Andrews Balls

The reset in global bond yields in the early 2020s established a foundation for the return fixed income investors can earn just from being exposed to the broader market. Starting yields – historically highly correlated with five-year forward returns – are now at levels that simply weren’t available for most of the prior decade. This means investors can once again look to bonds as a potential return-generating asset class, not only as a defensive allocation.

But yield is only the starting point. The central question for investors today is what that yield exposure should look like. Increasingly, the answer may point to a global bond allocation across both developed (DM) and emerging markets (EM).

As geopolitical fragmentation reshapes trade, policy, and capital flows, dispersion across countries and markets is widening, meaning outcomes for growth, inflation, and interest rates are diverging more across regions (for more, see our latest Secular Outlook, “Rupture and Resilience”^[1]). Divergent economic paths are producing greater variation across countries, currencies, and credit markets – in effect, expanding the opportunity set for active managers to pursue returns beyond what that broader market can offer.

The result is a rare alignment: a strong, global starting yield foundation to support broader market returns (beta^[2]) paired with opportunistic conditions for returns driven by active investment decisions (alpha^[3]).

Why global beta is attractive beta

A fixed income allocation built solely from the traditional building blocks of certain DM bonds – investment grade credit, high yield, securitized assets – can constrain return potential by limiting the opportunity set.

A genuinely global allocation works differently. By investing across DM and EM, investors can often benefit from today’s more attractive starting yield levels in a variety of markets (see Figure 1). Incorporating sovereign debt and local rates across DM and EM may help expand return potential, improve resilience across macro environments, and support performance potential relative to risk.

The reason is embedded diversification. Bonds across DM and EM local markets generally respond to different drivers – distinct rate cycles, divergent fiscal trajectories, differentiated currency dynamics. Owning that breadth itself is a potential source of return, because it has the ability to harvest risk premia that a narrower allocation structurally cannot access, while also helping support risk mitigation.

Today, for example, we believe EM economies warrant renewed attention. EM balance sheets have been relatively conservative and look strong from a fiscal standpoint. EM inflation, even excluding China, is now lower than U.S. inflation for the first time in recorded history – a reflection of hawkish, credible central banks that hiked rates aggressively and are cutting slowly. Real (inflation-adjusted) yields remain elevated relative to DM, which has created a persistent valuation advantage.

Portfolios that exclude EM local exposure are forgoing a significant share of the global fixed income opportunity at a time when its diversification properties appear most attractive.

A macro lens: AI, energy, and structural dispersion

The case for global bond allocations rests largely on diversification. What we see changing today – and strengthening that case – is the rise in structural dispersion across countries and markets amid persistent differences in growth, inflation, and capital flows.

The global economy is being reorganized today along two powerful structural vectors: a headwind from reconfigured energy markets and a tailwind from AI-driven investment. Crucially, these forces are asymmetric, creating winners and losers across both DM and EM.

In DM, the U.S. has benefited from AI exposure and relative energy independence, while Europe, the U.K., and Japan face the opposite combination (see Figure 2). Across EM, the dispersion is equally sharp: Korea and Taiwan sit in the AI-beneficiary quadrant despite energy vulnerability; Brazil and the Gulf states have benefited from commodity exposure; others face headwinds in both dimensions.

In this environment, a global allocation can pursue superior outcomes. When every market faces the same forces and effects, there is less to differentiate. When those forces are asymmetric, as they are today, the breadth of available opportunities can be a primary performance driver.

From beta to alpha: active management in a divergent world

These same forces are widening the gap between active and passive outcomes. Divergent monetary policy paths, fiscal dynamics, and structural exposures to AI and energy are expanding the range of outcomes across rates, credit, and currencies, creating inefficiencies that skilled managers can look to exploit.

Rate-cycle divergence across DM and EM, structural shifts in terms of trade between energy importers and exporters, and the uneven impact of AI-driven capital spending are all creating pricing gaps that a domestic or regional allocation cannot access. Managers with the flexibility to allocate globally – positioning across rate cycles, and expressing relative value across yield curves and currencies – can pursue compounded excess returns over a full cycle.

Alpha generation in this environment entails identifying durable inefficiencies, such as the yield premium in EM economies where hawkish central banks have moved ahead of the Fed, or mispriced credit in sectors being reshaped by AI capital spending. It also means building portfolios for resilience, with an explicit focus on downside risk and low correlations, and letting valuation guide decisions across sectors, regions, and asset types.

In a more fragmented and uncertain world, static index exposures appear less equipped to navigate divergence, while active strategies can allocate dynamically across countries, sectors, and instruments. This is less about short-term positioning and more about secular opportunity. In an environment of persistent dispersion, earning a premium for complexity, maintaining discipline as spreads evolve, and preserving liquidity for future opportunities can lay the foundation for durable excess return.

By Andrew Balls, CIO for Global Fixed Income & Pramol Dhawan, Head of Emerging Markets Portfolio Management

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Notes:
[1] https://www.pimco.com/us/en/insights/rupture-and-resilience
[2] Beta is a measure of price sensitivity to market movements. Market beta is 1.
[3] Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. 

The post Global dond diversification: Higher yields and new opportunities for aAlpha appeared first on AdviserVoice.

What is the secular outlook for the coming year and what role do bonds play as an anchor in investor portfolios?

In our 2024 Secular Outlook, “Yield Advantage^[1],” we argued that central banks had largely tamed inflation and would soon start cutting interest rates. We said risks were shifting from growth and inflation to elevated risk asset valuations. We warned that the U.S. debt was on an unsustainable path. We highlighted that the post-pandemic inflation shock and rate-hiking cycle had produced a generational reset higher in bond yields – from the historical lows of the 2010s to levels that supported a strong multiyear outlook for global fixed income.

At the risk of understatement, a lot has happened in the ensuing 12 months:

• Trump 2.0: An unprecedented agenda to redirect U.S. fiscal, regulatory, immigration, national security, and trade policies.
• DM central banks began easing cycles, but themes of a global soft landing, U.S. exceptionalism, and disinflation are faltering in the face of a burgeoning trade war.
• Elections triggered an unforeseen fiscal and defence policy U-turn in Germany.

In short, the traditional world order – in which economics shaped politics – has been turned on its head. Politics is now driving economics, especially in the U.S. and increasingly in how other countries respond.

The fragmentation of trade and security alliances will likely become an independent driver of winners and losers, business cycles, and market volatility. Moreover, industries favored by national policies are now in play based on changing administrations and regional priorities – evident in the U.S. pivot toward legacy fossil fuels and autos and Europe’s renewed focus on defense.

Our Secular Forum guest speakers this year included Robert Lighthizer, former U.S. trade representative during the first Trump administration; Roberto Campos Neto, former president of the Central Bank of Brazil; and Daron Acemoglu, MIT economics professor and Nobel laureate (see the full list of guest speakers and Global Advisory Board members here^[2]).

Navigating trade wars and the future of the U.S. dollar

While legal challenges to U.S. tariffs, if successful, could ratchet down the developing trade war, we believe elevated trade-related conflict will persist. Uncertainty about the endgame for trade policy and global security alliances has increased downside risks to global growth.

Absent sustained retaliation against the U.S., the trade war mostly lowers export demand – a disinflationary impact – for much of the world. The reallocation of China’s trade surplus to the rest of the world is a clear source of disinflationary risk. In contrast, U.S. inflation risks have risen, at least in the short term, as has the likelihood of monetary policy divergence between the U.S. and other countries.

Despite the recent decline in the U.S. dollar, we believe it would be almost impossible for the dollar to lose its dominant global reserve currency status over our secular horizon, in part due to the lack of viable challengers in markets for foreign exchange, foreign currency debt, and bank lending. The U.S. Treasury still professes to want a strong dollar, and the U.S. administration appears to be backing off from the idea of a Mar-a-Lago accord aiming to weaken the dollar.

We believe it would be almost impossible for the dollar to lose its dominant global reserve currency status over our secular horizon

But dollar bear markets are possible, over both the short and long term, reflecting historical multiyear dollar cycles. Changing policy and security priorities may alter relative global demand for U.S. and other assets – especially as overseas investors reassess their tolerance for unhedged dollar exposure.

We expect the dollar to continue to lose market share in cross-border payments as regional currency arrangements (e.g., the “mBridge” payments platform developed by China) broaden and deepen in a more fragmented world. A gradual shift away from the U.S. dollar could continue as global portfolios rebalance at the margin to more diversified allocations in risk assets.

Debt looms large

Although it is near record highs, debt remains sustainable in most developed countries. Notable exceptions include Japan, the U.S., and France, where debt is on an unsustainable long-term trajectory, even more so than last year (see Figure 1). Deficits will likely stay above pre-pandemic levels, partly due to rising interest costs.

Figure 1: Debt appears sustainable in most countries – with exceptions
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Source: PIMCO calculations, Bloomberg, and the International Monetary Fund World Economic Outlook. Note: The chart shows simple debt-to-GDP projections across G10 countries (plus Australia, New Zealand, Spain, Belgium). The projection assumes that the primary balance evolves as in the IMF projection (until 2029, after which it stays static), inflation is at target, real GDP growth at trend, and interest rates evolve along the forwards priced into financial markets as of 6 May 2025 (until 2029, after which they stay static), assuming weighted average maturity of 7 years across countries for simplicity. We adjust the IMF’s forecast for the U.S. to include the 2017 Trump tax cut extension.

However, these issues appear chronic rather than acute. We do not foresee a sudden fiscal crisis but instead expect episodic market volatility – as seen in the U.S. in 2023 and 2025, and more sharply in the U.K. in 2022. In our baseline, U.S. Treasuries remain the cleanest dirty shirt in the sovereign closet over our secular timeline, underpinned by the dollar’s reserve currency status.

Fiscal policy in the U.S., Germany, and some advanced economies may be less restrictive than we forecasted a year ago. The Trump 2.0 fiscal package is likely to widen U.S. deficits and debt beyond prior policy projections. Yet overall fiscal space remains constrained, limiting room to respond to future downturns. That said, central banks have much more space to cut rates than in the decade before the pandemic.

Despite any short-term bump from tariffs, we expect inflation to return to Fed target levels over the secular horizon. We expect the Fed to cut rates to around neutral – roughly 3% – and well below neutral in the event of a recession, including to zero if necessary.

