From Rates to Risk: Investing Amid Middle East Volatility

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Voice-over: Welcome to Fixing Your Interest. Today’s episode takes you inside bond markets at a moment of heightened geopolitical uncertainty and shifting macro dynamics. In conversation today are Christan Stracke, PIMCO President, and Andrew Balls, CIO of Global Fixed Income.

Together, they explore how the current backdrop - including the conflict in Iran - is shaping inflation pressures, interest‑rate expectations and market volatility across developed and emerging economies.

They’ll unpack what’s been driving the recent moves in rates, how central banks may respond, what this environment means for building portfolios, and where investors might find opportunities amid the uncertainty.

Christian Stracke: Andrew, lots of talk about here. First, let's talk about the cyclical outlook. Obviously, the market and everyone is focused on Iran and the Middle East. So maybe start us there. How do you see that affecting the cyclical outlook, particularly in the UK and in Europe?

Andrew Balls: When you have a lot of uncertainty, and nobody has a great handle on, precisely how this is going to play out. You have forward markets, which give you an indication of how, for example, the oil markets are pricing and it's a reasonable guide.

Coming into this, the economic outlook is pretty reasonable. A lot of uncertainty around credit markets, AI, credit market impulse, weakening labor market in the US. In the UK, actually a pretty good actually outlook, by European standards. And then you have this shock and, and then you've had this big market reaction over this past ten days. In terms of the macro impact, again forward markets are pricing in a rise in the oil price, but not that dramatic. So there is some impact on inflation, there is some impact on growth. But the size of the market movements are very, very large, relative to that and concentrated in Europe and in the UK.

And you always have fundamentals and you have technicals, market dynamics. So on the fundamentals there’s more of an impact from energy markets, particularly natural gas markets, for Europe and the UK - oil importing countries. The US of course, these days is a net oil exporter.

Central banks, which may be a bit more focused on headline inflation. The ECB always has been like that. The Bank of England at the moment is unusually focused on headline inflation.

And then you have the technicals. A crowded position has been that a lot of market participants - Pimco included - have seen UK terminal rates as too high. So have been positioned in anticipation of lower terminal rates.

Europe, where we haven't tended to have a position has been a popular trade, to be long the front end of the European curve. Or more complicated ways to do that using volatility markets. But as a hedge against downside risks and AI-related risks.

The ECB was at 2%, and inflation's at 2% priced to stay there. I think a lot of market participants had anticipated this was a very good hedge and the probability of what we call the bearish flattener, the sell off in the front end of the curve, seemed very unlikely. And then that's happened.

One really interesting thing. Markets tend to price the last war, the last cycle. And so we had the 2022 experience, energy shock related to the situation in Ukraine. And central banks responded very, very forcefully during that period. Superficial similarities, but a lot of differences.

The first one is we don't know precisely what's going to happen here, but the market is pricing a temporary energy price shock. And it's always the extent of the shock and then the duration of the shock, which will be important for macro. Secondly, in 2022, you had a lot of fiscal stimulus post-COVID in the system.

That was very important. It’s not the same today, although there is the “One Big Beautiful Bill” in the US. So there is some US stimulus. Third, in 2022 you're coming out of lockdown, there’s pent up demand. I think there's a lot of differences today. And then of course, inflation was well, well above target.

So for us portfolio managers, again: be humble. During a crisis there's a lot of uncertainty.

But the extent of the market reaction to price in 40 basis points - as of today - of hiking by the end of the year for the ECB. And going from pricing in cuts for the Bank of England to a modest probability of a hike over the course of this year. I think probably the pricing has moved a little bit away from the fundamentals.

So I think that there are things for us to do as active managers. In the US, it’s still priced for the Fed to ease policy rates this year, but it has taken out one of the cuts.

And so, you know, be humble. Don't over trade during a period of volatility. But I think that, probably central banks are going to be very focused on inflation expectations. But different economic conditions, weaker labor markets in the US and UK compared with 2022, it does look like the extent of the shift in pricing looks a little bit exaggerated to us.

And that, you know, probably reflects these market dynamics that I've talked about.

Christian Stracke: So do you think the market actually believes that the ECB is going to hike rates by 40 basis points? Or do you think that's an overreaction to this unwind?

Andrew Balls: I think it looks like an overreaction, to the unwind. But when you look across your sets of probabilities this is certainly possible. With these sorts of very dramatic periods, the technicals can dominate the fundamentals for some time.

