Loading...

Follow PIMCO Blog on Feedspot

Continue with Google
Continue with Facebook
or

Valid
PIMCO Blog by Daniel J. Ivascyn,joachim Fels,tina.. - 4d ago

What can investors expect over the next three to five years? Dan Ivascyn, group CIO, and Joachim Fels, global economic advisor, discuss economic and market conditions and what investors should consider over the secular horizon.

For more insights on developments that could move economies and markets, see our recent Secular Outlook, Dealing With Disruption.

READ HERE

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

The Federal Open Market Committee (FOMC) is poised to cut the policy rate at its meeting on July 30–31, but members of the committee are divided. Markets are pricing a 25 basis point (bp) cut, and we believe that is the most likely outcome, but we also see a meaningful chance of a 50 bp cut.

Following the June 18–19 meeting, a majority of the FOMC was still in favor of keeping rates on hold through the end of 2019 (according to the Fed’s economic projections and “dot plot”). However, the tone of Fed communications has taken a somewhat more dovish shift in the weeks since. Of note, Fed Chair Jerome Powell, in his semiannual testimony before Congress last week (and during a dinner speech at the Bank of France on Tuesday), didn’t discuss the prospect of maintaining the current level of the interest rates (i.e., not cutting) – we see this as evidence that he and others on the Fed’s Board of Governors are in favor of easing and were very likely the participants forecasting at least 50 bps in rate cuts by the end of this year.

Why cut? Potential areas of concern in U.S. economy

With U.S. real GDP growth likely to average a solid 2.5% in the first half of 2019, and the unemployment rate sitting at 3.7% – a multi-decade low – various commentators have stated that the economic data don’t justify a rate cut. Furthermore, Powell and other FOMC officials have characterized the U.S. economy as “in a good place.” However, we see several compelling arguments for somewhat more accommodative monetary policy.

  • Real growth in goods-producing sectors has decelerated materially. Despite solid overall GDP growth year-to-date, a closer look at the data reveals severely negative growth momentum in U.S. manufacturing, investment, and exports. And according to surveys, business confidence in the outlook has deteriorated.
  • Labor market momentum is slowing. While our baseline outlook continues to be for a healthy U.S. consumer to support growth, there is a real risk that the areas of economic weakness spill over into labor markets and consumption more than expected. Payroll growth and (more importantly) aggregate hours worked are slowing as companies cut back hours and slow the pace of hiring in response to weaker sales growth.
  • Data are confirming that the real neutral interest rate is lower than some FOMC participants previously thought. Indeed, the U.S. economy appears quite sensitive to rising interest rates. Growth in real investment in structures has slowed as the Fed has raised rates over the last two years. Private construction investment has decelerated, and commercial real estate construction is currently contracting by over 10% year-over-year (source: Commerce Department, Haver Analytics).
  • The Fed’s openness to rate cuts has been an important contributor to easier financial conditions, despite higher business uncertainty. Lower interest rates account for much of the easing in financial conditions over the last several months. As a result, if the Fed doesn’t cut rates and bond market yields rise, there is a meaningful risk that ensuing tightening of financial conditions restrains growth.
  • Inflationary pressures are modest and financial stability risks manageable.Although the timing of the stronger-than-expected June core CPI print was awkward for the Fed, a broader assessment of the wages and prices data suggests that the inflationary risks of easier monetary policy are modest. Of note, unit labor costs – which adjust wages for productivity gains, and are therefore a better measure of the likely pass-through of higher wage inflation to consumers – have declined for the past two quarters, according to Bureau of Labor Statistics data.
Key takeaways

In our view, a 25 bp cut remains the most likely outcome of the July Fed meeting; however, we wouldn’t rule out a 50 bp cut. Recent U.S. economic data have been somewhat more encouraging, but the broader growth trends in a number of sectors still look notably weak. This, coupled with less room for conventional monetary policy easing and the potential costs of a recession (a retrenchment in labor force participation and a contraction in investments that enhance future productivity), argue for easier monetary policy – including a strong case for a 50 bp cut in July – to help insulate the U.S. expansion from negative economic shocks.

Learn the key takeaways from PIMCO’s Secular Outlook for the economy, policy, and markets over the long term.

ACCESS NOW

Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

U.S. core consumer price inflation (CPI) was firmer than expected in June, with a 0.3% rise that boosted the year-over-year rate to 2.1%. The timing of the strong print is somewhat awkward for Federal Reserve officials who have signaled a willingness to cut interest rates in July, and for Chairman Jerome Powell, who emphasized the absence of inflationary pressures during his semiannual testimony to Congress this week.

