PIMCO: Bonds provide resilience in uncertain economic times

September 15, 2023

^{This article was written in Dutch. This article is an English translation.}

With economic uncertainty plaguing the world, it is vital not to lose sight of any potential risk. How is the restrictive monetary policy now filtering through to the real economy and what does this mean for the investment markets?

By Patrick Dunnewolt, Head of Benelux, PIMCO

The recent shocks in the banking system make it clear that central bank action to curb inflation will have a major impact and that we need to consider broader economic implications. We foresee three major economic themes that could unfold in the second half of 2023.

First, the likelihood of a significant tightening of credit conditions, particularly in the US, has increased significantly due to bank failures and rising borrowing costs. This has also increased the risk that the recession will start sooner than expected and will also be deeper. Second, while central banks are nearing the end of their tightening trajectory, this does not mean that they will simply move to policy normalization or even monetary easing. Policymakers will probably wait until inflation falls towards the target level. Third, recession risks and further tensions in the banking system are unlikely to be cushioned by more large-scale budget support unless there are serious and tangible consequences for the economy.

Choosing bonds?

The rule of thumb is that bonds often thrive in uncertain times, especially now that current interest rates – historically a fairly accurate indicator of returns – received a significant boost from a repricing last year. Bonds have a long history of being an effective diversification and asset preservation tool, and we expect these attributes to play out even better than currently priced in. In addition, there may be price increases in the offing if the economy continues to deteriorate. In other words, bonds are now clearly worth considering.

Given the prevailing macroeconomic and geopolitical uncertainty and inflation dynamics that are hard to fathom, it seems that markets are not out of volatility anytime soon. But it's precisely those situations that present opportunities for active managers, especially those with a broad and flexible spectrum of investment opportunities. Valuations remain attractive and we currently prefer higher quality liquid investments. We believe caution is warranted in this climate. Later this year, as the economic outlook becomes clearer and cyclically sensitive market sectors are repriced, the time may be ripe for an offensive approach.

Emerging Markets: Stronger Performance Ahead?

We are watching developments in emerging markets with great interest. Emerging markets have endured one global setback after another over the past year and now appear to be on the verge of a recovery phase, as inflation is moderating and monetary policy stance is becoming increasingly clear.

Structural developments such as deepening local markets and nearshoring (bringing supply chains closer to home) are supportive of emerging market fundamentals. Due to the 2022 outflows from funds invested in emerging markets, investors are currently both structurally and tactically underweight in this asset class, which we believe is undervalued relative to its historical average.

In addition, high real interest rates in emerging markets provide a buffer against the risk that these markets will be penalized by further rate hikes by the US Federal Reserve (Fed) and a strong US dollar. At the same time, the reopening of the Chinese economy is providing a boost and the spike in inflation and fiscal pressure already appears to be over.

So it looks like emerging markets are already past the worst. We are becoming increasingly bullish on these markets as a whole and on local currency-specific emerging country government bonds in particular. Still, we remain cautious until the outlook for monetary policy becomes clearer. Indeed, much depends on how well the Fed manages to curb inflation and how well China can restore economic activity.

Opportunities in private markets for the patient investor

For several months now, we have been pointing out that investors should focus more on public credit markets, where all factors are priced in, and that private markets only come into focus at a later stage, when prices there have become somewhat more realistic. Private markets have experienced impressive growth over the past decade, potentially putting them under pressure for an extended period of time, especially in the event of a harder economic landing.

Although private assets are still incorrectly valued, the number of new transactions on the private markets is slowly looking more attractive. We are therefore increasingly willing to take positions as soon as opportunities arise.

We see opportunities in segments where de-risking in the banking system and reduced access to credit are likely to have far-reaching consequences. We have worked with banks on a number of occasions to resolve balance sheet issues, both in the US and other regions. As policy and balance sheet-related pressures mount, we expect many lenders to recapitalize their businesses and become increasingly less able to extend new loans, even to the most high-quality borrowers.

The commercial real estate sector may face new challenges. However, we would like to emphasize that this sector is anything but homogeneous. We aim to remain invested high in the capital structure, in a variety of issuers. We differentiate ourselves by avoiding lower quality risks, concentrated investments or mezzanine investments.

The time is ripe for pension funds

Fixed-income securities have recently become a lot more interesting and this development is good for Dutch pension funds, which have seen their funding ratios rise as a result.

Now that interest rates on fixed-income securities have risen, bonds may play a more important role again. This will enable pension funds to better meet their obligations and generate more growth. Another advantage is that a portfolio with equities, bonds and private assets can generate additional returns that are more stable than can be expected from a portfolio focused solely on equities. In this respect, emerging market government bonds are an interesting option.