10 questions with PIMCO's Adam Bowe
Not long after I started at Livewire, I was fortunate enough to interview PIMCO’s Sydney-based portfolio manager Adam Bowe. Bowe is incredibly knowledgeable and equally generous when it comes to sharing his insights.
As a special instalment of Livewire’s Outlook Series, I sat down with Bowe once again late last year and peppered him with 10 questions.
In this wire, you’ll get an update on how Bowe and the PIMCO team are seeing markets - a lot has changed since our first interview in September – as well as insights into the year that has just passed and how he is positioned as we head into 2023 and beyond.
Without further ado, I give you 10 questions with PIMCO’s Adam Bowe.
1. 2022 saw no factor dominate – growth, defensive, value, and income all rotated through in true Game of Thrones fashion. How do you invest in an environment like that?
As global bond managers, we think less about growth, defensive, and value factors. Risk factors that dominate bond returns are duration, curve, credit, FX and volatility. And thinking of these through a bond investor's lens, really 'duration' - interest rate sensitivity - was the one that drove markets through 2022.
As central banks responded to elevated inflation and a strong rebound in growth coming out of the pandemic, 2022 saw some of the largest drawdowns in bond markets, all driven by interest rates. It was not a typical drawdown where you would see credit defaults or impairments, or permanent loss of capital.
Constructing bond portfolios with less interest rate sensitivity or duration was the key in 2022.
2. Where does 2022 rank in terms of the most challenging years of your investment career – knowing that you have been in markets for around two decades?
I spent some time thinking about this one and to be honest, every year throws up its challenges. Every couple of years the market tends to have a massive bout of volatility. I was thinking back through my career. I started during the tech wreck, and then we had the Gulf Wars, the GFC, the European sovereign crisis, Australia's commodity boom and bust, China de-pegging their currency, a global pandemic and then the inflation scare of 2022. So it was pretty tough to sit down and rank them all - I couldn't come up with a ranking. To me, just reflecting on it all, volatility brings opportunity and there's never a lack of either in a financial markets career.
3. What is your base, bull and bear cases for the global economy in 2023?
BASE CASE: As we move into next year, the base case is that most parts of the developed world will enter into a mild recession. Rates will stabilise at high levels, bonds should do reasonably well as rates stabilise, while risky assets will likely start to struggle. Inflation will start to moderate back towards central bank targets, but will likely take a couple of years to get there. That's the baseline.
BULL AND BEAR CASE: Now, looking at the risks for a bull and bear case, I think the BULL CASE is the soft landing. That's what central banks are shooting for. If they pull off this perfect soft landing, inflation could moderate a bit more quickly than we're expecting. Central banks could stop hiking through the first quarter of next year and even start contemplating easing in the second half. Bonds and equities would both do reasonably well in that environment as financial conditions ease. It’s kind of a risk parity environment where bonds and equities do reasonably well. I think that's the bull case for financial markets.
Then the BEAR CASE is that inflation remains sticky and elevated. Central banks would continue to lift interest rates right through the first half and have to keep them elevated. I think this is the key: they would have to keep them elevated despite growth slowing and looming recession risk because inflation won't come down. That's a really difficult environment for financial markets where I don't think many assets do particularly well.
I think the skew of risk is slightly more towards a soft landing than a deeper recession. In the absence of more sequential supply shocks, inflation is starting to moderate. I always think there's a level of interest rates that stops people spending and brings inflation down.
4. Aside from inflation, what is the one thing investors need to be aware of in 2023? (either from a risk or opportunity perspective)
I think we're pivoting from inflation risk to recession risk. We're seeing a really tight monetary policy around the world and growth is slowing pretty rapidly. Our base case is we're shifting from inflation concerns to growth and recession concerns. For that, investors need to start thinking about which assets have already priced (or nearly priced) that in and which ones haven't.
When you look around the world, things like Australian property probably haven’t quite factored that in yet, even though we've seen some reasonable declines. And equity markets are still pretty elevated. Switching from inflation concerns to growth and recession concerns, the key is making sure you've got a portfolio that's resilient to that really challenging economic environment next year.
