The chief investment officer of one of the world’s largest bond funds says complacency has crept into financial markets just as the global economic recovery has taken hold.
Dan Ivascyn, who heads up investments at the $US1.6 trillion bond fund PIMCO, told The Australian Financial Review that as central banks prepare to wind back years of stimulus amid a favourable economic backdrop, high valuations meant there was little margin for error.
“The world still relies on central banks to engineer real economic or financial market outcomes and there is a strong sense that central banks remain in control,” the 47-year-old fund manager said in an interview in Sydney on Wednesday.
“Anything that rattles that confidence could create more volatility.”
The west coast-based asset manager published its Cyclical Outlook titled As Good As It Gets this week, which recognised that an improved global growth picture was not without investment risks.
“Economies are growing above capacity with limited inflation pressure – it sounds like a pretty good deal. The only thing that is less appealing is valuations,” said Mr Ivascyn.
“Credit spreads have tightened and equities are higher but from a valuations perspective, things look stretched.”
Mr Ivascyn said the fund had responded by gradually reducing its exposure to US corporate debt that it thought was expensive in favour of better-value emerging market debt, and US housing exposures.
“If you look at the long history of periods of financial market volatility, typically the source of the last crisis is not the cause of the next,” he said.
One of the reasons, is that regulators crack down and make it harder for the same degrees of excess to build.
“We have seen that in housing and the banking sector. It’s real hard to get a home loan in the US, but its very easy to get an automobile loan [where excessive lending has taken place].”
Mr Ivascyn said all the signs were good for the housing market and the fund was looking to add exposure to the sector via mortgage-backed securities or companies with exposure to the theme.
The corporate sector held firm during the 2008 financial crisis, but is one where he sees increased risk relative to the valuations.
Amazon a ‘real and significant’ force
The disruptive force of online retailers such as Amazon on the traditional retail sector “is real and significant” in credit markets.
“It’s happening so quickly that it’s very hard to use traditional valuation techniques to understand the nature of that change.”
“It is a dangerous area of the market. You are seeing some of this risk bleed into the highly rated supermarket sector, which investors thought was well protected from this dynamic.”
PIMCO has cut its exposure to commercial mortgage-backed securities. But Mr Ivascyn said the fund was mobilising its property and corporate analysts to get their heads around the long-term impacts in the sector.
“There will be a tremendous long-term opportunity to provide capital to the retail sector. There will be many losers but there will also be winners and we are beginning to see this in certain segments in the market.”
His words carried warnings to Australian credit and equity investors that have already been spooked by the imminent arrival of Amazon.
“There are parts of the world where this threat hasn’t even arrived yet. Investors shouldn’t be complacent – they should use these case studies for where other markets may be headed over five to 10 years.”
Mr Ivascyn assumed the role of chief investment officer after the acrimonious departure of the so-called “bond king” Bill Gross, three years ago.
That led to billions of dollars of outflows but strong subsequent performance has helped PIMCO win back investors. Ivascyn’s Dynamic Income Fund has been a top performer, returning 17 per cent over six months.
He said PIMCO was gradually taking risk out of its portfolio and moving out of US corporate credit into emerging market exposures where valuations where more attractive. It was relatively neutral on bond rates.
Fed ‘probably’ needs to tighten more
Mr Ivascyn said: “The Fed probably does need to tighten more than the market anticipates.”
But he believes this is likely to amount to only an additional one to two rate hikes relative to market pricing of one hike before the end of the year and one in 2018.
He is cautious about the potential impact of the Federal Reserve’s winding down of its balance sheet and a general withdrawal of stimulus around the world,
“We have said for years, if you believe all this balance sheet expansion helped create growth stability and support asset prices in theory, if that is removed it may lead to a bit of more volatility and pressure on asset prices.
“We generally believe in that symmetry although its more complicated than that – it’s why our outlook is positive in terms of near-term fundamentals but more careful given valuations.”
Since assuming the role of CIO, Mr Ivascyn has become a key figure in global bond markets.
He was in Sydney after a two-week-long tour of the Asia region and said the fund had become more constructive on China and was encouraged by improved economic data. It forecast the Chinese economy to grow by 5.5 to 6 per cent as it seeks to reign in excessive credit.
“We see this consolidation of power as a means to be more efficient in navigating some of the challenges the economy faces and have been impressed with some of the more recent decisions in that regard.”
The fund still owns a core position in Australian bonds, which acts as a hedge should China’s economic growth disappoint.
“In Australia we think there’s some positive momentum in the economy – as long as global growth is sound we will see that.”
The fund did not have a “strong conviction on the dollar”, which may go higher in the near term if the Federal Reserve raises rates but was weighed down by better relative performance of other economies.
The key to winning in the bond market over the long term will be to solve the riddle of the Phillips Curve that has perplexed economists, including Fed chairman Janet Yellen.
Even as jobs have been added, wages have not increased as much as would have been anticipated by the Phillips Curve, which predicts a negative relationship between inflation and unemployment.
“We generally believe that if economies grow above capacity for too long, if you take unemployment lower and lower, at some point you see signs of wage pressure,” Mr Ivascyn said.
“The more people think the Philips Curve is no longer appropriate, the increased risk there is them being surprised by some wage pressure.”
But Mr Ivascyn said there were reasons why the Philips Curve was flatter – technology, globalisation and the “leverage a typical worker has”.
“There is much less collective bargaining. It is one worker representing themselves, which puts pressure structurally on wages. There are shortages in certain sectors – the worker base isn’t as transferable as some would believe.”
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