By Daniel J. Ivascyn, Alfred T. Murata, Joshua Anderson, Esteban Burbano
We see meaningful value in high quality, more liquid bonds that offer compelling yields and potential price appreciation should the economy weaken.
Many investors have taken a wait-and-see approach, but we think the time to add exposure to bonds is now. Here, Dan Ivascyn, Alfred Murata, and Josh Anderson, who manage PIMCO Income Strategy, talk with Esteban Burbano, fixed income strategist. They discuss the uncertain economic outlook and how they are positioned not only for attractive bond yields today, but for potential resilience and price appreciation tomorrow.
Q: Inflation, and what it means for interest rates, has been a key driver of market volatility over the past two years. What is PIMCO’s outlook for Fed policy and the economy?
Ivascyn: Inflation remains well above the U.S. Federal Reserve’s 2% target, but the labor market appears to be slowing. Recent payroll, unemployment, and income data were weak. October manufacturing and services indexes were also weaker than expected. We now think it’s likely the Fed will remain on pause through year end. Still, these reports have been noisy, with major prior-month revisions, and much uncertainty remains. If inflation remains sticky – a possibility next year – the Fed will likely leave restrictive policy in place or raise rates again in 2024. In contrast, the market is pricing in a very low chance the Fed will hike again.
Tighter monetary policy for longer would raise the prospect of a hard landing as we enter 2024. Indeed, for inflation to return to the Fed’s target, some economic weakness is necessary and appears likely as much of the post-pandemic fiscal stimulus begins to wane, chipped away by inflation and strong consumer spending.
Central banks have not had a great historical record in bringing inflation down from these elevated levels and avoiding a hard landing. We also must acknowledge the geopolitical uncertainty ignited by wars in the Middle East and Ukraine. We are in a highly uncertain environment.
Q: Could you elaborate on the hard landing scenario, and what it means for portfolio positioning in the Income Strategy?
Ivascyn: We see about a 50% probability of a recession over the next 12 to 18 months. By market pricing, we think consensus is a bit more optimistic than we are. However, a 50/50 chance of recession means there’s a 50% chance that we avoid one. Given this outlook, we did take the opportunity when spreads were tighter to reduce exposure to the most economically sensitive areas of the portfolio and looked to upgrade into higher-quality, more resilient assets.
Today we’re focusing on the higher-quality, more liquid areas of the market with strong, resilient yields, and we’re letting the “risk-free” or low-risk rates do much of the heavy lifting across the portfolio, while providing flexibility. We want to stay as nimble as possible because we anticipate attractive alpha-generating opportunities over the next 12 months amid elevated market volatility.
Q: How does PIMCO’s outlook on interest rates factor into how the team is managing the Income Strategy?
Murata: We think duration, or interest rate exposure, is attractive and will enhance portfolio returns over the coming years.
We have been adding duration over the last two years, going from close to one year in 2021 – a near historic low for the strategy – to duration of about 4.7 years at the end of September. We expect duration to be negatively correlated to credit spreads, meaning should credit spreads materially widen – which is likely in an economic downturn – we think duration will rally. That’s not what happened in 2022, when credit spreads widened and duration went higher as well. We therefore believe it’s prudent to have a healthy amount of duration in the strategy – though the it is still underweight duration versus broader fixed income indices like the Bloomberg U.S. Aggregate Index.