Kanish Chugh: Over the past few months, we've seen resilient growth alongside persistent inflation, geopolitical uncertainty, and substantially higher yields. The question today is no longer simply what happened, but what did these higher yields mean for portfolios? Today, we're joined by Adam Bowe and Sachin Gupta. Thank you so much for joining us. And we're going to discuss what's changed in PIMCO's outlook. We're going to look at how portfolios have adapted and also what investors should be thinking about in terms of their portfolios and allocating capital.
Now, Sachin, the Middle East conflict, energy shocks, they've been dominating markets in recent months. But what has surprised you most about the resilience of the global economy? And have the energy shocks been the real driver of the central bank rate hikes recently?
Sachin Gupta: It's a really good question to start off. Number one, I would say what certainly has surprised the markets is how long the conflict has continued. And I would remind our investors, of course, that we did have an MOU signed between the US and Iran quite early on, frankly, but then things broke down and it continued. The second thing that has been somewhat surprising, as you alluded to, is the resilience of the global economy through this conflict. Energy prices have gone high and stayed high. Refined products have gone higher and stayed higher yet. And even with all of that, the consumer globally has been relatively resilient.
Now, there's a possibility that that's because the consumer is looking through this and hoping for the conflict to end soon. There's also a possibility that there is a wealth effect because, after all, equity markets have done wonderfully well and most people's portfolios have some allocation to equities. And so that's potentially also helped consumers probably weather this so far. From our standpoint, though, it is difficult for this to continue for a long time for two obvious reasons.
Number one, it is rare that consumers continue to consume at a pace which is substantially higher than how their earnings are running. And so that can happen over shorter periods of time, but over time the gravity of earnings pulls the consumption down. The other thing which worries us when we look forward is how narrow the strength in the equity market has been, which is predominantly coming from tech and the expectations of AI and so on and so forth. And so these two things do create some vulnerability, and I think that should be an important driver for our clients' portfolio allocation decisions.
Kanish Chugh: And Adam, switching closer to home, we've seen a series of hikes from the RBA. How are you thinking now about the Australian economy from here?
Adam Bowe: Yeah, that's right. If we cast our minds back to the beginning of the year, the RBA had started hiking even before the conflict. And now we're at a level of cash rates that are higher than where we were coming out of COVID. And you've got to remember, back then we had inflation around 8%, not three and a bit. We had unemployment rate in the low threes, not high fours. So very high level of cash rate relative to the unemployment market, relative to where inflation is, and sort of leads me to think that the policy cycle here is a little bit more mature than it is elsewhere. And you can start to see signs that policy is gaining traction and looks tight.
So as I mentioned, we've got the unemployment rate rising here, got house prices falling here, real GDP growth in the first half of this year was almost half the pace it was in the second half of last year. Consumer discretionary stocks are struggling. So all those signs that you would look for to suggest that high interest rates are starting to bite the economy look like that's occurring. So certainly as we peer into next year, I think that soft sluggish growth probably likely to continue and we'll have an RBA that's a little bit more worried about growth concerns next year than inflation concerns.
Kanish Chugh: And if we pivot to duration and we think about earlier in the year duration was under pressure and when we look at yields, which are now materially higher, how are you currently positioning for duration within portfolios? Is it more or less in terms of how the team are looking at that?
Adam Bowe: Yeah. So if we sort of stand back and I'll kind of go back to Sachin's points on drivers of interest rate increases around the world. I know there's been a lot of discussion around fiscal and a lot of hammering about deficits and bond supply, both in the sovereign sector, but also through the hyperscalers. What's really driven interest rates higher this year is a cyclical adjustment to central bank expectations. It's really been the front end of yield curves that have risen fastest and it's dragged the whole curve.
So while there have been concerns about bond supply, fiscal deficits, that hasn't been the key driver of interest rates this year. It's been a market adjusting to a cyclically different rate expectation from central banks around the world responding to inflation and a little bit more resilient growth. So the question around us to get conviction around interest rates have been what's been the driver? It's been that. Has it gone far enough now?
As I said in Australia, it certainly looks like policy is starting to bite already. The level of interest rates and cash rates priced in around the developed world looks a little more than we're expecting central banks to deliver. So given that's been the key driver, we have become more confident on duration as a general statement. And you can see that reflected in our broader portfolio. So duration running a little longer than we were at the start of the year and certainly longer than benchmark, seeing plenty of opportunities to lock these elevated level of interest rates in portfolios.
