Many investors are assessing their bond allocations as the Federal Reserve gradually raises U.S. interest rates and as equity markets have recently set record highs. Scott Mather, PIMCO’s CIO for U.S. core strategies, explains the role core bonds can play amid the uncertain outlook for both bonds and equities, and discusses PIMCO’s Total Return Strategy, which has been navigating changing environments for 30 years. He co-manages the Total Return Strategy with Mark Kiesel, CIO for global credit, and Mihir Worah, CIO for asset allocation and real return.
Q: What stands out to you as you look back on the past three years of co-managing PIMCO’s Total Return Strategy?
Mather: What’s striking about the past three years is how eventful they have been. Although the global financial crisis was one of the defining events of the past decade, we have still seen some dramatic changes just since 2014.
For example, exactly three years ago, the price of crude oil was beginning a 50% slide from a starting level of more than $100/bbl. It has hovered around $50/bbl since that steep drop, which has had meaningful implications for growth, inflation and policy around the world. Soon after that, some of the world’s largest central banks, including the European Central Bank and the Bank of Japan, experimented with negative interest rate policy. In contrast, the Federal Reserve raised its policy rate in 2015 for the first time in almost a decade and followed with three more rate hikes. Brexit and the election of U.S. President Donald Trump in 2016 signaled the rise of populism. And all along, China’s growth slowed – from 7.4% in 2014 to the most recent rate of 6.7% – as policymakers attempt to guide the economy toward a slower but more domestic, consumer-led growth model. China has also been focused on liberalizing its capital account, but not without some volatility along the way.
Some things, however, have changed little: In particular, the past several years have been characterized by extraordinary, accommodative central bank policy in Europe, Japan and the U.S., despite the Fed’s efforts to normalize rates. Low interest rates across the world have fueled an intense search for yield, and that hasn’t changed much. Remarkably, the U.S. 10-year Treasury bond yield is about the same as it was three years ago.
Looking ahead, though, we see substantial probability for change to the status quo. How the global economy and the markets adapt to less accommodative central bank policy could define the next three years.
Q: What have been the drivers for the Total Return Strategy over the past three years?
Mather: In looking at the specific strategies that drove Total Return, it helps to put them in context: The better part of the post-crisis period was defined by unprecedented policy support from central banks globally. More recently, we have seen that support wane as central banks have sought to normalize policy and/or reached the limits of policy effectiveness. As this shift has developed, fundamentals have reasserted themselves and policy-supported valuations have begun to look less attractive. In this environment, the conservative and diversified approach we employ in the Total Return Strategy has proven beneficial. We used a mix of strategies, from interest rate strategies emphasizing defensive postures on the yield curve to a more diversified approach to credit.
Ultimately, PIMCO’s investment process – which is how we arrived at these strategies – and our deep bench of investment professionals drive the Total Return Strategy. Even though we are the “new” team, Mark, Mihir and I have all been with PIMCO for more than 15 years, and we have been contributing to the Total Return Strategy for many years through PIMCO’s investment process – at our quarterly economic forums, where PIMCO forms its top-down views, and in our daily Investment Committee meetings, where we debate and formulate investment strategies. That continuity has kept Total Return resilient for investors through the many different environments of the past three years – from market turbulence and political turmoil to fund outflows – and really since the strategy was launched 30 years ago.
Total Return is different from many of its competitors because it focuses not only on performance but also on capital preservation and diversification – factors we think are critical for investors in core bonds. The ability to construct a more diversified portfolio, which can help mitigate downside risk, is crucial in our effort to achieve both higher-than-benchmark returns and better risk-adjusted returns for investors. It is a major reason why we feel confident in the strategy as we look ahead.
Q: What is PIMCO’s outlook for interest rates and the economy?
Mather: We think the Fed is likely to raise the policy rate once more this year and perhaps twice in 2018. The pace of rate hikes could change if the Fed’s unwinding of its asset purchase program affects financial conditions more than expected, but overall, we expect the Fed to continue on a gradual path of normalizing interest rates.
Also, we expect Europe to reduce and then end its asset purchases, or quantitative easing, during 2018. Various other central banks, including the Bank of Canada and the Bank of England, have also shown a shift toward less accommodative stances. Bank of Japan signaled its limit last year by moving away from quantitative easing in favor of yield-curve targeting, and could potentially relax its yield curve target gradually over the next year or two.
This removal of central bank support globally will be an important factor in markets: Low interest rates have affected the performance of nearly every asset class for several years. In addition, the unprecedented support has helped maintain generally low market volatility and rewarded broad risk-taking. As this support is withdrawn, the result is likely to be higher market volatility and greater focus on fundamentals.
We are also mindful of the business cycle: Although global growth is steady, the U.S. economic expansion is into its ninth year, and growth is likely to moderate as tightening labor markets dampen the extent of job and output creation. Although fiscal stimulus of some sort seems probable in coming quarters, the likely magnitude and its impact on the economy have declined substantially relative to earlier in the year. True growth-oriented reform – the kind that could boost potential growth in the economy – seems less likely.
Q: Where do you see attractive opportunities within core bonds currently?
Mather: Core bond strategies typically serve an important role in investors’ portfolios because they have the potential for capital preservation, provide diversification away from equities and have had low correlations with risk assets in general. In an uncertain environment like this, with equities near record highs and risk assets overall at lofty valuations, we think this is a good time to consider lowering overall portfolio risk exposure and emphasizing more defensive strategies. In Total Return, we are taking a somewhat more defensive tack.
Because we think diversification is one of the keys to managing a core bond strategy, we draw on many sources of potential return rather than rely on just one or two based on our views on an individual company or sector.
In U.S. Treasuries, we are focused on medium-term maturities, mainly because we find both the long and short ends of the yield curve to be less attractive. We think rates are likely to be relatively range-bound in the near term, with the Fed’s rate normalization primarily affecting the front end of the yield curve. Importantly, we see value in high quality government exposure as uncertainties are rising in a world of low growth and diminishing central bank support.
We think inflation could prove to be stronger than many expect and that the softer inflation trends we’ve seen lately should diminish into 2018, so TIPS (Treasury Inflation-Protected Securities) holdings continue to offer value.
To enhance yield potential, we think mortgage-backed securities from the U.S. housing agencies are attractive and provide an alternative for adding yield to a portfolio without contributing credit risk. We also see value in mortgage credit, particularly non-agency mortgage securities, which offer a combination of attractive fundamentals and compelling yields. Many of the borrowers on the mortgages underlying these securities have improved their credit profiles over time – in part because of the de-leveraging that has occurred as their loan-to-value ratios have come down.
In corporate bonds, where we think valuations are stretched, we have become more selective. We favor the financial sector because valuations are still attractive, especially as bank balance sheets have become healthier.
As we look forward, most risk assets seem fully priced now, and with central banks pulling back their policy support, we think volatility is likely to rise. Yet, interest rates will probably remain low by historical standards. In this type of environment, an actively managed, diversified core bond allocation can potentially provide the resilience and anchor role for portfolios that many investors seek.