Implications From our Cyclical Outlook
Group CIO Dan Ivascyn discusses three main risks to inflation, expectations for rates and where we see some of the best opportunities today.
Text on screen: PIMCO
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Text on screen: Kimberley Stafford, Global Head of Product Strategy
Kim Stafford: Hello, I’m Kim Stafford. PIMCO recently published our cyclical economic outlook, and I’m here with PIMCO group CIO, Dan Ivascyn, to talk about how those views are informing some of the recent discussions taking place within PIMCO’s investment committee, or IC. Dan, thanks for joining us today.
Dan Ivascyn: Thanks, Kim.
Kim Stafford: Inflation, or the rate at which prices are moving up, has accelerated in recent months. But many think that this pace will slow in the second half of the year, whereby PIMCO has recently published in our cyclical outlook that we’ll reach an inflation inflection point. So can you share, what are the main risks to inflation, as you see them, and how can investors navigate these risks?
Text on screen: Daniel J. Ivascyn, Group Chief Investment Officer
Dan Ivascyn: Sure. So, let me start by saying, there are considerable risks to the inflation outlook over the near- and intermediate-term. We do believe, like many others, that there’ll be significant inflation pressure going into year-end. There’ll likely be significant overshooting, even relative to economic forecasts. But ultimately, we do believe that a lot of these areas where we’ve seen an uptick in inflation will prove to be transitory, and we’ll get back over the next couple of years to a slightly elevated but more normal inflationary environment.
Now, to get to the specific question, what risks are we looking at?
Text on screen: Main risks to inflation: Housing markets
Images on screen: For sale sign in front of a home, residential neighborhood
One relates to housing. Home price growth has been very strong. Most popular price indices focus on rents as opposed to housing. Historically, home prices, surprisingly, have not been all that correlated with rents. But when you look at home prices today versus the level of rents, that gap is very wide, from a historical perspective. We’ve even seen, with more recent numbers and economic releases that home price momentum continues to be quite strong. That’s an area where we’re very focused. We’re going to be looking at the degree to which these higher home prices are factoring into rents on a more sustainable basis.
Text on screen: Main risks to inflation: Labor market
Images on screen: Manufacturing and assembly line workers
The second big area of focus for us is the labor market, more broadly. It’s been a Covid related shock to key areas of the market. There’s been a tremendous policy response, so it’s not surprising, given that there remains considerable Covid-related uncertainty, that people will be hesitant to go back to work. There’s issues around school openings, daycare. There’s also been a lot of fiscal stimulus and support over the near-term.
But there also may have been some significant and sustained changes in preference across the workforce. So, understanding how permanent some of this pressure is, how much real slack there is currently within the labor force will matter. And then finally and perhaps most importantly,
Text on screen: Main risks to inflation: Inflationary expectations
Images on screen: The Federal Reserve building
a key area of focus is what the Fed has told us to focus on, and that is longer-term, more embedded inflationary expectations. At the recent Fed meeting, they did indicate that although they’re more tolerant of inflation overshooting, they’re very focused on multiple inputs around this question about inflation expectations from a longer-term or a more robust perspective.
They don’t want these to become unanchored, and to the degree that they become more anchored at higher levels of inflation, or when people become more concerned over the longer-term, this very well may force the Fed to act, and act more aggressively. We acknowledge that over the short-term, the risks to inflation are bias to the upside, which is why, when we think about constructing portfolios, despite a base case view that is fairly constructive, regarding inflation being transitory, we still remain fairly defensive in terms of interest rate risk. We are looking for sources of inflation protection across portfolios.
Kim Stafford: Great. So, we also look at economic growth in the wake of the pandemic has fueled gains in many financial assets. And, as such, we’ve seen valuations that are probably tighter, versus historical standards in the same typical phase of the recovery that we find ourselves in. Investors obviously want to take advantage of the current growth environment, so where do you see the best opportunities for investors today?
Dan Ivascyn: You’re absolutely right. We’re quite optimistic on the growth outlook, particularly in areas that have gotten the virus under control, but today, as you point out, at least using more traditional and historically based valuation models look fairly expensive. So one, investors need to be much more flexible with the opportunity set, to the extent they can be.
