Why PIMCO’s Adam Bowe suspects inflation is a transitory fad
Throughout our discussions with the managers of Australia’s top-rated funds, it’s become evident that their views around the biggest tail risk for markets have evolved. Out with COVID-19; in with inflation.
After all, U.S. consumer prices are soaring at the fastest pace since 2008, and news websites are littered with headlines about wage increases, booming asset prices, and costlier inputs. As scary as all that sounds, Adam Bowe of PIMCO prefers to take a more balanced approach.
“We're characterising it internally as a head fake. Some of it is just optical. If you look at year-over-year inflation numbers and you drop off the really negative ones, then the year-over-year numbers go up quite significantly.”
PIMCO believes that rates would be a lot higher if the global economy was experiencing euphoric conditions. Instead, Bowe says central banks are only likely to lift real interest rates from negative to somewhere around zero in the next cycle of rate hikes. While inflation could be a serious risk in the long-term, he’s of the view that the status quo – generating returns in a low-rate environment – remains for investors.
In this interview, Bowe expands on his views around the inflation argument and discusses opportunities in bond markets.
James Marlay: Hello and welcome to Livewire's 100 Top-Rated Fund series. My name is James Marlay, and we are talking bonds with Adam Bowe from PIMCO. Adam, great to have you here. Before we get into the discussion about markets and investing, I'd love to know a little bit about what motivates you personally. What gets you up in the morning?
Adam Bowe: I think for me, it's a combination of intellectual curiosity and the competitive nature of the role. Every day is motivated by having to process new information, having to re-optimise your portfolio, re-test your theses. I think to be successful over a long period of time it requires a love of career-long learning, which I really enjoy.
A combination of those two things, I think, is why I've probably stayed at a place like PIMCO for half my career now. It's a firm that has a really strong performance culture, so certainly ticks the box in terms of that competitive motivation for myself. It also leverages the intellectual capital of some of the smartest people in global finance and public policy, whether it's on our external global advisory board, some of our consultants, or just the very intelligent and talented global colleagues I interact with on a daily basis. So certainly ticks that intellectual curiosity role for me as well.
Inflation: A passing fad or here to stay?
James Marlay: Well, take us inside the room at PIMCO. What's the topic that you and your colleagues are spending the most time debating and trying to understand at the moment?
Adam Bowe: That's a good question. There's a couple, but I think a really important one that hasn't got as much attention it's getting now, over recent times, is the inflation outlook. I think our general view is we'll see some really high near term numbers as some of the base effects from last year's negative numbers roll off and recent higher energy prices.
And then we think it will be falling back and probably below central bank targets for a bit, and then sort of settle around central bank targets. But I think casting the net over a few years, it's the first time in a long time there are genuine two-way risks around that view. I'm not talking about in the next couple of years but beyond that.
The reason I say this, there are a few things that have changed in terms of long-term drivers of inflation. And I think it's dangerous. If we come out of this pandemic and people pull out the old secular stagnation thesis and dust it off and conclude that there are no inflation pressures, I think things have changed.
One important thing is that central banks have changed their frameworks for targeting inflation. If you take the Fed as a case in point, they're targeting average inflation outcomes now, so that means after a period of missing on the downside like now, they're shooting for a period of missing on the upside. That's a big change. You just looked locally here at the RBA, they've changed their framework as well. They said they're not lifting rates until they are sustainably within the target. That means they're going to be slow to remove accommodations. So that's a big change.
The other big change is fiscal, fiscal is very supportive at the same time. And more recently, due to the pandemic, but also global trade tension, when we look at our bottom-up credit research, there's a definite trend to simplifying and localising manufacturing and production.
So if you cast your mind back the last couple of decades, if globalisation of that has been a dampening pressure on inflation, then any move in the opposite direction has to work in the other direction. Like I said, we don't think it's a risk for the next couple of years, but for the first time in a long time, there are genuine two-way risks around longer-term inflation risk I think.
Positioning for either eventuality
James Marlay: So how is that flowing through to portfolios and how you're adjusting the way you're investing?
Adam Bowe: I think it's really important. I think the volatility over the last month has been in large part due to reactions to changing inflation expectations and those rising. It's important for bond portfolios, but it's important for multi-asset portfolios as well. When I have a look at ways that are influencing the way we're managing money and considerations that multi-asset managers should be making, there's plenty of attractive hedges for long-term inflation risk now. So they're the sorts of things we're debating.
Just looking at the bond space where we operate, inflation-linked bonds in most parts of the developed world have inflation expectations priced a little below central bank targets, or close to central bank targets. So that's a pretty reasonable price to pay for longer-term inflation risk. And then, for multi-asset managers, combining that with, whether it's allocations to some real assets or commodity prices that typically do well in inflation episodes as well. So there's plenty of debate.
As I said, I'd like to emphasise, certainly not worried about inflation for the next couple of years. And the expectation is for the near-term interest rates to be pretty rangebound. But as long-term investors, it's certainly something we're already casting our mind to.
