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Deficit Dynamics: Navigating the U.S. Fiscal Landscape

The U.S. holds a unique position with its global reserve currency, but rising deficits pose risks. Group CIO Dan Ivascyn discusses why understanding this landscape is crucial for investors.

Text on screen: PIMCO

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Text on screen: Kimberley Stafford, GLOBAL HEAD OF PRODUCT STRATEGY

Stafford: How do you think about a rising debt trajectory and its potential impact on bonds? Who's buying treasuries, and how can an active manager both position and protect around some of these broader themes that we're talking about?

Text on screen: Daniel J. Ivascyn, GROUP CHIEF INVESTMENT OFFICER

Ivascyn: Sure. So we'll start with deficits. We do think the United States is in a unique position relative to other developed market countries in that we still have the global reserve currency.

We still have this flight to quality dynamic to the United States, and a confidence in US institutions that allows us to be more irresponsible on the fiscal side than others.

But with that said, these deficits are notable. They're higher than most other developed countries, and there's going to be practical limitations in terms of impact. It's likely that our interest rates are inflation adjusted, or real rates are higher than they would be otherwise because of deficits. We expect yield curves to be steeper than they would be otherwise, and volatility will likely be higher as well. And over time, there are other areas of the world that will look more attractive in a relative sense.

Images on screen: The U.S. Treasury building, USD currency printing

So although we've spent a lot of time analyzing these debt levels or deficits in historical contexts and are of the view that we have a bit more time here in this country, it's a risk and it's a concern.

I think it's important to note that what may make sense over the longer term, in terms of setting up the conditions for higher sustainable growth, can be somewhat in conflict to the current environment, where we have an economy that's still operating with inflation above central bank targets. Where there's a tremendous amount of economic momentum, where labor markets are still relatively tight. This is going to be the tension. And the question, of course, will be and we're focused very much on how the Trump administration is going to deal with this tension between longer term goals and potential short-term concerns.

If, and we saw a flavor of this in the initial reaction to the Trump win, if some of these policies lead to near-term inflationary pressure, the markets are going to tighten financial conditions on their own. And that very well could mean not only higher interest rates, but at some point, some pressure on risk assets as well, to the extent that yields are going higher because of concerns around inflation, the Fed has said

Images on screen: The Federal Reserve Building

very, very clearly that they are going to react and respond if inflation does not get back to target or if it reaccelerates. And they're very, very focused on inflationary expectations. So it's going to be this tension that the administration is going to need to navigate. And we and the rest of the market are very, very focused in those areas.

We do think deficits are going to remain elevated. And they're already high in a strong economy, which means if the economy were to weaken, they would likely go even higher. So what are we doing about that across portfolios? We see attractive value in the bond market. But the US isn't the only game in town.

Text on screen: Key investor takeaways: 1. Global diversification

Images on screen: Australia and The United Kingdom city skylines

We've also been talking about a theme of diversifying our exposure across the globe. Other parts of the world, Australia, the United Kingdom, our high-quality markets, a better fiscal situation, arguably a less dynamic economy, and a little bit of economic weakness is really good for fixed income performance, all else equal, and even some higher quality areas of the emerging markets that have a significant yield advantage we think makes sense.

Text on screen: Key investor takeaways: 2. Reduced exposure to long-term lending

Images on screen: Stock market ticker tape

Number two, we're concentrating the bulk of our interest rate exposure in the front end of the yield curve. We're a bit more hesitant to lend long term, both because we do think inflation will be a greater risk, and we do think that sustainability issues will remain in focus. So we'd like to concentrate our interest rate exposure in that five-to-ten-year part of the curve. And also, we're not wildly overweight interest rate risk. We're back to neutral and even some of our more flexible strategies, we're still running a pretty significant underweight.

And then also, even though our base case view is that inflation will likely remain in that 2.5% type zone and even potentially trend lower over time,

Text on screen: Key investor takeaways: 3. Inflation protection

Images on screen: Pumping gas into a car

inflation protection is very, very attractive. Whether you're looking at Treasury inflation protected securities or other types of fixed income inflation protection, or you're looking at commodity values at historical context, the cost to insure against inflation still is quite low, and across most of our diversified strategies, we have a pretty solid allocation or overweight to inflation protected securities.

Text on screen: Key investor takeaways: 4. Liquidity

Images on screen: PIMCO trade floor

Last but not least, liquidity or flexibility. We think this is an environment where running more liquidity, all else equal, provides flexibility in a world with more political uncertainty, especially on the debt side. We just think it makes a lot of sense to have flexibility to respond to what will likely be an environment of ongoing volatility.

So those are the things that we're doing. It's a risk. We think it's a manageable risk. And in some sense, higher debt is not bad for the end investor because the US government's forced to borrow at a higher yield. And of course, we and our clients are the beneficiaries of higher real rates than would be the case otherwise. Practical limits. Sure, you don't want it to get too out of control, but we do think again, this is partially why we're able to source better value, and still a pretty high-quality segment of the fixed income markets.

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Disclosure


All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Equities may decline in value due to both real and perceived general market, economic and industry conditions.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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