Text on screen: TITLE – Areas of opportunity for investors today:, BULLETS – Select COVID recovery themes, Housing-related assets, Equities, Illiquidity premiums
We still like a lot of the targeted Covid recovery themes, within the corporate area, within the commercial real estate markets, areas like the leisure and the lodging sectors.
We do think that housing related credit assets remain quite attractive. In fact, many of these assets can continue to perform well, even if home prices were to decline significantly.
The reason for that is this many of these legacy assets have seen borrowers build up tremendous equity in their properties. So that continues to be a key theme for PIMCO across both public and private strategies. The agency mortgage backed securities market, though, has become much more expensive. The Fed has been supporting the agency mortgage market, and in the process they’ve taken valuations from incredibly attractive a year ago towards the fair to even rich side today.
So, we have been looking across portfolios to reduce some of our agency mortgage backed securities exposure.
We remain fairly constructive on equities, going into year-end and into 2022, but we do think, from a valuation perspective, equities look reasonably attractive at the moment.
And then if investors can give up some liquidity, Not everyone can, but the difference between more complex, less liquid risk, and more generic, easy to own liquid expressions of similar risks, is very wide, in a historical context. So although nominal returns may be lower this time coming out of the crisis than versus the last significant crisis back in 2009, a tremendous advantage for investors that can take on increased complexity. Because you can pick up yield, pick up return, and not take on more market exposure.
Kim Stafford: So the current recovery, you had mentioned, is aided by monetary policy. And many people wonder about when the Federal Reserve will potentially withdraw their supports, what will happen? So, when this does happen, do you expect similar volatility, like the kind that we saw in 2013 with the taper tantrum? Or do you expect that markets are a little bit better prepared this time and may respond a little bit more calmly?
Dan Ivascyn: Very good question, and we won’t know for sure. Our sense is that the one risk area that everyone’s talking about tends not to be the area that causes significant volatility. But assets are priced at fairly high levels, and it won’t take much in the way of negative surprise to increase volatility. There’s a lot of debt in the world, there’s been tremendous
Image on screen: Central banks, and the Federal Reserve building
central bank balance sheet expansion. So our base case view is that the tapering process will be incredibly well-telegraphed. We also think this time around, they may be more up front with the idea that they may begin the tapering process, and then pause that tapering process, if they think that markets need a little bit more time to deal with this policy shift.
So, even though we may not have a taper tantrum in the traditional sense, we do think there’ll be higher volatility, and that could be quite attractive for an active manager that can respond to that volatility, and take advantage of some overshooting that almost inevitably happens in that type of environment.
Kim Stafford: Emerging markets have definitely had a tougher time through the pandemic. Do we see value in EM now, and how can investors take advantage of any improvement that we might see in the asset class?
Dan Ivascyn: So, yes, we are spending a lot more time looking at the emerging market opportunity set.
Text on screen: Valuations look fairly attractive in certain areas of emerging markets, but we remain cautious
Images on screen: Emerging market countries
Perhaps not surprisingly, valuations look fairly attractive in certain areas of the emerging market world, at least relative to valuations in the developed market. But, there’s also a lot of unique risks.
So, we are cautious and we’re targeted in our approach there, acknowledging these increased risks, political being one of the examples.
Text on screen: TITLE – Emerging market opportunities; BULLETS – Select external debt, Targeted currencies, Tactical positions in local markets
So there are some areas that we like, certain external debt from higher quality countries look attractive versus their corporate counterparts. We do have some targeted investments in some emerging market currencies, and then we even have a few tactical positions in local markets, as well. The exact and precise mix, depending on the type of mandate, with some of the higher risk mandates involved a bit more in some of the credit sensitive assets, or some of the less liquid, lower rated segments of that opportunity set. So, we like the sector, we think it represents a good source of diversification on a more targeted basis. But again, you have to be careful there, given the heightened idiosyncratic risks across a lot of the opportunity set.
Kim Stafford: Thanks very much, Dan. And thanks to all of you for joining us. We’ll see you next time.
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