Bonds have continued to rally so far this year, even as the Federal Reserve contemplates raising interest rates. In the following interview, Scott Mather, CIO U.S. Core Strategies, discusses recent developments in the bond markets, the outlook for the year ahead and the investment implications for PIMCO’s Total Return Strategy. Mather co-manages the strategy with Mark Kiesel, CIO Global Credit, and Mihir Worah, CIO Real Return and Asset Allocation.
Q: Scott, you and the team took over the strategy at a challenging time, considering market volatility and client outflows, yet performance has generally been strong. Have you needed to make adjustments to how you manage the strategy in light of this backdrop?
A: The short answer is no. The important thing to recognize is that Total Return, as a high-quality core bond strategy, operates in some of the most liquid markets in the world. Whether there are inflows or outflows, every day we ensure that the strategy maintains the target exposures we have set for the portfolio in each fixed income sector. Flows are not a reason to change the way we manage the strategy.
Indeed, we are intensely focused on performance for our clients in Total Return, and flows have not been an issue in that regard. I think the generally strong performance across the strategy in the past few months proves that. We believe our performance reflects our time-tested investment process.
Q: Let’s turn to markets. Bonds have rallied since September, and long-term yields have fallen sharply. What’s been driving this move?
A: There are a number of factors drawing yields down in the U.S., including low yields outside of the country and the expansion of quantitative easing programs by the Bank of Japan (BOJ) and the European Central Bank (ECB). Those lower-yielding markets are exerting a gravitational pull on longer-dated Treasury yields.
Another factor is the market’s preoccupation – or maybe fixation – with the drop in energy prices and what that is doing to headline inflation. Unlike some market participants, we do not believe that the lower headline inflation stemming from energy prices might be an omen of a deflationary outcome for the U.S., or that it will push the Federal Reserve’s first interest rate rise out much further into the future. But those beliefs have undoubtedly pushed yields down.
Similarly, while some have pointed to isolated signs of weaker U.S. growth as a reason for lower yields, we do not think U.S. economic growth should have played a large part in the drop of long-term yields.
Q: Looking to the year ahead, what is PIMCO’s outlook for global growth and inflation?
A: In terms of the big picture, we think divergence will be an overarching market theme this year, within both developed and emerging markets. The big changes in commodity prices have created both winners and losers throughout emerging markets, and many will be wrestling with these changes. In the developed markets, we have the divergence between the U.S., which is shifting to a level of growth above potential, and most other developed markets, which are struggling just to reach their own, lower levels of potential growth. Finally, and not insignificantly, we have monetary policy divergence, with the ECB and BOJ on full throttle even as the Fed contemplates its first rate hike in this cycle.
For investors, the key is to take advantage of the divergences. It is going to be a riskier world in many ways, with higher levels of financial market volatility, but investors may be able to find opportunities in the market’s overshoots.
Q: Turning to the Federal Reserve, fed funds futures as of the end of January suggest investors expect only one rate hike this year and for rates to be only 1.5% by the end of 2017. That is a substantial lowering of expectations since September. Is the market too dovish on the Fed?
A: Yes, that appears to be the case; we think the market has overshot the mark in suggesting that the Fed will not move until the end of this year.
The Fed has been very clear that while the data and international developments matter in its decision-making, lower energy prices are positive for growth and should result in an improved labor market and wage growth. While the Fed would like to see faster wage growth and may thus be willing to allow the economy to “run a bit hot,” it is increasingly unwilling to keep rates at zero in the face of a strong economy and a labor market that will likely reach full employment levels in the second half of the year.
Leaving rates at zero would mean that monetary policy is getting more accommodative as slack disappears. This would raise the risk of a more urgent need to abruptly raise rates in the future, which is something the Fed should try to avoid. With respect to inflation, the Fed clearly looks through the energy-induced drop in headline inflation (even though the market appears reluctant to follow this commonsensical approach). The Fed knows that it is wages that ultimately matter most, and all indicators point to rising wage trends. Modest moves upward in interest rates are unlikely to alter the improving labor market and wage trends. Lastly, we do not think a move off of zero would damage economic growth prospects and such a move may actually help prolong and sustain the expansion. Zero percent rate policy is a distortion from equilibrium pricing with diminishing returns, and it increasingly represents a cost and risk to the economy rather than a stimulative benefit.
Monetary policy would remain extremely accommodative and supportive of growth with rates at levels below 2% (which we think is close to the New Neutral equilibrium rate), especially when one also considers the effect of the Fed’s still very large balance sheet, which undoubtedly will continue to ease monetary conditions well into the future. In addition, as foreign central banks ease policy, global financial conditions should also ease and thus allow the Fed to begin to normalize rates sooner than otherwise. So a move off of the “emergency policy rate” as early as this summer makes sense.
That said, given its desire to reflate the U.S. economy, the Fed is going to move at a slow pace and will make sure to continue to let the economy grow above potential and allow inflation to accelerate to target and perhaps beyond in the years ahead.
Q: Turning back to the Total Return Strategy, can you discuss the investment positioning in light of PIMCO’s macro outlook?
A: We have several investment strategies that we think will pay off in the year ahead.
First, we have moved our yield curve exposure out of what we think is the significantly overpriced front end and focused our exposure in seven- to 10-year maturities. Also, certain sectors are misvalued, in our view, including inflation-linked securities. In the TIPS market, for example, 10-year breakeven inflation has been priced as low as 1.5% recently, which reflects very low, and we think unrealistic, 10-year inflation expectations. Once oil prices have bottomed and headline inflation turns back up, we think the market will focus on TIPS as an underpriced asset class.
We also think the dollar is likely at the start of a long-lasting, upward trend, though it may experience volatility along the way. Not only did it rise from relatively cheap levels, but given continued divergences in the global economy, the dollar still has a significant tailwind.
In general, more global divergence, more volatility and more overshoots will create great opportunities for active fixed income investors. But a good defense is required as monetary policy is likely to represent a headwind for all financial assets instead of the steady tailwind it has been for the past several years.
Q: With yields persistently low, how would you respond to investors who are wondering about the role of core bonds in their portfolios?
A: All financial assets, not just bonds, have seen their prices elevated over the past several years as a result of monetary policies around the world. Future returns have been pulled forward to today, and that means prospective returns on many financial instruments are going to be lower. Also, one should remember that interest rate rises will happen very gradually relative to history, and that the ultimate destination of equilibrium rates is going to be much lower than it has been at any other time in the past several decades.
Still, it is important for investors to remember why they own bonds: A well-diversified core bond strategy serves as an anchor to the portfolio. It has the potential to provide income and capital preservation and to generally perform well when riskier investments do not.
It is also important to distinguish between a strategy that blindly invests in the index, and is thus completely beholden to the ups and downs of the markets, and an active fixed income strategy. In today’s low-yield environment, the benefits of active management are more important than ever. Alpha will be a larger percentage of return going forward.