Recession risks are very real

Transcript

We've seen central banks take some pretty significant steps very recently. For example, the Reserve Bank of Australia and the Federal Reserve. It's been a pretty decent change in language, so can you let us know what's happened?

Yeah, that's right. It's been a volatile few weeks and we're starting to see some pretty meaningful actions by central banks, as you said. So the RBA have cut another 25 basis points. Federal Reserve cut 50 basis points inter-meeting, which we haven't seen since the global financial crisis. And the central banks are doing this in direct response to the economic fallout of the coronavirus.

Obviously central banks can't do anything to address the human tragedy side of the virus, but certainly what they're attempting to do is treat the economic symptoms of the spread of the virus. So even now, if we get to a point where the virus is contained, the economic implications and slowdown is already very real and sizable.

We saw the first signs of that in the February China PMIs that came out, down around 30 which is lower than they got to during the global financial crisis. So very, very sharp falls in economic activity, even if we start to see an improvement in the spread of the virus from here.

With that backdrop, what do we think is the prospect of a global and or a local recession? And from the local perspective, do we think that this gives the Morrison government a reason to step away from its promise of budget surpluses and provide some tax breaks and government spending assistance?

It's a good question. Focusing domestically, when you're this close to the effective lower bound in cash rates, the RBA have been very clear they won't cut below 0.25, they're one cut away now. So when you're that close to the effective lower bound of cash rates, and you're faced with a global shock that we're seeing, recession risks are very real and we can't shy away from that.

So far on the fiscal side, we haven't seen much. I think there's now been enough slippage, but the government was basically forecasting a very modest surplus, close to budget balance. I think now we've seen enough fiscal slippage from the bushfires, from the coronavirus, that we can probably kiss that surplus goodbye, but nothing meaningful from the federal government in terms of a significant expansion that would get us more constructive on the outlook.

That's the one policy tool that would get us more constructive on the outlook if we saw something more large scale from the federal government, but we're yet to see that. All they've spoken about is sort of targeted and measured responses, so enough to probably say goodbye to the surplus, but not enough to move the needle economically and get us more constructive.

So from a portfolio perspective, what's PIMCO doing across the investment spectrum of government bonds and corporate credit sectors?

I think the first take away for us as bond managers is that during this period of volatility, once again, even though the starting point of interest rates was low, bonds are doing their job. As equity markets and risky assets came under stress, bonds did very well.

So even though interest rates are low, we're not in a position where we're significantly underweight interest rate risk or duration, because bonds are still performing the role that we expect them to. So we're largely neutral duration. 

And then in terms of sector allocation, which is probably where we're allocating more risk budget at this point, we're very cautious on any industry companies that rely heavily on offshore demand, because we're seeing that very weak, particularly in Asia. So ones obviously that stand out there in this environment are airports and airlines - very cautious on them at the moment. 

And a lot more comfortable owning bonds issued by corporates that come from a regulated utility industry, so are largely insulated from any fluctuations in external demand, they get paid on their regulatory asset base regardless of demand. So those types of defensive utilities are really attractive in this environment.

And then the final sector we really like, which I think we spoke about a couple of months back as well is the State Government bond market in Australia. 

So that's a market that is very liquid. You get, on a 10-year government bond, relative to a state government bond, you pick up about 50 basis points. So federal government bonds, Commonwealth government bonds are already down around 80 basis points, so 50 on top of that's meaningful now. 

And we think they do reasonably well in most states of the world, where our baseline is for low and anchored interest rates, and in that environment, you pick up the extra yield. In a more constructive environment, I think yields rise and those spreads will come in a little bit, so that you'll do well there as well.

And then if we pivot to a more negative environment where the RBA cut to a quarter and are forced to start some sort of balance sheet expansion or quantitative easing programme, state government bonds will likely be included in that and spreads will do well. So that's another sector, quite defensive, that we like in this environment.

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