Investment implications of a low-growth “window of weakness”

J. Fels/ A. Balls (PIMCO) | In looking at the investment implications of the cyclical window of weakness for the global economy, we note global rates markets price in recession-like conditions already, while corporate credit markets and risk markets more generally appear to price in better outcomes, either in terms of the macro outlook, the efficacy of central banks in continuing to supress volatility, or both.

In this environment we think it prudent to focus on capital preservation and to be relatively light on top-down macro risk positions in our portfolios, combined with a cautious approach on corporate credit. Given the uncertainty in the outlook – and the potential for right tail as well as left tail risk – we will wait for more clarity and will take advantage of opportunities as they present themselves, rather than placing a great deal of weight on our baseline outlook in our portfolio construction.

A slowdown or modest recession would not necessarily have a supersized impact on spread markets. However, following a long period of risk-seeking behavior and dip buying, we seek to protect portfolios against the risk of more significant market dislocation. We will maintain a very close focus on liquidity management.

Duration

On duration, the level of yields continues to look too low given our baseline outlook. That said, and notwithstanding the recent retracement, in the event that recession risk increases we see the potential for an ongoing global grab for duration that may be quite insensitive to yield levels. U.S. Treasury duration continues to look like the best source of “hard” duration to provide a hedge to risk assets in portfolios.

Overall, we expect to remain fairly close to neutral on duration across our investment strategies, depending on the other balance of positions in portfolios. Similarly, while we see a range of relative value opportunities, we do not have high top- down conviction on curve positioning.

Credit

We will remain cautious on corporate credit risk, reflecting both tight valuations at a time of above-average recession risk and our concerns over credit market structure: We’re closely watching the increase in corporate issuance and investment industry allocation to credit combined with the decline in dealer balance sheets for trading.

We favor “bend-but-don’t-break” credit (short-dated and default-remote) and will look to implement the high conviction ideas of our global team of credit analysts and portfolio managers. But we will be very wary of exposure to generic corporate credit at tight valuations.

We continue to see structured credit, notably U.S. non-agency mortgages and other residential mortgage-backed securities (RMBS), as offering relatively attractive valuation, a more defensive source of credit risk, and a less crowded sector.

U.S. Treasury duration continues to look like the best source of “hard” duration to provide a hedge to risk assets in portfolios.

Overall, we expect to remain fairly close to neutral on duration across our investment strategies, depending on the other balance of positions in portfolios. Similarly, while we see a range of relative value opportunities, we do not have high top- down conviction on curve positioning.

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