Equity markets are still overvalued despite the deep declines we have seen this year. That is the view of Andrew Balls, CIO of Pimco, world’s largest active bond investor. According to him, both a mild recession, and falling earnings expectations are not yet sufficiently priced in.
Pimco’s multi-asset portfolios underweight equity positions for that reason. ‘We do not yet see the mild recession that is being priced into several bond markets reflected in equity valuations. On top of that, earnings expectations are also yet to come down as far as we are concerned, and so price-earnings ratios are still too positive at the moment,’ says Balls (photo).
Both equities and bonds are losing double-digit percentages this year, but the normal negative correlation between high-quality bonds and equities will recover in the coming months, according to the California-based fund house’s analysis. Balls makes the statement at a time when the market is increasingly showing a come-back from fixed income.
“The hedging characteristics of high-quality core bonds, which should typically rise in value when equities fall, will improve,” Balls notes in an outlook note for the next 12 months. Investors returning to fixed income will be rewarded, he said
Both yields and prices will rise
Many bond markets are now pricing in a mild recession, but if that recession becomes deeper than the market expects, bond prices will start to see considerable upward movement. Where Pimco’s portfolios have long been underweight duration and underweight interest rate risk, positions are now being upgraded to neutral.
“On top of rising rates come the increasingly attractive-looking yields we expect over the next 12 months,” said Balls. On the negative correlation between the price and yield of a bond, Pimco is not worried about the next 12 months.
He said it is very difficult to say anything meaningful about expected yields in the short term due to the foggy inflation forecasts, “but under current market conditions, as far as we are concerned, you can assume that yields can be achieved that are in line with long-term expectations,” sadi Balls without quantifying long-term expectations.
Inflation anchored, but Fed pivots in next 12 months
US core inflation (6.6 per cent) turned out to be 0.1 per cent above market expectations last week. This came as no surprise to Tiffany Wilding, North America economist at Pimco.
“Core inflation rates are still above central bank targets, and they are firmly anchored there as far as we are concerned,” Wilding said.
Pimco expects policy rates to peak between a range of 4.5 to 5 per cent over the next 12 months. After that, the Fed will pause to assess the impact of its tightening on the economy, according to the asset manager’s economic office.
Implications for investments
The answer to where the opportunities lie, according to Pimco, is threefold. Ten-year US government bonds currently look more attractive than previously expected, argues Balls, who also says he is enamoured with corporate bonds. He also has private credit in his sights.
Balls: “We have seen several mispricings in the credit market recently, mainly within financials. Also, the high yield and attractive spread in the structured credit market is an opportunity for us. We are additionally holding some ‘dry powder’ to also invest in private credit markets in the coming years.”
As far as Balls is concerned, the gap between private and public asset valuations remains extreme, but as private markets adjust and the challenges in corporate credit and real estate become clear, opportunities should emerge. “This is one of our most compelling views,” he said.
Caution remains in place
Yet Pimco still remains cautious, argues Balls, “if inflation continues to hover stronger than we expect, central banks could be forced to raise interest rates more than currently priced in. If recessions in developed markets are mild, as we expect, policymakers could be slow to cut policy rates to stimulate growth.”
The combination of expected higher unemployment and stubbornly above-target inflation has put central bankers in a tough spot, “but their overall performance so far shows that they are doing all they can to reduce inflation,” Wilding said.