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Cyclical Outlook Key Takeaways: Strained Markets, Strong Bonds

High quality fixed income investments can help center portfolios while offering attractive yield potential amid a likely recession in 2023.

After enduring one of the worst years on record across asset classes, investors should find more cause for optimism in 2023, even as the global economy faces challenges.

In our latest Cyclical Outlook, “Strained Markets, Strong Bonds,” we discuss how we are investing against a backdrop of a likely recession as central banks continue to battle inflation. This blog post summarizes our views over the next six to 12 months.

The economic backdrop
Economic activity has been more resilient than expected, but the outlook has deteriorated. Financial conditions have tightened, and our baseline view is for modest recessions across developed markets (DM).

We see three key economic themes:

· Inflation is likely to moderate, and risks to the inflation outlook appear more balanced than they did several months ago.

· Central banks are closer to holding policy at restrictive levels as opposed to getting policy there.

· Shallow recessions won’t be painless, as unemployment is likely to rise.

The U.K. is likely already in a recession. We expect the euro area to follow, and the U.S. and Canada to slip into recession later in the first half of 2023.

We believe that euro area and U.K. headline inflation – which appear to be following the U.S. with a lag – peaked just above 10% in the fourth quarter of 2022, while U.S. CPI (Consumer Price Index) inflation likely peaked near 9% in mid-2022.

We expect DM central banks to continue to raise interest rates for the next quarter or so. As 2023 progresses, inflation moderates, and unemployment rises, the need for restrictive policy will get less clear.

Since the U.S. appears to be leading DM inflationary trends, and inflation could fall faster in the U.S. than elsewhere, the U.S. Federal Reserve (Fed) may be the first central bank to discuss cutting rates in the second half of 2023.

China’s reopening may also provide a tailwind to the global economy and could quicken the easing of supply-chain disruptions.

Investment implications
In our concentric circles investment framework, where risk increases toward the edge, we are prioritizing investments nearest the core, focusing on high quality fixed income sectors that offer more attractive yields than they have in several years. We’re seeking to make portfolios resilient, targeting securities that should be able to withstand even a more significant downturn.

This figure depicts PIMCO’s concept of concentric circles, which places the least risky, most liquid asset classes at the center, including overnight repurchase (repo) rates, commercial paper, and ultra-short and short-term bonds, then expanding to somewhat riskier assets including longer-term sovereign bonds, mortgage-backed securities, and investment grade corporates, and populating the outer rings with less liquid, higher-risk assets, such as high yield corporates, emerging market investments, equities, and real estate.

Within our framework, changing the price of borrowing at the center – starting with central bank policy rates – creates ripples that radiate outward, affecting the prices of risk assets at the perimeter.

We believe uncertainty over the outlook for Fed policy should be much lower in 2023. If the Fed and other central banks can convince investors that the center will hold, then assets near the core should perform well, feeding into improved returns at the edges. But if there is a loss of confidence on inflation, and policymakers must raise rates more than expected, this will have negative consequences for the outer circles.

The repricing of the front end of the yield curve in 2022 has boosted the allure of short-dated bonds at the center of these circles.

In our baseline, we expect a yield range of about 3.25% to 4.25% for the 10-year U.S. Treasury, and broader ranges across economic scenarios for 2023, with a view of being neutral on duration – a gauge of interest rate risk – or having a tactical underweight position at current levels.

We retain a positive view on U.S. agency mortgage-backed securities (MBS), high quality assets with relatively attractive spreads that could benefit from an expected decline in interest rate volatility.

In credit and structured products, we continue to strongly favor up-in-quality and up-in-liquidity positioning in core portfolios. Private credit markets, which can be slower to reprice than public markets, may be at risk of further short-term declines, but a patient approach can take advantage of opportunities down the road.

Because any recession could challenge riskier assets, we are cautious in more economically sensitive areas of financial markets, such as floating-rate bank loans. Equities have also become less attractive amid higher interest rates.

Although emerging market (EM) valuations screen as historically cheap and EM appears poised to perform well down the road, we remain cautious as much still depends on the Fed’s ability to tame inflation and China’s ability to reactivate economic activity.
Source: PIMCO, By Tiffany Wilding, North American Economist, and Andrew Balls, CIO, Global Fixed Income, at PIMCO

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