After the markets’ wide swings in the past six months, volatility has remained high. Portfolio managers for PIMCO’s Income Strategy, Dan Ivascyn, Alfred Murata, and Josh Anderson, discuss how they are positioning the strategy to prepare for continued volatility and to take advantage of it.
Q: Markets were whipsawed over the past two quarters, with the sharp downturn in late 2018 and strong rebound in the first quarter this year. What’s driving the volatility?
Dan Ivascyn: We think the volatility in the fourth quarter last year was likely due to weakness in global economic growth, ongoing fear or caution around central bank policy, and even a little political uncertainty, particularly in December. Also, all of this occurred around the holiday season, when liquidity tends to be more challenging.
In the first quarter, returns bounced back, with very strong performance in equities, credit, and high quality bonds. Led by the U.S. Federal Reserve, central banks signaled that they are close to ending the tightening cycle – in fact, it very well may have ended – and their dovish stance, combined with few signs of inflation pressure and positive, albeit slowing, growth, has boosted confidence in the markets.
We’re pleased that the Income Strategy was resilient in the fourth quarter and thus far this year. But our overall positioning remains defensive and – I can’t emphasize this enough – we strive for resiliency at this late stage of the economic cycle, when volatility is likely to remain high.
Q: You mentioned slowing growth. What is PIMCO’s outlook for the economy?
Ivascyn: Despite some talk in the marketplace about the possibility of a recession, we don’t see it just yet. In fact, our updated outlook calls for steady, positive growth across the globe this year, with global real GDP growth likely around 2.75% in 2019. In the U.S., we still see growth of around 2.25%, and despite recent weakness in China, we believe the authorities there are very focused on stability, and we expect growth somewhere in the 6% range.
If there is some resolution to U.S.-China trade frictions and stabilization in other areas of the world – a Brexit resolution perhaps – we could even see an uptick in growth and an improvement in risk asset prices later this year.
Q: What do you expect for U.S. interest rates through the rest of 2019 now that the Fed has pivoted to “patience?”
Ivascyn: We think it’s likely that the Fed will remain on hold through the remainder of this year. We see the risks as symmetric in terms of rate hikes versus cuts. To us, that means the continuation of range-bound interest rates overall. We’ve argued for some time that the neutral policy rate in the U.S., the level that neither stimulates nor suppresses growth, is a lot lower today than in the past (our New Neutral thesis). And when the Fed raised the policy rate in December, it came very close to our estimate of the neutral rate.
It is important to note that the yield curve is much flatter today than it was just a few months ago. In the U.S., we’ve even seen some modest yield curve inversion, which historically has signaled increased risk of recession. But we don’t see a material risk of recession over the next 12 months.
In fact, if growth surprises to the upside later in the year, we think rates could drift a little higher. So we have been reducing our interest rate exposure, notably in our current favored part of the yield curve, between five and seven years. We used the recent bond rally as an opportunity to smooth our exposure across the yield curve and take more defensive positioning on interest rate risk overall.
Q: Have there been any other shifts in positioning over the past quarter, especially given the sharp swings in the markets?
Alfred Murata: We try to position the portfolio to achieve the Income Strategy’s objectives: generating income and preserving capital. From a structural perspective, we tend to invest one portion of the portfolio in higher-yielding assets, such as non-agency mortgage-backed securities, which tend to do well in a strong growth environment, and invest the other portion in higher-quality assets that tend to perform well in a weaker growth environment, such as U.S. Treasuries or agency mortgage-backed securities.
In 2016 and 2017, we began reducing our allocations to higher-yielding assets to lower risk in the strategy. And so during the big sell-off in risk assets at the end of last year, we were defensively positioned, which enabled us to go on offense and look to buy attractive assets at depressed prices, including non-agency mortgage-backed securities.