The historical likelihood of a recession in the U.S. over any five-year period is about two-thirds, but the probability appears higher over the next five years given the current backdrop.

Shifting global economic and inflation outlooks

Outside of the U.S., major DM economies face distinct growth challenges, while EM countries are bolstered by prudent debt management but also influenced by global trade shifts and DM policies.

Europe

Eurozone growth may decelerate from around 1% pre-pandemic to about 0.5% over the next five years, weighed down by weaker demographics and slower productivity growth. The region lags in the global tech race, faces stiff competition from China, and struggles with high energy costs amid a less favorable trade environment. Germany’s shift to higher defense and infrastructure spending is significant but unlikely to be matched elsewhere.

Inflation is unlikely to return to the pre-pandemic 1% norm, due to deglobalization and higher inflation expectations, but will likely settle below the European Central Bank’s 2% target. Equilibrium interest rates will likely stay low and below the current nominal level of about 2%.

China

China’s economy is shifting to a lower growth path amid rising debt and worsening demographics. Old growth drivers – property and infrastructure spending – are giving way to policies boosting consumption, manufacturing, and technology, signaling a deliberate pivot from debt-fueled booms to sustainable, innovation-led growth.

Yet deflationary pressures and structural constraints suggest growth will remain on a slower trajectory. China remains a global manufacturing hub, but trade and geopolitical tensions cast doubt on exports as a reliable growth engine.

Emerging markets

The question of whether new risks emanating from the U.S. automatically translate into higher risk premia for the rest of the world underscores how tight the historical link between DM policy rates and EM borrowing costs can be. While the risks are clear, encouragingly, many emerging economies have maintained manageable debt levels, positioning them to weather potential headwinds.

The rise of digital currencies – including stablecoin issuers that hold increasingly large portfolios of U.S. Treasuries – highlights how quickly capital flows can evolve. As this ecosystem matures, it could reshape EM capital flows and currency management.

Potential disruptions to the base case

We are alert to potential disruptions that – while low-probability events, in our view – could fundamentally shake up our baseline secular outlook. Among them:

• Accelerated AI-related disruption. AI advances could occur more quickly than expected and show up as faster growth in GDP and productivity data. Our base case remains that the full impact of new AI large language models manifests more gradually.
• A loss of Fed credibility – stemming from a Supreme Court ruling or a chair unwilling to uphold price stability – is unlikely but would be severe, likely sparking a surge in inflation expectations and bond yields, a sharp dollar decline, and a broad sell-off in risk assets.
• U.S exceptionalism 2.0. The narrative of U.S. economic and financial outperformance relative to the rest of the world has faded this year. Yet the U.S. entered 2025 with strong productivity, tech leadership, and deep capital markets fueling consistent profit growth. With GDP growth outpacing peers by at least a percentage point, these advantages can endure. If trade and fiscal uncertainties ease, U.S. exceptionalism could reemerge.

Investment implications: Fixed income for a fragmented era

In fixed income, investors are paid to build resilient portfolios. We continue to advocate seizing the yield advantage in high quality bonds rather than chasing equities at elevated valuations.

The equity risk premium – the difference between equity yields and bond yields – is likely the main ingredient in asset allocation as it gauges the relative value between stocks and bonds. The most straightforward way to compute the premium is to subtract the real (inflation-adjusted) bond yield from the cyclically adjusted earnings yield. The Figure 2 chart shows the U.S. equity risk premium stands at zero and is exceptionally low by historical standards.

Figure 2: Equities appear expensive on an absolute basis and relative to U.S. Treasuries
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Source: Bloomberg, Robert Shiller online data, Global Financial Data, and PIMCO as of 31 May 2025. All value metrics are relative to the S&P 500 Index. The real equity yield ratio refers to the average real earnings over the past 10 years divided by the last price. The 30-year real bond yield corresponds to the yield on 30-year U.S. Treasury Inflation-Protected Securities (TIPS), backfilled with the nominal yield on 30-year U.S. Treasuries minus expected inflation. To compute inflation expectations, we estimate trend inflation according to Cieslak and Povala (2015) calibration and forecast inflation 30 years ahead.

A mean reversion to a higher equity risk premium typically involves a bond rally, an equity sell-off, or both. The same chart shows two prior times when the premium was zero or negative: in 1987 and in 1996–2001. Following the zero equity risk premium in September 1987, the stock market declined by almost 25%, while 30-year real bond yields fell by 80 basis points (bps). In December 1999, the equity risk premium reached its minimum level during the chart period, preceding an equity drawdown of almost 40% that ended in February 2003. In that same time, 30-year real bond yields fell by about 200 bps.

In addition, corporate profits relative to GDP are near historic highs. Rising tariffs and geopolitical tensions could all weigh on future profits.

Yield advantage remains compelling

Valuations point to a lower probability of equity outperformance over fixed income in part because the outlook for high quality fixed income is as good as it has been in a long time. After steep post-pandemic rate hikes, bond markets have made it to the other side: Investors can now benefit from higher yields plus potential price appreciation given central banks have ample room to cut rates.

Forecasting fixed income returns is relatively straightforward: Over a secular horizon, the starting yield on a bond portfolio can be a good guide to expected returns (see Figure 3). The yields on the Bloomberg U.S. Aggregate and the Global Aggregate (U.S.-dollar-hedged) Indexes, two common benchmarks for high quality bonds, are about 4.74% and 4.94%, respectively, as of 5 June 2025.

Figure 3: Strong link between starting bond yields and five-year forward returns
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Source: Bloomberg and PIMCO as of 30 May 2025. Past performance is not a guarantee or a reliable indicator of future performance. Chart is provided for illustrative purposes only and is not indicative of the past or future performance of any PIMCO product. Yield and return are for the Bloomberg U.S. Aggregate Bond Index. It is not possible to invest directly in an unmanaged index.

From there, active managers can seek to construct portfolios yielding about 5%–7% by capitalising on attractive yields available in high grade investments. We anticipate maintaining an up-in-quality bias.

Harnessing global opportunities through active strategies

Powerful secular forces – local currency adoption, disciplined fiscal policies, and diversified funding – are converging to create durable opportunities. Active management, with the agility to exploit country-specific nuances and relative value differences, is crucial to navigating inevitable volatility.

The opportunity to generate alpha – returns exceeding market benchmarks – is as rich as it has ever been across global markets (see Figure 4).

Figure 4: Global bond markets offer attractive and diverse opportunities
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Source: Bloomberg and PIMCO as of 30 May 2025. For illustrative purposes only. Yield to maturity (YTM) is the estimated total return of a bond if held to maturity. YTM accounts for the present value of a bond’s future coupon payments. The index proxies are the following: U.S.: U.S. Generic 10Y Government Bond Index; Germany: German Generic 10Y Government Bond Index; U.K.: U.K. Generic 10Y Government Bond Index; Canada: Canadian Generic 10Y Government Bond Index; Australia: Australian Generic 10Y Government Bond Index; Japan: Japanese Generic 10Y Government Bond Index; Brazil: Brazilian Generic 10Y Government Bond Index; Mexico: Mexican Generic 10Y Government Bond Index; Indonesia: Indonesian Generic 10Y Government Bond Index; South Africa: South Africa Generic 10Y Government Bond Index.

Many DM economies offer a combination of attractive bond yields and a challenged economic outlook, which can benefit bond investors. In addition, we see EM countries building upon their demonstrated resilience. Historically, global diversification has offered superior volatility-adjusted returns to single country portfolios. We believe that diversification is the one free lunch available to asset allocators.

The importance of duration and curve positioning

Given attractive starting valuations in fixed income, along with expected weaker growth and stabilising inflation, we anticipate being biased to run more overweight duration positions in our portfolios than has been typical in recent years.

U.S. Treasuries have provided a hedging role for portfolios in every recession dating back to World War II, given the historical inverse correlation between stocks and bonds. High quality global bond markets have provided similar properties.

A core PIMCO thesis remains that yield curves will re-steepen over our secular horizon, as investors continue to demand more compensation to hold longer-term bonds relative to cash and short-term bills. Estimates of the Treasury term premium are positive and up substantially since the decade before the pandemic. There is potential for further steepening given the budget debate in the U.S.

A core PIMCO thesis remains that yield curves will re-steepen over our secular horizon

Active management can enhance bonds’ role as a hedge through yield curve positioning. We anticipate maintaining a bias to be overweight in the 5- to 10-year part of global yield curves and to be underweight in the long end over time. That said, given rising long end real yields, we also see a limit to how much further the rise in term premia has to run.

Indeed, in the event of a sharp rise in longer-dated yields, we would anticipate significant damage to equity and credit markets – and, in turn, the foundations for a downward correction in real yields. We also expect central banks will step in and use their balance sheets if any market moves threaten broad financial market disruption.

Resilient opportunities beyond corporate credit

Credit markets offer abundant opportunities but also specific risks, demanding careful sector and asset selection and a value-driven investment approach.

The period since the global financial crisis (GFC) has been exceptional: a long expansion, fueled by massive government policy support in the wake of both the GFC and the pandemic, that rewarded aggressive lending. This contrasts sharply with the decades right before the GFC, which saw less support, greater volatility, and uneven returns in economically sensitive credit areas.

Credit spreads remain tight relative to historic averages, despite elevated secular recession potential, highlighting areas of complacency across public and private corporate credit markets. AI advances could stoke volatility, as leveraged loan and private direct lending markets feature large allocations to technology and other industries in the sights of AI disruptors. A correction in inflated U.S. equity valuations could also trigger broader risk asset repricing. Amid limited fiscal space, a genuine credit default cycle – unlike the recent “buy the dip” era – may unfold for the first time in years, catching many investors unprepared.

In a weaker growth environment, lower-quality, economically sensitive companies face risks. Elevated short-term interest rates could increasingly challenge midsize companies that borrow in floating-rate debt markets. We express caution in areas of corporate private credit where capital formation has outpaced investable opportunities, leading to potential disappointment. Stresses are becoming evident in private equity and private credit and could worsen sharply in a recession.

Some additional convergence between public and private markets appears likely over the secular horizon. However, there are meaningful barriers to stronger convergence, driven by liquidity, transparency, credit quality, and structural considerations. Active managers with broad, global capabilities spanning public and private markets can react to dislocations in value across different segments of public and private credit markets, while offering unbiased solutions that consider liquidity, true credit quality, and relative valuations to best serve investors.

