Cyclical outlook: prevailing under pressure
Endowus Insights

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Cyclical outlook: prevailing under pressure

Updated
8
Dec 2022
published
4
Nov 2022
fixed income - higher bond yields

Our thoughts:

With higher yields across maturities, we believe the case is now stronger for investing in bonds. We believe high-quality fixed income markets can now be expected to deliver returns much more consistent with long-term averages, and we think the front end of yield curves in most markets already price in sufficient monetary tightening.

In this article, originally published by PIMCO in October 2022, Tiffany Wilding, North American economist, and Andrew Balls, CIO global fixed income, share why they believe that higher yields contribute to a compelling case for bonds.

Investors have reason enough for concern. Markets are volatile. Inflation is persistent. Recession risk looms.

But there is a bright spot to consider: With yields now higher, we believe bonds are attractive again.

In our latest Cyclical Outlook: Prevailing Under Pressure, we discuss the case for bonds, including greater potential for income and diversification than seen in years, in our view. We also discuss other assets and analyse in detail the factors driving inflation, as well as the monetary responses and the potential for recession. This blog post summarises our views of the next six to 12 months.

The economic backdrop

Geopolitical tensions, elevated market volatility, and the fastest pace of central bank tightening in decades are contributing to an unusually uncertain economic environment.

Our baseline forecast is for shallow recessions across developed markets, especially in the euro area and the UK, which face disruptions from the war in Ukraine. US real GDP will also likely experience a period of modest contraction.

Meanwhile, core inflation rates that are above central bank targets now appear more entrenched, and although headline inflation is still likely to eventually moderate meaningfully over our cyclical horizon, it now looks likely to take more time.

The combination of higher unemployment and stubbornly above-target inflation has put central bankers in a tough spot, but their overall actions to date suggest they are squarely focused on bringing inflation down.

In the US, for example, we expect the Federal Reserve will raise its policy rate to a range of 4.5% to 5% and then pause to assess the impact on the economy of its tightening.

Investment implications

With higher yields across maturities, we believe the case is now stronger for investing in bonds. We believe high-quality fixed income markets can now be expected to deliver returns much more consistent with long-term averages, and we think the front end of yield curves in most markets already price in sufficient monetary tightening.

We see abundant opportunities to look to harness this growing value in bond markets. For example, investors could combine exposure to high quality benchmark yields – which have increased significantly in the past year – with select exposure to high quality spread sectors, and add potential alpha from active management. We believe the return potential is compelling in light of our cyclical outlook, and that many investors could be rewarded by returning to fixed income.

Further, in addition to higher income potential, yields are high enough to provide the potential for capital gains in the event of weaker-than-expected growth and inflation outcomes or in the event of more pronounced equity market weakness.

We expect that more normal negative correlations between high-quality bonds and equities will re-assert themselves, thus improving the hedging characteristics of quality core bonds, which generally should rise in value when equities fall.

Also, the higher yields offered in bond markets today could help compensate those who choose to wait out this period of uncertainty and potentially higher volatility.

Still, caution is warranted, and if inflation is more sticky than we expect, central banks could be forced to hike rates by more than is priced in currently, and if recessions are as shallow as we expect, then policymakers may be slow to cut policy rates to boost growth, given the high inflation starting point.

Thus, in core fixed-income portfolios, this is an environment where we are prepared to take the active and deliberate decision to reduce risk across a range of risk factors and to keep some dry powder (i.e. maintain liquidity).

Liquidity management is always important, but is especially important in a difficult and highly uncertain market environment. In line with our secular outlook, we will look to maintain portfolios that will be resilient across a range of economic, geopolitical, and market outcomes.

We share our views on other assets in the full Cyclical Outlook, but here we make one final point: We believe the anticipated real economic and financial market volatility will lead to attractive opportunities for investors with patience and fresh capital.

The gap between private and public asset valuations remains extreme, but as private markets adjust and challenges become apparent across the corporate credit and real estate space, there should arise opportunities to potentially generate outsize returns. This is one of our highest conviction views.

This article was originally published on 4 Oct 2022 by PIMCO.

PIMCO is one of the world's premier fixed income investment managers managing $2 trillion in assets for central banks, sovereign wealth funds, public and private pension funds, corporations, foundations and endowments, and individual investors. Founded in 1971, PIMCO introduced investors to a total return approach to fixed income investing. In the 50 years since, PIMCO has continued to bring innovation and expertise to its partnership with clients seeking the best investment solutions. Today the firm has offices across the globe and professionals united by a single purpose: creating opportunities for investors in every environment. PIMCO is owned by Allianz S.E., a leading global diversified financial services provider.

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PIMCO disclaimer

PIMCO Asia Pte Ltd is regulated by the Monetary Authority of Singapore as a holder of a capital markets services license and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised.

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. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Diversification does not ensure against loss.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1. Roll-down is a form of return that is realised as a bond approaches maturity, assuming an upward sloping yield curve.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. 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. ©2022, PIMCO.

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