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Olivia A. Albrecht, Michael Story
Extraordinary central bank support has driven prices higher for safe-haven and risky assets alike, despite challenging economic fundamentals. This leaves investors in a quandary: Should they respond to today’s unusual combination of elevated, macro-driven risk and thin compensation by stretching for additional yield and continuing to capitalize on central banks’ reflationary policy for asset prices? Or should investors focus on capital preservation after remarkable gains, acknowledging that central banks cannot drive a wedge between fundamentals and asset valuations forever? This is the challenge investors face in the New Normal (see Figure 1).
The answer of course lies in striking the right balance between the aims to capitalize on the current environment and to preserve investment gains, which, in turn, requires setting realistic return expectations. And to do this properly, we should differentiate between alpha, or above-market returns, and beta, or market returns.
Alpha, beta and volatility Looking first at beta, we expect a lackluster environment over the cyclical horizon. The current yield on the Barclays Global Aggregate Bond Index −1.6% as of 30 April 2013 − may, in fact, be the best indicator of beta return expectations going forward. This assumption, in our opinion, reasonably implies neither capital loss nor capital gain on the benchmark. There is little room left for yields to decline, and yet a global rising-rate environment seems very unlikely given below-trend global growth, elevated unemployment, biting fiscal austerity and unusual policy uncertainty, particularly in Europe. Therefore, we expect lower returns over a longer time horizon and an eventual rise in interest rates.
Clearly, beta shouldn’t tell the whole story. With today’s low yields, alpha is going to have to play a greater role in overall portfolio returns for investors in seeking their return targets – for some, simply beating inflation. So what is a realistic alpha expectation going forward? Some have argued that the current low yield/tight spread environment translates into a less alpha-rich landscape. We disagree.
We believe successful active management requires new information and asset re-pricing, and for better or worse, market-driving news and major re-pricing seem to have become a prominent market feature since the financial crisis. Financial markets have become particularly sensitive to unpredictable political outcomes, and unorthodox central banking is focused increasingly on manipulating the markets as a means of indirectly influencing economic outcomes. We expect both of these conditions to persist and to create bouts of market volatility in coming years – in fact, even more so than in recent years as political relationships are redefined and central banks are forced to devise more creative ways of stabilizing the systems.
We therefore believe the current environment affords a healthy opportunity set for alpha generation. Under normal market conditions, PIMCO’s core, global bond strategies are designed to generate consistent alpha, and we are focused on this target in what we believe to be an alpha-rich environment.
Generating alpha In efforts to generate alpha in global bond portfolios, we look at several strategies.
Credit risk. We look to scale exposure to credit risk, most notably between corporate credit risk and sovereign credit risk.
Issue selection. This bottom-up component of active management is more attractive than it has been in years.
Sector rotation. Should we anticipate the end of the Federal Reserve’s quantitative easing program, we could consider deploying a large underweight to agency mortgage-backed securities, a reversal of our overweight position for most of the past five years.
Tactical positions in currency markets. We typically limit currency strategies’ contribution to alpha in our global bond strategies due to their disproportionate level of volatility. However, as central banks are increasingly comfortable with influencing exchange rates, currencies should become more volatile, which may create some attractive, short-term opportunities.
Alpha and rising interest rates What happens to these alpha opportunities if interest rates rise?
Our view is that a rising-rate environment over the next year or so is not very realistic given the macroeconomic environment – we anticipate an extended period of low rates anchored by global central banks. However, should rates rise sooner than we expect, we would not anticipate concurrent rate rises across global markets. Regional business cycles remain distinctly unsynchronized, with each of the major economies struggling through its own unique set of economic, political and financial challenges. As a result, we believe the advantage of global diversification in core bond allocations is stronger than ever.
Nevertheless, in rising rate environments, global bond portfolio managers can draw on a number of specific alpha strategies to offset the possibility of capital losses from rising rates. For example, if interest rates were to rise in the current market:
Investment Conclusions To come full circle, what are reasonable return expectations coming into the fifth year of the New Normal, a landscape defined by an exceptionally challenging combination of tempered global growth, hyperactive central bank intervention in financial markets and elevated systemic risk? Our base case is that beta returns will be muted and alpha returns will play a much larger role in portfolio performance than they have historically.
In our view, the key to achieving alpha in this environment is the flexibility to pursue many different sources of added return potential as events unfold. PIMCO’s Global Bond Strategy is designed to provide enough flexibility to navigate today’s challenging combination of macro-driven volatility and thin levels of compensation. Our time-tested investment framework – which focuses on macro-systemic risk assessment, intense bottom-up issue analysis, contained volatility and low tracking error – is designed to seek potential returns in all markets.
A word about risk: Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2013, PIMCO.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2014, PIMCO.
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