Text on screen: Stephen Chang, Portfolio Manager, Asia
Text on screen: What are the key takeaways from our latest Cyclical forum?
Chang: Central banks have been raising interest rates sharply over the past 12 months to fight inflation. This has contributed to recent volatility across the financial sector, as the effects of tighter monetary policy filter into markets and the economy with a lag.
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Key takeaways from PIMCO’s latest Cyclical Outlook
- Central Banks: less tightening, but slower easing.
- Bonds continue to look attractive at current yield levels, in our view.
- We are prioritizing higher-quality, more liquid investments.
Peak policy rates are now likely to be lower than markets previously were pricing. But normalizing monetary policy, and then eventually easing, will take more time and need inflation to decrease closer to target levels. In the meantime, unemployment is likely to rise.
Broadly, we believe bonds continue to look attractive at current yield levels, offering a balance between income generation and cushion against potential economic downturns. During this part of the economic cycle, we prefer higher-quality, more liquid investments, and are avoiding lower-quality, more economically sensitive areas that are most exposed to the effects of tighter monetary policy.
We are starting to see more attractive opportunities in newer deals within private markets, but prices of existing assets have been slower to adjust compared with public markets. In a world of higher funding rates, forced deleveraging is likely.
Text on screen: Can you share PIMCO’s views on the impact of recent bank failures?
Chang: Bank failures, wider elevated volatility in bank stocks, rising cost of capital, and ongoing potential for deposit flight from more fragile small and midsize U.S. banks, all suggest that credit conditions may significantly tighten, particularly in the U.S.
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PIMCO’s views on the recent bank failures
- Significant credit tightening more likely – raising the risk of a sooner, deeper recession.
- However, good reasons to believe this is not a repeat of the Global Financial Crisis.
- Central banks likely need to do less heavy lifting to get the same result: tighter financial conditions.
These events will likely lead to an earlier recession, in the case of the U.S., and act as yet another headwind that could very well pull Europe into recession as well. We think the risk of a deeper recession has gone up, since banks – even large, so-called national champion banks – may retrench and shift their operations to a more conservative approach.
Still, there are good reasons to believe that this is not 2008. Households still have excess savings, aggregate corporate debt-to-GDP ratios appear manageable, and so far bank losses have mostly resulted from rising interest rates, not from risky lending or credit defaults. The largest U.S. systemically important banks remain financially sound and have been the beneficiary of deposit outflows at smaller banks. Improved valuations and greater certainty in the capital structure reinforces our bias for senior debt over subordinated bank issues.
All of this means central banks likely need to do less heavy lifting to get to the same result: tighter financial conditions – which slow down credit growth, demand, and eventually inflation. Wages, and in turn services inflation, are likely to moderate more slowly and will feature in how the Fed assesses the trade-off between financial stability and inflation risks.
Text on screen: What is PIMCO’s view on the implications of our outlook for Asia?
Chang: With China’s faster reopening, and the smaller extent of tightening that has taken place across many Asian economies, we see fewer macro headwinds for the region on a relative basis. In fact, recent credit events in U.S. and European banks may lead to a less hawkish stance by the Fed, such that Asia central banks can act according to their respective economic circumstances.
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The implications for PIMCO’s Asia outlook
- Recent credit events may lead to a less hawkish Fed, which would allow Asia central banks to act with greater autonomy.
- Issuers in Asia may be able to take advantage of the access to onshore lending.
The Asia banking system overall should be in good shape, reflecting a tight regulatory framework, with strong capitalization and less reliance on wholesale funding.
While global credit sentiment may have weakened from recent events, issuers in Asia may be able to take advantage of the access to onshore lending where liquidity conditions remain sufficient, notably in India and Indonesia.
We see an earlier-than-expected economic recovery in China, and the extent of the upside will depend on the rebound of consumer confidence and deployment of excess savings. Growth support will be driven more by consumption than property or infrastructure investment, following on from the sectoral rotation from 2022.
We see pockets of opportunity in select Asia financials, and in corporate credit across investment grade and high yield, while noting that market volatility will likely remain elevated.