Short-dated corporate bonds, gold and quality large-cap stocks are some of the investment opportunities coming to the fore at this latter stage of the market cycle, according to PIMCO’s Mihir Worah.
Worah, head of PIMCO’s real return portfolio management team and co-manager of the $1bn PIMCO GIS Global Multi-Asset fund, said there were “ample signs of change in the wind for investors”.
Rising of rates by the Federal Reserve, US inflation hitting targets for the first time since 2012, disruption of the established global trade order and higher volatility are signalling a potential shift in markets.
“All of this is leading to a tricky investment environment,” said Worah. “While recession indicators are not flashing a red warning signal that a downturn is imminent, which would imply a retreat to a defensive position, they are flashing a yellow ‘caution’ signal.
“This together with expectations for higher volatility, market dispersion and inflation risks suggest a regime of careful portfolio construction and opportunistic investments.”
He added: “With market dynamics shifting and the potential for greater change ahead, investors may find it difficult to determine optimal portfolio positioning.”
Below, Worah highlights five potential investment opportunities ahead of a shifting market environment.
Shorter maturity US corporate bonds
The PIMCO fund manager said the recent flattening of the US Treasury yield curve, while to be expected at this point of the cycle, may have been ‘overdone’.
“Taking a simplified view, yield curves tend to flatten late in the cycle as the Fed hikes more than expected and then steepen in a recession as the Fed cuts rates,” he noted.
Year-on-year US Treasury yield curve
Source: US Department of Treasury
However, Worah said there are reasons that the flattening of the yield curve could begin to unwind, with appetite for long-dated bonds likely to fall.
As such, the manager said it is starting to back short-term US corporate bonds that offer more attractive yields.
“We favour shorter-term US corporate bonds, which are offering more attractive yields than they have in years due to a combination of Fed rate hikes, accompanied by wider Libor and credit spreads,” he said.
“Their shorter maturity not only makes them less sensitive to higher interest rates, but they may also be more defensive in the event of a slowdown or recession.”
Gold
Traditionally seen as a ‘safe haven’ during more risk-off market conditions, gold has lost some of its shine in recent years as the post-crisis equity bull run has continued apace amid more pro-risk sentiment.
As the below chart shows, the Bloomberg Gold Sub index has registered a 16.23 per cent decline – in US dollar terms – over the past five years.
Performance of index over 5yrs
Source: FE Trustnet
However, the PIMCO manager said the yellow metal may be trading at a discount to its intrinsic value for several reasons.
“Gold has been underperforming relative to its historical average, likely because in the near term, gold’s properties as a metal and as a currency are causing it to drop amid trade tensions and the stronger US dollar, dominating its properties as a long-term store of value,” said Worah.
“This leads – in our view – to an opportunity to add a risk-off hedge to portfolios at an attractive valuation.”
Basket of emerging market currencies
After a stand-out year in 2017, emerging market assets have struggled in 2018 so far. Hampered by the impact of strong US dollar, the ongoing threat to the established trade order and slower growth, emerging markets have suffered disproportionately.
“Emerging market assets have had a tough run in 2018, but we believe their underperformance is overdone given current risks,” Worah explained.
“In particular, we see an unexplained risk premium associated with emerging market currencies, which leads us to conclude that a diversified and appropriately-sized investment should be part of any long-term asset allocation.”
US large-caps over small-caps
The accommodative policies put in place by central banks following the global financial crisis have favoured more growth-focused strategies over the past decade.
Indeed, domestically-oriented US small-caps have outperformed the S&P 500 index by almost 5 per cent this year, according to Worah, which itself has performed particularly strongly.
As the below chart shows, the S&P 500 index has delivered a total return of 8.42 per cent – in US dollar terms – compared with a gain of 12.21 per cent for the Russell 2000 index, a commonly-used small-cap benchmark.
Performance of indices YTD
Source: FE Analytics
However, Worah said he believes that as the end of the cycle draws closer it will be more appropriate to stick by higher quality large-caps to protect against a potential downturn.
He said: “Consistent with the theme for high quality to outperform at this stage of the business cycle, and given attractive entry points, we favour an overweight of large-cap relative to small-cap equities.”
Alternative risk premia
Lastly, Worah noted that higher volatility and stretched valuations are likely to result in lower risk-adjusted returns from traditional risk premia such as equity, duration and credit.
However, while smart beta strategies – aimed at delivering returns regardless of market direction or minimising risk – have largely focused on equities, there are alternative strategies investing in other asset classes.
“A rich universe of strategies is available in the fixed income and commodity markets that can be combined with equities and currencies to form diversified portfolios that seek to harness the benefits of alternative risk premia,” he said.
“Including diversifying but liquid strategies is important, as many strategies that earn an ‘illiquidity’ premium, such as private equity and venture investing, also have a high beta – correlation – to equity markets, which may not be desirable at the current phase of the business cycle.”
Under Worah the Pimco GIS Global Multi-Asset fund has delivered a total return of 28.69 per cent compared with a 26.01 per cent gain for the average IA Mixed Investment 20-60% Shares sector fund between 30 January 2014 and 11 September 2018.
The fund – which Worah has managed alongside Geraldine Sundstrom since July 2015 – has an ongoing charges figure (OCF) of 0.95 per cent.