Seeking risk PIMCO lowers duration and hedges short and long ends.
The Pacific Investment Management Company’s (PIMCO) main investment theme now is the “new neutral,” postulating that despite valiant efforts by governments and central banks, long-term interest rates will remain low for years, although it may be wise to hedge the short and long ends of the interest rate curve.
Esteban Burbano, portfolio strategist at PIMCO, gave members of the NeuGroup’s Treasurers’ Group of Thirty (T30) a rundown on where the bond giant sees interest rates, inflation, and monetary policy headed, and how that has impacted its portfolios. PIMCO views the US as a bright spot, forecasting 2.25% growth this year, up from 1.6% last year. Although a far cry from the 3% growth the Trump Administration believes its recently submitted 2018 budget will produce, it nevertheless beats the 2% growth PIMCO anticipates globally.
At the December forum, PIMCO executives pondered whether the election of President Trump produced “dynamics” to change that trajectory and potentially revive “animal spirits,” Mr. Burbano said. He added that the last few months have shown, however, how difficult it is to implement the aggressive agenda supported by the president, and that doing so will likely take years.
“That’s a challenge,” Mr. Burbano said, “Because we think the market has already priced in that momentum.”
Despite inflation falling in recent months, PIMCO still sees the Fed raising short-term rates twice more this year, if only to build monetary firepower to counter the next economic downturn. That will lift short-term rates, but PIMCO believes the 10-year rate will hardly budge, in part because sovereign rates elsewhere are so much lower—often negative—that will continue flocking to longer-term U.S. treasuries to pick up yield. Inflation is also likely to remain low, given central government’s enormous debt overhang that inhibits governments from pursue pro-growth policies.
Mr. Burbano noted that much of the stability in economic growth of recent years stems from central banks expanding their balance sheets—totaling more than $20 trillion today—through quantitative easing (QE) measures, which involve buying up financial assets to keep rates low. The Fed is no longer purchasing assets, and while the European Central Bank (ECB) and Bank of Japan (BoJ) continue to do so, they will experience diminishing returns, Mr. Burbano said, adding that, “At least in theory, the central banks will have to start normalizing their balance sheets.”
The Fed is three to four years ahead of other central banks, so the big question now is what it will do with the roughly $4.5 trillion in assets it has purchased. PIMCO’s view is the central bank will reduce reinvestments as bonds mature, allowing the level of assets to slowly diminish.
“We think the Fed will likely reduce a portion of reinvestments starting next year, and probably stop reinvestments sometime in 2019, to get to a balance sheet size of around $3 billion by 2021 or 2022,” Mr. Burbano said. He added that this may have implications for Treasury yields and agency mortgages, with repercussions for fixed income investors.
The ECB has started tapering QE purchases, but will continue to grow its balance sheet for the time being. However, central banks have never before pursued deleveraging on such scale, and it’s unclear now just how quickly they will pursue such policies, creating concerns for PIMCO analysts.
“To summarize … We think interest rates will remain low, but there are potential swing factors in the horizon that could change the trajectory of global growth and inflation in the future,” Mr. Burbano said. “The baseline remains mildly positive around the world and in the US, but we think the tails on the left and right have increased.”
Consequently, PIMCO is pursuing a more conservative portfolio today, lowering its duration and credit exposures, not because it is pessimistic about the economy but because of the uncertainties ahead. “Plus, current valuations are already pricing in a lot of the positive expectations,” Mr. Burbano said.
Among the potential risk tails is a rise in populism in Europe. Although French voters rejection of the National Front suggests the populist current isn’t as strong as feared, another PIMCO advisor and former UK prime minister, Gordon Brown, has said to beware of Italy, which may have elections later this year and has suffered more economically. In addition, China’s National Congress will meet later this year to choose new leadership, in the midst of an overheated real estate market and what some see as a bubble in terms of credit creation.
Mr. Burbano said PIMCO is managing its Income Portfolio conservatively, in part because it sees asset valuations as fairly priced. It has also lowered the overall duration of the portfolio to less than three years, while favoring US duration, which is attractive relative to other high quality, developed market duration.
“We’ve been hedging the duration of the portfolio down, at the front end and the long end, and we also have a slightly negative exposure to Japan, as a hedge against global reflation risk,” Mr. Burbano said.
PIMCO holds a positive view on the Eurozone’s macroeconomic picture. But it has limited duration exposure from core countries in its Income Portfolio, due to their lack of yield. It has found attractive opportunities in high-quality asset-backed securities, Mr. Burbano said.
PIMCO began increasing US duration exposure in the Income Portfolio after President Trump’s election. However, the total exposure to US duration in the portfolio has come down somewhat since March as interest rates in the US have modestly declined.
“It’s important to have some US duration in the portfolio as a hedge against a risk-off environment,” Mr. Burbano said. “We’re also finding opportunities in higher yielding sectors of the market, such as emerging markets, high yield, and some securitized products. The challenge is not overexposing the portfolios to those sectors, given valuations today.”