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Kimberly Stafford, Global Head of Product Strategy: How can investors build resilience into portfolios? And just in practical terms, what does reaching for resilience mean for investors?
Dan Ivascyn, Group Chief Investment Officer, PIMCO: Sure, let me start very high level. Looking forward, we are a bit more constructive on returns. We have had a significant repricing in markets, and there will be a greater prospect for return across fixed-income markets. With some of the increased capital investment shifting demographic trend, we do expect real interest rates over the longer term to be a bit higher than we grew accustomed to, which means that even higher-quality segments of the bond market will offer higher returns than what we grew accustomed to during much of the post-GFC recovery period, which now is almost 15 years in duration.
We do think inflation will likely be elevated. We do believe that over time central banks will get inflation back under control, but under control will likely mean higher inflation rates than what we, again, grew accustomed to for much of the last 10-15 year period.
So what that argues for would be higher allocations to quality fixed income, less need to go down the credit spectrum to pick up incremental yield.
So this adjustment process will likely mean value returning to some high-quality areas of the market. Investors that are uncomfortable with the greater volatility not wanting as big an allocation to some of those most credit-sensitive sectors of the market. Then also the area of inflation protection.
We do think over a five-year or five-plus year period, sourcing inflation protection across portfolios will make a lot of sense as well. And that can be done directly in TIPS markets or other inflation-protected areas of the fixed-income markets. Also, when we look at commodities, they appear to be quite under-owned. They’ll be a lot of volatility near term, but over a multi-year period, we do think it makes sense for investors to think about allocations in those areas.
Kimberley Stafford: Makes sense. Thank you. And look, maybe drilling down specifically to corporations and consumers. There’s a lot of factors in the balance that could potentially lead to higher credit losses or even defaults given the risk that we see and given, like we talked about, probably less likely policy support on the horizon. So what is our outlook for credit markets?
Dan Ivascyn: Well, let’s start at a high level.
Recessionary risk is elevated. Anytime you have a higher risk of recession, you want to be very, very cautious about credit-sensitive investments, but initial conditions are quite strong. Household balance sheets are strong, we’re at or well beyond full employment. We don’t see the same challenges in the banking sector. We don’t see the same extreme imbalances or the maturity transformation or leverage on leverage that we’ve seen during prior cycles. So from that perspective, we’re constructive. The big challenge is we have an inflation problem, not a growth problem. So, you have policymakers tightening at a point in time where growth is already relatively low and it appears to be declining quite quickly. It’s been a long time since there has been a recession without massive policy support, which means it doesn’t have to be a crisis environment like the GFC or the COVID period.
We don’t think it’s time to jump into the higher-risk segments of the market just yet. We think you should stay defensive, stay resilient until you get paid enough to take that more significant risk.
And then just in terms of corporate credit more specifically, you have seen significant growth in some of the lower-rated or private segments of the corporate credit market. You’ve also seen a resulting deterioration of fundamentals in certain areas of this market. So we do think on a relative basis those areas warrant caution, especially those areas within the private space that haven’t repriced yet.
Where we would be the most cautious currently are areas that have tended to be slow to react. We think one of the most exciting opportunities on a go-forward basis will be to have contingent capital to be prepared for opportunities in that space, just given how large those sectors have become. We think that will be a great opportunity for investors to supplement their more traditional allocations to fixed income, public equity or private equity.
Then last but not least, I want to bring it back to the housing market. Our core view is that even if the economy slows significantly, you can get some weakness in home prices in real terms. You could even have scenarios where home prices go down on a national basis. That doesn’t have to be a major problem because this is a market today with very, very high-quality borrowers, very little excess, very little building over the last decade relative to household formation.
When you look at some of the areas around household credit, asset-backed credit, mortgage credit, banking credit, or financial sector credit, that’s where you see the type of resiliency in pretty attractive spread levels that we think will lead the charge over the next five years.
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