With US inflation easing to 4.9% in April, the Federal Reserve is expected to end its interest rate hiking cycle over the coming months. However, uncertainty now lies in whether the central bank will keep rates at their current level for longer or begin to cut them before the end of the year.
Pimco portfolio managers Erin Browne and Emmanuel Sharef believe a greater allocation to fixed income may help to navigate the uncertainty surrounding central bank policy coupled with a risk of recession in the US.
They said: “Through this year’s changing market narratives – soft landing, overheating, and credit crunch – the underlying macro conditions have pointed steadily toward the same fundamental theme: Bonds are back.
“Elevated macro uncertainty, a likely economic downturn, and higher yields that bolster return potential all may support a shift in allocation toward fixed income. Restrictive monetary policies are affecting global economies after long and variable lags, credit is tightening, and signs of breakage have started to appear in the financial sector.
“Pimco’s business cycle models forecast a recession in the US later this year. How different asset classes will perform is likely to depend heavily on the severity of the recession (when or if it happens) and, crucially, on central bank behaviour.”
Tilting towards bonds
In Pimco’s asset allocation outlook for the months ahead, the firm revealed an overweight position on inflation-linked bonds. Browne and Sharef explained this was due to bonds’ ability to safeguard portfolios during both a recession and an upside inflation surprise.
They said: “In light of our macro and market forecasts, we favour bonds as a portfolio allocation due to their diversification, capital preservation, and upside opportunities. In equities, however, we remain cautious as earnings expectations appear too high, and valuations too rich.
“Much depends on the decisions of the Federal Reserve and related macro forces, but as the economy shifts toward recession, fixed income may help portfolios navigate challenge and uncertainty.”
Pimco asset allocation outlook
Explaining the firm’s allocation to credit, the duo said: “We are modestly overweight credit, emphasizing higher quality issues. Non-agency MBS stands out given its strong fundamentals and attractive valuations.
“High all-in yields and wider spreads in investment grade corporate credit should provide greater downside cushion in a recession. However, we are cautious on lower quality issues as tight financial conditions are expected to weigh on fundamentals, though we believe defaults should remain in-line with historical averages.”
Elsewhere, the asset manager’s cautious weighting to equities comes due to an ‘increasingly fragile’ outlook for growth coupled with ‘overly optimistic’ valuations, particularly in the US – Pimco’s largest underweight in the asset class. However, Browne and Sharef highlighted opportunities in emerging markets over the next 6-12 months as China’s reopening boosts the sector.