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P ersistent trends in economies around the world are providing opportunities for focused, long-term investors in the credit markets. Mark Kiesel, Chief Investment Officer Global Credit, discusses promising themes PIMCO sees over the next three to five years, including the U.S. energy revolution, the rising Asian consumer, the ramifications of global banking regulation and latent demand in the U.S. housing market. PIMCO’s global investment professionals gathered in May at our annual Secular Forum to discuss our long-term, or secular, views of economies and markets around the world.

Q: What is PIMCO’s secular outlook for the global credit markets?
We remain constructive on credit over the secular horizon as major central banks pursue accommodative monetary policy, private sector fundamentals improve and technical factors continue to support fixed income markets.

While we believe the Fed is likely to gradually start normalizing policy, including raising the fed funds rate in the second half of 2015, many developed market central banks – including the European Central Bank (ECB), the Bank of Japan (BOJ), the Reserve Bank of Australia and the People’s Bank of China – are either further easing policy or remaining highly accommodative with a reflationary bias, which should support the private sector and credit markets. U.S. fiscal policy could also improve, with fewer left-tail risks and potential for more right-tail risks like immigration reform and a freeing up of credit, especially mortgage lending, to the private sector. Moreover, we may also see lower healthcare costs, potential corporate tax reform and growing infrastructure investment in the U.S.

Right-tail risks could also outweigh left-tail risks in emerging markets. In addition to rising infrastructure spending, we see prospects for public-private sector partnerships and better policy. And major emerging market central banks, specifically in India and China, are easing and gradually moving to more business-friendly, transparent policies that could gain traction.

Fundamentals are looking up in the private sector as well. We see a better consumer outlook not only in the U.S., but also in Europe and Asia. Business balance sheets around the world are also quite solid. And, given aging populations and an ongoing saving/investment imbalance, technicals continue to support fixed income over the secular horizon.

Interest rates, led by the U.S., could head higher in the next three to five years, so while investors should be mindful of duration exposure, we see that as a net positive factor for high-quality credit, particularly at the long end of the yield curve. Higher interest rates should result in less supply in terms of issuance as well as more demand from long-term investors such as insurance companies and pension funds.

Q: How does that outlook vary regionally?
Kiesel: Our strategy in the U.S. currently is to favor cyclical consumer sectors – gaming, lodging, airlines, theme parks and autos. We are also constructive on housing and housing-related sectors like home improvement, title insurance and building materials. Indeed, housing is a strong secular theme, as are energy and healthcare.

We see green shoots in Europe; ECB policy is a strong catalyst for equities and cyclicals, and we also like bank capital and exporters (due to weaker currency).

In China, we are favoring sectors that benefit from easier monetary policy. We also see value over the long term in companies that are uniquely positioned to tap into Asian consumption, as well as growing usage of mobile technologies, data and connected devices.

And in Japan, a weaker currency is supporting cyclical sectors and exporters, while banks and financials stand to benefit from the BOJ’s significant quantitative easing program.

Q: PIMCO has stated there is potential for further episodes of volatility, partly because increased regulation has meant that banks and brokerages are less able to function as market makers. How does this affect credit markets?
Kiesel: We have generally looked to maintain substantial cash positions in our portfolios given our expectation that, starting with the Fed, central banks will gradually begin to normalize policy over the secular horizon. We are keeping dry powder and are focused on long-term fundamentals – but we think volatility will also lead to opportunities.

For example, in Europe, the U.S. and across Asia, regulators are trying to make banks safer. This has had some unintended consequences; many banks have restricted credit availability and some lenders have been less willing to make loans. In the U.S., this has been a headwind for housing because some potential first-time homebuyers cannot get mortgages and banks are worried about put-back risk (the forced repurchase of mortgages by the originator). But it’s also created opportunities for PIMCO, such as in bank capital securities as these banks de-risk and de-lever. As banks become safer, it generally benefits bondholders.

Q: Where do you see the most compelling longer-term secular opportunities?
Kiesel: We think the U.S. energy revolution is one of the most important investment opportunities for the next decade. The U.S. will produce more of the world’s oil and gas over this timeframe due to geological advantages, horizontal drilling technology and advances in fracking completion techniques. Certainly, clarity over the rule of law and property rights benefits the U.S. in many ways, including in the energy sector, as do a deep and developed oilfield service sector, superior infrastructure and takeaway capacity, and large, liquid capital markets.

Specifically, pipelines and master limited partnerships in key growth shale regions are essential to energy flow and they offer an attractive opportunity to invest in volume growth. Liquefied natural gas will also be a significant growth area for the U.S. economy, and we expect to see good opportunities in exploration and production companies as well.

Ultimately, we feel U.S. energy will outperform the market secularly as energy prices gradually recover and as the U.S. produces more of the world’s supply of natural gas and oil. Many of these energy companies are growing at double the rate of the U.S. economy – and we think they can sustain that growth.

U.S. housing is another compelling secular opportunity, considering inventories are still near 20-year lows and there is significant pent-up demand. According to the U.S. Census Bureau, almost one-third of 18-34-year-olds live with their parents, household formation is up over 1 million since last year and labor markets are improving significantly. The U.S. economy added almost 800,000 jobs in the 25-34-year-old cohort in the last year, according to the Bureau of Labor Statistics, the strongest job growth for this key group of potential first-time homebuyers in 15 years.

We expect housing demand to pick up as credit improves gradually. Households are finally in a position to relever, and we are now seeing mortgage debt growth – something we haven’t seen in seven years. Finally, almost 5 million previously foreclosed homeowners could become eligible for credit again over the next five years.

Q: Conversely, what areas are you avoiding?
Kiesel: One sector we are avoiding is metals and mining, which lacks barriers to entry, pricing power and growth over the secular horizon.

We are also avoiding companies with management teams that are not putting bondholders first in the capital structure. For instance, technology companies are holding substantial amounts of cash, and activist shareholders are increasingly pressuring them to release that cash to equityholders. Another example is companies that issue bonds and use the proceeds to buy back stock or pay a special dividend.

Finally, we pass on companies that are facing a lot of competition, those with poor pricing power and those with weak asset coverage in the event of deterioration in their business profile. Retail is a classic case of a sector with low recovery and significant secular challenges.

Q: Considering these secular views, will the credit team do anything differently in the years ahead?
Kiesel: Our team of more than 60 analysts and 40 portfolio managers around the world is focused on long-term themes, as we always have been. We look for companies with strong barriers to entry, superior growth potential, pricing power, favorable asset quality and potential downside risk protection, and investments that we believe are likely to benefit from the rule of law, property rights and transparency. These have been our keys to success in the past, and we will continue to employ them in the future.

The Author

Mark R. Kiesel

CIO Global Credit

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