My sense is with the European Central Bank, the easiest thing to do in a bit of uncertainty is to do nothing. The markets had been pricing them to be at 2%. Interestingly, we’ve got all the meetings coming up for the ECB, the, the Bank of England, the Fed. So I think it's probably a good opportunity to signal that you'll be very, very, vigilant on second round effects, inflation expectations, but in the baseline not do anything.

And, and that's you know, broadly consistent with the central bank rhetoric that we’ve seen. And to be fair, if nobody has a great handle on the size and the path for the oil price, including the central banks. The UK rates are restrictive - we had anticipated before this shock, the Bank of England would be easing, perhaps easing more than the market was pricing. Inflation was set to come back to the target in the first half of this year. It may get pushed off a little bit in terms of the timing, but I think the fundamental picture, remains pretty similar. Underlying growth is not that strong. So again, the Bank of England will be cautious.

Christian Stracke: Let's talk about portfolios. You head up, global fixed income for PIMCO. Any changes you're making in portfolios here? You say you don't ever want to overtrade in the middle of a crisis. This also raises even more questions about the US dollar.

Andrew Balls: Well, I think the first thing is liquidity management. Be very careful in terms of liquidity management. We have been doing this for some time: cautious on credit, up in quality, careful in terms of liquidity management and be ready to respond to events.

So I think that's the first thing: there are some trades that we like. The prices have moved and we've been adding to those trades, but fairly selectively, being fairly careful at the moment. The dollar is interesting. We've had a view to be overweight emerging market, currencies versus the dollar. As the primary expression of that view, I think that remains fine. E.M. has performed quite well in this period.

If you look at the FX market, modestly, modestly, weaker currencies, a flight to the US dollar, but on average, it's half a percent or whatever. Not big moves. And then if you look at EM local rates markets, they've basically performed in line with G10 markets 

Christian Stracke: Even better than in some cases.

Andrew Balls: Always country by country.

Andrew Balls: And there will be winners and, and losers. One of the metrics would be the energy importers versus the energy exporters. Countries exposed in the Middle East.

But in general terms there are good starting conditions, high real yields. In cases where we have a positive view - Brazil, Colombia, this is a positive in terms of, fundamentals. So, country by country, and with active management. I always want to apologize and say of course we like active management, it's Pimco, but it is very, very important, in emerging markets.

Christian Stracke: Especially in a case like this. A bit more on emerging markets. I mean, what are you looking for? What would change your views and make you start to change some positions?

Andrew Balls: Well, I think it's very similar to the G10 markets really. The extent of the shock. The baseline in line with forwards I don't think is that threatening. Although, with huge amounts of uncertainty. But you can think of scenarios of more, larger oil price moves and more permanent shocks.

So I think you look for that regional exposure which of course is important. But we tend to like the high quality names, and there may well be opportunities in the region as well, of course, with very strong balance sheets in a lot of the countries. 

So I think it's, it's not business as normal in the sense that these are unusual shocks, but the standard active management for emerging market approach makes sense. 

Christian Stracke: Yeah.

Andrew Balls: How about for credit markets? You until recently were head of credit research as one of many, many jobs. But how do you see some of this from the credit market position? 

Christian Stracke: You mentioned it on at the beginning of your comments about going into this there was already a lot of questions around AI, the impact of AI. There were macro questions around that, but also specific questions in credit markets. And particularly software companies where those are large, borrowers and the bank loan market, as well as in the private credit market.

So you had a lot of these questions already percolating, and now you're hit with the shock and that, that raises even more questions. I think the way that we see it is, still the main show in credit is what we had coming into this, which is these questions around the private credit ecosystem, potential contagion from private credit, then amplified by questions around AI, particularly around software exposures, which are as much as a third of many portfolios in private credit.

There have been headlines just in the last week or two around private credit managers needing to limit redemptions out of some of the evergreen retail vehicles, which then, of course, drives confidence even weaker in those products. And there can be a bit of a self-fulfilling prophecy in that space. And then, of course, let's remember credit particularly down in credit, single Bs, triple Z type and private credit of the similar profile - these are all very cyclically exposed.

One of the reasons that things have held up recently has been the economy's been pretty strong, so it's hard to get too much of a default wave when the economy is strong, the fed is cutting rates, etc..