Stricter bank capital and liquidity rules will likely continue to push many lending activities in the U.S. to the private credit market, especially asset-based finance. This opens opportunities for investors to act as senior lenders in areas once dominated by regional banks. We continue to see attractive opportunities in high quality areas including consumer, residential mortgage, real estate, and hard assets, where starting conditions and valuations appear favourable relative to corporate credit.

About our forums

PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioral science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights.

At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues.

At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analysing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.

By Richard Clarida, Global Economic Advisor, Andrew Balls, Chief Investment Officer, Global Fixed Income and Dan Ivascyn, Group Chief Investment Officer

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Notes:
[1] https://www.pimco.com/au/en/insights/yield-advantage
[2] https://www.pimco.com/au/en/insights/the-fragmentation-era#d28e90b3-a9d8-4441-ba01-830919070204

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. 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With stock valuations and volatility unusually elevated, and credit spreads tight, high quality fixed income can offer attractive yields, stability, and a robust longer-term outlook for patient investors.

At a time of sweeping geopolitical change and clear challenges for riskier assets, bond markets offer a source of stability.

Key takeaways

The world has entered a period of geopolitical uncertainty, with the U.S. now at the center of the storm. Here are our near-term economic views:

• Global uncertainty: The Trump administration has taken aggressive early measures to address trade deficits and shrink the size of government. It remains unclear whether the current policy volatility will evolve into a more stable U.S. strategy. As tariff barriers rise, global uncertainty is increasing, particularly for export-dependent economies.
• Threats to U.S. exceptionalism: With both business and consumer confidence declining, the U.S. economic and financial-market exceptionalism of recent years could be fading.
• National interests take new precedence: Protectionist U.S. policies, coupled with the prospect for government spending cuts, are stoking concerns about U.S. recession risks and a rekindling of inflation. In contrast, the prospect of increased fiscal spending is improving the outlooks for countries such as Germany and China. Major central banks will aim to continue easing policy to neutral levels.

This newfound U.S.-led uncertainty has fueled a sell-off in risk assets and a surge in volatility. Meanwhile, high quality bonds have flourished, delivering comparable total returns to equities over the past year while offering favorable valuations today. Here are our near-term investment views:

• Seek stable sources of return in turbulent times: Historically, starting bond yields closely correlate with five-year forward returns. Yields are attractive today, positioning bonds well in this environment. We believe it’s a good time to reduce concentrated positions in U.S. risk assets, particularly with valuations still elevated.
• Diversify across global markets: Global fixed income opportunities remain robust, offering strategies to further enhance diversification.
• Favor asset-based finance over corporate credit: We prefer asset-based finance relative to corporate credit across public and private markets.

Economic outlook: Global reordering

Pandemic disruptions are behind us. Labor markets have normalized. Although inflation in developed market (DM) economies may linger above post-financial-crisis averages, it’s broadly within reach of central bank targets. Monetary policy is gradually returning to more neutral levels.

The focus has turned to a new disruptor: U.S. policy. The Trump administration, elected on a platform of change, is pledging to pursue three interconnected goals that will reshape the U.S. and global economies:

• balancing the U.S. trade deficit (see Figure 1)
• reducing elevated fiscal deficits
• reversing the decades-long decline in the U.S. labor force’s share of income.

Correcting these imbalances would require structural changes, including curbing the share of GDP derived from consumption in the U.S., reducing the contribution to GDP from manufacturing and savings in trade surplus economies, and lowering the concentration of global excess savings flows entering U.S. capital markets.

Implementing these changes faces economic, political, and market constraints, both in the U.S. and abroad. Doing so over a six- to 12-month cyclical horizon would likely disrupt economies and markets, even if the result is eventually a more balanced global system.

We anticipated such disruption in our January 2025 Cyclical Outlook, “Uncertainty Is Certain.” Policy uncertainty is now unfolding daily and emanating mainly from the U.S., historically a source of global stability.

Threats to U.S. exceptionalism

This shift reflects an international role reversal, with the U.S. signaling a pullback from some traditional functions while other countries step in to fill the voids. Long-held assumptions about the U.S. as a reliable international leader are being challenged.

These changes may coincide with the twilight of the recent U.S. capital markets outperformance relative to the rest of the world. In Europe, the peace dividend – the economic benefits of reduced military spending after the end of the Cold War – looks to be over, with countries across the continent now set to increase their defense budgets.

In January, we said our baseline called for an economically manageable increase in tariffs – which, along with U.S. tax and spending policy, would leave federal fiscal deficits largely unchanged in 2025 and 2026.

However, we also said these pivots, depending on their scope, widened the range of possible growth outcomes in the U.S. and deepened economic risks elsewhere, especially for countries heavily reliant on global trade and that run surpluses with the U.S. We thought U.S. equity market volatility would be a limiting factor.

The Trump administration has since launched aggressive measures on trade, government containment, and immigration. These are likely to slow the U.S. economy more than previously expected and hurt the labor market, regardless of whether government spending cuts are codified into law.

Officials have argued that some near-term pain is acceptable in pursuit of longer-term goals, suggesting the tolerance for economic and market volatility is higher than previously thought. Eventually, higher prices, especially for food and energy, and lower equity values are likely to be a political constraint.

Rising risks to U.S. growth and inflation…

While the ultimate implementation remains uncertain, disruptive U.S. policy announcements have already damped U.S. consumer and business sentiment and will likely weigh on investment and hiring decisions (see Figure 2). Globally, if businesses face tariff-related risks that are close to impossible to calibrate, then the likely result is delayed decisions on investment and expansion. In other words, tariff uncertainty is proving to be a headwind to growth, even if tariffs fail to materialise.

We see a risk that U.S. growth and labor market momentum downshift more decisively. After U.S. real GDP grew 2.5% to 3% annually over the past few years, we expect a below-trend pace in 2025 and 2026.

The average effective tariff rate on U.S. imports has increased an estimated 7.5 percentage points from actions against Canada, Mexico, and China. We expect additional trade policy measures to raise that figure significantly throughout the year, as Europe and other southeast Asian countries could face U.S. tariffs.

Businesses are likely to pass on tariff costs, boosting inflation during the period of price adjustment and delaying the return to the Federal Reserve’s 2% target. More concerning for Fed officials, surveys of consumers and business suggest inflation expectations are moving higher.

In Congress, the focus is already on U.S. tax policy. Given the circuitous nature of the legislative process and the very narrow Republican majorities, especially in the House of Representatives, we do not expect to see a signed bill until summer, if not later. While we still expect trade, spending, and tax policies to have a neutral net effect on the U.S. fiscal impulse in 2025, a more significant near-term growth slowdown could tilt the scales toward larger, more stimulative tax cuts.

…While potential for fiscal stimulus and rate cuts helps the global outlook

Recent policy actions in other major economies appear to incrementally improve what were otherwise bleaker outlooks. Expectations for fiscal expansion are rising in countries such as China, Germany, Japan, and Canada.

China and Germany have strong incentives to implement structural changes. China’s housing overbuild and debt-deflation cycle contributed to an over reliance on exports – a model now strained by other countries’ unwillingness to import China’s production capacity. China appears more willing to implement policies to boost consumption while continuing to invest in technology and AI.

Germany is prioritising increased spending on defence and infrastructure after the pandemic, the war in Ukraine, and intense competition from China have upended the German economic model. Other European countries could follow suit but may have less capacity than Germany, which tends to run fiscal surpluses.

We expect growth trends to remain stable and mediocre outside of the U.S. Trade uncertainty remains a headwind, but easier financial conditions in more interest-rate-sensitive economies and fiscal loosening should provide some offsetting support.

Looser labor markets and an expected moderation in wage inflation should keep inflation outside of the U.S. on a declining path, allowing DM central banks to continue easing policy to neutral levels. We expect 50–100 basis points (bps) of additional rate cuts across DM economies over the rest of 2025. The Bank of Japan remains an outlier and is likely to raise rates in the face of elevated inflation expectations.

As a baseline, we expect the Fed to cut rates by another 50 bps later this year. The Fed is in a tricky spot, as higher inflation and lower growth risks have contrasting implications for the central bank’s price stability and full employment goals.

The main risk is that slowdowns in the labor market and real GDP growth cause the Fed to cut rates more deeply than the market is currently pricing, even if sticky inflation and rising inflation expectations delay the Fed’s reaction to early signs of an economic downturn. In the end, we expect Fed officials will cut more aggressively if they see recession risks rising faster than inflation expectations. In contrast, we believe the likelihood of the Fed reversing course and hiking rates in response to tariff-related inflation is low.

Investment implications: Seek simplicity, stability, and diversification

In this unusually uncertain macroeconomic environment, it’s prudent to prioritise simple, stable investments over trying to predict the unpredictable.

Elevated uncertainty is likely to challenge the U.S. equity outperformance of recent years. There is a strong case to diversify away from highly priced U.S. equities into a broader mix of global, high quality bonds. We believe we are in the early stages of a multiyear period in which fixed income can outperform equities while offering a more favourable risk-adjusted profile.

Historically, starting bond yields correlate very closely with five-year forward returns (see Figure 3). Yields on high quality bond portfolios are 4.65% based on the Bloomberg US Aggregate Index, and 4.80% based on the Global Aggregate Index (U.S. dollar hedged), as of 28 March 2025. Building on that baseline, active managers can identify opportunities in high quality sectors to seek alpha – returns above market benchmarks – to enhance the yields investors earn.

Meanwhile, the equity risk premium – a measure of the additional returns investors require to invest in riskier equities – turned negative in late 2024 for the first time in more than two decades, driven by historically elevated stock valuations coupled with the highest bond yields in years. It has since risen but remains near historical lows. (For more, see our February PIMCO Perspectives^[1].)

The portfolio diversification benefits of bonds have been on display in recent months. Equities and bonds typically move in opposite directions, allowing one part of a balanced portfolio to gain when another falters. As stocks have slumped, high quality bonds have thrived, delivering total returns comparable to equities over the past year while presenting favourable valuations today.

Duration looks more attractive

It remains unclear whether recent market volatility marks peak pessimism regarding U.S. policy uncertainty, or if the disruption will persist and further erode business and consumer confidence both in the U.S. and abroad, affecting economies and asset prices even more.

The rosy assumptions that buoyed risk asset pricing earlier this year have given way to a more cautious outlook. The decline in risk assets has accompanied a rally in U.S. Treasuries and Canadian government bonds, which contrasts with higher yields in Europe and the U.K. – in part the result of Germany’s planned fiscal spending increase.

Even after this year’s Treasury rally, the U.S. 10-year note yield remains firmly in the middle of our expected cyclical range of 3.75% – 4.75%. However, if recession risks rise, there is the potential for markets to price in more Fed rate cutting and for this range to shift down.

The German bond market experienced a sharp repricing in early March, reflecting changing political attitudes toward public spending. This shift is significant, given Germany’s unique position in the euro zone with its low debt levels.

Beyond Germany, we expect increased defense spending across Europe – though with measures likely to be less bold, given that countries with weaker initial fiscal conditions will struggle to fund such initiatives. Consequently, we have raised our expected range for the 10-year bund yield to 2.5%–3.5% from 2%–3%, indicating potential for further repricing.

Broadly, we favor an overweight to duration, a gauge of interest rate sensitivity. At a time of asymmetric risks across countries, we look to global diversification in high quality duration. We favor the U.K. and Australia for overweight duration positions. We view European duration as less attractive, given fiscal pressures, and expect yield curves to steepen across eurozone markets.

Rich global opportunities

The flip side of serial U.S. trade deficits has been the glut of foreign excess savings fueling U.S. capital markets. The world has been heavily weighted toward U.S. investments, particularly equities (see Figure 4), which now appear more vulnerable.

In this environment, we believe it makes sense to capitalize on global opportunities, particularly as bonds have become more attractive. In high quality duration, in credit, and in securities markets, we will look to emphasize the global opportunity set.

Emerging markets (EM) offer interesting alpha opportunities as well as diversification benefits. In high quality EM, historical default rates align with U.S. corporate credit, and premiums for structuring and illiquidity remain attractive. We see value in local currency opportunities that could benefit from capital flows being redirected from the U.S., as well as in hard dollar spreads where investment grade credit is increasingly available.

The risks to U.S. exceptionalism have reduced the attractiveness of the U.S. dollar. At the same time, tariff risks caution against short positions in the U.S. dollar, in case currency adjustment is the release valve should unexpected tariffs cause other currencies to depreciate. We favor carefully managed foreign exchange positions, to generate income outside of the U.S. while seeking to minimize correlations to the U.S. dollar or equity markets.

Favour asset-based finance over corporate credit

We are cautious on corporate credit, as we believe spreads fail to adequately account for potential downside risks.

While corporate bonds play an important role in portfolios, we currently see greater value in high quality alternatives. That includes credit derivative indices and an overweight position in agency mortgage-backed securities (MBS). We prefer high quality fixed income and securitised products.

In private credit, we believe asset-based finance (ABF) strategies offer the most favorable opportunities and entry points. We can identify attractive cash flow profiles that are typically fixed-rate, amortizing, and secured by tangible assets. This creates a narrower range of outcomes, making ABF a valuable addition to portfolios as other private credit assets face increased uncertainty.

This is especially true in corporate direct lending, where demand/supply imbalances (with more investor demand for loans than borrowers seeking solutions), weaker lender protections, and floating-rate coupons lead to a wider range of outcomes. We see competition in this space increasing, with significant investor dry powder chasing deals and banks returning to syndicated loan markets.

This is contributing to convergence in spreads between public and private leveraged credit markets. Contrary to expectations that the Trump administration would ignite merger and acquisition activity, heightened uncertainty has hindered M&A and slowed new deal flow.

Conclusion

With stock valuations and volatility unusually elevated, and credit spreads tight, high quality fixed income can offer attractive yields, stability, and a robust longer-term outlook for patient investors.

By Tiffany Wilding, managing director and economist and Andrew Balls, CIO Global Fixed Income.

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[1] Where to Look When Equities Are Priced for Exceptionalism.

The post CPD: Seeking stability appeared first on AdviserVoice.

Global economic outlook and elevated equity valuations affect bond market yields and may benefit client portfolios.

Key takeaways

The change in U.S. leadership increases global economic uncertainty in 2025. The incoming administration’s protectionist proposals have the power to reshape trade relationships and alter economic dynamics worldwide. With actual policies and their impacts still uncertain, we foresee a wide range of potential outcomes. Here are our near-term economic views:

• Uncertainty is certain: Proposed U.S. policy pivots have broadened the spectrum of potential growth outcomes. Inflation risks in the U.S. and recession risks in many non-U.S. economies have both increased. Our baseline expectation is for economically manageable U.S. tariff increases on China and other trading partners. However, more forceful efforts to rectify longstanding trade imbalances could disrupt the global economy and financial markets. Across developed markets (DM), we expect inflation to continue converging toward target levels, enabling DM central banks to keep cutting interest rates. However, price level adjustments from higher tariffs could delay additional progress, especially in the U.S. Greater policy uncertainty amid a generally strong U.S. economy argues for a more gradual, data-dependent approach.

While the range of potential outcomes has widened in both directions – from brighter upsides to bleaker downsides – U.S. risk assets increasingly rely on optimistic scenarios. Buoyed by expectations of lower taxes and relaxed regulations, U.S. stocks have scaled new heights while credit spreads are near record lows. Although this momentum could continue, history indicates limited room for further sustained gains at current valuations. In contrast, bonds present an appealing opportunity in both the near term and over a longer horizon. Here are our investment views:

• Bonds are better positioned: Bonds are poised to play a crucial role in portfolios in 2025. We believe bond yields are attractive at a time when equity valuations and credit spreads are not, giving high quality fixed income a favourable starting point. Unlike cash, bonds stand to benefit from capital appreciation as policy rates fall, enhancing bonds’ role as a diversifier and stabiliser for equity exposure in portfolios.
• Use relative value as a guide: Exploring investments across diverse markets provides a broader perspective. Elevated U.S. deficits and divergent global economic paths enhance already appealing global diversification opportunities. Uncovering innovative, structural sources of return can also reduce reliance on directional bets related to economic growth or interest rates.

In this context, we see promising fixed income opportunities in the U.S. and other DM countries, particularly the U.K. and Australia, as well as in select emerging markets (EM). We also prefer agency mortgage-backed securities and asset-based investments over other credit sectors in both public and private markets.

Economic outlook: Uncertainty is certain

In our October 2024 Cyclical Outlook, “Securing the Soft Landing,” we said the U.S. economy, like others, appeared poised for a rare soft landing – moderating growth and inflation without recession. We said DM economies appeared on track to return to target inflation levels in 2025. We saw risks stemming from the U.S. election and persistently high sovereign debt levels.

The broad contours of that forecast remain in place. We expect global real GDP growth to slow modestly. Lower immigration and higher tariffs are likely to temper U.S. growth despite an otherwise robust economy. Meanwhile, Europe continues to lag with subpar economic performance.

China’s economic outlook remains precarious, with growth and inflation risks tilted downward due to still-cautious fiscal support, a deleveraging housing sector that has contributed to anemic private sector credit demand, high real interest rates, and excess manufacturing capacity. Despite a prolonged property sector downturn, China maintained a 5% growth target in 2024, bolstered by expanded manufacturing – particularly in semiconductors and technology – alongside infrastructure investment and export growth.

However, this growth model is faltering under the weight of escalating trade tensions, a sluggish consumer base, and longer-term declines in population and productivity growth. Central government officials are likely to lower the growth target to around 4.5% for 2025, with core inflation likely to remain subdued. This expectation already assumes a stimulus package of about 1.5 trillion Chinese yuan (1%–1.5% of GDP) will be necessary to bolster consumption in the year ahead.

The DM outlook for inflation gradually converging toward central bank targets remains intact, although higher U.S. tariffs could delay this process. Looser labor markets and declining inflation should allow DM central banks to keep cutting rates. We expect 50 to 150 basis points (bps) of DM central bank rate cuts in 2025, depending on the region.

The Bank of Japan (BOJ) remains the exception. We expect the BOJ to hike by 50 bps as higher inflation expectations support underlying inflation despite currency volatility.

Risks and potential outcomes

The U.S. election has expanded the range of potential economic outcomes. Our baseline scenario assumes economically manageable U.S. tariff hikes against China and other trading partners, while tax, spending, and trade policies leave net U.S. fiscal deficits unchanged around 6%–7% through 2025 and 2026 – an outcome with more limited economic implications.

However, the risk is that the incoming administration pursues more aggressive policy pivots (see Figure 1) to address persistent trade and fiscal deficits – policies that the administration argues will lead to more sustainable and equitable U.S. growth over time. Achieving meaningful changes in global trade imbalances would require altering global savings and investment patterns, reducing the consumption share of GDP in the U.S. and the manufacturing share elsewhere (e.g., China).

Without reforms in China or other trade surplus countries to cut implicit manufacturing subsidies and stimulate consumption, the U.S. could try to implement interventionist trade policies (e.g., a system of universal tariffs or foreign direct investment taxes) to compel these changes. However, distributing the burden of the U.S.’s global reserve status by making U.S. assets more expensive to hold would likely raise the cost of capital and – absent more aggressive fiscal deficit reduction – increase U.S. government borrowing costs.

Such aggressive short-term measures to reverse long-term trends would likely contribute to economic disruptions, near-term currency volatility, and U.S. equity market underperformance, even if they were to succeed at creating stronger, more balanced global growth longer term. Hence, President-elect Donald Trump’s tolerance for U.S. equity market volatility is a key question for the outlook.

These proposed policy pivots amplify both upside and downside risks to U.S. growth – especially as the exact combination, timing, and scope of any such policies remain unclear. However, we think the balance of potential policy outcomes increases near-term U.S. inflationary risks while posing greater downside risks to growth for non-U.S. countries, particularly those with high global trade exposure that run persistent surpluses with the U.S.

For example, any larger-than-expected U.S. government spending cuts, aggressive trade actions, or immigrant deportation could pose cyclical downside risks to both U.S. and global growth. Conversely, greater U.S. tax cuts and deregulation could enhance U.S. growth prospects, potentially aiding consumer and business confidence and risk asset performance. A focus on achieving fairer global trade, more efficient markets, and a sustainable U.S. debt trajectory could help maintain rising U.S. living standards. Thoughtful immigration overhauls that expand the productive labor force, streamlined regulations that encourage investment, and opening export markets for U.S. projects could also yield benefits for U.S. businesses and workers.

In the very near term, higher trade policy uncertainty could weigh on global industrial production, investment, and trade regardless of actual policy outcomes. While these isolationist, pro-U.S.-growth policies offer mixed risks for U.S. growth, they are generally more likely to be inflationary, especially since the U.S. economy is currently estimated to be operating at or near its potential.

The U.S. Federal Reserve (Fed) has taken note of these changing risks. In December, when the Fed cut its policy rate by 25 bps, officials revised projections to indicate fewer expected cuts in 2025 amid greater uncertainty around continued inflation progress. Fed Chair Jerome Powell said that some officials had factored potential Trump administration policies into their revised projections.

Although conventional wisdom suggests that central banks should look through one-off price level adjustments, such as those from tariffs, any tariffs that are accompanied by other pro-U.S.-growth policies could come with more persistent inflationary pressures. In various scenarios, Fed officials could remain concerned about the knock-on effects of rising inflation expectations and elevated wage growth. As a result, they could react by cutting less than previously expected, at least at first.

Thus, after 100 bps of policy rate reductions in 2024, the timing of further Fed cuts has become less certain, indicating a more gradual, data-driven approach in 2025. The futures market has reflected this uncertainty in recent months (see Figure 2). Despite the Fed cutting its policy rate by 100 bps during this period, market pricing removed the expectation of 100 bps of additional easing in the year ahead.

The long-term outlook for U.S. government debt is likely to remain a significant concern. Nevertheless, there is a possibility of some incremental deficit improvement with the potential for rollback of certain Biden administration policies – such as renewable energy investment credits and other elements of the 2022 Inflation Reduction Act – and cuts to Medicaid. Higher tariffs could also reduce deficits through increased government revenue collection.

Still, any meaningful deficit improvement will be difficult, with the expected extension of the Tax Cuts and Jobs Act – Trump’s first-term bill – and some additional tax cuts, including, for example, provisions to raise state and local tax (SALT) deduction caps. Although some spending reductions could be found through policies to improve government efficiency and reduce waste, any larger-scale cuts, including reforms to Social Security and Medicare programs, will require an act of Congress and likely be difficult to pass given the narrow Republican majorities, especially in the House of Representatives.

Investment implications: Bonds are better positioned

Financial markets seem to be pricing in a very positive baseline expectation – reflected in the strength of U.S. and other equity markets in recent months – at a time of elevated geopolitical uncertainty. Historically high equity valuations and U.S. deficits, along with the potential for escalating trade tensions, raise questions about the durability of stock market gains. Risks appear tilted to the downside, with little margin for safety. This environment presents a compelling case for taking some chips off the table.

We believe bond yields are increasingly attractive when measured against equity valuations and credit spreads. High quality fixed income starting yields – which are highly correlated with five-year forward returns – are 5.10% based on the Bloomberg US Aggregate Index, and 4.91% based on the Global Aggregate Index (U.S. dollar hedged), as of 10 January 2025. While continued equity gains would require valuations to be sustained well above long-term norms, bonds simply need historical trends to hold to generate attractive returns in line with starting yields.

Bond market returns can be further enhanced by capital gains in adverse macroeconomic or market scenarios. Historical trends also support bonds as an attractive risk hedge and portfolio diversifier (see Figure 3). Looking back at bond and equity markets on average since 1973, during similar periods when U.S. core bonds are yielding around 5% or greater while U.S. equities’ earnings ratios are around 30 or higher, bonds have offered higher five-year subsequent returns, and with potentially lower volatility (for more, see our December commentary, “From Cash to Bonds: A Strategic Shift in Post-Pandemic Investing^[1]”).

Rates and curve

Markets are pricing in terminal policy rates for global central bank easing cycles that appear somewhat high relative to our baseline outlook. There is significant near-term potential for lower central bank rates outside the U.S. in the event of more aggressive U.S. trade policies that weaken global growth and weigh on commodity prices (see Figure 4). In the U.S., even as elevated policy uncertainty could lead to a lengthier pause in the Fed’s cutting cycle, intermediate-maturity yields look attractive relative to our long-term 0%–1% neutral real interest rate baseline.

Given that, we expect to be overweight duration, a gauge of interest rate risk, particularly after the recent rise in yields.

Over our longer-term secular horizon, we still expect yield curves to gradually steepen, driven by central bank easing and a continuation of the recent rise in term premium amid concerns about elevated sovereign debt (for more, see our December PIMCO Perspectives, “Thoughts from the Bond Vigilantes”^[2]). However, we see scope for some cyclical flattening in the U.S. due to the possibility of delayed Fed cutting amid potential near-term inflationary pressures and marginal deficit improvement.

Balancing these secular and cyclical views, we are underweight the 30-year area of the U.S. yield curve and overweight in the five- to 10-year maturity range. U.S. Treasury Inflation-Protected Securities (TIPS) also remain a reasonably priced hedge against higher inflation outcomes, in our view.

Credit outlook

Corporate credit spreads are historically tight. While we expect corporate credit can continue to do fine in our baseline scenario, the range of outcomes appears skewed toward wider versus tighter spreads given the balance of global risks. Overall, we favor higher-quality bonds and maintaining liquidity.

We continue to prefer structured products, the investment grade credit default swap index (CDX), and high quality investment grade credit versus lower-quality investments. Given broadly tight credit conditions, we are shifting focus beyond global market-weight spread allocations toward high quality spread in harder-to-source areas. U.S. agency mortgage-backed securities (MBS) remain an attractively priced, high quality, and more liquid alternative to corporate credit.

Within private credit, we continue to prefer asset-based lending, especially assets tied to higher-quality DM consumers and residential mortgages. We also see value in many non-consumer forms of asset-based risk, emphasising sectors with secular tailwinds such as aviation and data infrastructure. We remain cautious on the existing stock of lower-quality, floating-rate debt outstanding, especially in corporate markets.

We have also observed a trend toward more aggressive financial engineering in some corporate credit areas. That is creating opportunities to use independent credit analysis to identify potential gaps involving perceived credit fundamentals and ratings.

Global views

While we see U.S. duration as attractive, at the same time upside and downside risks are more evenly balanced due to trade, fiscal, and regulatory policies. In the rest of the world, the balance of risks leans toward the downside. This environment supports global diversification across bond markets, particularly high quality duration. We favor the U.K. and Australia based on valuations and economic risks compared with the U.S. Tariffs can further bolster the case for global diversification, as many of the biggest disruptions are likely to occur outside the U.S.

EM local debt, external debt, and foreign exchange positions offer reasonable return potential and reduce reliance on U.S. credit, as these markets appear to price in more downside risk than do U.S. equities or corporate credit. We see foreign exchange carry strategies as an attractive and relatively liquid way to generate income from EM exposures, when combined with careful management of the currency basket to avoid excessive U.S. dollar correlation. At the same time, with the U.S. dollar likely to strengthen on tariffs, we favour long U.S. dollar positions versus the euro, Canadian dollar, and Chinese yuan, which can offer reasonable return potential in the baseline scenario and may offer protection against more adverse trade outcomes.

Structural tilts and active management

As the most accessible markets become increasingly expensive, sophisticated investors can unlock value through more structural strategies. The concept of structural alpha involves identifying repeatable structural inefficiencies in markets – e.g., decisions made by noneconomic investors such as central banks – and creating a diversified portfolio of these inefficiencies, reducing reliance on a directional macro view.

One example of structural inefficiency is home country bias, where investors feel more comfortable investing in their own country than elsewhere. We see this as a growing opportunity as capital markets continue to expand outside of the U.S.

Another example is the rise of passive exchange-traded funds (ETFs). Required daily data disclosure by ETFs has created an information advantage for active asset managers, who can track trading shifts in less liquid market areas. Also, as ETFs gain traction in mainstream sectors such as corporate credit, they enable larger trades. In recent years, synthetic indices of diversified credit instruments have become more liquid than the underlying bonds and have often outperformed those bonds due to technical factors, creating further opportunities to enhance returns.

Conclusions

Favourable global economic conditions, the capital preservation qualities of fixed income, and the potential for capital gains position bonds as a critical element of portfolios in 2025 and a source of diversification to complement exposure to riskier assets. Short-term volatility presents opportunity for active bond managers, while current yields and historical valuation trends suggest more predictable longer-term returns that are likely to be attractive compared with both cash and equities.

By Tiffany Wilding, managing director and economist and Andrew Balls, CIO Global Fixed Income. 

———–

References:
[1] https://www.pimco.com/gbl/en/insights/from-cash-to-bonds-a-strategic-shift-in-post-pandemic-investing
[2] https://www.pimco.com/gbl/en/insights/thoughts-from-the-bond-vigilantes

About our forums: PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioural science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights. At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues. At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analysing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Structured products such as Collateralised Debt Obligations (CDOs), Constant Proportion Portfolio Insurance (CPPI), and Constant Proportion Debt Obligations (CPDOs) are complex instruments, typically involving a high degree of risk and intended for qualified investors only. Use of these instruments may involve derivative instruments that could lose more than the principal amount invested. The market value may also be affected by changes in economic, financial, and political environment (including, but not limited to spot and forward interest and exchange rates), maturity, market, and the credit quality of any issuer. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Diversification does not ensure against loss. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice. Correlation is a statistical measure of how two securities move in relation to each other. Duration is the measure of a bond’s price sensitivity to interest rates and is expressed in years. PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.

The post Uncertainty is certain – cyclical outlook appeared first on AdviserVoice.

How does the current economic climate impact investor portfolios?

The fixed income outlook remains strong across multiple economic scenarios as the U.S. Federal Reserve joins other central banks in cutting interest rates.

Key takeaways

In the wake of pandemic shocks, economies appear more “normal” than at any time since 2019. Yet policy rates remain elevated. As central banks cut interest rates to more neutral levels, key questions include how fast they get there and what those neutral levels will look like. Here are our near-term economic views:

• The factors that supported relative U.S. economic strength are diminishing. That suggests some recoupling with the rest of the world and further progress on curbing inflation.
• Developed markets (DM) appear on track to return to target inflation levels in 2025, driven by normalizing consumer demand and increased competition for limited job openings. In the U.S., labor markets appear looser than in 2019, heightening the risk of rising unemployment. The Fed, like other DM central banks, is expected to realign monetary policy to this new cyclical reality.
• The U.S. economy, like others, appears poised to achieve a rare soft landing – moderating growth and inflation without recession. But there are risks, such as the upcoming U.S. election and its implications for tariffs, trade, fiscal policy, inflation, and economic growth. High budget deficits will likely persist, limiting the potential for further fiscal stimulus and adding to economic risks.

