In our Asset Allocation Outlook 2016, “Altitude Adjustment,” published in February, we argued that investors should adjust their return expectations lower and volatility forecasts higher in the current environment while paying greater attention to market liquidity, bond/stock correlation and currency factors in portfolio construction.
We also reaffirmed our view that the global economy was not at the precipice of another recession and that the most probable outlook for the global economy was one of slow but positive growth.
Since our publication in February, risk markets have recovered substantially from lows that were driven by a decline in oil prices and concerns that China was likely to devalue its currency significantly. The recovery was due in part to acknowledgement from central banks that while accommodative monetary policy was needed, ever more negative interest rates and currency wars were likely to be destabilizing. In particular, the Federal Reserve indicated extreme caution as it lifts off the zero bound. While market conditions feel distinctly different from a few months ago, many of the key themes we articulated remain relevant today.
Overall risk position:
We remain modestly overweight on overall risk positioning but have dialed risk down slightly in recognition of fatter left tail risks and the recovery in prices. Many assets have priced in lower long-term rates, but volatility will continue to be driven by divergent monetary policies and commodity prices. Given our base case of continued modest growth with diminishing deflation fears over time, we believe returns can still be earned via targeted risk-taking.
We are underweight equities with a focus on country and sector selection, which remain critical. Given heightened volatility and rich valuations, we believe favoring higher carry assets, like credit, is more prudent in this environment than relying on capital appreciation, like equities, for returns.
We are underweight U.S. equities given the risk of slower growth in earnings in the face of full valuations. Beyond the U.S., we are overweight Europe and Japan as accommodative monetary policy should provide tailwinds to these regions. With improving developments in oil and China, and a Fed that is wary of further U.S. dollar (USD) strength, we have initiated a modest overweight in emerging markets.
We are neutral interest rate duration in multi-asset portfolios. Given ultra-low interest rates, we are cautious of the risks of rising rates; however, the diversification and tail risk hedging benefits of high quality bonds are important in the context of a multi-asset portfolio. We prefer U.S. Treasuries versus lower-yielding AAA sovereigns, and we maintain small allocations to higher-yielding peripheral European debt and emerging markets.
Spreads in both investment grade and high yield credit reached levels last quarter not seen since 2011. At a juncture where we foresee dissipating deflationary fears and steady global growth, spreads at these levels appear to offer superior risk-adjusted returns relative to equities – thus we maintain an overweight. Nevertheless, we maintain caution within the energy and mining sectors, favoring trades on improving commodity prices implemented through real assets or currencies.
We continue to believe that exposure to inflation breakevens in the U.S. remains attractive as improvements in the labor market will continue to feed positive inflationary pressures, and a bottom or slight recovery in oil prices may also serve to lift market expectations for future inflation. We maintain our neutral position in commodities, emphasizing relative value opportunities across energy, metals and agriculture sectors.
Our currency positions are more nuanced and tactical than they have been in the past due to the fact that in developed markets, central bank reaction functions argue against large moves. Currently we are underweight the Chinese yuan as a portfolio hedge and overweight cheap commodity currencies like the Mexican peso and Russian ruble.
Click here for further insights into PIMCO’s asset allocation views, and please stay tuned for our next annual Asset Allocation Secular Outlook this summer following our 2016 PIMCO Secular Forum.