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2022 Focus: Expanding the Opportunity Set

With inflationary risks and less accommodative policies likely to increase volatility, Group CIO Dan Ivascyn offers strategies that may hedge inflation, broaden the opportunity set and potentially earn stronger returns from more complex areas of the market.

Text on screen: PIMCO

Text on screen: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.

Text on screen: Kimberley Stafford, Global Head of Product Strategy

Stafford: Hello. I'm Kim Stafford, and I'm here again with PIMCO group CIO Dan Ivascyn to give you an inside look at the recent discussions happening within PIMCO's Investment Committee, or IC. Dan, thanks for joining us today.

Ivascyn: Thanks, Kim.

Stafford: So, Dan, before we get into the detailed questions any high-level thoughts for investors as we look into 2022?

Text on screen: Daniel J. Ivascyn, Group Chief Investment Officer

Ivascyn: I just want to start by thanking all of our clients. We are honored that you trust us to navigate investment environments on your behalf, and we'll go into the New Year trying as hard as we always do to generate returns. 2021 was a relatively strong period for most investment returns.

Unfortunately we do believe 2022 is going to get a bit more difficult where we anticipate elevated volatility, less accommodation from policymakers. So we're probably entering a more challenging period. But, again, 2021 was generally a good year, and it was a good year because of all of the confidence from our clients all around the globe.

Stafford: Identifying possible sources of volatility will be critical in navigating the year ahead. One area of concern for many clients is the outlook for inflation. Dan, can you help us describe how you're positioning portfolios to help navigate different potential inflation scenarios?

Ivascyn: Sure. You're absolutely right. We do see inflation continuing to rise during the first quarter of next year, perhaps peaking in February or March, and we acknowledge that the risks are to the upside.

But even in our base case we see core inflation during the first quarter getting up above 6%, and that's a level that should be concerning to central banks as well as end investors. The good news is that also in our base case thinking inflation will begin to dissipate throughout the remainder of 2022 and end up at a level that's reasonably acceptable to central banks as well.

But this is going to pose considerable challenges for policymakers, challenges for market participants. It's likely going to be accompanied by a lot of volatility.

Text on screen: We remain defensive on interest rate exposure

Images on screen: PIMCO trade floor

So to answer your specific question, we remain fairly defensive regarding interest rate exposure.

And then stepping back and thinking about a multi-asset portfolio, even some of the more flexible PIMCO portfolios, the cost to protect against inflationary events remains quite reasonable.

Text on screen: TITLE – Assets with inflation-protection potential: BULLETS – Treasury Inflation-Protected Securities (TIPS), Commodities, Commodity-related companies, Real estate

So a lot of our more flexible portfolios have direct exposure to TIPS, as an example. Many of our multi-asset portfolios have some exposure to commodities, commodity-related companies, other real estate-oriented companies that should continue to benefit from more of a reflationary environment.

So the bottom line is base case view constructive, key area of uncertainty, and therefore volatility on a go-forward basis, and still positioned relatively defensively in case inflation does continue to surprise on the upside.

Stafford: Another potential source of volatility is the outlook for monetary policy. Central banks have largely suppressed volatility for much of the decade following 2008. But with changes in policy stances and market expectations, it could actually be a source of volatility going forward. So does this volatility create opportunities for investors?

Ivascyn: It has to a degree. We've been able to take advantage of more recent localized volatility, but, again, I think volatility, more extreme uncertainty, very well could be a key theme for 2022. And it's very, very hard to separate inflationary risks with policy risks.

Images on screen: Global central banks

Central banks have told us that if inflation remains elevated, if it begins to become more embedded in longer-term inflation expectations like we're seeing in the U.K., as an example, policymakers will react. They will move.

And also it's important to acknowledge that risk asset valuations are stretched. They're on the expensive side of fair, and a lot of that relates to the fact that risk assets have grown accustomed to a relatively low real interest rate regime.

More active central banks very well can create some decent volatility, even downside volatility, across risk assets.

We want to be prepared if, in fact, that's the case during the first half of 2022.

Text on screen: TITLE – Three ways to consider preparing for downside volatility:, BULLETS – Increase portfolio flexibility, Build up liquidity, Move into positions that are easier to trade

Across PIMCO portfolios we've been steadily increasing portfolio flexibility. That typically means liquidity or at least moving into positions that are easier to trade, to allow us to go on the offense if that scenario occurs.

Stafford: Can you discuss where PIMCO sees stronger return potential at a time when generic market valuations don't look particularly attractive, particularly given yields and spreads are already compressed?

Ivascyn: Sure. One is to expand your opportunity set if you're able to do so.

Text on screen: Areas of opportunity: 1. Expand opportunity set geographically

Images on screen: Emerging market countries

Expand geographically. Certain emerging markets that have really struggled with this terrible COVID virus stand to benefit as we gain a handle on the health situation on a global basis.

It's important to look at EM at the country and the actual financial instrument level, given that there's so many unique and idiosyncratic risks across different regions of the EM opportunity set. But that's an example of an area that could potentially provide some attractive returns. It's a sector that's a bit out of favor, but offers a valuation advantage versus others.

Text on screen: Areas of opportunity: 2. Maintain more liquidity

Images on screen: PIMCO trade floor

The second point I emphasized earlier, which is maintain more liquidity, more flexibility. Market structures continue to be weak, liquidity tends to be challenged, especially when there's big flows going through markets, and that leads to an environment where we expect to see overshooting of fundamentals in both directions.

And this potentially creates a very attractive opportunity for active asset managers that have sufficient portfolio flexibility to take advantage of this overshooting.

Text on screen: Areas of opportunity: 3. Consider more complex areas of the market

Images on screen: Global real estate

The last point I would make is, this has been a very, very unique crisis environment where you had a massive shock but also a massive policy response. That's made the easiest-to-own areas of the higher-yielding segments of the market to be expensive relative to the more complex, less-liquid areas.

So moving out of more generic forms of corporate and sovereign credit into some of these more off-the-run, less-liquid segments of the market. Global real estate, some of the opportunities in direct private lending, other more complex asset-backed instruments, provide additional yield premium but also the type of resiliency that's hard to source in the more traditional public markets today.

Stafford: There's been elevated market volatility in China's high-yield market this year. Can you please describe PIMCO's outlook for China, and are we beginning to see value in the high-yield sector there?

Ivascyn: Sure. So in terms of China more broadly, they've seen quite strong growth in recent years. And with strong growth, as well as the continued development of capital markets that are relatively young in nature, are going to lead to bouts of volatility.

So you have a market, particularly within the corporate opportunity set, that's relatively untested, where there's lots of leverage, lots of stress, and lots of uncertainty as to how these workouts are going to evolve, particularly within the offshore segments of the market.

So we went into this period as a firm underweight risk. We have been looking to take advantage of very, very high-quality Chinese names that have widened in sympathy with some of these higher-yielding credits. We've only begun to begin to look at the areas that are the most stressed.

So this will provide opportunities for end investors, but you need to go into these situations realizing that there's going to be a tremendous amount of uncertainty around the restructuring process. These are untested markets. We are investing more resources in these areas, because with volatility comes opportunity.

Images on screen: PIMCO trade floor

So we're investing there carefully, we're expanding our resources there, and in some of our higher-risk, higher-returning credit strategies, beginning to take a closer look at some of these more distressed names. We'll likely become more involved as valuations become a bit more attractive.

Stafford: Well, thank you very much, Dan, and thanks to all of you for joining us. We'll see you next time.

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