PIMCO’s Global Bond Strategy aims to benefit from the diversification, income and price appreciation that the world’s bond markets can offer. In the interview below, Sudi Mariappa, head of global portfolio management, discusses the outlook for the global economy and how that outlook is shaping PIMCO’s Global Bond Strategy.
Q: What elements of PIMCO’s cyclical and secular economic outlook are most relevant for the Global Bond Strategy?
Mariappa: Probably the single most important theme we see in the outlook is that the developed world has moved into a period of below-trend growth and weaker housing dynamics, while we see the emerging world continue to show strong growth. This has been a major shift from what had traditionally been a situation where the developed world, like the U.S., Europe and Japan, had been growth engines and the primary sources of capital. Now, the situation has reversed, and the developing world is lending and financing consumption in the developed world. We believe that this shift will continue over the secular 3-5 year horizon, and will lead to higher global real rates and a bottoming of the dis-inflationary influence that emerging markets have exerted over the past decade.
In the short term, the process is being accelerated by the liquidity crisis of last summer that resulted from upheaval in the U.S. housing market, subprime mortgages and related asset-backed securities. This turmoil in financial markets is affecting economic fundamentals because it spurred a prolonged period of tighter credit availability around the world.
A weak U.S. dollar is also part of PIMCO’s long-term outlook, which is particularly significant for the Global Bond strategy. We believe that the dollar is likely to continue weakening against many global currencies, particularly in emerging Asia, as major global trade and investment balances undergo a correction. The dollar will also be impacted by a slow shift in how global central banks are managing surplus reserves. This view of a secular dollar weakness underscores the need for global asset and currency diversification.
Q: How has the recent subprime meltdown and credit crunch affected global bond markets? Has it opened up opportunities for PIMCO?
Mariappa: The primary linkages between the U.S. story and the global story have been asset prices in different markets, availability of credit and monetary policy coordination. Although the subprime troubles started in the U.S., there was an immediate effect around the world because markets are globalized. Who would have thought some of the first cracks would have appeared in German banks, and that one of the first policy reactions would have been the European Central Bank flooding the market with liquidity last summer? Due to global financial market linkages, there is no longer any one single, isolated domestic market.
So the subprime problem provided a spark for global investors to quickly cut back on risk, pull back on lending, and reduce the ample liquidity that had been elevating the price of financial assets. This gave PIMCO opportunities to “extract a liquidity premium,” which basically means to buy things that may offer value during market dislocations. Around the globe, asset prices – particularly for credit products -- were discounted with little regard for the fundamental value or credit worthiness of the specific assets.
One example has been in U.S. high-grade mortgages – loans that were issued well before the housing market topped out, or which have a low loan-to-value ratio or a very high credit rating for the borrower. For example, a high-grade mortgage that was issued in 2005 should generally be valued at 100 cents on the dollar because these securities are viewed as “money good” with a low risk of default. But because of balance sheet pressures and other market dynamics, investors have at times been forced to liquidate even high quality assets, and these types of mortgages may trade with a discount of 2 or 3 cents on the dollar despite very strong fundamentals.
Another area of opportunity has been the re-intermediation of loans to the banking sector. It took 20 years to shift from the traditional situation, where banks were the only lenders, to a situation where there were a variety of large non-bank lenders. These lenders operated off the balance sheets of banks and were funded using asset backed commercial paper. As financial markets quickly scaled back on risk, trillions of dollars of this short-term paper was suddenly difficult to roll over, so banks had to intermediate over a very short time by extending credit to the entities, which brought the risk back on to the banks’ balance sheets. This happened around the world – at banks in the U.S., Spain, France, Japan, and many other places – and we were able to pick up bank debt at attractive spreads compared to where it had been just a few months earlier. We still like these banks’ credit, and believe there is a certain element of systemic support, but in situations like this we can buy the debt at relatively cheap levels.
Q: What has been the global central bank response to the crisis? Is this opening up opportunities in the Global Bond Strategy?
Mariappa: Central banks respond to their domestic economies first, and don’t necessarily look to each other to decide how to proceed with policy. But there are what I call “risk scenarios” that they have to consider when facing slowdowns in other areas of the global economy that could impact their own domestic economies. Several central banks that had been raising rates – The Reserve Bank of Australia, Bank of Canada, the ECB, Bank of Japan, and others – have already paused or reversed course.
The Bank of England, for example, cut its benchmark rate by a quarter point on December 5, because its economy is starting to feel economic strains due to the global credit crunch. Likewise, the Bank of Canada cut its rate by a quarter point on December 4, less than six months after its last interest rate hike. At the Group of Seven meeting in October, BOJ Governor Fukui said that the U.S. slowdown adds uncertainty to the global outlook, and clearly to the Japanese outlook. In essence what he was saying was that the Fed is in a position where it may have to cut interest rates aggressively, and that the BOJ will likely have to stop hiking rates for an extended period.
The lag effect for various economies will differ in timing and magnitude, but in general it’s hard for central banks to ignore the Fed and what is going on in the U.S. The various central banks’ responses to the crisis, against the backdrop of the inflation picture in each economy, are allowing PIMCO to make strategic investments that focus on yield curves and duration around the world.
Q: How is PIMCO’s positive outlook for emerging markets being expressed in the Global Bond Strategy?
