DE-RISKING PORTFOLIOS
A main risk the U.S. economy may face over our cyclical horizon of six to 12 months is a pickup in inflation. It could be fueled by higher wages and a tight labor market, as rising confidence and “animal spirits“ translate into higher spending by consumers and businesses. Fiscal policy changes could also be inflationary. Trump’s proposed tax policy changes would likely be supportive for consumers and businesses, although they could increase import prices. At the same time, fiscal stimulus and infrastructure spending could further bid up scarce labor resources. Importantly, U.S. fiscal stimulus is set to increase even as the U.S. economy enters its eighth year of expansion and labor markets are tight. This increases the risk of the U.S. economy overheating, particularly if the Fed were to make a policy mistake.
Interestingly, equity and credit markets appear to be pricing in mostly right-tail outcomes, or positive scenarios, while ignoring many of the left-tail risks, or negative scenarios. With the market increasingly romancing mostly the positives, we have been de-risking portfolios broadly across the credit markets, particularly given the recent strong post-election performance in equities, investment grade corporate bonds, high yield bonds, bank loans and emerging markets corporate bonds.
While we continue to see select opportunities in the credit markets (mainly in higher-credit bonds, agency mortgages and non-agency mortgages), we believe it makes sense for investors to increase cash balances and go up in quality. Left-tail risks are increasing, and there is growing risk that the U.S. economy could overheat under Trump’s policies, leading to more aggressive interest rate increases by the Federal Reserve over the next year. Simply put, the probability of U.S. recession over our cyclical horizon has moderately increased while valuations in many areas of the credit market have become less attractive. See our Cyclical Outlook, “Into the Unknown,” for details of our forecast for global markets and economies.
SELECT OPPORTUNITIES IN CREDIT
Compared with about a year ago, when PIMCO increased credit risk (see our Global Credit Perspectives, “The Case for Credit” and “Time to Move”), we are taking less overall credit and “spread risk“ and have been shifting our portfolios into areas of the credit market where we see the most favorable risk/reward. This shift, while subtle, underscores our views on credit sectors positioned to withstand the potential changes and uncertainties in the market outlook. Specifically, we see opportunity in the following areas in global fixed income credit sectors:
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High quality corporate bonds. We favor industries tied to the U.S. consumer, including cable, telecom, gaming, airlines and lodging, which should remain supported by solid consumer fundamentals, rising confidence and prospective tax cuts. We also continue to like banks and financials, which benefit both from moderately higher interest rates and steeper yield curves as well as the potential for less onerous and costly regulation under Trump. Finally, we continue to believe mid-stream energy/MLPs/pipelines offer the most attractive risk/reward in the energy sector given higher energy prices and the prospect for a pickup in volume growth in the U.S. shale regions.
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Bank capital/specialty finance. We believe select opportunities exist in U.S./UK/European bank capital securities and specialty finance companies where our bottom-up credit research seeks to identify companies with improving fundamentals. These sectors should benefit from a gradual pickup in nominal GDP, an improvement in earnings growth and rising equity market capitalization. Current bank capital valuations have cheapened relative to high yield, and deregulation should be particularly supportive for specialty finance companies.
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Non-agency mortgages. The risk/reward on non-agency mortgages continues to look attractive given current loss-adjusted spreads and a healthy U.S. housing market, which remains supported by a solid labor market, deleveraged consumer balance sheets and favorable demand/supply.
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Agency mortgages. Valuations on high-quality agency mortgages have cheapened considerably over the past few months. They are now increasingly attractive both outright as well as relative to U.S. Treasuries given the recent backup in interest rates.
NAVIGATING CHANGE, RISK AND OPPORTUNITY
In 2017, investors will need more than ever the ability to recognize, analyze and adapt to change. Navigating change can potentially be profitable; however, it requires discipline, courage and strong risk management skills as well as an appreciation for both left- and right-tail risks.
In 2016, investors were rewarded for being patient, selective, diligent in bottom-up research and proactive in capitalizing on the year’s major events (the slump in energy prices, Brexit and Trump) and the related dislocations in markets. It was a year that produced not only strong performance in the credit market but also one in which prudent active management rewarded investors.
Similarly, 2017 should also be an excellent year for active management in the credit markets. We anticipate fatter tail risks – both left and right. Nevertheless, change can also lead to opportunity! Importantly, given the amount of uncertainty and change occurring around the world, active managers are in an excellent position to capitalize on any future dislocations in markets.
Best wishes for a prosperous 2017.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Investing in MLPs involves risks that differ from equities, including limited control and limited rights to vote on matters affecting the partnership. MLPs are a partnership organised in the US and are subject to certain tax risks. Conflicts of interest may arise amongst common unit holders, subordinated unit holders and the general partner or managing member. MLPs may be affected by macro-economic and other factors affecting the stock market in general, expectations of interest rates, investor sentiment towards MLPs or the energy sector, changes in a particular issuer’s financial condition, or unfavorable or unanticipated poor performance of a particular issuer. MLP cash distributions are not guaranteed and depend on each partnership’s ability to generate adequate cash flow. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.
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