Wednesday, July 18th, 2012
by Curtis Mewbourne, PIMCO
- Asset classes are likely to be affected by the situation in Europe and, more broadly, by high debt levels in developed countries. The related political debate about austerity vs. growth is also critical.
- Fixed income investors should note whether countries control their own currencies and can monetize their debts. Those that can may be greater inflation risks. Those that cannot may be greater credit risks.
- These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes.
- We encourage investors to broaden their opportunity sets, for example, looking more closely at emerging market government bonds. They also may consider assets such as real estate and commodities, which may partially replace traditional domestic equities.
Navigating the global landscape these days is tough. Macro risks range from uncertainty about the future of Europe to mixed messages about the U.S. economy – not to mention a host of concerns about indebtedness, policy and politics.
In the following interview, portfolio manager Curtis Mewbourne discusses how investors can approach asset allocation in such an environment and over the longer term.
Q: What are the most critical factors likely to affect asset classes over the next three to five years?
Mewbourne: Investors need to monitor the situation in Europe, whether they are directly invested there or not, because of the systemic implications of a potential shock to Europe’s banking system or sovereign debt. The eurozone has the second largest economy and the largest banking system in the world, and the slowdown that we are already seeing in emerging market growth is partially driven by slower demand for goods and services from Europe.
More broadly, asset classes are likely to be affected by high debt levels in Japan, the U.S. and other developed countries as well as the related political debate about the trade-off between austerity and growth. Unemployment levels remain elevated in many countries, partly as a result of austerity measures.
These factors are contributing to market volatility and lower returns, which in turn are challenging investor expectations about asset classes. For example, European equity markets in some cases are at the lowest levels in years, and, as a result, investors may be questioning the notion that European equities provide reasonable returns above inflation – a key point for pension-fund managers and other investors.
Similarly, the low policy interest rates that central banks are implementing around the globe contribute to government bonds in several countries trading at very low levels. These low yields create an asymmetric return profile: There is not much room for further price appreciation, while concerns about possible future inflation could lead to significant volatility and price declines. For fixed income investors, it is critical to understand whether bonds have credit risk, inflation risk or both. Countries with their own currencies have more flexibility to print money and monetize their debts, and hence typically have more inflation risk and less credit risk. Countries that do not have the ability to print their own currencies have the opposite. This largely explains the divergence between Europe and the U.S./U.K./Japan in terms of government bond yields and knock-on effects on risk premium valuations.
Put simply, nominal government bonds and traditional equity investments, at least in the case of Europe, have not performed in the way that investors have expected and likely may not perform according to textbook expectations going forward.
Q: Will we see more convergence – or divergence – in the behavior of asset classes?
Mewbourne: It depends on which asset classes we are talking about, but there are a few high level themes that are relevant to understanding how asset classes may behave. Very high global debt levels and unconventional monetary policies mean that balance sheets are more levered and the global economy is more vulnerable to policy changes. Under such conditions it is likely that certain macro factors, such as policy changes, will affect many asset classes in roughly the same way at the same time. Over the past few years, we have seen periods of heightened correlations between regional markets as well as between previously uncorrelated asset classes.
This is not set in stone. In some cases capital will move from one area to another, or fundamental economic differences will lead to divergence of asset classes. We have seen that recently in currency markets where there has been a large shift away from emerging market currencies and into the U.S. dollar.
Q: PIMCO has talked about the emergence of credit risk in the sovereign market. How will this affect portfolio construction?
Mewbourne: As I was saying before, fixed income is an asset class that has become quite different from textbook explanations. For example, five to seven years ago it was a reasonable decision for a European citizen saving for her child’s education to invest in government bonds, counting on a low probability of principal loss, little volatility and a modest return. Fast forward to today, and government bonds in many European countries have behaved quite differently than expected. The clearest example is the loss of principal on the restructuring of Greek bonds; but also prices of other European sovereign bonds suggest higher probabilities of potential losses. In all, the expected volatility, risk and returns on such bonds have changed, and therefore they likely play a different role in investors’ portfolios.
This shift is a challenge for certain institutional investors, such as insurance companies and some banks, whose business models or regulatory requirements require high-quality bonds with low probability of principal loss and low volatility.
Q: Staying with the topic of risk, what are some other risk factors investors should be managing, and how should they go about doing so?
Mewbourne: Investors need to think about the potential loss of principal on bonds of overly leveraged countries and companies. They also need to think about the loss of purchasing power from inflation as a result of central banks pursuing very low interest rates. When interest rates are lower than inflation, the resulting negative real yields eat away at investors’ purchasing power.
