In this Q&A, PIMCO’s Gordon Harding, fixed income strategist, and Terry Oh, Head of Global Wealth Management – UK & MEA, explain why fixed income can offer the potential for attractive yield and stability amid today’s financial market volatility, and how an income strategy can potentially benefit.
What’s going on in the global economy?
It is clear that recent shocks to the banking sector show that central banks’ efforts to tame inflation are having an intensifying effect, with broader economic consequences likely to follow. As a result we see three key economic themes over our cyclical horizon of the next six to 12 months.
Firstly, bank failures and the rising cost of capital have raised the prospect of a significant tightening of credit conditions, and therefore the risk of a sooner and deeper recession in the US – and this could act as yet another headwind that could very well pull Europe into recession as well.
Central banks are likely near the end of their hiking paths, but not tightening further is different than normalizing or even easing policy, which will likely require inflation falling toward target levels. Finally, recessionary risks and any further bank stress are unlikely to be met with another large fiscal response unless the economic implications are clear and severe.
However, we do believe fixed income markets can benefit. Uncertain environments tend to be good for bonds, particularly after last year’s repricing pushed current yield levels – historically a strong indicator of returns – much higher. Bonds appear poised to exhibit more of their traditional qualities of diversification and capital preservation, with the potential for upside price performance in the event of further economic deterioration.
Volatility should provide fertile ground for active managers, especially those with a broad, flexible opportunity set.
Do you see this changing?
There are good reasons to believe that this is not 2008. Households still have excess savings, aggregate corporate debt-to-GDP ratios appear manageable with interest-to-income ratios still low, and so far bank losses generally have emanated from rising interest rates, which reduce the value of long-duration assets, not from risky lending or credit defaults. The largest U.S. systemically important banks, which are subject to regular liquidity and capital stress tests, are still financially sound and have been the beneficiary of deposit outflows at smaller banks.
All of this means central banks likely need to do less heavy lifting to get the same result: tighter financial conditions, which slow credit growth, demand, and eventually inflation. However, not tightening further is distinct from normalizing or even easing policy, which we still believe will require inflation falling toward central bank targets.
At PIMCO, we have previously said that going from 8% to 4% inflation in the U.S. should be relatively easy, but going from 4% to 2% would require more time, as “stickier” categories related to wage inflation were likely to moderate more slowly and in response to weakening labor markets. We continue to expect core U.S. consumer price index (CPI) inflation to end 2023 at around 3%, still above the 2% inflation target of the U.S. Federal Reserve (Fed), while European inflation is still likely to end the year higher.
We believe it’s important to remain cautious in this environment, seeking higher-quality, more liquid, and resilient investments. Later this year, if the economic outlook reaches a point of greater clarity, accompanied by a repricing of economically sensitive market sectors, it could be time to go on the offensive.
Why income today?
Amidst the economic uncertainty, ongoing cost-of-living pressures in the UK specifically, and elevated interest rates leading to higher borrowing costs, generating a consistent income is key. The UK experienced a difficult year in 2022, with the crisis in government gilts (where the announcement of unfunded tax cuts led to a sudden drop in gilt values), as well as rising interest rates and inflation proving a challenge for fixed income investors. Indeed, UK inflation hit a peak of 11.1% in October 2022 and, while it has subsequently fallen, it remains well above the Bank of England’s 2% target.
However, this macroeconomic backdrop is one in which income strategies can potentially thrive. Bond yields are at the highest levels in many years and credit spreads (the difference in yields between government bonds and riskier bonds) are relatively attractive, which could be conducive to both attractive income generation and potential capital gains if yields were to fall. Higher yields offer increased return potential going forward as starting yields historically have a strong correlation with future returns. Consistent income can also help build returns over time while, historically in our Income strategy, years with capital losses have often been followed by capital gains. In addition, bonds are better able to provide diversification to portfolios now that yields have risen so much over the past couple of years and therefore have more room to fall in the event of a slower economy.
And why PIMCO for income?
PIMCO is one of the largest fixed income managers in the world by assets under management. PIMCO’s breadth of expertise and trusted market presence enable us to develop high quality relationships with issuers and gain direct access to their management, enhancing our ability to structure advantageous terms and secure favourable allocations. This scale means we can sometimes structure the terms of an issue directly with the issuer, a process known as reverse inquiry.
This can be invaluable in such a large and diverse global market – the worldwide bond market is worth around $125 trillion1.
At PIMCO, we take an active approach to fixed income investing – one in which we express high conviction views without allowing any single risk to dominate returns. During our 50+ years of fixed income leadership, we have found this helps us to deliver positive outcomes for investors and avoid outsized risks that may be inherent in passive approaches.
In our view, the differences between stocks and bonds, including how they trade, create bond-market specific headwinds for passive strategies, giving active managers more of a potential edge in fixed income than in equities. At PIMCO, what we don’t own is as important as what we do.
It’s worth noting here that even including different rate environments, fixed income drawdowns are multiple times lower than those of equities. That is to say, when investors get the jitters, equities tend to suffer more than fixed income.
Our Income strategy is now one of the largest actively managed strategic bond strategy in the world, albeit small in comparison to the scale of opportunities offered by the (circa $130 trillion)2 global bond market. It has now achieved more than a decade of delivering income for investors. It adopts a flexible, global, and diversified approach to fixed income markets, balancing higher-yielding assets (which perform differently in varying growth environments) with high quality fixed income to help weather the challenges of changing markets. A global approach means that, no matter which way markets and interest rates move, opportunities can be accessed around the world.
How are you positioning your income strategy for success?
We are focused on high quality, highly liquid (relatively easy to trade) securities, which we believe should provide resilience should the economy fall into a worse-than-expected recession. We plan to use that liquidity to take advantage of any valuation overshoots we see across markets in coming months.
We remain cautious on corporate credit overall, but do see attractive opportunities that we believe will remain resilient. The healthcare and telecom sectors are two sectors we favour, as well as banks, with spreads that have widened since the end of 2021. But, overall, we favour high quality, securitized credit (when a number of financial assets are combined together to create a package of securities, such as mortgages or other loans) over generic corporate credit because they offer ample collateral, to provide protection in a downturn, and very attractive spreads in our view.
The views and expectations expressed are those of PIMCO. Statements concerning financial market trends are based on current market conditions, which will fluctuate.
Gordon Harding, Vice President, Fixed Income Strategist, PIMCO
Terry Oh, Head of Global Wealth Management – UK & MEA, PIMCO
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 low interest rate environments increase this risk. 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. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Diversification does not ensure against loss.
PIMCO Europe Ltd (Company No. 2604517, 11 Baker Street, London W1U 3AH, UK) is authorised and regulated by the FCA. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser.