The US economy is doing about 2.5 percent real growth and 4.5 percent nominal growth with the labor market tightening pretty dramatically, said Mark Kiesel, Global Head of Corporate Bond Portfolio Management at PIMCO.
The decline in domestic inflation is transitory and PIMCO agrees with Fed Chair Janet Yellen that US inflation is headed towards the 2 percent target. In a 2 percent inflation world, 10-year Treasury yields should not be at 2 percent, he noted.
Asked why 10-year Treasury yields have been hovering around the 2 percent level, Mark said people are probably looking backwards without realizing what’s going to happen going forward. The US economy is 70 percent domestic consumption and with the labor market tightening fundamentals remain strong, he explained.
Asked if the biggest surprise in the US bond markets this year has been the 10-year yield still hanging around 2 percent, Mark answered in affirmative. Part of the reasons for low US yields have been the uncertainties around global economies/emerging markets and low domestic inflation due to depressed energy prices. Additionally, there has been a big widening in credit spreads and that’s really a function of supply. Everyone wants to issue bonds before a Fed hike, he observed.
Asked about his opinion on high-yield credit (below investment-grade bonds) because there has been a lot of debate whether or not the high-yield segment is a train wreck that’s going to hit the markets when the Fed raises the short-term rate, Mark said PIMCO actually sees value in high yield space.
PIMCO’s high-yield portfolios are currently yielding just 7 to under 8 percent, which is basically a low double-B (BB credit-rating)/high single-B (B+ credit-rating) yield, outside of energy, metals and mining, where the fundamentals are quite strong.
PIMCO sees the corporate default rate outside energy remain benign at a relatively low 2 percent. The energy, metals and mining sector has scared investors while literally more than a trillion dollar of news securities have hit the markets this year. Basically it’s a supply dynamic with too many bonds being issued into the market where people are taking a step back waiting for the Fed to act, which has caused the spreads to widen. It’s not fundamentals, but purely technicals that have been driving value in high-yields, he noted.
BofA Merrill Lynch’s head of credit strategy and chief of high-yields in a research-paper observed in the high-yields niche, for five months in a row more than 50 percent of the sectors have had negative price returns, which is the longest streak since 08.
He also observed there’s been a knock on effect that has now gone beyond energy and materials to new sectors such as retail and telecom but has not started to hit media as well as healthcare, which are the signs of a late stage cycle within high-yield.
Asked what would make PIMCO more cautious with so many people sounding the alarm, Mark said PIMCO would be alarmed if inflation picked up dramatically and the Fed had to slam the brakes on the US economy. PIMCO would be alarmed if nominal and real GDP growth turned negative, but doesn’t foresee such an event and believes the US economy is increasingly looking good. It’s true that some issuers are pushing the limits, but the reality is the health of the high-yield market, particularly the consumer and the housing sectors are doing very well, he argued.
Asked if there is a liquidity problem in the fixed-income market, Mark said the markets got a shell-shock of supply with over a trillion dollar of new issues hitting the market.
Additionally, there has been $120 billion worth of “fallen-angels” this year, companies that were downgraded from investment grade to junk. Investors are basically frozen right now on the sidelines with all these factors hitting the markets at once.
The liquidity in the investment-grade bond market is still quite good. But there could be a wave of defaults in the oil and gas sectors in the next 12-18 months with banks restricting credit, and capital markets shutting up. Access to capital would be difficult for energy companies going forward, which represents an opportunity for PIMCO, he concluded.
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