Given the issues that we have discussed, the time they need to spend thinking about and focusing on political risks has increased significantly, and they need to increase significantly their efforts in understanding and factoring such risks into their investment decisions.
Q: Let’s talk about opportunities: Are there new or emerging opportunities that investors should be thinking about? And can you offer some insights into alternative ways for investors to capture these opportunities?
Mewbourne: Markets are still healing from the major financial dislocation of 2008 and 2009 and, in a sense, the recovery creates opportunities in many areas for investors to identify and take advantage of attractive risk-adjusted returns. This requires a very active focus, as those opportunities can be in sectors that have become more credit sensitive and require more resources to review.
For example, in the non-agency mortgage market in the U.S., investors need to understand the underlying loans, a process that can take considerable time and knowledge but also lead to some very good opportunities.
Another example is the U.S. municipal bond market. That asset class has become much more credit sensitive and requires much more credit focus, but investors can really benefit from rolling up their sleeves and doing their credit research.
Also, the heightened market volatility that we expect in the years ahead can lead to greater risks but also opportunities during periods in which investors look to exit the same strategies at the same time. Given the geopolitical landscape, we expect overshoots in currency and commodity markets to result in buying opportunities.
Q: Ultimately, what are the key things investors should be thinking about or doing in their portfolios, considering PIMCO’s secular outlook?
Mewbourne: As risk and return characteristics transform, our view is that investors need to transform the way they think about using asset classes. We encourage them to broaden to the greatest degree possible their opportunity sets, for example, looking at emerging market government bonds as a replacement for some more traditional developed market government bonds.
Developed market government bonds have become riskier in some respects, and emerging market bonds are becoming less risky, and in cases where they pay a higher rate than inflation, they may be less risky both in terms of credit risk and the risk of purchasing power erosion.
We also encourage investors to broaden the type of financial instruments they consider. While they need to appreciate the risks of different instruments, they may benefit from investments in areas such as real estate and commodities as part of overall portfolio construction, and those areas can replace some of the roles that traditional domestic equities have played in the past both in terms of expected returns and volatility.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Tags: Asset Allocation, Asset Classes, Austerity, Banking System, Critical Factors, Debt Levels, Domestic Equities, Emerging Market, Eurozone, Global Landscape, Government Bonds, Indebtedness, Inflation Risks, Investor Expectations, Market Volatility, Mixed Messages, Other Developed Countries, PIMCO, Political Debate, Portfolio Manager, Sovereign Debt
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Friday, July 15th, 2011
On Your Mind: Debt Ceiling and the US Dollar
by the Schwab Center for Financial Research
There’s been a lot of media attention on the US debt ceiling and the outlook for the US dollar. Here, we’ll answer some of the questions we’ve been receiving from clients.
The US debt ceiling
- What are the chances of the United States defaulting on its debt?
- Will the United States automatically default if the debt ceiling isn’t raised by August 2?
- When can we expect a resolution to this issue?
- What will happen if the United States does default?
- What does this mean for investors?
Outlook for the US dollar
- Is there a risk of the dollar collapsing in the short term?
- Is the world going to abandon the dollar as a reserve currency?
The US debt ceiling
We believe that there will, in fact, be a resolution to the debt-limit debate, and that default on US Treasury debt remains unlikely. The United States has a resilient economy and a strong ability to pay, despite the current political debate. That said, the situation illustrates the importance, we believe, of a global, broadly diversified portfolio.
What are the chances of the United States defaulting on its debt?
We believe a default is extremely unlikely. We expect that the political debate will continue, but believe that the negative consequences, both political and economic, will become more apparent the longer the delay. According to the Treasury, those consequences could include delay of Social Security payments, Medicare, military salaries and other expenses, and ultimately default. As the deadline approaches and the potential pain becomes more apparent to the average citizen, or is reflected in a rise in yields, we believe that politicians will act and raise the debt ceiling.
Will the United States automatically default if the debt ceiling isn’t raised by August 2?
If the debt ceiling isn’t raised by August 2, the Treasury has stated that its cash-flow management strategies will run out and it will either need to issue new debt above the limit (which it can’t legally do) or stop payment on a variety of obligations, including debt payments. A default could be staved off for a short time if the federal government prioritized payments to bondholders over paying its other bills, but as of yet no there’s no legal prioritization for payments. Given the enormous amount of interest and principal due on the federal government’s outstanding debt, this temporary solution wouldn’t be sustainable for long. However, we believe that the debt ceiling will be raised, allowing the government to avoid suspending payment to its bondholders or to anybody else.
