Markets are in a strange place right now.
The rally in global bonds and interest rates suggests investors are reaching for certainty. Yet at the same time the S&P 500 has traded within a 1% daily band for more than 6 weeks and volatility is low.
According to PIMCO in its latest Asset Allocation Outlook, this “seemingly improbable combination – investors’ search for security amid an eerie calm in markets”, shows that the global economic recovery is not yet secured.
But Mihir P. Worah, PIMCO’s CIO of asset allocation and real return, and Geraldine Sundstrom, MD of portfolio manager asset allocation, say that this calm comes even though “systemic risks are rising due to experimental central bank policies and expanding leverage”.
The cyclical outlook is stable, but the longer term outlook is still fluid, the pair say. That, they say, means the “dissonance between the near and long-term outlooks is playing out in markets, and we expect periodic bouts of volatility until the tension is resolved”.
This tension means PIMCO is carrying excess cash to take advantage of what it seems to believe will be inevitable bouts of profitability.
We believe that finding refuge in negative-yielding bonds or gold is not the optimal way to navigate the current environment as our base case remains that a global recession is not imminent. A modest risk-on bias is still warranted, in our view. However, in light of stretched valuations and complacency across many assets, we are maintaining ample dry powder and remain focused on portfolio liquidity, and we anticipate low market returns will be the norm for the foreseeable future.
Cash on the sidelines, an abundance of central bank liquidity and low market returns into the future means PIMCO is searching for other ways to build overall portfolio returns.
To achieve its return goals, the company’s evaluation of short-term opportunities and risks manifests in the following themes:
- PIMCO likes corporate bonds where they can get “equity-like risk higher up in the capital structure” because”risk-adjusted returns on select credit sectors are more attractive”.
- They like Emerging Markets (EM) as well because “headwinds against EM investments are fading”.
- The company is mildly underweight stocks that may not seem overly expensive, versus bonds, but given “there is higher uncertainty around future earnings growth as profit margins are quite elevated and will be difficult to sustain if wages continue to rise” they’re being a little cautious.
- The firm likes inflation-linked bonds, especially US TIPS, which are “an attractive stand-in for defensive high-quality government bonds given low levels of inflation expectations”.
- They also like REITs (real estate investment trusts) which “appear attractive in a world of persistently low long-term interest rates”.
Buying REITs is consistent with one of the firm’s strongest held views – it really likes hard assets. Worah and Sundstrom say “the commodity correction has largely played out and argued real assets were particularly attractive in a world where inflation expectations were poised for a rebound”.
- PIMCO is also being more tactical in managing currency exposures. It favours “a basket of higher-yielding commodity-linked currencies versus a basket of Asian currencies”.
No wonder the Australian and Kiwi dollars are doing well despite the actions and hopes of the RBA and the RBNZ.
- PIMCO also says it favours “increasing exposure to structural alpha or alternative risk premia strategies that can act as enhanced diversifies by delivering attractive potential returns that tend to be uncorrelated to traditional assets”.
But there is a warning in its apparent strategy and tactics.
Worah and Sundstrom conclude by noting that while the firm still favours a moderate risk on weighting they have “reduced the overall level of risk in our multi-asset portfolios over the course of this year, reflecting rallies across most asset classes even as growth remains slow, extremely low government bond yields persist and central banks are slowly approaching the limits of monetary accommodation”.
That’s almost full circle to their idea that “dissonance between the near and long-term outlooks” is going to lead to increased market volatility.
After the eerie summer and Olympics calm, that volatility may arrive sooner than many traders or investors think.