Navigating Change: Opportunities in Quality Credit, Specialty Finance and Mortgages
BY MARK R KIESEL JANUARY 2017
The global economy is going through significant change, as Donald Trump’s incoming administration and shifts in public sentiment in other major economies create potential for new opportunities and risks. For markets, the potential for both left- and right-tail outcomes has increased. Successfully navigating the new environment will require discipline, courage and strong risk management skills.
Indeed, Trump’s U.S. presidential victory is part of a global wave of change and comes at a critical juncture. Monetary policy in developed markets has been losing its effectiveness as the benefits of low interest rates and global quantitative easing have gradually diminished. At the same time, increasing numbers of savers and key constituents in the financial sector have been highlighting the limitations and negative consequences of these policies. Now, due in part to rising populism, sentiment against meaningful austerity has also begun to unfold. These forces mean that a gradual shift from monetary policy toward fiscal policy is set to take place.
In addition, the benefits of globalization are increasingly being questioned, which could cause more nations to turn inward. If so, trade relationships have the potential to evolve more rapidly, particularly if protectionist measures come to fruition. At the same time, the world faces the prospect of heightened global conflict and the potential for a pickup in military spending. Finally, we now have the prospect for a new paradigm of pro-business and pro-growth policies in Washington – lower taxes, deregulation and increased infrastructure spending. Change is in the air – but the impact on markets can cut both ways!
These developments have the potential for both negative and positive consequences – left-tail and right-tail risks. The left-tail scenario involves the risks of trade restrictions and rising protectionism, anti-immigration policies, dollar strength, deterioration in the U.S./China relationship and an escalation of geopolitical conflicts. The right-tail scenario centers around upside potential in global growth due to increased government spending, lower taxes and deregulation. This could lead to a pickup in consumer and business spending due to rising confidence and “animal spirits,“ as Trump and his administration put in place pro-business, pro-growth initiatives.The world today faces considerable two-way risks!
A main risk the U.S. economy may face over our cyclical horizon of six to 12 months is a pickup in inflation. It could be fueled by higher wages and a tight labor market, as rising confidence and “animal spirits“ translate into higher spending by consumers and businesses. Fiscal policy changes could also be inflationary. Trump’s proposed tax policy changes would likely be supportive for consumers and businesses, although they could increase import prices. At the same time, fiscal stimulus and infrastructure spending could further bid up scarce labor resources. Importantly, U.S. fiscal stimulus is set to increase even as the U.S. economy enters its eighth year of expansion and labor markets are tight. This increases the risk of the U.S. economy overheating, particularly if the Fed were to make a policy mistake.
Interestingly, equity and credit markets appear to be pricing in mostly right-tail outcomes, or positive scenarios, while ignoring many of the left-tail risks, or negative scenarios. With the market increasingly romancing mostly the positives, we have been de-risking portfolios broadly across the credit markets, particularly given the recent strong post-election performance in equities, investment grade corporate bonds, high yield bonds, bank loans and emerging markets corporate bonds.
While we continue to see select opportunities in the credit markets (mainly in higher-credit bonds, agency mortgages and non-agency mortgages), we believe it makes sense for investors to increase cash balances and go up in quality. Left-tail risks are increasing, and there is growing risk that the U.S. economy could overheat under Trump’s policies, leading to more aggressive interest rate increases by the Federal Reserve over the next year. Simply put, the probability of U.S. recession over our cyclical horizon has moderately increased while valuations in many areas of the credit market have become less attractive. See our Cyclical Outlook, “Into the Unknown,” for details of our forecast for global markets and economies.
SELECT OPPORTUNITIES IN CREDIT
Compared with about a year ago, when PIMCO increased credit risk (see our Global Credit Perspectives, “The Case for Credit” and “Time to Move”), we are taking less overall credit and “spread risk“ and have been shifting our portfolios into areas of the credit market where we see the most favorable risk/reward. This shift, while subtle, underscores our views on credit sectors positioned to withstand the potential changes and uncertainties in the market outlook. Specifically, we see opportunity in the following areas in global fixed income credit sectors:
●High quality corporate bonds. We favor industries tied to the U.S. consumer, including cable, telecom, gaming, airlines and lodging, which should remain supported by solid consumer fundamentals, rising confidence and prospective tax cuts. We also continue to like banks and financials, which benefit both from moderately higher interest rates and steeper yield curves as well as the potential for less onerous and costly regulation under Trump. Finally, we continue to believe mid-stream energy/MLPs/pipelines offer the most attractive risk/reward in the energy sector given higher energy prices and the prospect for a pickup in volume growth in the U.S. shale regions.
●Bank capital/specialty finance. We believe select opportunities exist in U.S./UK/European bank capital securities and specialty finance companies where our bottom-up credit research seeks to identify companies with improving fundamentals. These sectors should benefit from a gradual pickup in nominal GDP, an improvement in earnings growth and rising equity market capitalization. Current bank capital valuations have cheapened relative to high yield, and deregulation should be particularly supportive for specialty finance companies.
●Non-agency mortgages. The risk/reward on non-agency mortgages continues to look attractive given current loss-adjusted spreads and a healthy U.S. housing market, which remains supported by a solid labor market, deleveraged consumer balance sheets and favorable demand/supply.
●Agency mortgages. Valuations on high-quality agency mortgages have cheapened considerably over the past few months. They are now increasingly attractive both outright as well as relative to U.S. Treasuries given the recent backup in interest rates.
NAVIGATING CHANGE, RISK AND OPPORTUNITY
In 2017, investors will need more than ever the ability to recognize, analyze and adapt to change. Navigating change can potentially be profitable; however, it requires discipline, courage and strong risk management skills as well as an appreciation for both left- and right-tail risks.
In 2016, investors were rewarded for being patient, selective, diligent in bottom-up research and proactive in capitalizing on the year’s major events (the slump in energy prices, Brexit and Trump) and the related dislocations in markets. It was a year that produced not only strong performance in the credit market but also one in which prudent active management rewarded investors.
Similarly, 2017 should also be an excellent year for active management in the credit markets. We anticipate fatter tail risks – both left and right. Nevertheless, change can also lead to opportunity! Importantly, given the amount of uncertainty and change occurring around the world, active managers are in an excellent position to capitalize on any future dislocations in markets.Best wishes for a prosperous 2017.