When can we expect a resolution to this issue?
A deal would probably need to be made no later than July 22 in order to meet the August 2 deadline for completed legislation. Once the broad outlines of a deal are agreed upon, it normally takes two to three weeks to hammer out the specifics and produce draft legislation. That schedule would likely be compressed here, given the urgency of the situation. Once draft legislation is complete, both the House and Senate must vote to approve it—and this may be the trickiest step of all. President Obama and House and Senate leaders will have to forge bipartisan coalitions in both chambers to get the bill across the finish line. We believe that this will be difficult, but it is very likely to happen.
What will happen if the United States does default?
It’s impossible to say with any degree of certainty because this has never happened before. The three major bond rating agencies have said that they would lower the US’s current AAA rating even if interest and principal payments were interrupted for only a few days. Should this occur, we still expect that global demand for Treasuries and confidence in ultimate payment won’t disappear. Treasury yields would likely rise in the event of a default, and we expect more volatility in Treasury yields until an agreement is reached.
What does this mean for investors?
For the moment, we see less upside and more risk in new Treasury purchases for price-sensitive bond investors. However, we believe that buy-and-hold investors should remain confident that US capacity to pay will ultimately remain strong. We don’t believe that a dramatic change in investment strategy is warranted for most investors.
Fundamental demand for US Treasuries has remained strong, as evidenced by yields that remain near historical lows. This, we believe, is due to a number of factors, including:
- Confidence that the debt limit will be raised
- Weaker economic data leading to continued demand for Treasuries
- Some positive sentiment (toward Treasuries) that a serious budget/deficit debate will lead to a strong US fiscal position
- Some negative sentiment (toward the economy) that large and/or rapid cuts in government spending might slow economic growth in the short term.
It’s true that we’ve seen a recent increase in yields, which we believe has to do with the debt-ceiling debate as well as many other variables: the ongoing challenges in Europe and, specifically, Greece; changing market consensus about the pace of US economic recovery; and the recent end to the Federal Reserve’s bond-buying program (QE2).
Outlook for the US Dollar
Recent events have caused some investors to wonder about the dollar’s short-term prospects and its status as a world reserve currency. While there are genuine reasons for the dollar’s weakness—including large deficits, a loose federal monetary policy, and a less-than-robust economic recovery—we believe that a sudden collapse of the dollar or a precipitous change in its reserve currency status is unlikely. Additionally, we believe that a global, broadly diversified portfolio can help investors protect US-denominated portfolios from a dollar decline.
Is there a risk of the dollar collapsing in the short term?
A sudden sharp decline of the dollar would not be in anyone’s interest. This includes Japan and China, which are the largest external holders of US Treasuries. It would destroy the value of their massive foreign currency reserves that are heavily overweight in dollars. Sudden sharp moves in exchange rates are generally seen as a threat to the stability of economies and global financial markets. Were the dollar to suffer a sharp decline, it would most likely lead to concerted currency market interventions similar to the recent G7 intervention to stabilize the yen.
Because the whole world is so dependent on the dollar, no one wants violent moves in the currency. Therefore, a possible shift away from the dollar is likely to take place over several years or even decades and not in the near term. This will give you time to assess your portfolio and the changes you might want to make.
Is the world going to abandon the dollar as a reserve currency?
It’s unlikely that the dollar will lose its status as the world’s number one reserve currency anytime soon. Talk of creating new supra-national currencies or even a global fiat currency has gotten louder due to recent events and negative sentiment toward the US Fed’s monetary policy. But even if there is a will to work toward creating new currencies, the countries involved are nowhere near realizing those plans.
No other existing currency can offer the necessary stability and liquidity to replace the dollar as the world’s reserve currency in the foreseeable future. This suggests that the dollar will keep its status for now.
In the mid- to long-term, however, we believe it’s possible that the dollar will eventually share its reserve status with other currencies such as the euro, the yen and maybe even the Chinese yuan. The creation of new currencies is also possible. However, keeping the euro area’s difficulties in mind, the success of such endeavors first has to be proven, and takes time.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Examples provided are for illustrative (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.
Diversification does not eliminate the risk of investment losses.
Tags: Cash Flow Management, Citizen, Deadline Approaches, Debt Ceiling, Debt Limit, Diversified Portfolio, Limit Debate, Management Strategies, Media Attention, Medicare, Military Salaries, Negative Consequences, Political Debate, Politicians, Reserve Currency, Schwab, Social Security, Social Security Payments, Treasury, United States
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