At our recently concluded Secular Forum, PIMCO investment professionals from around the globe gathered in Newport Beach to discuss and debate the secular outlook for major world economies. With insight from guest speakers and new MBA/PhD hires, PIMCO coined the phrase The New Neutral to define its secular three- to five-year outlook for the world economies. In his most recent Investment Outlook, Bill Gross further elaborated on The New Neutral.
What are the key aspects of the New Neutral framework? We believe high financial leverage (aggregate government, household and corporate sector debt relative to GDP) and weakening demographics (the declining working age population relative to the aggregate population) in the U.S. and many other developed economies will result in a New Neutral real policy rate of around 0 basis points (bps) in most developed economies, instead of the 200–300 bps that most forecasts assume. A lower neutral real policy rate should benefit most asset valuations relative to traditionally assumed “fair value,” in our view – and this has several implications for unconstrained bond investing.
The benefits of active management in The New Neutral
As Carmen Reinhart highlighted in March 2011 (see ”The Liquidation of Government Debt,” by Carmen M. Reinhart and M. Belen Sbrancia, National Bureau of Economic Research), historically high debt/GDP ratios have been reduced by (a) austerity, (b) economic growth, (c) defaults, (d) inflation or (e) financial repression. Globally, there remains little appetite for austerity. Demographics in the developed world prevent an “old-normal”-like economic growth spurt. That leaves (c) defaults, (d) inflation and (e) financial repression as feasible means to reduce high debt burdens. We think a combination of these factors will characterize The New Neutral and lead to negative real returns on cash. While traditional beta returns will likely outperform cash, passive portfolios may suffer from a low Sharpe ratio driven by low real absolute returns. An active global unconstrained bond approach is designed to provide higher returns than traditional beta while maintaining lower volatility through a focus on higher real absolute return opportunities globally.
PIMCO’s approach to unconstrained bond investing since we began managing Unconstrained Bond Strategies in 2007 has focused on an absolute return orientation, a high Sharpe ratio and, most importantly, a dynamic allocation of risk across global markets where PIMCO has its highest convictions. The New Neutral period with the prospect for low real returns and a low risk premium in traditional markets offers attractive opportunities for PIMCO to add value to client portfolios through active management of risk.
Duration opportunities in developed and emerging markets
In the developed markets (DM), we expect neutral real policy rates to remain around 0 bps, driven by high debt and weakening demographics. The Federal Open Market Committee forecasts a roughly 2% real neutral fed funds rate. Many other developed market real rates are expected to rise to about 2% in the secular horizon. Given this difference in our outlook and central bank forecasts, we believe maintaining modest long developed market duration is an attractive way to enhance risk-adjusted returns in unconstrained portfolios.
In emerging markets (EM), implied forward real yields are higher relative to those in developed economies. Low expected real growth in developed markets combined with strong and improving balance sheets in these select emerging economies makes duration in these emerging economies attractive to hold in unconstrained portfolios.
We see several secular implications for credit
It is a common perception that as the U.S. economy recovers over the next three to five years, credit spreads should compress and low quality (high yield) should outperform high quality (investment grade). We disagree – The New Neutral is also characterized by low growth versus expectations. We expect real growth to hover around 2% over the secular horizon instead of around the “old normal” 3%. While we recognize that in The New Neutral central bank policies will likely succeed in clipping the left tail and preventing a large recession and massive defaults, we believe defaults in the low quality space will be higher than expectations given low real growth. Hence, our preference would be in high quality U.S. credit over low quality. In cases where we go into low quality, we plan to focus on shorter maturities to stay ahead of the anticipated pickup in defaults.
It remains important to focus on deleveraging in the credit space in The New Neutral, though low volatility, tight spreads and improved financial conditions are also conducive for increasing corporate sector leverage. Additionally, we believe areas tied to the housing recovery, like non-agency mortgages, offer better value than corporate high yield in The New Neutral.
In contrast to the U.S., the European Central Bank, through its announcements of Targeted Longer-Term Refinancing Operations (TLTRO) and non-sterilization of the Securities Markets Programme (SMP), in addition to cutting the deposit rate to negative, is finally acting on its long-ago stated words of “whatever it takes” to keep the eurozone united. Under a supportive central bank, peripheral European credit remains one of the few areas in the developed credit markets where spread compression remains a possibility. Within peripheral credit, our preference would be for sovereign, followed by financial and finally nonfinancial credit.
Many developed economies, suffering from high debt and weakening demographics, would lag many emerging economies, which have improving demographics and many of which have also successfully been deleveraging. Given these dynamics, emerging market credit offers attractive opportunities relative to many developed markets. Within emerging market credit, our preference is for sovereign followed by high quality quasi-sovereign financial and nonfinancial institutions while avoiding low-quality corporates that have been able to take advantage of the easy global financial conditions to increase leverage even as their default risk remains elevated.
EM currencies likely to benefit in The New Neutral
DM currencies, through low real yields, will remain the funding currencies for global investments. Japan should see more investments as policymakers try to engineer inflation while keeping real yields suppressed through quantitative easing programs. In Europe, while short-term inflows into peripheral credit to take advantage of ECB policies theoretically should support the currency, low long-term real yields should be negative for the currency. Mexico, Brazil, Korea, Poland and India’s currencies stand to benefit given high real yields, particularly if central bank policies there can manage to put a lid on inflation.
Unconstrained strategies can capitalize on bouts of market volatility
We expect low economic volatility in The New Neutral given the likelihood that debt and demographics prevent high “old-normal”-like growth while central bank policies may mitigate the left tail risks. The financial sector, however, can still exhibit periods of high volatility as central bank policies adjust and financial asset liquidity remains low given increased regulation limiting use of dealer balance sheets. In additional to focusing on duration, credit and currency, PIMCO’s approach to unconstrained investing also involves taking advantage of bouts of market volatility amid low expected real growth volatility in The New Neutral.
- PIMCO’s The New Neutral is characterized by a convergence to modest trend growth rates, low volatility, low real rates, multi-speed global growth and low returns on financial assets.
- PIMCO’s unconstrained approach to global fixed income investing is designed to help investors achieve returns that exceed traditional benchmark returns while maintaining lower volatility.
- Our approach also utilizes all areas of global fixed income markets involving duration, credit, currency and volatility risks.
- Currently, given the New Neutral outlook for the world economy, we like modest DM and EM duration, select DM high quality credit, European peripheral credit and EM sovereign and quasi-sovereign credit, select EM currencies and volatility exposure in an attempt to construct a global diversified unconstrained bond portfolio.