As trade tensions subsided, investors found calmer waters in the fourth quarter of 2019. Can that continue? Here, lead portfolio managers for PIMCO’s Income Strategy, Dan Ivascyn, Alfred Murata, and Josh Anderson, discuss their outlook and strategy for the year ahead.
Q: For much of last year, global growth was slowing, while recession risk, trade tensions, and brexit uncertainty were rising. But these risks seemed to ease and the tone improved during the fourth quarter. What is PIMCO’s outlook for 2020?
Ivascyn: First and perhaps most important in our outlook for 2020, we think global growth will generally be positive across most key areas of the world – a little slower than we might like and a little slower than in the past. But we think the risk of recession has dissipated somewhat, and we expect steady growth and relatively low inflation. Unlike last year, when the U.S. was leading the rest of the world, we see growth momentum coming from outside the U.S.
There are still risks. With animal spirits alive and well and inflation expectations very low, we see some risk of an inflation surprise. Also, consistent with our longer-term outlook, we expect significant political uncertainty to continue. This year, the U.S. presidential election, in particular, could potentially lead to significant changes in the direction of fiscal policy and politics more broadly. Finally, there is always the potential for an external shock to global growth; the outbreak of the coronavirus is a risk we have been closely monitoring.
Our view at the moment is not that different from the consensus – range-bound markets, somewhat lower returns than last year, and a generally supportive environment for taking risk. That’s not too surprising after the major central bank pivot toward easing in early 2019 and three rate cuts by the U.S. Federal Reserve last year. However, given some of the uncertainties present in markets, we are cognizant of the potential tail risks that remain. As part of our investment process, we spend a lot of time thinking about what aspects of our base case could be wrong if we entered a less friendly economic environment.
Q: With a macro view of continued positive, albeit slowing, global growth this year, how is the Income Strategy positioned?
Murata: In PIMCO’s Income Strategy, our approach is to divide the portfolio into two general components: one invested in higher-yielding assets that tend to perform well if economic growth is stronger than expected and the other invested in higher-quality assets that should perform well if economic growth is weaker than expected.
For the higher-yielding portion of the portfolio, we continue to find value in non-agency mortgage-backed securities (MBS) – bonds backed by residential loans (that are not supported by some form of government or private guarantee). We have seen continued deleveraging in this sector as borrowers pay down their loans, in contrast to corporate credit where companies have increased leverage.
In the higher-quality portion of the portfolio, one opportunity we have found very attractive over the past few months is U.S. agency MBS, which are also backed by residential mortgages but have have a U.S. government or U.S. agency guarantee. These are high quality securities with an attractive liquidity profile. The sector significantly repriced recently, given the movement in U.S. interest rates in 2019, creating an attractive opportunity for us.
Q: Can you discuss the strategy’s duration positioning?
Murata: There are two reasons to have duration in an investment portfolio. The first is capital appreciation potential if you expect interest rates to fall. Loading up on interest rate duration was a useful strategy in the past and at points during 2019, when longer-term interest rates were dropping, but that is not the case today. Rates are now so low that there is a potential risk of rates increasing. The yield on the Bloomberg Barclays Global Aggregate Index is less than 1.5%, and the duration is more than seven years; if interest rates rise by just 20-30 basis points, an investor closely tracking that index could end up with a negative return, even over a one-year holding period.
The second reason to hold duration is to mitigate the impact of a possible sell-off in risk assets. And that is why we want some interest rate exposure in the Income Strategy. We hold duration largely in the U.S. because yields are high relative to other high quality government bond markets.
Ivascyn: That said, we do not believe we need a high degree of downside risk mitigation, because we have reduced credit risk in the portfolio gradually, and many of our positions in the housing-related sectors have improved in credit quality in recent years. So our interest rate positioning is simply a reflection of our positioning more broadly, a focus on: less credit risk, less equity beta, less risk of real principal loss in the event of a significant economic slowdown.
Q: Are you concerned about the possibility of a downturn?
Ivascyn: Although we have a positive outlook overall for 2020, if the environment were to weaken, as it did in late 2018 and early 2016, we think central banks may not have the tools to deal as effectively today with a slowdown in growth or a dislocation in the markets.
Our focus is to structure the Income portfolio in a way that offers a unique value proposition for investors: Unlike many competitors that rely heavily on corporate credit, we aim to find resilient areas of the market where we can maintain yield without increasing risk. We are finding those opportunities in the consumer and housing-related sectors, and the mortgage markets.
Q: What do you like about housing-related investments?
Anderson: It’s been more than 12 years since the onset of the U.S. housing crisis and many housing-related investments now have stable cash flows – yet their credit ratings and yield spreads often do not reflect this. In our view, the fundamentals in U.S. housing are strong: Household formation is increasing, housing supply is tight, mortgage rates are low, and incomes are rising. The deleveraging in the sector, which Alfred mentioned, is also important because home prices have risen at the same time, making these loans generally more stable and helping to reduce volatility in the sector. Exposure to MBS is one reason that the Income Strategy has been able to maintain low volatility over the past few years.
More recently, agency MBS were an important contributor to performance in the fourth quarter, and we steadily added to our holdings during 2019. Mortgage prepayments (refinancings) declined during the fourth quarter, and yields remain attractive.
Investing in securitized mortgages requires time and expertise, which PIMCO has developed over many years. We view this expertise as a key competitive advantage and a key driver of the strategy’s success.
Q: The Income Strategy has taken a cautious approach to corporate credit for some time. What is your current view?
Ivascyn: We are cautious on credit. Given strong demand for yield globally, we would not be surprised to see spreads tighten over the next several months in both investment grade and high yield corporate bonds. But we are willing to give up some return potential because we see weakening fundamentals, including lower underwriting standards.
There are pockets of corporate credit that we find interesting. First, we actively seek out “bend but don’t break” investments
– those that may come under pressure in the short term but have characteristics that minimize our downside risk, such as a senior position in the capital structure, backing with hard assets, or long-term cash flows we believe are resilient.
Second, we continue to like the financial sector – banks, in particular. They tend to have more price volatility than industrials, but overall the stricter regulatory environment since the financial crisis has made banks fundamentally strong. Our exposure to U.K. banks, for example, was a contributor to performance last year as Brexit concerns subsided somewhat and spreads tightened.
Finally, we look for special situations in corporate credit where we can have some control and unlock value for investors. We don’t take large positions, but they can have a positive impact on returns.
Q: As we turn the page on the decade, what can investors expect from the Income Strategy going forward?
Ivascyn: Investors can definitely expect the same philosophy and approach. We want to utilize the flexibility we have in the strategy to provide the most robust income-oriented portfolio we can.
To that end, the portfolio is not anchored to a particular benchmark. As Alfred mentioned, some popular benchmarks now entail higher risk and much lower return expectations per unit of risk compared to the past.
Perhaps most important, we will invest the Income portfolio in a way that is consistent with PIMCO’s macro views: We are a bit cautious now, and so we try to be creative in how we generate income, not simply take advantage of the typical trade-off of more corporate risk, or equity beta, in exchange for a higher dividend rate. We aim to generate a strong return, but we also want to fulfill a key objective for the strategy: capital preservation.
Investing is a team sport, and we will continue to leverage our entire portfolio management group, including risk management and analytics, to uncover the best ideas for the Income Strategy in the years ahead.