As developed economies slow and potential trade and geopolitical conflicts loom, investors should favor caution and flexibility in portfolio positioning. These are our near-term investment views:

• We expect yield curves to steepen as central banks lower short-term rates, creating a favorable environment for fixed income investments. Historically, high quality bonds tend to perform well during soft landings and even better in recessions. Moreover, bonds have recently resumed their traditional inverse relationship with equities, providing valuable diversification benefits.
• Bond yields are attractive in both nominal and inflation-adjusted terms, with the five-year area of the yield curve particularly appealing. Cash rates are set to decline alongside policy rates, while high government deficits may drive long-term bond yields higher over time.
• We maintain a cautious stance given some complacency we see in corporate credit due to tighter valuations, favoring higher-quality credit and structured products. Lower-quality, floating-rate private market areas appear more vulnerable to economic downturns and interest rate changes than prices suggest, with credit risks poised to rise just as yields fall, potentially benefiting borrowers but hurting investors. U.S. agency mortgage- backed securities (MBS) offer an attractive and liquid alternative to corporate credit. Additionally, asset-based sectors, in both consumer and non-consumer areas, provide appealing opportunities for private market investors, particularly relative to corporate lending.
• In foreign exchange, we are somewhat underweight the U.S. dollar as the Fed cuts rates, while diversifying into currencies from both DM and emerging markets (EM).

Economic outlook: Recoupling and a reframing of risks

The U.S. economy distinguished itself in 2023 and 2024, achieving growth rates of 2.5%–3%, while DM peers largely stagnated at 0%–1%. U.S. productivity has also outpaced DM peers since the pandemic. In our April 2024 Cyclical Outlook, “Diverging Markets, Diversified Portfolios,” we identified two main drivers:

• Fiscal policy: A larger cumulative fiscal stimulus since 2021 has led to greater private wealth accumulation in the U.S., which has taken longer to dissipate.
• Monetary policy: The pass-through of higher interest rates to households has been slower in the U.S., largely due to the existing stock of low-rate, long-term mortgages.

Additionally, the prominence of U.S. private credit markets has likely kept financial conditions more accommodative. An influx of investor capital in lower-quality corporate lending has intensified competition for deals while providing financing for weaker companies that may struggle to access other markets.

The U.S. has also been less affected by international spillovers from Chinese economic weakness. European countries, and Germany in particular, have been hurt by weaker trade with China and greater Chinese import competition. Financial gains and capital accumulation from generative artificial intelligence (AI) have also relatively benefited the U.S.

The U.S. also made more modest progress in 2024 than DM peers in reducing inflation. Core personal consumption expenditures (PCE) inflation, the Fed’s preferred gauge, is expected to finish this year near where it ended 2023, as tough base effects are likely to lift the reported year-over-year rate in the next several months.

In contrast, core inflation in other DMs has likely slowed by 1–1.5 percentage points during that period (see Figure 1). Europe achieved additional inflation progress as weak demand and corporate margin compression offset stillelevated unit labor cost inflation.

The factors that supported U.S. outperformance are fading, suggesting some recoupling with the global economy. Measures of U.S. real wealth balances more closely resemble those of other DMs. The monetary policy shocks that have impeded growth elsewhere are also abating.

European growth is likely to recover to a more normal pace as rates decline and trade conditions improve after the energy price spikes of 2022. This will help offset curtailed government spending and a weak global manufacturing environment. Immigration – which bolstered growth in many DMs, particularly the U.S. – is expected to become a growth headwind as policies implemented in mid-2024 to limit immigration appear to be working.

Despite some cyclical growth recoupling, we believe the U.S. economy maintains some distinct advantages. Notably, robust capital spending and AI investment trends present significant upside growth potential, especially compared with Germany and other EU countries that are more exposed to Chinese competition and more reliant on imported energy sources. Recent economic data revisions that have left the U.S. savings rate within prepandemic ranges should moderate concerns of an overextended U.S. consumer.

Monetary policy is normalising…

More resilient U.S. growth and inflation delayed the Federal Reserve in commencing its rate-cutting cycle relative to other central banks. However, forward-looking inflation indicators suggest that further progress toward the Fed’s 2% inflation target is likely in 2025. Factors supporting this outlook include unit labor cost inflation nearer to 2%, a vacancy-to-unemployed ratio lower than 2019 levels (see Figure 2), and a rising unemployment rate that may risk overshooting the Fed’s comfort zone of around 4.2%.

Elsewhere across DM, weaker demand, loosening labor markets, and anchored inflation expectations also point to near-target inflation in 2025. Canada stands out as a DM economy where inflation is most likely to undershoot target levels, while labor market indicators in Australia point to somewhat slower progress there.

Consequently, central banks, especially the Fed, are focused on returning monetary policy rates to estimated neutral levels. We expect DM central banks to cut rates by 175–225 basis points (bps) in 2025.

The Bank of Japan (BOJ), which still has a policy rate below neutral estimates, remains the notable outlier. We expect the BOJ to continue with gradual rate hikes despite recent market volatility and yen strength. Japan has been the one economy where elevated inflation has raised inflation expectations, while wage inflation remains firm.

…But what is normal?

With DM economic conditions now resembling their pre-pandemic baseline more than at any time since 2019, the focus now turns to the question, “What is ‘normal’ monetary policy?”

Factors that could support a somewhat higher neutral rate than a decade ago include higher government debt levels, potentially higher defense spending, generally stronger private sector balance sheets, and increased investment needs associated with secular global transformations, such as realigned trade relationships and the rapid development of AI.

However, given longer-term trends in demographics and wealth disparity, and the uncertain pace and magnitude of investment cycles, we’ve maintained our 0%–1% estimate for the long-run neutral real rate, as we detailed in our latest Secular Outlook, “Yield Advantage.” That suggests a neutral nominal policy rate in the range of 2%–3%. When we published that Secular Outlook in June, we noted how market pricing at the time implied that the neutral policy rate was unlikely to fall below 4%. Since then, market pricing has moved more in line with our expectations.

Given the uncertainty around the level of neutral policy rates, it’s natural for central banks to embark on a series of cuts to see how their economies respond. If growth reaccelerates and upside inflation risks reemerge, central banks can always pause or slow easing. Otherwise, if growth plummets or employment falters, there is capacity to cut more aggressively. Across a range of scenarios, we believe there is room for central banks to cut rates.

Risks and uncertainty

Risks to the global outlook have shifted. Inflation risks have diminished – but not disappeared – as supply/demand in labor markets and beyond have come into better balance. Growth is slowing. While DM economy recessions are not our base case, we believe the risks are somewhat elevated compared with historical average frequency. There are also scenarios where economic growth proves more resilient and inflation could reaccelerate.

In the U.S., the main risk is that slower activity and labor market growth fuel self-stoking cycles, ultimately resulting in a more pronounced downturn. Other DMs appear more stable. Still, their continued low growth makes them susceptible to negative shocks, such as market mishaps or escalating geopolitical situations.

China faces its own challenges. Its growth model, reliant on exports and manufacturing investment, seems to be hitting limits. It faces a significant housing inventory overhang, weak consumer demand, and rising trade tensions. In response, China’s government recently announced measures designed to boost asset prices and mitigate the decline in housing prices.

However, the efficacy of these policies may hinge on a return of confidence and whether the efforts will provide more widespread direct government support to households. Fiscal response is also likely and may help generate momentum for growth in the next one to two quarters.

We expect China’s growth to slow to 4%–4.5% in 2025 from 5% in 2023 and 2024, while the country continues to export deflation globally. Demand for commodities, especially related to construction, may get some support from the recently announced policies but isn’t likely to rise as much as in past cycles, given controls on new housing supply.

Geopolitical risks continue to loom large as a source of uncertainty – from the conflicts in the Middle East and Ukraine to elections across many countries during our cyclical horizon, with implications for broad market sentiment and specific countries and sectors.

The upcoming U.S. election is one such source of uncertainty, with pivotal policy implications:

• U.S. deficits will be the biggest loser no matter which party wins. Tax reform will dominate Washington next year, when the individual provisions of the 2017 Tax Cuts and Jobs Act are set to expire. We do not expect much additional fiscal stimulus, given likely narrow majorities or a divided government and lack of fiscal space. However, fiscal consolidation isn’t expected either. Annual deficits are likely to remain high (6%–7% of GDP) before any additional policy changes, due to lack of political will to curb entitlement spending as well as few offsets to pay for extending most of the 2017 tax cuts. This reinforces our curve steepening view in the U.S.
• The direction of travel of tariffs is also clear regardless of who wins. However, the potential for globally disruptive trade policies appears greater under a second term for former President Donald Trump, while Vice President Kamala Harris seems more likely to continue the current more targeted approach should she prevail. In the short run, higher tariffs would likely be inflationary and drag on growth. Tariffs could make tangible U.S. investments more expensive, hurt U.S. export sectors by making them less competitive, and weigh on demand. Tariffs would likely also be inflationary for close U.S. trade partners – to the extent that their governments retaliate with similar trade barriers – but deflationary elsewhere, as slower global growth from rising trade uncertainty could weigh on commodities, while goods previously supplied to U.S. markets could be redirected. The relative implications of tariffs will create a tough economic environment for the Fed. Monetary policymakers will have to be mindful that higher short-run inflation (as the additional costs of tariffs are passed on to consumers) risks rising inflation expectations, despite the downside risks to growth as real incomes fall.

Investment implications: Favourable conditions for high quality bonds

Uncertainty, global dispersion, and potential volatility create a favorable environment for active fixed income investors, especially as falling interest rates provide a tailwind for bonds. Historically, bonds tend to perform well during soft landings and even better in harder landing scenarios. Recently, bonds have resumed their traditional inverse relationship with equities, offering diversification and hedging benefits for portfolios. Additionally, bonds appear inexpensive compared with other assets such as stocks, in our view.

We expect yield curves to continue to steepen – in line with their performance in past easing cycles – as the Fed and other central banks continue cutting short-term rates. While recession is not our baseline, economic risks remain a source of uncertainty as U.S. growth slows. The risks are compounded by uncertainties around the upcoming U.S. election, particularly the outlook for global trade. This context calls for a careful approach to position sizing and maintaining flexibility in portfolios.

