By: Randy Myers
As the COVID-19 pandemic maintains its grip on much of the world, the economic outlook remains uncertain. But at least it’s no longer the radical uncertainty that existed when in March, when the pandemic gained its foothold in the U.S. and the potential risks were so unquantifiable that some investors disengaged and sent the financial markets spiraling downward. That radical uncertainty has given way to what financial market veteran Anthony Crescenzi calls “regular uncertainty” now that the coronavirus behind the pandemic is better understood. And that’s a good thing for investors, because it makes it easier to price risk and settle on an investment strategy.
Not that there won’t be bumps along the way. The coronavirus remains a significant threat. Crescenzi, an executive vice president, market strategist and generalist portfolio manager with global investment management firm PIMCO, told participants at the SVIA’s 2020 Fall Forum in mid-October that U.S. economic activity likely won’t return to 2019 levels until at least 2022. That means short-term interest rates are poised to remain at or near their current low levels for some time, an outlook reinforced by the Federal Reserve’s plan to maintain its current accommodative monetary policy until the inflation rate moves above 2% and shows signs of staying there, and the unemployment rate reaches a level consistent with full employment.
In this low-rate environment, one challenge for fixed-income investors is to determine where on the yield curve it makes most sense to invest. Crescenzi identified the “pivot point” on the curve in the U.S.—the point above which yields could show some movement—as seven years. Accordingly, he said, PIMCO is generally underweight duration a little bit in its fixed-income portfolios, mostly at the long end of the curve. “The long (Treasury) bond could easily rally down to 0% in a very stressful situation,” he observed, possibly even falling into negative territory as investors speculate about the potential for negative interest rates in the U.S. Since bond prices go up when yields fall, that could generate profits for fixed-income investors. Crescenzi warned, however, that “it’s important not to be too underweight on duration because there’s still a hedge value to Treasuries in high-quality fixed income.”
Crescenzi also said the chances of seeing negative rates in the U.S. are low. Negative rates impose costs on banks when it prompts people to want to hold physical cash, he said, and Federal Reserve Chair Jerome Powell doesn’t seem to like the concept, either.
Crescenzi said PIMCO likes to hold liquid assets in its fixed-income portfolios right now, in part because intermediaries, like investment banks and brokerage firms, no longer want to hold large inventories of bonds. That can make it difficult to sell illiquid securities when markets are stressed, pressuring prices and exacerbating losses for investors who must sell.
Agency mortgage-backed securities are among the liquid securities PIMCO favors at the moment, Crescenzi said, noting that that approximately $300 billion trade daily, or about half the volume of U.S. Treasuries. “We also like non-agency mortgage-backed securities,” he said, noting that the housing market looks attractive because of demographics, the low rate environment and low levels of housing inventory. He said PIMCO also is bullish on housing in the private markets for investors who can afford to give up some liquidity, especially in select areas of the commercial real estate market. Further down in the capital structure, he said, “we like bank capital securities.” Investors have to be careful about volatility in that sector, he warned, but may find that 6% yields, where available, represent adequate compensation for the volatility risk.
Crescenzi identified four potential disruptors to the economy and financial markets moving forward—populism, the climate, technology, and China—but said there were reasons in each case for some optimism. While the surge in populism in recent years is rooted to some degree in the income inequality that’s developed in the U.S. and some other developed economies, for example, there are movements afoot that could address that inequality. He cited the emphasis placed on stakeholder capitalism as opposed to shareholder capitalism at the World Economic Forum this year, a movement that’s also been embraced by the Business Roundtable, whose members are the chief executive officers of major U.S. companies. Meanwhile, potential government expenditures on infrastructure, especially if Democrats sweep the White House and both chambers of Congress in the November elections, could create jobs and opportunities that temper income inequality. So, too, could government spending to address climate change, an issue that younger generations are eager to address.
Finally, worries about competition between the U.S. and China, especially in the technology space, may be overblown, Crescenzi suggested, noting that there’s room for the technology pie to grow rather than simply be divided up. He also observed that tense relations between political foes don’t always hurt the business environment, citing the Cold War between the U.S. and Russia from 1947 to 1991 as an example.
While some investors worry what would happen to the financial markets if President Trump is not reelected to a second term, Crescenzi said the consensus view of a win by Democratic presidential candidate Joe Biden is that while Democratic tax and regulatory policies may impose a hit on corporate profits, that hit could be offset by increased spending on infrastructure. And, he said, he does not expect a dramatic increase in the corporate tax rate if Biden is elected—a jump to perhaps 24% or 25% from the current 21%.
“The consensus view is that a Democratic sweep would mean the most in terms of spending,” Crescenzi said. “In fact, the proposals by Donald Trump toward spending, if he were to win, we think would get watered down in ways that a Biden win would not. And so it seems that the spending boost, the net influence on growth, at least initially, would be larger under Biden. This is why markets are not fearful despite the ascension of Biden in the polls—because of all the spending that’s likely under a Biden administration.”