Developed markets have turned optimistic after the U.S. presidential election, pricing in higher inflation and GDP growth in the U.S. Asset markets have reacted, with U.S. equity markets rallying, global interest rates rising and yield curves steepening. Nevertheless, substantial uncertainty still looms around policies that are intended by the new administration and those that will actually be enacted. While higher growth is a possibility, our view is that fiscal expansion and protective trade policy when the economy is operating near full capacity makes higher inflation almost a certainty.
From an asset allocation perspective, the recent developments have caused us to view Treasury Inflation-Protected Securities (TIPS) rather than nominal government bonds as the “risk-free” asset. Moreover, we are cautious on emerging markets (EM). While EM asset valuations are cheap compared to the U.S., they have been large beneficiaries of increased globalization over the last couple of decades and may face some headwinds. We think higher volatility is also likely, and we feel it is important to emphasize uncorrelated return drivers, such as alternative risk premia strategies, in multi-asset portfolios.
Overall risk position:
We are modestly overweight risk. Given our base case of modest global growth aided by a fiscal boost in the U.S., we believe positive returns can still be earned via targeted risk-taking. We are maintaining ample dry powder and remain focused on relative value and bottom-up opportunities.
We have pared our modest underweight and are now neutral equities, with a continued focus on country and sector selection. While valuations are the fullest in the U.S., the third-quarter earnings seasons have been better than expected in the U.S. and Europe. Additionally, potential changes to U.S. tax policy and regulation may provide further support to domestically oriented U.S. corporations. We have therefore increased our exposure to U.S. stocks with a bias toward small capitalization stocks. In contrast, we’ve reduced our exposure to Japanese equities, as consensus earnings expectations look too ambitious versus our own forecasts. Finally, we’ve cut our EM overweight down to neutral given the heightened risk of protectionist and anti-trade policies in the U.S.
With the fairly sharp pick-up in yields, we’ve moderated our underweight to high quality government bonds. In the U.S., we prefer TIPS. In Europe, we see better value within nominal bonds in German Bunds and are overweight, particularly relative to France, given relatively tight spreads and a full political calendar ahead.
Income generation still remains the core focus of our multi-asset portfolios. We continue to believe high quality bonds offer an attractive means to escape negative-yielding assets without taking excessive risk at a time when we believe recession probabilities are still fairly low. In particular, our overweight to credit is focused on non-agency mortgage-backed securities, which will likely benefit from an ongoing recovery in the housing market and remain well-insulated from many global risks hanging over financial markets, leading to low-to-modest correlations with other spread sectors. We also have added senior, short weighted-average-life collateralized loan obligations (CLOs) as another source of high quality yield.
We maintain an overweight to real assets, with a focus on U.S. TIPS. Inflation expectations have risen recently, yet value remains, as we expect inflation is on course to reach and possibly exceed the Fed’s 2% target over the coming months. More importantly, given the outlook we face with fiscal expansion and protectionism, TIPS offer the benefits of inflation protection with portfolio diversification characteristics similar to nominal Treasuries. Some are beginning to view them as the new “risk-free” asset. Finally, we have reduced our overweight in REITs, given broadly fair valuations and their sensitivity to rising rates.
We continue to favor the U.S. dollar against a basket of Asian currencies – a region that has benefited inordinately from global trade. We also have a modest underweight in the euro, anticipating continued dovish monetary policy from the European Central Bank. We are holding small tactical positions in some of the higher-carry “commodity currencies” given the excessive cheapening seen post elections.
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Mihir Worah is PIMCO’s chief investment officer for asset allocation and real return. Geraldine Sundstrom is a managing director and portfolio manager focusing on asset allocation strategies. They are regular contributors to the PIMCO Blog.