"Rising rates don't keep me up at night": PIMCO's Bowe
To say it has been a challenging period for bonds would be an understatement. In fact, the first quarter of this year saw the worst start to a calendar year in history for bond returns. As they say in the classics however, it is always darkest before the dawn and seasoned investors know that with volatility comes opportunity.
Before we talk about the opportunities, it's worth revisiting what caused the volatility. Broadly, it has been the unwinding of the unprecedented, post-GFC monetary policy experiment that the world embarked upon. More specifically, it was the US Federal Reserve’s pivot in January when the central bank finally acknowledged that the inflation genie was well and truly out of the bottle, and likely to be more ‘persistent’ than ‘transitory’.
After acknowledging that supply and demand imbalances were likely to go on longer than expected, the Fed went on to say that it must be "humble and nimble". That was code for hiking rates much faster than everyone previously expected.
Fast forward to today and we have so far seen four rate hikes, for a total of 225 basis points in the US, as well as five rate hikes in Australia, for a total of 225 basis points. The moves have been swift, but not as swift as the moves we saw in bond markets.
I recently sat down with Adam Bowe, Executive Vice President and Portfolio Manager at PIMCO, who acknowledged that the moves have been the swiftest he has seen in his storied career.
“I've been doing this for a bit more than 20 years, but that was probably the swiftest move in interest rates that I've seen. We've seen on the way down during the GFC and during COVID, interest rates plummeted very quickly, but this has certainly been the swiftest move up in yields that I've experienced," says Bowe.
"So, it has been swift and it has been challenging to navigate, and it's been challenging to navigate in terms of multi-asset portfolios too, because you had most parts of your portfolio declining at the same time, whether you were in bonds, equities or most other assets."
Whilst things have changed quickly, Bowe believes that the reset in interest rates has been healthy and that there is now a greater risk that investors need to be aware of, and that is recession risk.
“Broadly I think it's been a healthy reset. From here, to be really anxious about a continuation of that swift move, you really have to think that inflation expectations ratchet higher. We've got to acknowledge we've got high levels of inflation right now, up in the high single digits for a lot of parts of the developed world. For that not to come down, you either need recurring supply shocks on food and oil or new supply chain issues. Absent those things, in an environment where restrictive monetary policy is cooling demand, then inflation starts to come lower as we crest in the back half of this year into next year. It'll take a while to get back to central banks' targets, but it should crest and start to move lower. So, it has been a swift move, the swiftest one I've seen, but they're the reasons why we're confident that most of that move is behind us," says Bowe.
In saying that, Bowe notes that for each interest rate hike from central banks around the world, whilst the risk of runaway inflation is reduced, the risk of recession goes up.
“I think with every 50 basis point, 75 basis point, 100 basis point hike from central banks around the world up to levels that are now getting restrictive, I think the risk that inflation is a concern next year goes down and the risk of the recession next year goes up."
Better than a 50% chance of a recession
Bowe rates the chances of a recession in various parts of the developed world as at least 50%, noting that “We're going from an environment of very easy policy to very restrictive policy in a space of a short period. I think you can look at this in a lot of different ways and in a lot of different sectors. But when you look at Australia, with the market expecting policy rates up above 3.5%, our analysis suggests that's going to be as tight as households have experienced for a long time in Australia.
What that means for mortgage rates, given the extent of leverage that households have taken on since the last time rates were 3.5-4%, is that it's going to be really restrictive. So, when we look at what that's done to financial conditions - not just interest rates, but currencies and asset prices, cost of commodities - all of this is really restrictive on households and corporates.
"We'd be putting at least a 50% chance that as we navigate 2023, we find ourselves in recessions in different parts of the developed world," says Bowe.
All is not lost for investors
As mentioned above, the sharp move in rates has created opportunities and, rather than being worried, Bowe believes now is the right time to be putting capital to work and taking advantage of the opportunities on offer – provided the focus is on quality.
“The main thing, I think, is not reaching out the risk spectrum. You don't have to reach for yield. You don't have to take the risk you used to have to take to generate the same sort of yields and returns”, says Bowe.
He goes on to highlight quality as one of the main factors to consider in the current environment of elevated inflation and restrictive policy, which could see growth slow materially into 2023.
“Focus on quality in your portfolio, and being higher up in the capital structure, making sure the assets that you do own are going to be resilient in that environment next year where recession risks are elevated.”
As part of the Income Series, we are showing all contributors the chart of the Aussie 10-year bond yield since 1993, highlighting the sharp move we have seen since the start of the year. Bowe notes that three things jump out when looking at this chart, which helps illustrate his outlook for bonds.