But here you have real questions. Now your base case of economy a little weaker, inflation a little higher Fed and central banks a little less likely to cut rates and probably not enough to really drive a material change in sentiment and in defaults.

But it wouldn't take much more in terms of negative economic outlook and negative economic circumstances than what you described for there to be a material increase because it’s pretty cuspy, in terms of once you're already at the edge, it doesn't take much more to push you over the edge. And a lot of credit is at the edge.

The problem is that you have maturities coming up in 2027 and in 2028, they need to be refinanced. If no one's willing to refinance them, even if they're reasonably good credits, but there's money coming out of the system, then that will force a deterioration in credit conditions.

So, this Iran shock, maybe it just lasts for a couple of weeks. And so we get over it. But if you do have several weeks or months of these high oil prices leading to high gasoline and fuel prices leading to deteriorating consumer sentiment, then things will spread outside of software.

Andrew Balls: And then the yield comparison is interesting. I'm just looking at the yields available in public investment grade credit, they look very attractive. And again, a lot of uncertainty in the world, but one thing with fixed income is that over the next few years, the best guide to future returns is the yield on the portfolio.

So the yield on public credit vehicles looks good.

Christian Stracke: Especially higher quality.

Andrew Balls: So another source of pressure in terms of are you getting paid sufficiently for the liquidity give up in the, the lock up on the less well tradable vehicle.

Christian Stracke: The other hand, it'll create some opportunities. First of all, is the opportunity you mentioned, which is high quality credit has widened, yields have gone higher and spreads have gone higher. And so you can construct portfolios that generate a 6 or 7% yield. Which is quite interesting, especially in the context of really what's the trajectory for equities.

And if you are going to realize your yield of 6 to 7%, that's pretty interesting. Relative to what are the returns going to be in equities. The other thing is that there's still this really serious and important capex cycle around digital infrastructure, data centers, the chips and all of these things that need to get built out.

And for a while now, one of the more exciting opportunities in credit has been financing these things. If there's a tightening of credit conditions and yet this capex still needs to happen, it just means that the yields you're going to generate on these are going to be even higher. We're talking investment grade type of structures not having to go down into high yield.

Andrew Balls: It's really interesting. And I mean we've talked about uncertainty in difficult markets. But during this period  large issuance from high quality credit issuers just, just this week. I'm not sure if it's record size, but very large.

Christian Stracke: Very large. Yeah. That's right.

Andrew Balls: So, very, very interesting. You spend a lot of time with clients in Europe, in Asia and in the US, but particularly here in Europe. What's the focus for clients at the moment?

Christian Stracke: I think the focus, of course, is, as you would expect to be. How long does this last? And if it does last longer, what is the economic impact going to be? And you helped, you helped us with some of those questions. Maybe a year ago, when we had Liberation Day and the tariff shock and the valuation gap between US equities and European equities, taking that very simply, was so wide. Well, now we've narrowed the valuation gap. Multiples in European equities have, have gone higher while the US has gone a little more flat. So there's less of a compelling reason to diversify into European equities, for instance. And that I just highlight the European equities as that's kind of the center of a lot of focus. But then from that European credit, European real estate, European private credit, etc. it all kind of percolates from there. So there are even more questions around what is going to happen to global, rebalancing of portfolios.

Andrew Balls: We're still working on the cyclical outlook committee. We had the meetings in Newport Beach last week and continuing this week. But definitely one of the, the conclusions - it's always an uncertain world - but in an unusually uncertain world, there’s a lot to be said for global diversification across high quality markets, across high quality emerging markets, as well. 

And there are lots of uncertainties in the world, but over time, diversification, global diversification, is the only free lunch. I always think this managing global fixed income myself, but, I think more broadly there’s a lot to be said for the, the global diversified approach.

And it's pretty grim what is happening in the Middle East, at the moment, lots of challenges, for sure. But for us as investment managers, there will be good opportunities across the global landscape.

So, lots to keep us busy.

Christian Stracke: For sure. All right. Well, thanks very much.

Andrew Balls: Okay. Good to talk to you.

Voice-over: Thanks for joining us on Fixing Your Interest as we examined the forces influencing today’s bond markets - from shifting inflation dynamics to the policy paths now facing central banks. Stay with us as we continue to navigate the challenges and opportunities across the investment landscape. For further insights, analysis and resources, visit PIMCO.com.