Dealing With an Inflation Head Fake

Investment conclusions: Flexibility and liquidity

In this environment, with the potential for ongoing volatility, we seek to maintain flexibility in our portfolio positioning to be able to respond to events as they unfold. This includes careful scaling of positions, very careful liquidity management, and – in some cases – staying close to benchmark weights for now as we look to be better able to take advantage of compelling opportunities later. Given current valuations, we see little cost in going "up in liquidity," and a patient approach now should allow us to be aggressive in seizing the good opportunities that are likely to arise in a more volatile environment.

Duration

We expect to be fairly close to home in terms of duration, with interest rates at more reasonable levels after the recent market moves. Based on a 1% to 2% range for the U.S. 10-year Treasury bond yield, we expect to move further into the higher end of the range in the near term. But, while markets will continue to speculate about the extent of central banks' resolve, and we certainly have the environment for possible overshooting relative to fundamentals, we do not expect any big shift in global yields as we leave the COVID period behind compared with the levels that were prevailing before the COVID shock. We believe that bonds continue to serve as both a store of value and a potent hedge for risk assets in terms of overall asset allocation. (For further insights, please read PIMCO's recent research paper, "The Discreet Charm of Fixed Income .")

Among the larger central banks, the U.S. Federal Reserve, the Bank of Japan, and the Bank of England have reacted with relative equanimity to the recent market moves, seeing these as the result of a stronger outlook. The European Central Bank may have been more concerned about higher yields, though its recent communications have made it somewhat hard to tell, in holistic and multifaceted ways.

In most cases, central banks tend to be more concerned about expectations for rate hikes being priced into the front ends of yield curves rather than the level of longer-dated yields. This observation, together with inflation head fake concerns, reinforces our long-standing structural bias toward curve steepening positions. Given the steepening we have already witnessed in the U.S., there is also a good case for global diversification in expressing this curve-steepening view across the U.K., Europe, and Japan.

Credit

We expect to continue to have overweights overall in spread sectors. In our view, U.S. non-agency mortgage-backed securities (MBS) and some other global structured products, including U.K. residential MBS, offer good valuations versus generic cash corporate bonds as well as good defensive qualities, as was demonstrated by their overall resilience during the pandemic-induced market shock in 2020.

In corporate credit, we see the valuation and liquidity offered by credit default swap indices as attractive versus cash corporate bonds in most cases. But we will continue to emphasize alpha generation in credit single-name selection with the help of our global team of credit portfolio managers and analysts. We see attractive opportunities in COVID-recovery sectors, housing, industrial/aerospace, and select banks and financials, and we will likely maintain a focus on these opportunities in credit-focused strategies. We also expect private credit strategies to benefit from an environment in which long-term investors who can tolerate the elevated risks can look to extract attractive liquidity premiums.

Currencies and emerging markets

While the current period of heightened volatility will tend to counsel for lower exposure to currency trades, our baseline view is that the combination of strong growth across countries and the U.S. Fed's commitment to be very slow in raising short-term interest rates should be consistent with further modest U.S. dollar depreciation over time. In our portfolios, this may suggest some exposure to high-quality emerging market (EM) currencies, but overall we expect to be quite cautious on tactical exposures to EM assets during a period where higher volatility may continue to weigh on EM assets.

Equities

In asset allocation portfolios, we expect to maintain an overweight to equities, with a preference for cyclical over defensive stocks. In spite of recent volatility, company fundamentals remain generally sound, as indicated by the most recent earnings season and corporate earnings guidance. Sector and security selection remain critical and we favor securities exposed to fiscal stimulus, the cyclical recovery, and secular disruptions in technology. We also continue to favor equity markets in the U.S. and Asia, regions that appear likely to emerge from the pandemic earlier and should benefit from fiscal support measures.

Commodities

We see modest upside for commodities, driven by accelerating global growth, investment in infrastructure, and generally tight levels of current inventories. However, we expect aggregate price gains to be limited. We do not believe that we are at the start of a new commodity supercycle because we do not see broad tightness across the majority of markets. Taking oil as an example, while inventories have drawn down and demand is recovering strongly, OPEC market share is at multi-decade lows, incremental shale supply can come online at prices around today's values, and the cost of energy from renewables continues to fall each year. Given the importance of oil within the overall commodity complex along with continued technological innovation, we find a supercycle in commodities very unlikely.