Rates and curve

We see U.S. Treasury yields as broadly fair at current levels. The five-year area of the yield curve appears particularly attractive in both the U.S. and other DM countries. As central banks lower policy rates, it creates reinvestment risk for cash and other short-term instruments. We prefer locking in attractive yields on intermediateduration bonds, which can benefit from price appreciation and historically have tended to perform well during rate cutting cycles. Meanwhile, we remain cautious on long-duration bonds as high government deficits could push long-term yields higher over time.

The anticipated pace of Fed easing priced into the front end of the curve appears reasonable, given current economic conditions and the Fed’s half-point initial cut in September. Expectations for the terminal rate also look reasonable given our baseline view on the long-run neutral rate (0%–1%), as discussed above, although we remain mindful of potential inflationary tail risks. If a recession hits, there is room for terminal rates to drop significantly.

Bond and equity markets have resumed their traditional inverse relationship – meaning the correlation between duration (a gauge of interest rate risk) and equities is negative – so bonds can better hedge portfolios against equity market downturns. That can be especially important at a time of rising geopolitical risks. Adding to an allocation of inflation-linked bonds is appealing, given attractive pricing for inflation protection, with yields attractive on both a real (inflation-adjusted) and nominal basis.

Credit outlook

We maintain a cautious stance on corporate credit due to tighter valuations and somewhat elevated recession risks. We prefer higher-quality credit and structured products over lower-quality credit at this point in the cycle, with an emphasis on liquidity, flexibility, and robust positioning against potential macroeconomic downturns.

Generally, we favor high quality investment grade credit. We set a high bar for considering lower credit quality, especially in portfolios with high quality benchmarks. Elsewhere in credit markets, we’re wary of deteriorating covenant protections in leveraged credits, which could lead to lower recoveries during idiosyncratic or systemic shocks.

Agency mortgage-backed securities (MBS) appear attractively valued and provide a reasonably priced, liquid alternative to corporate credit for investors who can tolerate occasional short-term volatility.

In private credit markets, we believe that excessive growth and complacency are likely to result in weaker future returns when compared with current yield levels. Significant capital formation has resulted in weaker lender protections and compressed compensation for illiquidity relative to similar returns available to active managers in public credit markets.

We believe many lower-quality, floating-rate borrowers in private markets are more susceptible to economic weakness and interest rate changes than market prices suggest. As the Fed lowers rates to prevent a recession, floating-rate coupons will likely also decrease significantly. This means yields will drop just as economic and credit risks rise, which may benefit borrowers but hurt investors. This could also be the first time these markets are tested during economic downturn scenarios.

Given this backdrop, investors today may be receiving inadequate compensation for risk in lower-quality private corporate credit – especially compared with attractive excess return opportunities in more liquid forms of credit or 2 similarly less liquid opportunities in asset-based lending. (For more, see our 10 July 2024 publication, “Navigating Public and Private Credit Markets: Liquidity, Risk, and Return Potential”).

Disruption to bank business models is creating attractive entry points for private capital across a range of asset-based opportunities, including consumer-related (e.g., residential mortgages, student loans) and non-consumer (e.g., aviation, equipment) assets. Relative to private corporate markets, we find many asset-based opportunities benefit from a combination of attractive starting valuations and favorable fundamentals, especially in areas tied to the higher-quality consumer balance sheet. These markets are also less crowded on a relative basis, as capital formation in private asset-based lending remains considerably more scarce than that of U.S. and European corporate lending markets.

We believe we are closer to a bottom in private real estate markets, but that this will be a slower recovery relative to previous cycles. We favor investments in data infrastructure and debt-related opportunities relative to equity at current valuations. Our emphasis is on sectors and assets tied to data infrastructure, logistics, warehouses, and certain multifamily assets.

Global views

Given dispersion in economic outlooks and central bank policy paths, we favor duration positions in the U.K. and Australia, where terminal pricing for the central bank cycles (see Figure 3) still looks somewhat high versus the U.S., the eurozone, and other global markets.

In the eurozone, the market’s terminal rate pricing for the European Central Bank looks reasonable, but there is some uncertainty on the timing of how quickly the easing cycle proceeds. Overall, we are neutral on duration but favor curve steepening positions given the flatness of the curve between the 10- and 30-year points.

Looking at foreign exchange (FX), we prefer an underweight position in the U.S. dollar, given risk of weakening as the Fed lowers rates, while diversifying with EM and DM positions. Careful scaling of positions is needed here, however, given the uncertainties surrounding the U.S. election.

A stable-to-weaker U.S. dollar amid rate-cutting cycles across DM should enable EM central banks to cut rates as well. While the Fed was on hold, many of these central banks had to keep rates higher than their benign domestic inflation would normally require.

We prefer investments in markets with steep yield curves and stable or improving political conditions, such as South Africa and Peru. Turkey also remains of interest given the ongoing pivot to greater economic orthodoxy. The favorable global environment we expect should remain supportive of EM external debt spreads.

Certain commodities can help diversify portfolios and provide hedging properties against inflation risks. The shifting global landscape continues to support gold and precious metals, with EM central banks purchasing gold at unprecedented rates since Russia’s invasion of Ukraine. Meanwhile, the desire of OPEC+ to return supply to the market and concerns over global transport demand have limited the upside to oil prices, even as recent events in the Middle East and Ukraine underscore the fragility of global supply chains. The capital spending cycle linked to the energy transition also supports prices of base metals, although lingering downside risks to growth in China pose challenges.

By Tiffany Wilding, managing director and economist and Andrew Balls, CIO Global Fixed Income. 

———–

References:
[1] Liquidity refers to normal market conditions.
[2] Ibid.

About our forums
PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioral science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights. At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues. At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analyzing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.

Past performance is not a guarantee or a reliable indicator of future results.  All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise.  Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. References to Agency and non-agency mortgagebacked securities refer to mortgages issued in the United States. Structured products such as Collateralized Debt Obligations (CDOs), Constant Proportion Portfolio Insurance (CPPI), and Constant Proportion Debt Obligations (CPDOs) are complex instruments, typically Global Bond Fund and Market Update with Sachin Gupta 15/08/2024 Portfolio Manager provides an update on the Global Bond Fund and recent market moves. Sachin Gupta Watch Video Tiffany Wilding Economist Andrew Balls CIO Global Fixed Income involving a high degree of risk and intended for qualified investors only. Use of these instruments may involve derivative instruments that could lose more than the principal amount invested. The market value may also be affected by changes in economic, financial, and political environment (including, but not limited to spot and forward interest and exchange rates), maturity, market, and the credit quality of any issuer. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be appropriate for all investors. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Diversification does not ensure against loss. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice. Correlation is a statistical measure of how two securities move in relation to each other. Duration is the measure of a bond’s price sensitivity to interest rates and is expressed in years. PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. CMR2024-0927-3898197

The post Cyclical outlook – securing the soft landing appeared first on AdviserVoice.

Andrew Balls

In a world of insecure stability, investors must prepare for 5 policy pivots that will test markets.

In PIMCO’s recently published Secular Outlook, Pivot Points, authors Richard Clarida, Andrew Balls and Daniel J. Ivascyn explain how over the next five years, there could be up to five significant pivots in the direction and scope of the monetary, fiscal, trade, geopolitical and exchange rate policies pursued by the world’s major countries.

But while the direction of some of these pivots may be known, the path that policies actually take, their impact on the global economy and markets, and their ultimate destination are all highly uncertain.

These policy shifts will coincide and collide with the rising risk of recession in a world of insecure stability, with any pivot to fiscal policy that materializes unlikely by itself to boost global growth prospects in a sustainable way as the Federal Reserve attempts to hike rates and shrink its balance sheet.

Expansions may not die of old age, but if history is any guide, we believe the probability of a recession sometime in the next five years is around 70%.

Over our secular horizon, we see rising downside risks to the outlook for Chinese growth and eurozone stability.

Since the last Secular Forum in May 2016, the global economy has surprised on the upside, and markets have shrugged off and indeed rallied after Brexit and the U.S. Presidential election. Risk appetite has been robust, resulting in lofty equity valuations, tight credit spreads and low realized volatility.

We believe markets now look too relaxed and medium-term risks are building. In this environment, investors should consider using cyclical rallies to build cash to deploy when markets correct and risks are re-priced.

Secular pivot points with baseline outlook

• Monetary policy: We expect Fed balance sheet normalization, but less than many think, with a New Neutral destination for the fed funds rate.
• Fiscal policy: We expect that any U.S. fiscal package that passes will be tilted to tax cuts, but light on reform; we see limited fiscal space in Europe.
• Trade policy: We expect the U.S. to focus on bilateral deals (e.g., China, NAFTA) and aggressive use of existing authority within the WTO.
• Exchange rate and geopolitical policies: Amid populist movements in Europe and beyond, we expect the euro to survive and Italy to remain in the eurozone. The Chinese yuan is likely to grind weaker.

Macroeconomic risks …

• In our view, downside and upside risks are roughly balanced for the U.S.; downside risk to growth in both Europe and China is rising over the secular horizon.
• We see a significantly lower tail risk of global deflation.
• We see a risk the fed funds rate lands to the downside of New Neutral levels.
• We are monitoring the global economy’s “driving-without-a-spare-tire” risk in the next recession, whenever it happens.

… and portfolio responses

• Focus on valuation – lots of “good news” is priced in to markets.
• Maintain focus on capital preservation.
• Seek relative value in rates and credit.
• Look to a global opportunity set, including emerging markets.

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Andrew Balls

PIMCO, a leading global investment management firm, has launched a dedicated Environmental, Social and Governance (ESG) investment platform globally, offering fixed income solutions to investors seeking attractive returns while making a positive social impact.

As part of this platform, the PIMCO ESG Global Bond Fund has been launched in Australia. The Fund, which marks PIMCO’s first dedicated ESG fund offered to Australian clients, has been launched to meet demand from clients looking to incorporate responsible and social considerations in fixed interest investing.

PIMCO’s unique ESG framework is underpinned by three key pillars: Exclusion, Evaluation and Engagement. The process not only excludes companies with business practices that are misaligned with sustainability principles, but also evaluates their ESG credentials and favours those with best-in-class ESG practices. Further, the team engages collaboratively with companies, encouraging them to improve their ESG practices and influence long term change.