Mariappa: Historically, whenever the U.S. caught a cold, emerging markets caught the flu. We believe this is not so much the case in this cycle, given the strong reserve positions, growing internal demand and fiscal improvements that most emerging markets have undergone in recent years. Consequently, we think that emerging economies should still do pretty well, even as the developed world slows. This continues to raise opportunities in emerging markets in currencies and external and local credit markets.
Emerging markets are naturally becoming an important element of the Global Bond Strategy. Our benchmark for many portfolios is the Lehman Global Aggregate, which includes only investment grade securities. Currently, almost half of the emerging market universe carries investment grade ratings, including sovereign debt from Mexico, South Korea, Chile, Russia, and others. We also see some opportunities off the benchmark where we believe that economic fundamentals are strong. For example, our emerging market team thinks that Brazil will be upgraded to investment grade some time over the next year.
The other side of the emerging market story is currencies. PIMCO’s outlook is for a weaker dollar, and much of that will come in the form of stronger currencies for emerging market countries that carry significant surpluses. We especially see currencies of emerging Asian countries and commodity producers poised to appreciate versus the dollar and euro. We expect that China will allow its currency to appreciate further over time, which will encourage smaller emerging Asian economies to allow greater currency flexibility. With credit ratings in these countries also improving, we’re seeing continued development in local bond markets, where securities are issued in local currencies. We expect that local markets will continue to grow and increase opportunities for global bond portfolios.
Q: You mentioned PIMCO’s view of a weakening U.S. dollar. What is driving this trend?
Mariappa: Although we’ve already seen a big move down in the dollar in recent years, and intensifying weakness over the last few months, we believe that secular trends – interest rate differentials, capital flows, foreign reserve surpluses in emerging markets, and trade and investment imbalances – continue to point toward longer-term dollar weakness.
We are seeing a lot of central banks in particular shifting some allocation out of dollars and into assets denominated in other currencies. They are also showing a preference for risk assets. Traditionally, these central banks intervened against appreciation of their local currencies by buying U.S. Treasuries. Now you are seeing them creating wealth funds – initially small but growing – because they don’t feel the need to continually intervene in currency markets. Take Brazil, for example, which issues debt in its local markets at double-digit interest rates, yet holds its reserves in Treasuries. They sustain a negative carry by doing this, and it makes sense for them to make a more economic decision to target higher returns on their reserves.
The outlook clearly emphasizes that emerging market economies – particularly commodity exporters and Asian producers – will likely gain the most versus the dollar. But we are also projecting emerging market currency appreciation against other major developed areas of the world, like the euro and yen.
Q: How does PIMCO approach the currency component of global bond investing?
Mariappa: We always separate the currency decision from the bond decision on any given investment, so within the Global Bond Strategy, we always have to look at hedged versus unhedged exposures. In a hedged investment, we aim to completely offset foreign currency exposure and just take on bond exposure. In an unhedged investment, we take on the bond exposure and allow some degree of currency exposure. In either case, our investment process is the same when it comes to security selection, but the question of currency risk is one that differs from investor to investor, and from investment to investment.
For example, let’s say we are interested in gaining exposure to a currency or basket of currencies. We then have to ask how much we want to take compared to the benchmark – and we make this decision based on the amount of expected risk or volatility it will add to the profile of the portfolio. In the case of more volatile currencies, the exposure is going to be minimal – maybe a single digit percentage of the portfolio. In other cases, it might be higher, but it’s all based on an absolute volatility perspective.
Q: What are the investment implications of PIMCO’s outlook for the Global Bond Strategy?
Mariappa: As mentioned before, emerging market debt and currencies are an area of that we are actively targeting. Given potential volatility, currency exposures within the emerging market spectrum are relatively small – in the range of about 5% for a basket including Russia, emerging Asia, Brazil and Mexico – but even in small concentrations, these positions may add significant value to a portfolio.
Within the developed world, we particularly like the Australian dollar and the Scandinavian countries. We think that they are going to react similar to emerging markets, with inflows due to commodity exports driving strength in local currencies. We’re not holding strong views on crosses between the euro, yen and U.S. dollar, and so we’re relatively neutral on those. Meanwhile we are avoiding currencies that have been supported entirely by speculative financial flows like the carry trade. The New Zealand dollar is one example of a currency that had been a key target of the carry trade in recent years.
We are still cautious on credit, but expect to continue seeing selective opportunities to buy sound credit at discounted prices. Given the ongoing problems in the U.S. and sluggish outlook for other developed nations, we don’t think that the adjustment in global credit is fully played out. We’ve had extremely low risk premiums in credit markets over the last few years, and we believe that the unwind has so far been minor in comparison. So we expect to see continued bouts in which equity markets adjust to a slower earnings outlook, or liquidity is temporarily scarce, and consequent volatility in credit will lead to attractive pricing.
We also see opportunities in yield curve and duration strategies in several places around the world. In Japan, for example, we think it is going to be difficult to continue on a path toward higher interest rates, given the risk of a hard landing posed by the U.S. economy. So with the BOJ on hold and no strong inflation in Japan, we expect to see interest rates there drift in a range. But the yield curve in Japan is very steep compared to many other markets, with short rates around 50 basis points and 10-year rates around 170. So on a hedged basis, we might be able to pick up additional yield over Treasuries by investing in long-term Japanese government bonds.
Another example has been the U.K., where markets have only recently come to accept that interest rates will fall. Even with the BoE’s recent 25 basis point rate cut, we believe that monetary policy is restrictive, and that the BOE will eventually cut rates further. This leads us to favor a steepening U.K. yield curve. For similar reasons, we are expecting steeper curves in Australia and Canada.