James Marlay: So the current inflationary pulse that people are feeling, that we're sensing as you and I talk, you're expecting that to dampen and roll off a little?
Adam Bowe: That's right. I'm more talking about the long-term. This one we're passing through at the moment; we're characterising it internally as a head fake. So some of it's just optical. If you look at year-over-year inflation numbers and you drop off the really negative ones then the year-over-year numbers go up quite significantly. Then we've had energy prices go up a little bit, there are some supply tensions, whether that's COVID related, whether it's a Suez Canal related, so that's all feeding through, but they're all temporary. So by the end of 2021 and even 2022, inflation's probably going to be at or a little below central bank targets.
Interest rates would be higher in euphoric markets
James Marlay: If we're to simplify the framework for thinking about where we might be in a market cycle and think about four parts of that cycle, being pessimism, scepticism, optimism, and euphoria, where would you say we are at the moment?
Adam Bowe: I think optimism. I put us in the optimistic camp. I think if you look back at last year was sort of cast away, the pessimism and scepticism of last year. A really good way of looking at that is just having a look at the inflation-linked market in bonds last year; the market was pricing central banks around the world to miss their inflation targets forever, to not even come close. It's very pessimistic and hugely sceptical that they'll ever be able to achieve it. Now, as I said, they're roughly close to targets now.
So certainly not euphoric in that market, but more optimistic that as we traverse through the second half of this year where I think the market is more pricing in an optimistic path to a post-pandemic world now. I certainly don't think we've hit the point of euphoria. I think interest rates will be a lot higher if that was the case. Inflation expectations would be higher.
Perhaps when we can travel in our state and overseas again and reconnect with friends and family and eat at restaurants like this without QR codes stuck to the menu, perhaps we'll get there. But I think at the moment, optimism would be a reasonable characterisation of financial markets.
Why cash is not King
James Marlay: You talked earlier about the benefit of being able to think long-term. What's a long-term trend or thematic that you think is really important for investors to get right from this point?
Adam Bowe: From my perspective risk-free real returns are dead. Gone are the days when people could sit and risk-free, or close to risk-free assets like cash and term deposits, and generate some sort of real return, so a return on top of whatever the inflation rate is. At the moment that's deeply negative. Even when central banks, I think, go through the next cycle of lifting interest rates, it'll get back to somewhere around zero.
So if you're an investor sitting there and you require a real return, a real income stream, you have to start to think to yourself, what risks am I happy to assume? Because if you sit in riskless term deposits and cash, then the chances are - the probability is that over time - your capital after inflation is going to go backwards. So you have to ask yourself about that and it's going to be a different answer to it for each individual investor.
Do you take some term or maturity risk? Are you happy with credit risk? Are you happy to put more equity risk into your portfolio? So I think the answer is different for everyone, but if you're not asking that question, and it depends on the initial conditions of your portfolio, then I think you're taking a real risk looking forward from here.
One risk that I think is underappreciated and one risk premium is illiquidity risk. When you look at Australian investors, they're typically happy to take some illiquidity risk. A lot of people have an investment property that's not a particularly liquid investment product. But then when it comes to vehicles where liquidity is locked up for a couple of years, there's a lot of hesitancy with that. And as a result, I think there's a lot of opportunity in that space. So for investors who need to take some risk to meet their real income targets or real return targets, having a look at the broader opportunity set, particularly within global credit markets, then have some liquidity premium attached to them are going to be very attractive, I think.
Bowe's biggest tip: Think globally
James Marlay: If you were to distill your investing experience down into a single piece of advice that could just help people be more successful, what would you say?
Adam Bowe: The world is a big place, so cast your net widely and broadly. When you have a look at investors' portfolios, there's a very large degree in Australia of home bias in portfolios. I think that's going to hurt over the long term from here, particularly when you look at that home bias and what it's exposed to.
A typical portfolio that we might see on the retail or wholesale side would be a portfolio of cash, term deposits, a couple of hybrids, some blue-chip high dividend-paying funds, and probably an investment property. That's a really typical portfolio. At face value, you look at that and you say, "That's pretty well diversified. You've got some property equities. You got bond-like instruments in there." When you really take a look at that, that's a hugely concentrated bet on the Aussie housing market. It's either directly through the property, or indirectly through the banks, that fund them.
Having that home bias is a really concentrated bet on an asset class, you have to ask yourself, "Am I that highly convinced that the prospective returns from that are that attractive that I should be looking elsewhere and diversifying that?". I think it's a real opportunity in Australia.
The one piece of advice I would give would be the world's a big place, diversify that home bias risk. Portfolios can be attractive that construct really attractive income streams and risk-return objectives without having that massively concentrated home bias bet.
James Marlay: Adam, great to sit down and chat. It's been awesome to have someone with that bond market experience here with us today and appreciate you being part of Livewire's 100 Top-Rated Fund Series.
Adam Bowe: Thanks for having me.
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