Could you summarize Pimco’s cyclical macroeconomic views?
Pimco voted for a slight stagflationary outcome in the U.S. at our latest Cyclical Forum. The question debated by our global investment professionals was the extent of the current economic slowdown, not whether there would be a slowdown. While our most likely scenario is a soft landing of 2% to 2.5% GDP growth in the U.S., we recognize the possibility that a hard landing in the housing market can trigger a sharp slowdown in consumption and risk aversion in corporate investment and hiring.
We are aware of the other risk to our central forecast,the risk that the economy is resilient and rebounds from the current slower growth trend. The risk of this scenario is that the Fed remains biased toward tightening. We believe this scenario has a very low likelihood. Hence, when we weigh the risks to our central soft landing scenario, we believe, among the less likely scenarios, that the hard landing scenario has a higher probability than a rebound scenario. The reasons for our confidence in a slowdown scenario are many, but the most important is the weight of a housing slowdown within GDP calculus and the dynamics and externalities of a slowdown from current extended levels.
We recognize that corporate profits remain elevated and corporations are flush with cash, but this money is unlikely to provide a lift for the economy unless it is used for hiring and investment instead of stock buybacks and mergers and acquisitions.
What’s Pimco’s take on central bank policy around the world?
While the Fed is currently restrictive, other central banks like the Bank of Japan, the Bank of England’s Monetary Policy Committee and the European Central Bank are still moving in the tightening direction. Like the Fed, these central banks are concerned about the risks of inflation, inflated asset prices and normalizing risk premiums. They are using the interim between the Fed’s last tightening in August and the Fed’s first ease as a window of opportunity to normalize their own rate structure and other risk premiums, as well as to contain the effect of prior simulative monetary policy on asset prices.
What does Pimco expect in terms of market volatility?
We expect volatility to increase as it typically does around an economic turning point. Therefore, we have become cautious on our traditional volatility sales. Among these are selling straddles on Treasury futures, and running large concentrations of mortgage-backed securities, which is a volatility sale.
We therefore have reduced our core mortgage holdings with the anticipation of being able to put them back on at cheaper levels. We do note that given the low compensation for risk offered in spread markets, including investment-grade and high-yield corporate bonds as well as emerging market bonds, the current income offered by mortgages is actually relatively attractive, which has moderated the extent of our reduction in mortgage concentrations.
Pimco long has favored municipal bonds as a defensive strategy. Has that changed?
We have considered municipal bonds a very attractive defensive strategy for two reasons. One is that municipal yields in the long end were at attractive historical ratios to Treasuries. The second reason is that in an environment where we perceived a risk that rates could back up toward the high end of our 4% to 5.5% secular range expected for the 10-year Treasury note, municipal bond yields of close to 5% were very attractive to retail investors. This was especially so, given risks that tax policy could become more restrictive in the event that the Republicans were unable to make tax cuts permanent.
It now appears that the allure of municipals as a defensive strategy is not as high as we perceived six months ago. Rates appear to have peaked, and with indications now that the Republicans can hold a majority in the House of Representatives, the prospect of a change in tax policy is less likely to benefit munis as well. Accordingly, we plan to look selectively for opportunities to sell munis going forward.
