks achieve the elusive soft landing without any meaningful amount of rate hikes. Yet, history reminds us that sometimes “stuff happens” when monetary policy pivots.
Risk premiums and yields don’t reflect potential downside scenarios, in our view, which warrants caution and a rigorous approach to portfolio construction.
On upcoming inflation data, we believe it is important to avoid overemphasizing the potentially concerning spate of inflation data that is expected in early 2022. More generally, we plan to avoid major investment decisions that rely upon a short-term macro view and watch for potential overreactions by policymakers and investors to short-term information.
Despite our caution, we generally favor constructing portfolios that we believe offer positive carry relative to their benchmarks, incorporating spreads with an attractive risk-return profile. We are sanguine, after all, on the macro outlook, with economic growth expected to bolster cash flows, which may benefit investors.
Yet, to seek to capture those cash flows, which can move around, diminish, or disappear depending on the macroeconomic and financial situation, requires a rigorous approach to portfolio construction. For example, we generally favor reducing our reliance on beta (broad market performance) positioning, increasing our use of the global opportunity set, subjecting our portfolios to scenario analyses that gauge potential performance, and increasing the liquidity and flexibility of our portfolios to pursue opportunities as they arrive (by leaving room in our risk budgets to do so).
Let’s now turn to details on portfolio positioning.
Duration and yield curve
Duration levels: We generally intend to be underweight duration, largely on the basis of the dearth of risk premium that is embedded across the term structure. Given the likelihood for higher volatility, we anticipate active duration management to potentially be a more significant source of alpha than in the past. We continue to believe that duration can act as a diversifier to balance the more risky components of an investment portfolio, yet we monitor potential shifts in correlations.
As we note in our Secular Outlook, though a number of transformations may affect the global economy, we expect central banks to keep their policy rates low for years. Market participants appear to concur, and this is acting as a limiting force across the term structure of interest rates.
We generally expect to tilt portfolios having relatively high credit or equity exposure closer toward neutral on duration, with curve positioning run similarly.
Yield curve positioning: We lean toward positioning for a steeper yield curve, though slightly less than usual, given some evidence of weakening in the structural influences that have underpinned the steepener for decades and in light of the recent repricing of short-term rates for forthcoming rate hikes.
Given our secular outlook on central bank rates, we do not envision fixed income yields that meaningfully exceed the current level of forward rates, keeping them confined to a relatively tight range. Moreover, we do not expect market participants to build a significant amount of term premia into longer maturities, voiding those maturities of two of the biggest historical influences on yields.
Our macroeconomic outlook also supports our view on curve positioning, with a moderation in inflation expected to limit future rate hikes. This view is somewhat circumspect, however, given the wide range of potential outcomes, warranting modest positioning for curve exposure and utilizing our risk budgets in other areas of investing.
We see a number of opportunities to diversify our curve positioning, including by taking exposures along yield curves in Canada, the U.K., New Zealand, and Australia.
Given our view of continued economic growth and the degree to which markets are prepared for the hawkish pivot effectuated by the world’s central banks, we generally are overweight credit, with some caveats. For one, we seek to gain our credit exposure from diversified sources, with cash corporates making up a smaller portion of that exposure given the narrow scope for further contraction in credit spreads. As a substitute and in an effort to bolster the liquidity, carry, convexity, and roll-down of our corporate bond exposures, we lean increasingly toward credit indices, which we believe can therefore provide diversification benefits and demonstrate defensive characteristics.
Our credit specialists continue to identify individual credits warranting exposure, but we are leery of the structural challenges to liquidity in the corporate bond market posed by a breakdown in the principal-agent model, when credit spreads may be wider than fundamentals warrant.
We nonetheless expect that single-name selection is likely to remain a driver of returns in credit markets, including investments in BBB rated names, a segment that we prefer versus A rated names. We are investing in select recovery themes (hotels, aerospace, and tourism), though modestly, as well as financial companies, and in sectors that we believe stand to benefit from the major transformations we have identified.
