With policies and politics driving markets more than fundamentals, active management is critical, argues Scott Mather, head of global portfolio management at PIMCO. In the following interview, he surveys the landscape for bonds and currencies, identifying the developments that we believe may spell opportunity, and risk, for investors.
Q: What do you see as the main challenges in today’s investment environment?
A: Debt dynamics are the most important issue facing global investors. As we often hear, there is simply too much debt, particularly in the developed world, and it is constraining growth, as well as fiscal and monetary policies.
It was not that long ago that we accepted the notion of central bank independence. But, ultimately, each central bank reports, to some degree, to a political body, and the political pressure to address unemployment and lackluster economic performance has belied the concept, some might say façade, of independence.
Meanwhile, legislators have generally not engaged in intelligent fiscal planning that meaningfully addresses economic issues in the U.S. or other developed economies.
Thus, central bankers have implemented experimental policies to fill the gap, pushing many investors to take on risk and subsequently divorcing asset values from fundamentals, as well as increasing inflation risk.
We anticipate that the impact of ongoing global policy experimentalism on real economic growth and financial markets will likely vary substantially from country to country. That variance creates both risks and opportunities, and it may very well be unwise for investors to passively float through this environment.
Q: Could you elaborate on why passive management may be such a risk for global investors?
A: Passive investing may cause investors to miss opportunities and be exposed to risks that an active manager might mitigate.
Take sovereign bond exposure. If investors passively rely on market capitalization-weighted indexes, they could end up owning more and more debt from countries that are less and less creditworthy or countries in which inflation risk is rising. Overexposure to peripheral Europe has been and may continue to be a significant investment risk.
Although spreads have tightened in Italy and Spain since the ECB committed to “do whatever it takes” last July, we believe the underlying issues are far from solved. For that matter, debt and employment issues in the U.S. are not solved and we see long-term inflation and currency debasement risks emanating from policy measures. To varying degrees, circumstances are similar in Japan and the U.K.
All these factors could lead to shifts in global bond and currency markets. When global events and credit quality are moving quickly, investors should consider a manager who can actively respond to these changes. Indeed, we see investment opportunities from anticipating how policies may play out in different countries. With flexible, active, global strategies investors can potentially benefit from a broader opportunity set and the ability to go off benchmark in an effort to both avoid risks and tap opportunities.
Q: Speaking of opportunities, do you believe it has become more difficult to generate alpha with yields so low? Where do you see compelling opportunities to potentially add alpha going forward?
A: We have lowered our general expectations for total return given the lower-yielding environment, but not our alpha targets. In fact, we see more potential alpha opportunities than one might expect in a “normal” environment as we expect countries will choose different paths to address issues with debt, growth and inflation. And because we think the market reaction to economic events and policy responses could also vary greatly, we anticipate a period of “rolling crises” until debt loads are brought down from the danger zone. In this regard, we believe now is a good time to consider tapping the global investment opportunity set and seeking to compensate for that low beta.
I would highlight three key areas from which to seek alpha – yield curve, country selection and sector.
In the developed world, many central banks are keeping policy rates at zero. Such policies have contributed to a significant slope in the yield curve, and that creates opportunities for investors focused on risk-adjusted returns. Additionally, some central banks (including those in Australia, the eurozone, Japan, the U.K. and the U.S.) will likely deploy additional monetary stimulus through rate cuts and/or balance sheet expansion in the year ahead, providing opportunities for active positioning.
In our opinion, country differentiation is critical when investing in global regions. We anticipate greater variation between countries as the limits of debt sustainability and monetary and fiscal policies are tested to varying degrees. Ultimately, this may lead to quite a bit more bond market volatility and changing correlations across the globe. For example, the spread between Spanish and German yields at the end of 2012 was only 50 basis points higher than at the start of the year. Any appearance of calm, however, would be deceptive given that spreads oscillated substantially by up to 300 basis points throughout the year. We expect volatility, and the potential for alpha, to continue as long as the markets question Europe’s ability to address its problems.
To be sure, when investing in foreign securities, investors should carefully consider whether or not to take on currency exposure, which can heavily influence both returns and volatility. We anticipate a period of increasing currency volatility as a result of the aggressive monetary policies being pursued around the world – again presenting new opportunities for the active manager.
Q: You mention currencies, what are the trends in currency markets?
A: We think currency is going to increasingly be used as a policy tool.
After the financial crisis, there was a lot of attention given to the expansion of central bank balance sheets as the banks pursued quantitative easing. Public concern seems to have faded; in fact, it is hardly discussed at all as many opponents have acquiesced for the time being. Meanwhile, central banks feel pressured to tackle unemployment, without much help from fiscal policymakers. Out of this mix we get QE policies that may either explicitly or implicitly weaken a nation’s currency.
Switzerland was a dramatic example of this, explicitly targeting an exchange rate and pledging to print money to achieve it. This opened a new phase in monetary policy for the developed world. Now, other developed world central banks are explicitly using monetary policies to affect currency valuations.
Meanwhile, some emerging markets also are aggressively managing their currencies, and competitive currency devaluations have become much more likely, in our opinion. In the past, the carry trade, where a currency with low borrowing costs is traded for one that yields more, was a major factor for currency investors taking advantage of global interest rate differentials. But with so many nations near the zero bound, we believe carry is being overshadowed by many other factors.
Investors in the U.S. or other countries running sizable deficits and debts amid modest economic performance (or worse) should be wary of currency devaluation as a byproduct of central bank actions. Yet consider that not all currencies can or will decline; active management and a well-thought-out global view are critical for navigating, and potentially capitalizing on, what some believe may become outright currency wars.
Q: Could you discuss the future of the U.S. dollar? Do you believe it will continue to be the world’s reserve currency?
A: Our forecast over a secular horizon (three to five years, or more) is that the U.S. dollar will continue to be the primary reserve currency – but a less dominant one. In our opinion, there really is no reason why the world needs to have one hegemonic reserve currency, and increasingly the dollar is going to be rerated as its use as a store of value and medium of exchange diminishes. This process was bound to happen naturally over time, because as a share of world GDP the U.S. is not as large as it used to be. But poor U.S. debt dynamics, structurally weak growth and an aggressive monetary stance may accelerate the trend. Other economies are growing more quickly with less reliance on debt, and if investors were building a basket of currencies to store wealth, they would likely diversify and overweight currencies other than the dollar. Other developed world reserve currencies could undergo a similar reassessment.
Of course, the winners are ultimately countries with good growth and good balance sheets, including several emerging markets in Asia and Latin America. We believe this trend also favors slower growing but sound balance sheet countries such as Australia, Canada and Scandinavian countries. We suggest investors consider diversifying into such currencies – it makes little sense to us to hold all of one’s wealth in the U.S. dollar, a currency we see losing value over the long term.