The world’s largest active bond fund manager says markets are too optimistic about central banks’ ability to dodge a recession as they battle inflation in the US and Europe.
Daniel Ivascyn, chief investment officer at Pimco, which manages $1.8tn of assets, said he was preparing for a “harder landing” than other investors while top central bank chiefs prepare to continue their campaign of interest rate rises.
“The more tightening that people feel motivated to do, the more uncertainty around these lags and the greater risk to more extreme economic outlooks,” Ivascyn said in an interview with the Financial Times.
He noted that when rates have risen in the past, a lag of five or six quarters for the impact to be felt has been “the norm”.
“We would argue that the market may still be too confident in the quality of central bank decisions and their ability to engineer positive outcomes,” he said. “We think the market is a bit too optimistic about central banks’ ability to cut policy rates as quickly as the yield curves are implying.”
The US Federal Reserve, the European Central Bank and the Bank of England have all been rapidly raising rates after criticism that they had been too slow to react as inflation gathered pace.
At a conference in Sintra, Portugal, this week, the heads of all three indicated more action is likely to be needed while inflationary pressures persist. On Friday, the Nasdaq Composite stock market index recorded its strongest first half of the year in 40 years, in part on expectations that US interest rates would soon peak.
But core inflation, which is used as a gauge of underlying price pressure because it strips out volatile food and energy prices, has hovered around 5 per cent in the US and eurozone in recent months, while surging as high as 7.1 per cent in the UK for the year to May.
Ivascyn said: “Today we have a real legitimate inflation problem. It will likely be harder for central banks to cut policy even if the economy is weakening as long as inflation is comfortably above their [2 per cent] targets.”
Pimco, which is owned by German insurer Allianz, is repositioning funds to be “more defensive and more liquid” as it draws back investors following a terrible year for bond funds in 2022.
The California-based manager suffered €75bn of outflows last year, but Ivascyn said flows had “materially improved” as investors grab the higher yields now on offer. Pimco has attracted €14bn of assets in the first quarter of this year, Allianz has reported.
While Pimco thinks a “soft landing” is the most likely outcome for the US economy, Ivascyn said the group is avoiding areas of the market that would be most vulnerable in a recession.
Favouring high-quality government and corporate bonds for now, he is waiting for company credit ratings to be downgraded, which he said will prompt forced selling among vehicles such as collateralised loan obligations in the coming months and years. That will be the time to snap up bargains, he said.
“A great trade will be to take advantage of the violent repricing of the public markets and then wait for private markets to adjust over the next few years and then rotate into what should be a really attractive opportunity,” he said.
“Hold some cash because we think the next two, three years is going to be quite target rich for opportunities in the higher yielding space.”
However, he cautioned this cycle might be different to previous ones. Central banks may be less willing to provide support for fear of fuelling rising prices, while the fact that so much risk has been transferred to private markets would slow down the deterioration of credit valuations, but not prevent it.
“This could be more of an old fashioned cycle that lingers for a few years with inflation high but policymakers don’t come to the rescue,” he said.
Pimco’s move to safer bonds is part of a wider industry shift towards higher quality fixed-income assets. The latest survey of fund managers by Bank of America showed investors were the most overweight in investment-grade bonds compared with their high-yield counterparts since 2008.
Even for investors who do not think central banks will be able to bring inflation back down to target, Ivascyn said fixed income provided the best value we have seen for “many, many years”, with real inflation-adjusted yields in the US at levels not seen since the global financial crisis.
“You can be defensive in terms of interest rate risk, inflation risk, credit risk and generate a very, very attractive return,” he said.
“Which is different from saying ‘buy everything, it’s all going to be fine’.”