We continue to seek assets where our firm’s credit specialists can extract attractive illiquidity and complexity premiums. Our preferred assets in this regard include a number of structured products and asset-backed securities, including U.S. non-agency mortgage-backed securities (MBS). A shrinking market, we believe it remains filled with attractive structures from the standpoints of seniority, defensive characteristics relative to corporate credit, and cash flows. We are sanguine on the U.S. housing market.
On agency MBS, we generally are underweight, reflecting what we see as rich valuations and the potential for an overreaction to the Fed’s reduction in and ending of its monthly bond-buying program, which (prior to tapering) included $40 billion of agency MBS. From a portfolio perspective, a reduction in MBS holdings may improve the convexity profile of portfolios having MBS in their benchmark.
Our specialists have identified a number of opportunities to diversify credit exposures across countries and regions, and we are investing in them where fitting in our mandates. We are generally guarded on credits in emerging markets.
In contrast to the public credit markets, which are relatively easy for investors to access and thereby prone to richen, the private credit markets are not, and we see select opportunities for eligible investors who can bear the increased risk to consider private assets within their illiquid investment bucket.
We view inflation-linked securities both as diversifiers against inflation risks and as proxies for obtaining a modest amount of credit beta. We expect to keep global positioning for linkers close to flat, net of select relative value opportunities identified by our specialists. An eventual end to the Fed’s bond-buying program will remove a major sponsor of the market for U.S. Treasury Inflation-Protected Securities (TIPS).
Currencies and emerging markets
We see competing influences tugging at the major exchange rates. We therefore expect to be close to neutral on the U.S. dollar, which could benefit from the Fed’s hawkish pivot, yet be harmed by longer-term dynamics such as the large U.S. current account deficit and dependency on foreign money to finance deficits. We expect that our dollar holdings will be determined more by a medley of positions in currencies deemed attractive in their own right. This could well include certain EM currencies, for example, though we see scant opportunity across G-10 currencies.
On emerging market (EM) local and external debt, we are mindful of a number of risks of investing in the volatile asset class, especially amid tighter monetary policy in the U.S. We are nonetheless intrigued by a number of factors that give EM appeal in the context of a diversified portfolio and our preference for a reduced footprint in cash corporate credit instruments.
To be specific, while the historical volatility of EM assets is a reason for caution, their current appeal relates to basic investment principles that can make an asset attractive, including a significant price decline and extreme bearish sentiment. Both weighed on EM assets last year, especially EM local rates, which now have a significant real-yield cushion above developed markets. To us that cushion has value if viewed through a diversification lens.
On emerging markets currencies, we see a few opportunities and we view them as relatively liquid expressions for the EM asset class. More broadly we remain mindful of the idiosyncratic nature of investing in EM and we therefore will rely on our firm’s specialists to identify value.
As our asset allocation team discusses in their recent outlook, “Opportunity Amid Transformation,” PIMCO has a constructive view on global equities given the slowing yet positive earnings backdrop. That said, we are preparing for late-cycle dynamics, placing greater attention on security selection. We expect large cap and high quality companies stand to outperform late in the business cycle, consistent with historical patterns. Companies with pricing power also stand to gain, in our view. The semiconductor sector has potential to outperform over the long term, benefiting from strong demand related to transformational themes discussed in our Secular Outlook, including digitalization as well as many parts of the net zero carbon effort. Inflation trends are expected to adversely affect the earnings multiples for share prices, with a decline of a few percentage points likely in the base case.
The outlook for commodities markets is nuanced. We are relatively constructive on energy prices, yet we expect the price of crude oil to be constrained by increased energy output in the U.S., albeit more slowly than in past cycles given more disciplined capital deployment. Natural gas prices are supported by strong exports, though increased U.S. output has us more cautious on the outlook for 2022. Gold prices have meaningfully underperformed relative to real yields in our models, bringing prices close to their lowest in 15 years, though through a short-term lens gold screens only modestly cheap. We are attracted to the cap-and-trade emissions market, which we expect to be strongly supported by the transformation from brown to green. That tailwind along with favorable pricing is why we place the California allowance market as one of our top ideas in the commodities market.
To be sure, when considering all the asset classes discussed here, from commodities to bonds, we expect markets to be more volatile than usual, and that will require frequent reassessments of portfolio factor exposures. We take a long-term view, while recognizing the need for continuous assessment of near-term circumstances.