However, it’s worth noting that June inflation may have been boosted by the recent increase in import tariffs, while inflationary pressures from rising wages and tight labor markets remain notably subdued. Unit labor costs – which adjust wages for productivity gains, and are therefore a better measure of the likely pass-through of higher wage inflation to consumers – have declined for the past two quarters.

Overall, the latest CPI print didn’t materially change our outlook for moderate but stable core CPI inflation a little above 2% for 2019. And given weaker trends in U.S. real business investment, exports, and manufacturing growth, along with the recent unsustainable build in inventories and rising business uncertainty, we think both a 25- and a 50-basis-point (bp) cut to the federal funds rate are on the table at the upcoming July FOMC (Federal Open Market Committee) meeting.

Core goods subject to increased Chinese import tariffs see strong gains

Looking at the details of the June CPI report, firmer price gains were witnessed in core retail goods, used cars, and shelter prices.

Core retail goods prices (excluding autos and medical) increased 0.3% month over month, with more notable gains in categories that include Chinese products subject to higher import tariffs: Furniture and bedding, small appliances, and recreational vehicles were notably strong.

Relevant analysis suggests that so far, U.S. corporate margins have absorbed the brunt of the costs arising from the initial increase in tariffs on various Chinese imports last September. However, with the one-time earnings adjustment from the Tax Cuts and Jobs Act’s (TCJA) lower corporate tax rates largely complete, corporations may now be less willing to absorb the additional costs from the further tariff hikes implemented in mid-June. Price gains in apparel, which has not yet been hit by increased import duties, were also strong.

Used car prices bounce and rents continue to firm

Outside of the core retail categories, used car prices rebounded strongly (+1.6%) in June after four consecutive months of large declines. Tighter auto lending standards helped cool the used car market earlier this year, but used car prices at wholesale auctions, which tend to lead consumer prices by one or two months, have stabilized and point to a modest rebound in used car inflation in the third quarter.

Monthly price gains in rents and owner’s equivalent rents were also again firm. However, we had expected some firming resulting from low economywide shelter vacancy rates and the lagged effects of higher mortgage interest rates in 2017 and 2018, which reduced the affordability of owning a home.

Key takeaways

Thursday’s firmer-than-expected CPI print is awkward for the Fed, which has strongly signaled it will cut interest rates in July. However, the June print did not prompt a significant change in PIMCO’s near-term outlook for core CPI inflation (or personal consumption expenditures (PCE) inflation, the Fed’s preferred measure). Furthermore, some of the strength was likely related to business pass-through of higher import tariffs, which the Fed would likely look past due to the negative near-term implications for real growth. Overall, we continue to expect the Fed will cut the policy rate at its July meeting, with both a 25- and 50-bp cut up for discussion.

For more of PIMCO’s views on the complex drivers of inflation in the U.S. and globally, please visit our inflation page.

ACCESS NOW

Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

So far this year, the U.S. equity market has both set new record highs and experienced more than a –6% return in a single month. Even while garnering headlines, stock market performance may not be the most notable part of 2019. Bond yields have fallen dramatically this year: After peaking at 3.24% in early November 2018, the U.S. 10-year yield has fallen more than 100 basis points (bps). In fact, May’s 38 bps decline was the largest in a single month since early 2015.

 

Softening global growth, uncertainty stemming from U.S.–China tensions — and perhaps a recognition of the real and likely protracted nature of the conflict — as well as dovish pivots from the U.S. Federal Reserve and other central banks have all contributed to the move lower in sovereign yields globally. In fact, markets have become increasingly confident in Fed rate cuts, pushing interest rates to the lower end of many observers’ expected ranges.

So, where can interest rates go from here? First, a long-term perspective may be helpful.

The long view

We still see a New Normal/New Neutral world marked by lower growth (particularly given aging demographics in many regions of the world), persistently low inflation, and a likelihood of lower interest rates. We affirmed this view at our Secular Forum in May, in which we developed our outlook for the next three to five years.

Lower trend growth underpins our expectation for range-bound rates – so while rates can drift up from here, we don’t expect dramatically higher yields to prevail. This is also in line with our long-established New Neutral range for neutral policy rates of 2%–3% (the midpoint of which now corresponds to the Fed’s expectation as well).

