As volatility in late 2018 drove the U.S. stock market down nearly 20% from its peak and down 4.4% for the year, based on the S&P 500 Index, high quality bonds had a positive reversal of fortune and rallied in the fourth quarter. Portfolio managers for PIMCO’s Income Strategy, Dan Ivascyn and Alfred Murata, discuss how the strategy was positioned for the volatility and offer their outlook for 2019.
Q: What drove the change in investor sentiment during the fourth quarter, and what do you expect going forward?
Dan Ivascyn: Fourth-quarter market moves reflected investors’ reaction to a slowdown in growth, particularly outside the U.S., ongoing concerns over central bank policy, and significant uncertainty over global politics. Much of the volatility was also technical in nature, stemming from lower trading liquidity going into year-end.
It's important to put the volatility in perspective. The last decade can be categorized as a post-crisis environment when policymakers looked to suppress volatility. We think the market environment is changing, however, and will look very different in the future, due largely to political uncertainty and central banks taking a much less active role in suppressing volatility. We weren't surprised by the volatility in the fourth quarter, but it's very hard to predict exactly when these bouts of fear will occur.
From an investment perspective, it's critical to protect capital during these periods. To that end, we're defensively positioned overall and try to use the market volatility to go on offense. We're pleased with the resiliency in the Income Strategy during the fourth quarter.
Q: U.S. Treasury bond yields moved quite a bit over 2018, with the 10-year yield starting at 2.4%, peaking above 3.2% and finishing at 2.7%. What is your outlook for yields this year?
Ivascyn: We're not of the mindset that when you hit certain technical levels, yields rise automatically. When you look at a long-term chart of high quality government bond yields, periods of relatively range-bound bond markets are not atypical. We think this is one of those periods when rates will remain within a range over the longer term.
One reason for that is we don't see a meaningful breakout to higher inflation. Additionally, global growth rates are quite low and debt is still high. This is a concern because the next economic slowdown is highly likely to be accompanied by much lower bond yields. We saw a preview of what can happen to rates during a market sell-off in the fourth quarter, when high quality bonds rallied significantly.
In the short term, though, we think Treasuries and other high quality bond markets likely got a little ahead of themselves. We don't expect a significant rise in interest rates over the next 12 months, but we think there is still a meaningful chance of more tightening by the Federal Reserve. Over the next few months, we would not be surprised if high quality bond yields drift higher, which warrants a little caution.
Q: What were the key drivers of performance for the Income Strategy during the fourth quarter?
Alfred Murata: The Income Strategy’s combination of top-down economic views and bottom-up trade ideas worked well in 2018. Coming into the year, we thought economic growth would be relatively strong in the near term, but we were concerned about the possibility of a slowdown in the intermediate term. Because of that, we had reduced credit risk in the Income Strategy, and in the fourth quarter, we were able to go on offense and add credit positions at attractive prices. Very importantly, though, we were able to preserve capital by having a portion of the strategy invested in higher-quality assets; these high quality assets were the key drivers during the fourth quarter.
Overall, having a portion of the strategy invested in higher-quality assets, such as Treasuries and agency mortgage-backed securities, has typically enabled it to remain resilient during times of economic stress, while having a portion of the strategy invested in higher-yielding assets, such as non-agency mortgage-backed securities, has typically helped generate income and returns during benign economic environments.
Q: How did duration, or interest rate exposure, change over the quarter, and how are you thinking about duration in the strategy today?
Murata: We see two main reasons to have duration in a portfolio: to add potential total return and to help protect the portfolio against downside risks. In general, we have increased duration as rates have gone up, and we have reduced duration when rates have fallen.
During the fourth quarter, the Income Strategy’s duration positioning – mainly its exposure to U.S. Treasury bonds ‒ helped preserve capital for investors. We favor U.S. rates relative to most other developed markets given the combination of relatively high nominal and real rates. We also continue to hold some duration in Australia because we think the Reserve Bank of Australia (RBA) is unlikely to increase the policy rate in the near term due to the relatively soft housing market.
We have been more cautious on Japan and U.K. interest rates, where we hold negative duration exposure. In Japan, rates are so low that we don't think Japanese bonds have much potential to rally further, while we do think there’s the potential for interest rate normalization. In the U.K., Brexit uncertainty is creating volatility, but we recently added a negative duration position as we think Brexit is unlikely to result in a significant drop in U.K. rates, and in a benign scenario, interest rates could increase significantly.
Q: During the sell-off in the fourth quarter, corporate credit spreads, both investment grade and high yield, widened significantly from near historical lows. Do you think this is a buying opportunity?
Ivascyn: The widening in spreads brought corporate credit closer to fair value from a historical perspective, and we were active in certain segments of the market. From the standpoint of overall corporate exposure, we have shifted to a more constructive stance, at least over the short term.
We like the financial sector globally, and we took advantage of market volatility to add positions there. The capital positions of many financial institutions are near or at their highest levels in more than a decade. Currently, we like U.K. banks; we think even an extremely negative Brexit scenario does not represent meaningful default risk for many of the banks in that region.
That said, we have been selective in corporate credit markets overall and maintain high liquidity in that segment of the strategy. Our longer-term concerns within the corporate market remain: Elevated issuance and deterioration in investor protections across investment grade, high yield and bank loan markets lead us to be cautious.
So yes, we've increased exposure in select areas, but we are still cautious on corporate credit over the longer term.
Q: What other sectors do you find attractive for the Income Strategy?
Ivascyn: We continue to like housing-related investments. They provide attractive yields, and perhaps more importantly, in a negative economic environment – which we saw during the fourth quarter ‒ we think these positions should be much more resilient than corporate credit alternatives.
There's been some confusion in the market about U.S. housing of late, as increases in home prices and housing-related activity have slowed. However, from an affordability perspective ‒ price-to-rent, price-to-income and other longer-term valuation metrics – U.S. home prices look quite reasonable in our view. Given the low loan-to-value ratios on mortgages, rising homeowner equity, strong wage growth and low unemployment, we think housing will be a very resilient sector. Not only have we maintained our exposure, we've increased it over the last year or so.
Additionally, we like emerging markets as a diversifier within the Income Strategy. We often talk about having high quality assets that can serve as a hedge against risk in the Income Strategy, but almost as important is having resilient and diversifying positions within the higher-yielding portion of the strategy. The performance of emerging markets in general during the second half of last year, including the positive price performance of certain positions in the fourth quarter, showed that targeted investments in sectors with attractive total return potential can actually help suppress volatility in a portfolio, even during flight-to-quality events.
Q: What should investors expect in the markets and the Income Strategy in the year ahead?
Murata: First, we expect the markets to remain volatile. Having a balance of higher-quality and higher-yielding assets along with some “dry powder” in the Income Strategy should enable us to continue to seek to take advantage of dislocations in the markets.
Also, the increase in interest rates over the last year and the recent sell-off in credit mean that fixed income yields overall have been increasing, and that should be a positive factor for investors going forward.
Ivascyn: It's critically important to us as an active fixed income manager to distinguish ourselves during challenging market environments and focus on providing resiliency for investors during periods like the fourth quarter of 2018. Volatility within the corporate credit and emerging markets, in particular, is the highest it has been in quite some time. So the environment for expressing relative value and targeted views is better in these sectors today than at any point over the last several years. The Income team is very excited about taking advantage of these opportunities in 2019.