The Federal Reserve’s quarter-point interest-rate hike this past week was neither particularly contentious nor consequential. While the debate over whether to raise or not was irresistible fodder for TV talking heads and financial columnists (ahem), the move itself, the statement, and the presser brought to mind one of Ronald Reagan’s famous lines. To wit: “Well, I’m not surprised.”
It isn’t so complicated, is it? The Fed is trying to put the brakes on the economy, but the labor and the stock markets are determined to party on.
Some say this is a highly unsettled investing environment and have been shocked by the stock market’s recent run-up. Really? Any more unsettling or shocking than usual? Sure, the particulars may be singular—525 basis points in 11 rate hikes over 16 months, and the
S&P 500
is up some 19% year to date—but come on, unpredictability is the market’s North Star. (A basis point is 1/100th of a percentage point.)
Most of this gnashing of teeth has concerned equities, not fixed income. Over in that parallel universe of Treasuries, mortgage-backed securities, corporates, and agencies, other issues are brewing—some of which mirror equities, some of which don’t.
Top of mind on bond desks is if the Fed is near the end of its rate hiking, whether we’re in for an extended rate plateau—and if it’s time to find opportunities that would benefit from that flatlining and, around the bend, a series of rate cuts.
But there’s also just relative valuation, argues Pimco CEO Emmanuel “Manny” Roman. “The growth in the [equities] market has been six stocks. It’s been very, very narrow,” he says. “And stocks aren’t cheap. How much exposure do you want to have to equity, given the fact that the stock market has done much better than anyone expected? Is it time to take some money off the table and diversify your exposure?”
So postulates a man who has boatloads of bonds to sell you—Roman’s $1.79 trillion book is almost all fixed income, making Newport Beach, Calif.–based Pimco one of the biggest fixed-income managers on the planet. Still, as we will see, Roman has a holistic pedigree when it comes to investments and makes a compelling case.
“Right now, we are in a very target-rich environment,” he says about fixed income. “The first thing we say to a [Pimco] portfolio manager is, now is the time to deliver alpha [that is, excess returns], because there are just so many different things to do. That’s not always the case. You have 2006 and 2007, when Pimco didn’t do much because we thought everything was overpriced.”
Wait, you said “target rich,” Manny. Meaning what, specifically?
“It is a target-rich environment both in terms of absolute levels and opportunities in relative value,” he says. “Mortgage-backed securities are very attractive as liquid assets that benefit from direct government guarantees or agency guarantees, at spreads as wide as we have seen since the [2008-09 financial crisis]. Household and consumer-credit fundamentals are strong as well, and we like high-quality ABS [asset-backed securities] and MBS across the board. AAA-type ratings at attractive spreads, 50 to 200 basis points [to Treasuries], will be very resilient under harder-landing scenarios.”
Eddy Vataru, lead portfolio manager of the
Osterweis Total Return
fund (ticker: OSTRX), also favors MBS. “It’s a slam-dunk trade for me,” he says. “Spreads are wide like no other sector, and since I think the yield curve will steepen, that provides a nice tailwind for MBS, whose investors have suffered under this inverted curve.”
Let’s back up for a moment and look at the Treasury market. Jay Barry, J.P. Morgan’s co-head of U.S. rate strategy, believes that the Treasury is going to be increasing the amount of notes and bonds it sells from some $1.05 trillion this year to about $2.06 trillion next year—which, all things being equal, could put upward pressure on rates to attract investors. Barry’s thesis starts with the government’s insatiable appetite for money. “We continue to forecast a [federal budget] deficit of about $1.575 trillion in fiscal year 2024, or around 5.5% to 6% of GDP, which is 1½ percentage points higher than it was pre-Covid,” he says.
“We’re at an interesting crossroads here,” Barry continues. “Depending on where you are along the yield curve, Treasuries are at their highest levels in 10 to 15 years. If we’re right and the Fed is very close to finishing up its hiking cycle, this should make risk-free assets more attractive, particularly if inflation moderates in the coming months.”
Changes in rates also dictate prices of yield equivalents, such as real estate investment trusts. “We can argue whether we’re in the eighth inning or the ninth inning with the Fed tightening, but they’ve already raised 500 [basis points], so we’re kind of toward the end of the game here,” says Steve Sakwa, Evercore ISI’s head of real estate research.
“The bigger issue is, where does the 10-year [Treasury bond] settle out, because most of the [REITs we cover] have long-term fixed-rate debt,” he says. “When will the Fed start cutting, and when will those rate cuts flow into earnings for us?”
To play it safe, Sakwa favors more-defensive, recession-resistant REITs like those in healthcare—specifically, medical office buildings and assisted living—some shopping centers, and industrial REITs. “Over the past four cycles, when the Fed stops raising rates, REITs do well the following year on an absolute basis,” he says.
As with REITs, sometimes the road less traveled is more appealing. For instance, another of Roman’s fixed-income targets is emerging market debt. “Opportunities in emerging markets exist for the higher-risk segment of portfolios in local rates and currencies,” he says. “Central banks in EM are well ahead of developed country central banks in fighting inflation, which is paying dividends.” (Or yields, as it were.)
It makes sense that Roman, French by birth, has a cosmopolitan view, since he was raised in Paris by parents who were artists. Fear not, free-marketeers: He is a proud graduate of the University of Chicago Booth School of Business. He worked for 18 years at Goldman Sachs, where he served as co-head of worldwide global securities. He then joined investment manager GLG Partners, which was bought by
Man Group
(EMG.UK), where he became CEO before coming to Pimco in 2016. So he is hardly just a bond dude.
Roman follows some high-profile characters, including former Pimco CEO Mohamed El-Erian, currently president of Queens’ College, Cambridge, and chief economic adviser at
Allianz
(ALV.Germany), the German insurer that owns Pimco; and Bill Gross, who co-founded Pimco with $12 million in 1971. Gross, known as the Bond King, presided over Pimco’s investment ethos and ran its flagship
Pimco Total Return
(PTTRX), once the largest bond fund in the world, with $293 billion in assets. (Since Pimco’s founding, assets have grown a stunning 14,916,566%—a great deal of it due to Gross’ acumen.) But in 2014, Gross got into a major tiff and left.
Those wild and woolly days are long gone, and Pimco under Roman is more calm and collaborative, as evidenced when I asked him what his alpha was. “My biggest alpha is the fact that it’s a partnership with 3,000 people,” he says. “I have a wonderful partner in Dan Ivascyn. It’s all about one firm.” Roman needs to make sure his alpha drives alpha in his investors’ portfolios—in this rate cycle and the next.
Write to Andy Serwer at [email protected]
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