What’s more, our secular baseline outlook foresees a recession – not imminent, but likely over the next three to five years. As central banks have made exceedingly clear, policy rates should go to zero quickly in such a scenario and stay there for an extended period of time. The capital appreciation potential from interest rate exposure — particularly given the little room for shock absorption that low and decelerating growth implies — is a key consideration for investors today.

So interest rate exposure — or duration — may be warranted in the longer term. But what about today?

The short view

Interest rates in the low 2’s may seem unattractive if we’re not headed for an imminent recession, but there are reasons why maintaining interest rate exposure could be prudent. For one, a Fed biased toward preemptive rate cuts could put policy rates as low as 1.25%–1.5% ­if market expectations are correct, which would mean that the levels today for the 10-year yield may be appropriate. Second, given slowing global growth and deceleration ahead for the U.S. expansion (in part as stimulus effects wear off), there remains little distance from zero or negative growth rates. The downside risks to the economy — whether from more tariff action, trade wars, growth shocks, or declining confidence — may loom large.

With more downside risks, interest rate exposure may be the best way for investors to hedge credit or equity risk in portfolios. Not only does the U.S. have the highest yields globally from which to benefit while gaining diversifying exposure, but it also has the most room for rates to fall in the wake of a downside risk materializing. In fact, a recessionary shock — with policy rates heading to zero — could result in new lows for the U.S. 10-year and provide the capital appreciation that may be a much-needed ballast for investors in a more challenging market for risk assets. 

For more on rates and central banks, please see “Off-Target: Central Banks and the Mystique of 2%.”

READ NOW

Scott Mather is CIO of U.S. core strategies at PIMCO and a member of the Investment Committee. Anmol Sinha is a fixed income strategist at PIMCO.

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. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 
PIMCO Blog by Tina Adatia,joachim Fels - 3w ago

PIMCO experts discuss the secular trends that have the potential to disrupt the global economy, financial markets and investors’ portfolios over the next several years.

For more insights on developments that could move economies and markets, see our recent Secular Outlook,“Dealing With Disruption.”

READ HERE

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

Marc Seidner, CIO non-traditional strategies, explains the need for flexibility and liquidity and how bottom-up research will be key to sourcing attractive relative value opportunities.

For insights on developments that could move economies and markets, see our recent Secular Outlook, “Dealing With Disruption.”

READ HERE

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

A version of this piece originally appeared in the Financial Times on 19 June 2019.

Central banks around the world are pivoting toward easier monetary policy. In some countries this means rates are falling below previous record lows, and in the U.S. the Federal Reserve has paused a rate-hiking campaign and now appears more likely to lower rates than raise them further. Unfortunately, there is little evidence to suggest that lower and lower policy rates are successfully generating either better real growth outcomes or higher inflation.

Yet in pursuit of their 2% inflation target, major central banks seem willing to exhaust monetary policy “ammunition” at a time when economic output is at – or above – potential. In some countries, this policy stance has the potential to reduce monetary policy effectiveness, create imbalances that may sow the seeds for the next crisis, and leave central banks powerless to respond to that crisis. Perhaps it’s time to ask whether the 2% inflation target has outlived its usefulness.

The picture today: lower for longer

Despite largely maintaining policy rates below their own estimated “neutral” levels for more than a decade, the central banks of the U.S., the eurozone, and Australia, among others, have been guiding markets to expect lower rates for longer. This is happening even as many economies are operating with negative output gaps, meaning that employment rates are already above full capacity estimates and economic growth rates have been higher than what is deemed to be achievable in the steady state.

Over the past few decades, most of the world’s major central banks have adopted inflation targets that specify achieving an average inflation rate of around 2%. In many cases, such as with the U.S. Federal Reserve, 2% is not a legally required target but rather an adopted one. With inflation stubbornly below 2% across most of the developed world, central banks have felt compelled to keep interest rates low as well.

Why inflation targeting?

The main concern of today’s inflation-targeting central banks is that if inflation remains too low, it risks drifting into negative territory. The concern about a deflationary world is that it may cause the value of the assets or activity behind the world’s mountains of debt to decline, thus increasing the debt burden in real terms. Additionally, individuals and businesses may delay consumption and investment in a situation where prices are falling, eventually leading to a recession.

Environments like the Great Depression or the 2007/2008 crisis or other periods of large asset deflation (most usually housing deflations) are often cited as proof positive that the dangers of deflation should overwhelm other costs and risks born of artificially depressed rates.