5. Where and when do interest rates top out in 2023 in a) the US b) in Australia
Well, this is easier than it was six months ago. We're getting there. There is a little bit more clarity around where central banks might start to top out. In the US we're thinking close to 5%. After the December meeting they're getting up into the mid-fours, and then somewhere in Q1, they likely end up close to 5% and then hold it there for a bit. Australia? A little lower, a little slower, somewhere close to 4% through the first half. The main factor that's driving that wedge, that differential between four and five, is just how elevated leverage is in the household sector in Australia.
We go back to our analysis and when we look at the numbers, a 4% cash rate in Australia is about as tight as Australian households have ever witnessed.
You intuitively think the cash rate looks a lot lower than it was 10 years ago. But over that 10 years, a couple of important things have changed. Australian households have taken on about 25% more leverage versus their income. Every percentage point of interest rate rise means a higher proportion of their income is dedicated to servicing their debt. And the banks have widened out their borrowing rates, i.e. mortgages to cash rates. And remember that we have just experienced a decade of easing.
Often when the RBA cut by 25 basis points, the banks would only pass on 19, 20, 23 basis points. If you add all of that up, they kept back about three more hikes, nearly 75 basis points. If you combine those two things, wider spread of mortgage rates to the cash rate, and higher leverage, 4% is going to be about as tight as we've seen it for Australian households. This means we think we end up here in Australia with a little lower cash rate than the US and with the RBA going a little slower.
6. What is the probability of a recession in Australia in 2023? – last time we spoke, it was 50/50 – has the view changed?
Not in Australia. A couple of things have shifted for Australia. When I look at other parts of the developed world like the US, UK, and Europe, the base case now is they do enter recession, as we move into the first half. We've revised our probabilities globally for the developed world up over 50% now. That's our baseline expectation. For Australia, I still think it's 50/50. A couple of things that differentiate Australia relative to those other countries; first of all is the RBA's slower approach. We expect them to stop a little lower, and so that can slightly delay and slow the drag on growth.
Then the second point is we're shifting from a period in 2022 where China finished the year growing about 3%. We expect China to grow by about 5% next year. So a modest tailwind. Not particularly infrastructure, residential, or commodity-fueled growth improvement, however, moreso household consumption. But it goes from being a pretty significant headwind to the region to a modest tailwind. I think those two things differentiate Australia a little and I think, we're going to flirt with recession, but still 50/50.
7. Within fixed income, where are you seeing the most attractive opportunities geographically?
The way we’re thinking of 2023 is trying to think of our base case, where we see a really challenging economic environment, we have really restrictive monetary policy and flat to negative growth in most of the developed world.
When thinking about this, I started with where we don't want to invest, i.e. Where do we want to avoid? And that's parts of the world with weak balance sheets.
We've had such a significant rise in interest rates in a materially slow growth environment, so we really want to avoid weak balance sheets. And they're different depending on which country you look at. Starting in Australia, the weakest balance sheet is households as they are very levered. We really want to avoid household exposure through next year in Australia.
In Europe, it's more on the government side, the peripheral sovereigns with all the debt. Then the US, it's not the government, it's not households, it's more cyclical, highly levered parts of the corporate bond market in the US that we want to avoid... i.e. those with weak balance sheets in an environment of higher interest rates and really challenging growth.
Where are the strong balance sheets, where are the places that are going to be resilient, the places where we want to invest? Global banks and global financials. You compare their balance to sheets 10 years ago.
They've got more capital, less leverage, higher regulations, and their starting point entering next year is quite strong relative to other parts of the corporate bond market. Global financials look really attractive relative to other opportunities.
As I said, US households still look pretty good: US housing-related bonds – whether that's the government-guaranteed, government-owned agency mortgages, or the private sector, non-agency mortgages look really attractive. Highly rated AAA structured product around the world that has a lot of capital and credit enhancements built into the structure for that challenging environment also looks good.
Then if I had to rank sovereigns, it's the ones that have clean balance sheets and really high interest rates. New Zealand stands out: shorter maturity bonds are up around 5%. New Zealand has a very healthy balance sheet and economic environment, and a property market that's slowing quite rapidly. Those really healthy balance sheets, resilient to tough environments next year, are the ones we're focusing on.
8. Assuming the answer to the question above is NOT Australia, how does Australia rank in comparison?
There are some really attractive pockets in the Australian bond markets.
One that stands out to me is our state government bonds or semi-government bonds. This is a very resilient, high-quality AA, AAA type of sector.
State government bonds with yields up above 4% if you're looking at the long end, 10 years and longer. Yields above 4%, high quality, very liquid, resilient to most economic scenarios you can imagine next year. If you look at that and you think of the very high-quality part of the bond market locally, with yields materially above the RBA's long-term inflation target of 2-3%, it’s a really attractive opportunity to lock in interest rates and income that are likely to out-earn inflation over that 1- year period. Not all parts of the Australian bond market look attractive, however, and we are certainly avoiding some sectors, but that's one that stands out as a very high quality, resilient part of the bond market with positive real yields for next year.
9. Within fixed interest we’ve seen a tough period, followed by a period with abundant opportunity. Where are we now and what happens next?
Going back through those rolling crises of the last 20 years, I don't think we can ever discount volatility. I think the opportunity set in global bonds remains really rich next year, particularly in the first half. As I said, the base case is we're in this environment where central banks peak in terms of their interest rate rises and keep them elevated for the next couple of quarters. You've still got this window of really rich opportunities in global bond markets and an opportunity to rebuild resilience into your broader portfolio and lock in healthy levels of income above expected inflation over the next few years.
It's a really attractive and rich opportunity set.
If you look at yield levels of core bond funds, ie high-quality, liquid bonds that provide diversity in your broader portfolios, you’re looking at starting yields of between 4% and 5%, well above inflation targets. If you look at more credit-focused bond funds, you're looking at 6%-7% and if you're happy to forgo some liquidity and invest in some of the less trafficked areas of the global bond market which are credit intensive, you are up in low double digits still, 12%-13% in investment yields at the moment. I think the window remains pretty open for this rich opportunity set for fixed income as central banks keep interest rates elevated for another couple of quarters. I think you've still got that window to invest.
10. The growth fuelled rally of the last decade (prior to this) has seen a generation of investors neglect bonds. What is your message to those investors? What is your message to those who have always held bonds?
For the people who have held bonds, as I said at the start of the conversation, it has been a challenging year of big drawdowns but it's not a case of permanent capital impairment or defaults. This environment is different from the experience of the GFC, where you did see those big rapid defaults resulting in permanent capital loss. This time it's about mark-to-market underperformance due to higher interest rates. That would be the message for investors who have held bonds through this period.
For those investors who are pretty light on in terms of their bond exposure, which is a big part of the local market in Australia, I think it's time to think about why we hold bonds. What's the role of bonds in portfolio construction and why do you hold them? It’s for income and diversification.
As we look out to next year, we don't have to reach into risky parts of global financial markets just to try to eke out some yield and income above inflation. You can now generate healthy levels of real yield and real income on different types of bond funds without reaching out the risk spectrum too far, which I think is really important.
And we have seen a shift in the interest from our client base. For the first time in a long time, I'm getting invited to income-generating seminars and talking to clients about core bonds again, which is a big shift and understandable given the adjustment higher in interest rates.
When investors are thinking about 2023 and constructing income-generating portfolios, they’ve got a great opportunity to not take too much risk – in fact, they can de-risk some of the income-generating parts of their portfolio. It's a great opportunity to diversify where you're getting your income from. Australian investors, for too long, have generated their income from TDs, hybrids, investment property, and maybe high dividend stocks like bank stocks.
It's one big bet on the Aussie housing market and households, which we see as the one area where we're trying to avoid next year.
It's an opportunity to start the year and diversify away from that one big bet and generate some income from other pockets of the bond market that are really attractive. So that's the income side. A huge opportunity set. Opportunity to diversify away from concentrated exposures locally. Then, with inflation beginning to moderate and interest rates starting at a very elevated starting point, I think core bonds are really well positioned to provide that diversification benefit again.
It's a big question mark this year as equities initially underperformed and bonds underperformed, will bonds provide that diversification role? Will they do well when the risky parts of your portfolio do poorly going forward? And I think the point there is the starting point of interest rates certainly gives bonds the opportunity to do that.
And if your base case is like mine, that there's always a level of interest rates that stops people spending and inflation will likely begin to moderate back to target, bonds can start providing that diversification anchor in portfolios again.
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