- “It's been a really challenging period for bond returns. So, when you look at that chart, what's driven it is that rise in interest rates. For investors, it's important when you're looking at bond returns and you're seeing the negative numbers, it hasn't been a permanent capital impairment by credit risk or credit defaults, it's been this normalisation of interest rates. I say normalisation because you've got a great long-term chart there. We're not at abnormally high levels of interest rates. It has been a normalisation"
- “The second thing that jumps out is the wealth of income opportunities that we now have available to us, now that interest rates are normalised. We've come through a period where every question I was asked is, ‘Where can we source income from?’ And now we've had this normalisation, we have this wealth of opportunities. Investors no longer have to reach for yield into risky parts of the financial markets, whether it's really long-dated infrastructure assets, or if it's really risky lending into construction or just high dividend stocks instead of the corporate bonds from the same company that are further up the capital structure and giving you similar types of yield levels now.
- “We're back to yield levels that bonds can provide that diversification benefit now as well. When you're sitting down at below 1% on a 10-year yield, it's much more challenging for bonds to provide that diversification anchor when the risky parts of your portfolio underperform. From these levels, you've got that diversification anchor again, I think, going forward.
The PIMCO process
In building a high-quality, robust bond portfolio for clients, there is a key element of focus for the PIMCO team, and that is the neutral level of interest rates.
“That's our long-term anchor. Interest rates are like rubber bands. They stretch above and below neutral. So, as long as you have a reasonable handle on where that neutral level is, you have a longer-term anchor from which we can deviate in terms of interest rate moves. That's the critically important part of our process, where is that longer-term anchor?”
According to Bowe, the most important question being debated in the PIMCO war room is where that anchor is, given how tight conditions are, as previously discussed.
“We think we need to be above it, but how far above it do we need to be, and are we there yet? Because that's really important. That's the really important point that we're debating. We think that we're close to being there in a lot of the developed world in terms of what is now priced into bond markets. We can look at this in a lot of different ways, focusing on the vulnerable balance sheets, the most levered vulnerable balance sheets, and seeing just how restrictive this policy is going to be for them. In Australia that's households. We've got one of the most levered households on the planet, so when we look at Australia, we say, okay, well, what does a 3.5% cash rate mean for Australian households? Is that restrictive or not?”
What keeps Bowe up at night is, interestingly, not interest rates. Rather, it is the risk of defaults. And once again, it highlights the importance of only investing in high-quality opportunities.
“What keeps me up as a bond investor is defaults. That's where I get a permanent loss of capital. It's not because I lost money temporarily with interest rates. That's what keeps me up. As I said, in an environment where we think growth slows materially next year, that's what we're really focused on.
"We think the majority of the interest rate move is done. It could go up a little bit higher, but what will rob me of sleep moving forward is that lower growth environment next year, and making sure we're invested in bonds that are very resilient to materially slowing growth”, says Bowe.
Finally, Bowe ties it all together, summarising PIMCO’s investment thesis given the current conditions and outlook, and what he and his team are doing about it.
“So, at much higher levels of interest rates in a world where we think growth is slowing pretty materially, we have been incrementally adding some interest rate risk and duration. On the corporate side, it's trying to go up in quality and higher in the capital structure, so that when we go into that world where growth is materially lower, the bonds we own, the cash flows that we're earning are very resilient to states of the world where growth is a lot slower. Things that we like and have been buying are things like senior global financials. Heavily regulated entities, with balance sheets much stronger compared to where they were 10 years ago. They're much lower leveraged, with much more capital, and so major banks around the world when we go into next year should be much more resilient, relative to other parts of the corporate market.”
"The interest rates you can get now are really exciting", says Bowe
Senior bonds from global financial names that you would know around the world that are around the five-year maturity mark, you can sometimes get up above 6%. For a senior bank, that's probably considerably higher than their dividend yield, and you're up the capital structure in a very resilient entity in a world where growth is slowing.
So, things like global financials have become really attractive. Where we're trying to avoid is pockets of the credit market where we have highly levered, highly cyclical entities that probably have a shorter liquidity runway into next year. So, if they're higher levered in industries that are much more cyclical with balance sheets that have much less liquidity, then that's areas of the market that we're trying to avoid. So, just going up that capital structure, up in terms of quality, avoiding those highly levered, highly cyclical parts of global corporate markets, and adding a little bit more interest rate risk and duration to portfolios is how the mix has changed in the last six months.
“Ultimately, you can be much higher up the quality spectrum and take much less risk to achieve the same level of income that you did 12 months ago," says Bowe.
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