The focus on the risks of deflation may be misguided

Yet one should be careful about confusing cause and effect when examining recessions and deflation. Although economic recessions are typically accompanied by disinflationary forces, it is far from clear that disinflation or small negative rates of deflation actually cause economic crises. Japan has had such an environment for much of the past two decades, and yet its real economic growth per capita looks very similar to that of the U.S. or Europe over the same time period.

By contrast, a primary cause of most large deflations in housing or other areas is overinvestment, or a misallocation of capital. Ironically, many of those situations can be traced back to monetary policy that, in hindsight, may have been too easy. The U.S. housing bubble that was the chief catalyst of the global financial crisis would not have been as severe had policy rates not been kept far below what was thought to be neutral for such an extended period of time. Similarly, an extended period of below-neutral rates has been a prime driver of the high housing prices cited by many of today’s central banks (Australia, Canada, the Nordics, etc.) as a key risk to the economic outlook.

The risks of lower for longer

In addition to contributing to market imbalances, near-zero policy rates have exhausted central banks’ flexibility to react to future shocks or recessions, thus increasing the risks of an extended downturn. Low policy rates may also be creating frictions that lower potential growth via “zombification,” where marginally profitable (at best) companies still remain in business given the ease of access to cheap capital created by repressed interest rates. Suboptimal business behavior, investment, and consumption may be occurring due to the persistence of subsidized borrowing rates.

And while likely fueling these risks and distortions, low rates are clearly not delivering targeted inflation, and they may even be having the opposite effect: It has recently been observed that low rates correlate to low inflation outcomes, perhaps because they cause inflation expectations to fall rather than rise. After all, many real economy actors look to the level of interest rates to form their expectations about future inflation.

What now?

The “natural” rate of inflation may fluctuate over time because of the forces of technology, globalization, demographics, and so on. With potential growth rates that are barely positive and falling in places like Europe and Japan (owing much to challenging demographics), 2% may also not be the natural inflation rate for every region. If this is the case, then inflation targets should be looser, more variable over time, and differ across countries with different economic structures. What’s clear is that a new approach should be considered since the existing framework is not only failing to deliver its promised inflation goal, but also exhausting monetary policy flexibility while creating worrying distortions in the real economy.

For more of PIMCO’s views on developments driving global economies, see our recent Secular Outlook, “Dealing With Disruption.”

READ NOW

Scott Mather is CIO of U.S. core strategies at PIMCO and a member of PIMCO’s Investment Committee.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

As expected, the Federal Open Market Committee (FOMC) this week held steady on both the fed funds rate (2.25%–2.50%) and the interest on excess reserves (IOER, 2.35%). But, more importantly, the FOMC statement emphasized higher economic uncertainty, and FOMC officials weighed rate cuts in response to this more uncertain economic outlook. Indeed, roughly half of the FOMC officials are now forecasting 50 basis points of rate cuts will be appropriate before year-end 2019, while many of those who are not currently forecasting a cut, according to Fed Chairman Jerome Powell, “agree that the case for additional accommodation has strengthened since the May meeting.”

The Fed’s policy outlook now appears largely in line with PIMCO’s expectations that the policy outlook is binary: If U.S.–China trade tensions aren’t at least deescalated around the G-20 meeting or if other downside risks to the U.S. economy materialize, we see the potential for a 50 basis point policy rate cut as early as the July 31 FOMC meeting.

Conversely, if trade tensions improve and economic data is stable, we expect the Fed will try to delay taking any action.

Uncertainty underpins dovish tone

The tone of the FOMC statement and press conference was a notable shift from the May meeting, where Chairman Powell declined to discuss the economic conditions that would warrant rate cuts, and instead emphasized the still solid economic outlook and pointed to various transitory factors that have recently negatively affected core PCE inflation (personal consumption expenditures – the Fed’s preferred inflation measure).

To be sure, much has changed since that meeting, greatly increasing the uncertainty around the economic outlook. The Trump administration’s threatened tariffs on Mexican imports, though they were not implemented (at least not yet), along with escalation of tensions with China, have driven tremendous uncertainty in the U.S. economic outlook.

While our baseline outlook remains that the U.S. will avoid a recession at least over the next year or so, the renewed prospect for more economically disruptive trade and foreign policies, occurring while U.S. growth is already decelerating, greatly increases the risk of a more notable fall in economic growth or even an outright recession, in our view.