Over that time, we also increased the duration of the strategy while interest rates were rising, which was a benefit as bond yields fell. Having duration exposure can also help cushion a portfolio against the impact of a sell-off in risk assets, so our duration positioning contributed in that respect as well at the end of last year, even as yield-oriented allocations like corporate credit were adversely affected. Although we’re now less optimistic on interest rate exposure, we have retained some duration exposure because of its ability to hedge the portfolio against risk-off market environments.
Q: After the strong rally this year, where are you finding opportunities in credit?
Josh Anderson: Although we are generally cautious on corporate credit, we do participate when we see opportunities. For example, we like senior bank debt where spread levels look attractive. Many banks remain very high quality from a credit perspective, although some have reported weaker earnings of late, so we think there’s some tightening potential.
During periods of volatility or idiosyncratic events, we seek bonds from well-known companies whose spreads, or risk premiums, are far higher than their credit risk warrants. Also, we try to take advantage of “new-issue” risk premiums when a company’s new bonds are priced at spreads wider than those of its bonds in the secondary market. Finally, we look to invest in some short-term high yield bonds when we believe the probability of default is quite remote in the near term.
Ivascyn: We also continue to like housing-related credits. Household leverage, including mortgage debt, has declined over the last decade, and banking regulations after the financial crisis in 2008 have ensured that credit is extended mainly to the highest-quality borrowers. This is true in Europe as well as the U.S.
As Josh noted, however, we are much more cautious on generic corporate credit exposure. There we see leverage risk, very high issuance, and many investors seeking yield but not necessarily prepared to go through a default cycle when it occurs. During the fourth quarter last year, we got a preview of how volatile corporate credit can be. So we continue to be very defensive in the sector and if year-to-date momentum continues, we will likely look to reduce our exposure over the next several months into richer valuations.
Q: Are there areas of securitized credit, other than non-agency mortgage-backed securities, that look attractive for the Income Strategy?
Anderson: Yes, while non-agency mortgages remain a high conviction sector, we continue to find opportunities across the structured finance market. Currently, we like U.S. re-performing loans, U.K. prime mortgages, and super-prime student loans. We look to buy these securities at attractive yields relative to those of investment grade corporate bonds, and we view these assets as less risky and more liquid than high yield bonds.
Given the embedded credit support in many of these positions, they have proven to be quite resilient in the recent wave of market volatility. That said, securitized credit has lagged amid the rally that we’ve seen in other credit sectors so far this year, in part because of lower demand and in part because they experienced less of a drawdown in the fourth quarter. We think their overall relative value will lead to more spread tightening in time.
Q: Emerging markets have been a strong contributor to the Income Strategy year-to-date and over the past six months. What is your view on emerging markets and where do you see value now?
Ivascyn: At a high level, emerging markets offer a good source of diversification for the strategy. Because they have performed quite well over the last six months or so, we are getting a bit more cautious in some segments. But with global central banks keeping rates on hold and our cautiously optimistic outlook for growth, we think exposure to emerging markets represents a good way to diversify away from corporate credit risk.
Murata: We tend to take positions in emerging markets during periods of weakness in individual countries or issuers, or in the sector as a whole. For example, in the past we have added positions in Brazil and Russia during periods of volatility. More recently, we’ve seen volatility in Turkey and Mexico, which has presented opportunities for the strategy.
Q: After the strong start in 2019, what should investors expect from the markets and the Income Strategy over the remainder of this year?
Ivascyn: Given our outlook for the global economy and central bank policy, we think interest rates could drift a little higher into year-end. We therefore have positioned the Income Strategy quite defensively regarding interest rate risk – nearly the most defensive it’s ever been.
We aim to continue generating a steady dividend income, with some price appreciation from spread compression across the portfolio. With yields much lower today than they were a few months ago, yield curves flatter, and credit spreads tighter, we will be very focused on income generation. That said, we don’t want to overreach for income. We never want to put one of our key objectives of capital preservation at risk.
In the Income Strategy, we typically take a two- to three-year time horizon. We’re pleased with the course of the strategy over the last few years. At this point in the economic cycle, we are aiming to generate return with as little volatility as possible: Our entire team is focused first and foremost on that goal for the year ahead.