The founding belief of this new strategy is that investors in ESG portfolios should not have to sacrifice their financial objectives in order to achieve an ESG impact.  The Fund aims not to compromise on investment returns to achieve social objectives by benchmarking itself against a traditional global bond benchmark, and invests in a range of sovereign and investment grade corporate bonds from around the world. The fund is managed by a team led by Andrew Balls, Managing Director and CIO of Global Fixed Income and Alex Struc, Portfolio Manager and head of ESG portfolio management at PIMCO.

PIMCO globally has also launched a dedicated ESG fund in Europe and the U.K, and enhanced two of its socially responsible funds in the U.S. to incorporate a wider range of ESG considerations into the investment process.

Andrew Balls, Managing Director and CIO of Global Fixed Income, said:  “For many investors, screening out undesirable investment categories isn’t enough anymore; they want to use their investments to promote change in the world. Our ESG Fund provides the tools to do that without compromising on returns.”

Alex Struc, Portfolio Manager and head of ESG portfolio management at PIMCO, said:  “Historically, this type of strategy has been pursued by equity investors but we firmly believe that engagement as a debtholder is equally important. Across the vast fixed income universe, small change can have an enormous positive impact.”

Adrian Stewart, Head of PIMCO Australia and New Zealand, said: “Sustainable investing is increasingly an important focus for many of our clients, yet there is a shortage of compelling ESG-oriented fixed income solutions available to investors. Having spent the last few years developing our processes and team, we are excited to invite Australian investors to participate in what we believe is an engagement-driven, industry-leading ESG platform. We think that PIMCO is in a great position to fill this leadership vacuum in this maturing market.”

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Andrew Balls – Managing Director, CIO Global Fixed Income

Q: What is the impact of Brexit on our outlook for the UK and global economies?

Andrew Balls: At PIMCO we like to start with the long-term view, or what we call our secular outlook, which is our framework for the global economy over the next three to five years. We recently met to discuss this and concluded that the world looks “Stable But Not Secure” – a baseline of continued muddling through for the global economy but with rising risks. One such risk is the threat of growing populism and its political and economic consequences. This trend makes us cautious on Europe over the secular horizon, and the results of the referendum are consistent with this view.

That said, for now at least, we think Brexit is principally a UK event, with global knock-on effects contained. In the UK we expect a reduction in growth in the range of 1 to 1.5 percentage points over the next four quarters, dropping the growth rate to close to 0%. We think it is likely that the Bank of England (BOE) will react by cutting its policy rate from the current 0.5%.

Globally, the Eurozone will be most impacted, and we expect further easing measures from the European Central Bank. However, we think the impact of the increased uncertainty on Eurozone GDP will only be 0.2 or 0.3 percentage points.

We do not foresee a large spillover effect into the U.S. economy, but we do think the Federal Reserve could delay additional rate hikes. From a previous expectation of one or two rate increases in 2016, we think it now looks likely that the Fed will hike rates once this year. But it’s very fluid and it will ultimately depend on market movements and the economic data. What is clearer is that markets are pricing in very little Fed tightening over time – the next full 25bps rate increase is not priced in until the end of 2018. That to us seems implausible and we think it worth positioning for a faster pace of tightening.

Q: What are the risks to our baseline view?

Balls: One danger is that markets fail to stabilise, and we see a self-perpetuating cycle in which volatility begets more uncertainty, and this subdues economic activity over time. Reactions to date, however, do not support this. Markets seem to have broadly priced in the new reality and moved in line with our view – UK assets have been most impacted, particularly equities and currencies, and U.S. treasuries have rallied on a flight to quality. Eurozone banks have also seen selling pressure. But outside of this, moves have been more muted, and current levels do not appear too extreme given that many assets have hit comparable levels at other points earlier in June. We are only a few days in and this could change but so far the market indications are in line with our view that this is largely a UK event and certainly not a global systemic event.

One key barometer to look at is the U.S. dollar. Since the G20 meeting in Shanghai we’ve had no surprises out of China, but a stronger dollar increases the risks of another devaluation of the yuan, which could trigger considerable volatility, much as it did at the beginning of the year and in August 2015.

Q: Does Brexit threaten the long-term stability of the European Union (EU)?

Balls: As mentioned we see rising populism as a key risk over the secular horizon and we are cautious on European assets for this reason. Perhaps on the margin Brexit encourages other populist movements, but we do not see it as a significant change – the risks were already there. Indeed, the results of the Spanish election over the weekend were better than expected for the centre right party and worse for Podemos, the populist party, possibly influenced by demonstration effects from the UK.

It is also important to realise that the UK has voted to leave the EU, not the Eurozone (the single currency area), of which it has never been a member. To us a country leaving the Eurozone clearly poses far greater risks for stability of the Eurozone than a country potentially leaving the EU. For example, we feel that if Greece had exited the Eurozone in 2011/12 that would have been far more damaging than the UK exiting the EU today.

We also have a far clearer view of the ECB’s reaction function now than we did then, given its quantitative easing programme. This will help to limit volatility for European sovereigns. Nevertheless, the risk of a populist party taking power in the Eurozone in coming years, particularly in a big country, remains a clear concern.

Q: What are the next steps for the UK?

Mike Amey – Managing Director, Head of Sterling Portfolio Management

Mike Amey: With 52% of people voting to leave, on a 72% turnout, the UK government has been given a clear mandate to initiate and complete the UK’s exit from the EU. The current uncertainty is around who will lead this, following Prime Minister David Cameron’s announcement that he will resign. The selection of a new conservative party leader, who will in turn be prime minister, will be completed by early September. Now that Boris Johnson, the most prominent member of the leave campaign, has withdrawn from the race, the front runners are Theresa May, the current Home Secretary, and Michael Gove, the Justice Secretary. Until that contest is completed, the UK government is effectively in limbo.
There has been some talk among European leaders of forcing the UK to start negotiations before then, but the reality is that only the UK can invoke Article 50 of the Lisbon Treaty, which formally initiates the withdrawal process. We can’t see this happening until September at the earliest, and only once this occurs will the two-year window on negotiations start. So all in all we are looking at a minimum of two years before the UK gets even close to formally leaving the EU.

Q: Could you elaborate on how markets are functioning?

Amey: So far markets have been volatile but orderly and functional. Liquidity has been sufficient, heavy volumes are being traded, and markets are clearing. UK equities and sterling have been hit hard but levels are not alarming, and, as Andrew mentioned, many asset levels are comparable to lows reached earlier in the year. After initial volatility, markets also appear to be stabilising. We think this reflects the event being principally a UK one with global contagion contained. In part, this is due to the timeline mapped out above. This is going to take a long time to play out, with the biggest surprise having already occurred. It’s difficult to see how such a long time frame manifests itself in a broader systemic event. But again, we are in early days, and things could change.

Q: What are the consequences for the UK banking sector? Are the dislocations in UK bank equity and capital securities valuations justified?

Philippe Bodereau – Managing Director, Portfolio Manager, Global Head of Financial Research

Philippe Bodereau: We need to distinguish here between multi-national banks based in the UK, which are principally engaged in investment banking, and domestic UK banks, which are principally retail and commercial domestic lenders. For the former there will be potential disruption in terms of moving certain staff. They may also lose passport rights to do business across the EU, which could have an impact, but overall these are operational disruptions with limited macroeconomic significance. For the latter, however, the situation is very different, and we think the fall in share prices is justifiable. Lower interest rates, slower loan growth and rising credit losses all feed into lower forecasts for future earnings.

From a credit perspective, the outlook is much more sanguine. UK banks have high capital ratios of 12%-16%, and large and liquid balance sheets. They have performed well in recent stress tests, and we currently see no signs of what may be a political crisis turning into a banking crisis. We think the dislocations in valuations in this sector, particularly in UK bank capital and subordinated debt, could offer opportunities.

Q: Is the same true for Eurozone banks?

Bodereau: Eurozone banks have also seen high volatility following the Brexit result, but they have been very volatile year to date, with investors seemingly relentless in chasing down the weakest links. This includes Italian and Portuguese banks with high non-performing loans and capital deficits, and given existing solvency concerns and risk-off sentiment it’s no surprise these names are down. The sell-off in banks with stronger balance sheets and high dividends looks less justified, and after what was more indiscriminate selling on Friday, we are beginning to see differentiation return.

Q: Do we expect sterling to fall further, and what will be the impact on UK gilts?

Amey: As mentioned earlier we expect the UK’s growth rate to decline to close to zero. Therefore, we believe the Bank of England will be far more influenced by anaemic growth than any rise in inflation that results from sterling’s fall.
At current levels we believe sterling looks fairly reasonable and we do not expect a sharp bounce back. The general uncertainty is likely to prevent this as currency markets tend to be the principal mechanism for pricing political risk.
In terms of the impact on gilts, rates are down around 40 bps since before the vote, and we struggle to see any strong upward pressure given the likely rate cuts from the BOE, and the potential for additional quantitative easing. We do not, however, believe rates will go negative.

Q: Many have drawn parallels between the UK voting to leave the EU and the rise of Donald Trump in the U.S. Do you expect a similar market reaction in the event Trump wins the Presidency?

Balls: Who becomes U.S. president is a question of significant global importance and so the election of Donald Trump, where there is much uncertainty surrounding his views and suggested policies, would likely elicit a negative reaction from markets. Hillary Clinton by contrast is a much more known candidate. Overall, the EU referendum in the UK reinforces the need to pay attention to populism and political risks in the coming years, including in the U.S.

Q: Do we see buying opportunities in any sectors where valuations have significantly declined? What are the broader implications for portfolios?

Balls: The banking sector has seen the most dislocation in valuations, and we expect to find good opportunities there. More broadly we have a positive view on corporate credit, particularly of higher quality sectors, and in asset-backed securities – relatively low risk and high quality exposures that our colleague Dan Ivascyn calls “bend but don’t break” spread positions. We also continue to think that U.S. TIPS are attractively priced and offer valuable protection against the possibility of higher U.S. inflation over the coming years.

Amey: The overall takeaway is that populism is becoming an increasing risk to politics and markets, and therefore our investment portfolios. Right now we think the impact of Brexit will be largely contained to the UK, but we are less than a week into a post-Brexit world and we need to monitor the situation carefully. As such we will seek to take advantage of opportunities, while proceeding with caution.

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