In the face of these downside risks, we are not surprised that the Fed is discussing cuts. Although the central bank has some room to ease monetary policy in the event of a more pronounced downturn, the zero or “effective” lower bound (ELB) is still an important constraint. Our view – which we believe a number of Fed policymakers share and which Chair Powell mentioned during today’s press conference – is that this ELB constraint argues for a “stronger sooner” easing response when faced with greater downside risks to the outlook, even if a recession isn’t expected. If this more forceful approach ultimately reduces the chances of returning to the ELB, it appears to be the more prudent risk management strategy. This also supports the idea that the Fed will be pre-emptive – policymakers likely won’t wait until they see a meaningful slowdown in the economic data (which has a one- to two-month lag) to act.

If the Fed doesn’t cut

Financial conditions are back near year-to-date lows (though still meaningfully tighter versus 2018) on the back of markets already pricing in Fed rate cuts. Should the Fed fail to deliver on market expectations for cuts, we expect financial conditions to tighten materially.

On the other hand, if trade tensions improve and U.S. economic data are stable, we expect the Fed to try to delay taking any action, while carefully navigating the impact on financial conditions given market expectations following the June 18–19 FOMC meeting. That said, after the significant dovish changes at the June meeting, the Fed has limited additional tools to communicate dovishness without actually cutting going forward.

Learn the key takeaways from PIMCO’s Secular Outlook for the economy, policy, and markets over the long term.

READ HERE


Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

Negative yields on bonds are back with a vengeance. The five-year German government bond yield reached an all-time low of ‑0.69% after European Central Bank (ECB) President Mario Draghi delivered a dovish speech on 18 June, indicating that the ECB could provide additional stimulus if economic downside risks increase and the current inflation outlook remains subdued. This triggered a fall in bond yields globally, with a record of more than US$12 trillion of bonds trading at negative interest rates as of 19 June (see chart). Negative yields mean investors have to pay (rather than being paid) for owning these bonds.

While investors might be satisfied with positive returns from falling yields in the rearview mirror, the picture is quite different when looking ahead. Negative yields represent a significant challenge for investors in traditional benchmark-oriented strategies. The yield on five-year German bonds, for instance, would reduce invested capital by 0.69% each year, or approximately 3.45% over five years. With these negative yields embedded in the respective benchmark-oriented strategies, we believe investors should be exploring alternatives.

Lower compensation per unit of risk

In addition to falling rates, benchmark-oriented investors may be exposed to higher market risk, which is reflected in increased interest rate duration for traditional strategies. Duration measures a bond’s price sensitivity to changes in interest rates, and the duration of the Bloomberg Barclays Global Aggregate Index, for example, has increased by 25% since 2010.

A more flexible investment approach may offer value

Allocations to more flexible strategies are one option investors could consider to address the challenges of negative yields. Well-designed flexible bond strategies can help navigate even the most challenging markets by identifying attractive investments from a global opportunity set while seeking to ensure investors receive appropriate compensation for the risk. In the context of negative-yielding assets, this also means steering clear of markets where risks may outweigh future return potential. Compared with traditional benchmark-oriented strategies, which are anchored to an index, the flexibility of a dynamic strategy may allow for a more patient approach and the maintenance of dry powder to deploy during periods of future market volatility and dislocations.

For investors facing the challenges of a low-yield environment, dynamic strategies with attractive risk-adjusted return profiles, flexibility, and low correlations to core bonds and equities may offer a compelling complement to core bond allocations.


Marc Seidner is PIMCO’s CIO of non-traditional strategies, and Andrei Wagner is a PIMCO portfolio risk manager. Both are contributors to the PIMCO Blog.

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 is 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. 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. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available to all investors.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

In recent weeks, renewed trade concerns, slowing oil demand, and a notable acceleration in implied U.S. oil production have spurred a material sell-off in oil. Similar concerns caused oil prices to drop at the end of last year, which prompted OPEC+ (i.e., the Organization of the Petroleum Exporting Countries plus 10 additional oil-producing nations) to cut production, reversing policy set earlier in the year of increasing output ahead of a reintroduction of sanctions on Iran. While OPEC+ output is now near multiyear lows, we do not believe OPEC will abandon the production accord at its upcoming meetings in Vienna (likely in the first week of July) in order to meet revenue targets, given that last year’s experience – boosting output and needing to reverse course soon after – will be informing its decisions. Moreover, actual U.S. oil production may not be as strong as the implied data suggest.

All told, we believe this sell-off is overdone and that the current backdrop offers an attractive opportunity for investors, whether via owning commodities outright or via midstream investments.

Complicated backdrop: trade, production

Oil demand is quite leveraged to global trade and, as such, has lost demand momentum as global trade has faltered. Over the past month, markets have answered the trade tensions and repriced the likelihood of a U.S.–China deal, which in turn may drive some upside to oil demand. However, a recovery in economic activity would likely be a prerequisite for meaningful price appreciation in the near term. Longer term, the upcoming shift in the International Maritime Organization-imposed sulfur cap to 0.5% from 3.5% in waterborne shipping offers a positive catalyst for crude oil demand, particularly light sweet crude.

Another area of uncertainty is the speed of U.S. production growth. Real-time data is limited; the U.S. Department of Energy (DOE) bases weekly production estimates on lagged monthly data, which is subject to revisions long after initial publication. Petroleum economists often augment the lagged production data with an implied production estimate, calculated by including the unidentifiable portion of the oil balances with production. It is this latest string of implied production estimates that we find especially intriguing – and controversial: After largely flatlining during winter months, in part due to weather, U.S. implied production has surged from roughly 12 million b/d (barrels per day) in March to nearly 13 million b/d in May. This rapid increase, if real, would be unprecedented, and (remarkably) would have come just before new pipelines are set to ease the bottleneck in the Permian Basin.

Drilling into the implied data

Could U.S. production really have grown so quickly without a material increase in pipeline capacity? While producers continue to exceed expectations, it is curious that most indicators have not been directionally consistent. Specifically, daily natural gas pipeline data from oil plays has largely shown little growth the past five months, unlike last year, when output of both gas and oil were surging. Rig counts, unlike in 2018, have been falling, down 10% from December highs (according to Baker Hughes). In addition, estimates of completion activity in U.S. hydraulic fracturing have largely been flat the past 12 months (according to Primary Vision). Also, our top-down corporate sampling and bottom-up basin estimates struggle to corroborate this implied production surge. Lastly, physical crude oil has consistently been trading well backwardated (i.e., with a downward-sloping futures curve) in the Gulf Coast – typically a sign of a tight physical market – and Midland Basin prices have been improving as new pipelines near completion.

Implied output can be volatile, and we find this apparent surge in U.S. output tough to explain. But with U.S. inventories building sharply over past two months, rising U.S. output could once again hit the market, as it did in the second half of 2018. As new pipelines come online this year, just how far U.S. output will be above our year-end expectations of 13.4 million b/d will shape the oil price path.

Investor takeaways: midstream energy, roll yield

Looking ahead, we see two potential opportunities for investors. One is the U.S. midstream energy sector, which is the primary beneficiary of U.S. oil production growth due to the need to process, transport, store, blend, and export. We believe the midstream sector offers organic growth well above nominal GDP growth, along with attractive yields and attractive valuations.

Another strategy is to buy oil, typically via an allocation to a diversified commodity index with meaningful allocations to petroleum. Due to OPEC+ actions thus far, both voluntary and involuntary, the oil market remains quite backwardated, contributing to a positive “roll yield” for investors owning oil in addition to potential collateral yield. The likely commitment to continuing the OPEC+ production agreement should allow for this curve structure to remain. Roll yield has been a strong indicator of forward returns historically, and if the global economy remains on track, we see a similar opportunity today.

Learn more about investing in the U.S. midstream energy sector in our Viewpoint, “Tapping Opportunity in Oil and Gas Infrastructure.”

READ HERE

Greg Sharenow is a portfolio manager focusing on real assets and is a regular contributor to the PIMCO Blog.

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. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. Derivatives and commodity-linked derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available to all investors.

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 suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice. Investors should consult with their investment professional prior to making an investment decision.

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.

All investments contain risk and may lose value. This material is intended for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 L.P. in the United States and throughout the world. THE NEW NEUTRAL is a trademark of Pacific Investment Management Company LLC in the United States and throughout the world. ©2019, PIMCO

Read for later

Articles marked as Favorite are saved for later viewing.
close
  • Show original
  • .
  • Share
  • .
  • Favorite
  • .
  • Email
  • .
  • Add Tags 

Separate tags by commas
To access this feature, please upgrade your account.
Start your free month
Free Preview