Kanish Chugh: And Sachin, given your role within the global bond fund, does that view on duration stick with you and the team? And also has this volatility created opportunities as well for the team?
Sachin Gupta: The answer is yes to both actually. Similar to what Adam said, we think duration more broadly is looking quite attractive. As we were discussing previously, a lot of the rise in bond yields is because investors are expecting higher interest rates, central banks to deliver a full-blown hiking cycle in vast economies across the world. We don't think that will happen. We think that central banks will do some hiking, a little different than Australia because here we have seen some inflationary pressures earlier in the year and the response.
But in other places we don't see pressure in core inflation, but we do see central banks perhaps delivering some risk management hikes simply because headline inflation is high and they want to make sure that it doesn't start to spill over more broadly. So it's more risk management, it's talking tough. That does not require a series of rate hikes, taking rates high by 100 to 200 points, that's unlikely to happen. And so I think that presents an opportunity.
And so not only that, at the same time as this is happening in vast economies, there are some economies where this has not happened at all or much. And so we see opportunities in both directions. There are countries where we are long duration in global portfolios – the US, Australia is one of them, UK, Scandinavian economies, but there are countries where we are underweight duration, particularly in Asia, places like Singapore, Hong Kong and Japan where we don't think there is enough in the price and it looks asymmetric.
Kanish Chugh: Based on what you're seeing, Sachin, how does fixed income compare with other asset classes at the moment?
Sachin Gupta: So look, we already had a generational reset higher in yields a few years ago. When we came out of COVID, bond yields were ultra-low and we had a pretty substantial hiking cycle bringing the yields up and high quality bond yields went from 1 to 2% to 4 to 6% across economies. Now on top of that, this year's volatility and developments have made them look even more attractive. Now investors have the opportunity to invest in high quality bonds, whether focused on Australia or globally and build portfolios ranging from 6 to 7% in yields and staying very high up in quality and in liquidity.
And I think that that is a very important consideration for any sort of portfolio construction decision. A, it does and should raise the bar as investors look at other asset classes to say, "Hey, I can make 6 to 8% in high quality bonds. I need to make more in order to take risk." B, you get paid – in bonds, in high quality bonds – you get paid to wait and be patient before you allocate capital elsewhere. So I think it serves two purposes, provides incredible sort of ongoing yield and income, but at the same time, investors can exercise discipline when we look at other asset classes.
Kanish Chugh: And Adam, from an Australian investor perspective, when they can earn a relatively attractive return from cash and cash style products, why take that extra step into bonds? What can bonds add to a portfolio for them?
Adam Bowe: Yeah, I would start by just extending Sachin's comments to, he said when you're looking at riskier asset classes, you should be looking at your starting yields on your bond funds 6 to 8% as a hurdle return. If you can't beat that by a meaningful margin, then bonds look pretty good. I would use the same argument for cash and cash-like securities. Is 6 to 8% enough compensation to lock those interest rates in for five years or so relative to what you can get in the cash market? I think we've got to levels where they are now and they're quite attractive.
So kind of think for Australian investors, the flipside of what we had during COVID. So during COVID we had very low, generationally low interest rates, perfect opportunity to lock in your liabilities and fix your mortgages, and a lot of us did. Now we've got generationally high interest rates. It's the perfect opportunity to lock in interest rates on your assets. And that's really the choice between cash, TDs and bonds. So starting yields between 6 to 8% should be a really strong anchor for your expected returns.
As this year has shown, it's not a straight line, just about everything that could go wrong did go wrong in the bond market this year, but returns on Aussie bonds are mostly positive, not that different to equities in Australia, a little better than real estate that's going down. And so the opportunity to lock in those interest rates so that you've got a kind of visibility on those average returns over say the next five years are really attractive at the moment. And should riskier parts of your portfolio do poorly, your bonds should do well and they're daily liquid, you can sell them tomorrow and recycle back into risk markets.
Kanish Chugh: Thanks Adam. Thanks Sachin. If there's one thing to take away from today, it's that volatility creates opportunity and it pays to be patient. The funds today we've discussed are available in both managed fund and ETF structures. If you'd like to find out more, please visit the PIMCO website or speak to your account manager.