Economic and Market Commentary

Forecast Favors Fixed Income

Learn why we believe it is prime time for bonds, how we’re emphasizing diversification and caution and prioritizing quality, and where the opportunities are in today’s markets and beyond.

By Erin Browne, Emmanuel Sharef and Berdibek Ahmedov

21/11/2023

Text on screen: PIMCO

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Text on screen: Berdibek Ahmedov, Product Strategist, Multi-Asset Strategies

Berdibek: PIMCO recently published our asset allocation outlook for the year ahead, titled “Prime Time for Bonds.”

Erin, Can you start by sharing PIMCO’s economic outlook and what this implies for positioning in our multi-asset portfolios?

Text on screen: Erin Browne, Portfolio Manager, Asset Allocation

Erin: Absolutely, our base case economic outlook for the next 6-12 months includes both slowing growth as well as slowing inflation, along with the potential for a mild recession, the odds of which we characterize being about 50 percent.

Text on screen: TITLE – Positioning in our multi-asset portfolios: BULLETS – Emphasis on diversification, Prioritizing quality, Strongly favor fixed income, Neutral on equities

Given our outlook, we’re emphasizing diversification and caution in our portfolios and we’re prioritizing quality. We believe the shift from above trend to below trend economic growth, and the potential mild recession favors bonds and therefore we strongly favor fixed income in our multi-asset portfolios.

We maintain a neutral stance on equities due to the disconnect between valuations, earnings estimates, as well as economic fundamentals. We are coupling this with options-based downside risk mitigation strategies as well as a focus on relative value opportunities.

At current valuations equities do not adequately account for the potential downside risk of a deeper recession. And we also believe that equity volatility is currently undervalued considering the heightened economic volatility.

Berdibek: Thank you Erin, now turning to Emmanuel, how does the relative value of equities compare to fixed income today?

Text on screen: Emmanuel S. Sharef, Portfolio Manager, Asset Allocation

Emmanuel: So, a simple metric we use to look at equity valuations relative to bonds is called the equity risk premium, which tells us how much we’re being compensated for the extra risk and volatility of owning stocks. That measure is at its lowest level in over 20 years, similar to just before the great financial crisis.

Text on screen: Given low equity risk premium, fixed income offers better opportunities than equities

Images on screen: PIMCO trade floor

And when the equity risk premium is low, it means that bonds offer better opportunities compared to equities.

Another way to think about it is by comparing current bond yields to earnings yields on equities. As a reminder, starting bond yields tend to be reliable predictors of future returns, and as yields have risen, the return potential for high quality bonds has risen as well. And meanwhile, as Erin pointed out, equities have lower base-case returns now, and also downside risk in a recession and generally higher volatilities,

Text on screen: We believe the risk-adjusted returns on bonds may be higher than equities

Images on screen: PIMCO trade floor

so the risk-adjusted returns on bonds may actually be higher than for equities at the moment. And so we think in a portfolio context this means that it merits a much higher allocation to bonds than in the past.

Berdibek: Turning back to Erin, within equities, do you see any attractive relative value opportunities in specific themes or sectors today?

Erin: In short, yes. While our overall equity exposure is neutral, we see attractive opportunities for thematic and relative value investing.

Text on screen: TITLE – Attractive opportunities in thematic and relative value investing: BULLETS – Quality companies, SUB-BULLETS: Strong balance sheets, Healthy cash flows, BULLETS – Sectors with growth potential, SUB-BULLETS – Semiconductors, Renewable energy

Firstly, thematically, we prefer to invest in quality companies. Now, these are companies that typically have strong balance sheets, generate healthy cash flows, which really help them navigate economic downturns. The quality factor tends to outperform in both recessionary as well as in overheating scenarios.

We are also focused on sectors of the economy that have the potential for growth and maintaining margins throughout the cycle.

Some examples of this is, we are bullish on semiconductors and renewable energy. And we believe that they’ll benefit from tax credit incentives, as well as strong secular demands.

On the other hand, we have a negative view on equity sectors that we believe are more sensitive to interest rates and have not fully priced in a higher-for-longer environment.

Berdibek: Thank you Erin. Emmanuel, outside of equities and US duration, are there other asset classes that you find attractive today?

Emmanuel: Absolutely. So with global yields higher, there’s much less of the fixed income universe that has zero or negative yields, and so there are now many more opportunities to add high quality global fixed income exposure.

Images on screen: Housing in Australia, UK and Japan

Outside of US treasuries, we like bonds of countries with floating rate mortgage markets, because their economies are more sensitive to higher yields. Also not every country is in the same phase of the business cycle, and we favor those where growth is weakening more quickly and that are closer to recession than the US.

Turning to credit, we’re somewhat cautious on corporate bonds. Similar to my comments earlier on equities, there’s not much compensation for the increased risk of high yield or bank loans. Especially because these sectors are where the effect of higher rates or an economic slowdown will be felt most acutely.

Text on screen: TITLE – Where we see opportunities in credit: BULLETS – High-quality investment grade bonds, Securitized credit, SUB-BULLET - Agency mortgage-backed securities

So within credit we are focused on high quality investment grade bonds. We also like securitized credit and especially agency mortgage backed securities, which are high-quality, very liquid, and where spreads have widened to levels comparable to the great financial crisis.

And then finally, on emerging markets, there are select opportunities in local markets where inflation is already coming down, real interest rates are high, and central banks in some cases have already begun the cutting cycle.

Text on screen: For more insights and information, visit pimco.com

Text on screen: PIMCO

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