Geraldine Sundstrom, portfolio manager for the PIMCO Dynamic Multi-Asset Strategy, discusses how the strategy flexibly navigates financial markets and provides insights into how to prepare and position for a potentially challenging late-cycle environment.

Q: Can you describe the overall approach of the PIMCO Dynamic Multi-Asset Strategy?

A:It’s a global asset allocation strategy that invests dynamically across equities, credit, interest rates, real assets and currencies in an effort to provide attractive risk-adjusted returns over the full market cycle. We leverage PIMCO’s investment process, combining views on fundamentals, valuations and technicals into a structured, agile approach. The strategy is focused on an asymmetric approach to risk: We implement PIMCO’s macro and relative value ideas across asset classes, aiming to smooth the path of returns for our investors.

In the current environment, we believe the strategy’s inherent flexibility is a crucial advantage. As an economic cycle matures, it is typically helpful to migrate assets from credit toward equities, ideally focusing on regions with the best opportunity sets. Flexibility becomes critical late in the cycle, when the probability of a recession is rising. Equities may be the optimal asset class toward the end of the cycle, but once a recession hits, an equity allocation can deteriorate with astonishing speed. That’s why a flexible, dynamic approach to asset allocation is so important now, as the global economic expansion – nearly 10 years along – reaches the late stage.

Q: What is PIMCO’s economic outlook? Could the next recession be on the horizon?

A: Our recently published Secular Outlook, “Rude Awakenings,” explains why we believe the environment in the next three to five years is likely to be very different from the one we’ve witnessed since the global financial crisis. We will need to navigate a range of risks.

Market volatility is likely to be greater, for one thing, as major central banks normalize policy and withdraw from the extraordinary measures that kept a damper on volatility for years. Trade tensions among major players in the global economy are rising. As economic output approaches full capacity, we could very well wake up to an inflation surprise that pushes central banks to potentially become more aggressive. Finally, the rise of many populist, protectionist movements around the world could lead to another rude awakening: These movements gained traction at a time when economic growth globally has been stable and synchronized. If we were to have a recession, there’s a risk the populist sentiment could turn more radical and unpredictable.

I should emphasize that in the near term, the economic outlook remains benign, with synchronized above-trend global growth and gradually rising interest rates, especially in the U.S. A recession doesn’t seem to be around the corner. And when it does arrive, perhaps around the time U.S. fiscal stimulus begins to ebb, it will likely be shallow, but also long and risky. The monetary and fiscal ammunition to counter a recession is less potent this time around.

Q: How does this top-down outlook, combined with bottom-up ideas from around the world, inform how you manage a multi-asset portfolio today?

A: It’s time to focus on higher-quality investments. The seas are going to get rough, volatility will increase and eventually we’ll be faced with a recession. This is where quality comes in: Some regions have more resilient fundamentals and are positioned to fare better than others in an adverse environment. The U.S., for example, has much more room for maneuver than Europe or the emerging markets, so we are emphasizing U.S. equities, which have the added benefit of generally much stronger corporate balance sheets. Select equities in Japan are attractive as well.

We also believe it’s important to have an allocation to high-quality duration in a multi-asset portfolio, particularly in the belly of the U.S. yield curve. We are much more tactical and selective in our approach to European duration, which offers yields that can be more attractive to European investors on a hedged basis, but calls for a careful approach.

As for credit investments, we are generally cautious and have trimmed our exposure quite a bit, concentrating only on select securitized positions, non-agency mortgages and high-quality loans.

Market valuations are in no way cheap, in our view, so we tend to avoid being overexposed in any areas. Call it a “yellow light” scenario: We want to be prudent, but not fully risk-averse.

Q: The market environment in 2018 has been complicated. How has the strategy fared, and how are you preparing for the road ahead?

A: Markets have been challenging for investors across many regions and asset classes this year. The opportunity set is very narrow. Global bond markets are a little down; global equity markets are generally flat; markets have been choppy and at times highly volatile. It makes it difficult to extract a lot of value.

The Dynamic Multi-Asset Strategy has focused on managing the downside risks in this environment, allocating capital dynamically and maintaining flexibility as we watch for catalysts of cyclical change. Markets and portfolios are going through some rough waters, but perhaps calling this the end of the cycle could be premature. Agility is key – we need the ability to anticipate and respond to what’s next. Global growth could continue. Technicals could improve. And so we will scour the global opportunity set for entry points wherever value has been created in today’s rough waters.

On the other hand, should a recession come earlier than our forecast, we have the flexibility to adjust positioning accordingly, perhaps by shorting equities. We could aim to extract more value out of bellies of yield curves in Canada or the U.S. Agility is key.

Q: After depreciating sharply in 2017, the U.S. dollar is strengthening. How does this affect positioning?

A: We’re watching the dollar, and other currencies, very closely. Foreign exchange (FX) can have a significant impact on asset class returns nowadays: The world economy is highly integrated, and many corporations have large overseas earnings. For example, eurozone equities struggled in the first quarter of 2018 despite good domestic growth, largely due to the euro’s strength versus the U.S. dollar. We also need to pay careful attention to the divergence in monetary policy across markets, mindful of the impact it has on returns net of hedging costs. Ultimately, we think of currencies both as a direct risk and opportunity, and as an indirect influence on other assets.

Q: Can you describe your risk management approach, given the Dynamic Multi-Asset Strategy’s broad flexibility?

A: I think our approach can best be captured by saying “a big part of winning is not losing”. Risk management is integral to how we manage the strategy – we aim to smooth the path of returns and take a very asymmetric approach to upside and downside risks.

We employ a range of risk-management tools, such as standard value-at-risk (VaR), along with rigorous analysis of correlations and underlying risk factor exposures. Just because a portfolio is diversified across asset classes or regions doesn’t mean it’s necessarily diversified across risk factors – this is something we’ve been diagnosing and managing for many years at PIMCO.

Along with analysis, implementation is critical. If we believe an implementation idea offers a better risk/reward balance via options or derivatives, for example, we may go that route, also incorporating downside buffers to improve the strategy’s overall risk profile.

In the end, the amount of exposure to individual risk factors as well as total risk will tend to be highly dynamic and variable. When values seem fair and our baseline outlook is benign, we will tend to run more risk than when assets seem overvalued and the risk of a recession is high.

Q: Is this risk awareness part of why the strategy is much more relative-value-orientated today?

A: Yes. Given the clouds gathering on the secular horizon, we have reduced overall risk, reflecting a greater relative value approach. As I mentioned above, we’re favoring U.S. and Japan positions on the long side, whereas in Europe and emerging markets we are much more neutral and, in certain cases, actually short. We’re also very cautious on credit. Quality is the major differentiator here.

Of course, more risk-aware positioning tends to mean less exposure to potential market upsides as well as the downside. One way we can seek to capture more upside while maintaining our higher-quality focus is by targeting opportunities presented by market volatility. For example, when volatility spikes, as a way to monetize our short positions, we may sell covered puts to the downside, short-term of course. By managing this approach carefully, we can potentially improve overall outcomes.