Pimco Warns Bonds Are Facing Headwinds From Inflation, Central Banks

(Bloomberg) -- Bond markets will continue to face pressure from inflation and tighter monetary policy from the world’s central banks, making stocks a better bet during this stage of the economic cycle, Pacific Investment Management Co. said in its May asset-allocation outlook.

Bond yields have surged this year as traders price in an aggressive path of Federal Reserve interest-rate hikes until mid-2023, with the central bank widely expected to raise its key benchmark rate by a half-percentage point on Wednesday and indicate that further such moves are on the way. The Fed is also set to outline at this week’s meeting when it will start to reduce its bond holdings, a step that will likely pull tens of billions of dollars from the market each month as it allows securities to mature. 

Central banks globally are also pulling back pandemic-era stimulus.

“The rapid monetary tightening priced in by markets has created more value in fixed income markets, but the asset class still faces the headwinds of high inflation, robust growth, and increasing government bond supply as central banks begin to unwind their balance sheets,” said Erin Browne, Geraldine Sundstrom and Emmanuel Sharef, portfolio managers for asset allocation at Pimco.

High quality fixed-income securities such as U.S. Treasuries and investment-grade corporate bonds have endured their worst performance in decades so far this year, with long-dated yields starting the week at fresh multi-year highs. The classic 60/40 portfolio mix of equities and quality bonds registered a decline of 7% during April, its worst run since March of 2020, as both asset classes were hit at the same time.

Pimco said “higher rate levels” for bonds at this juncture would help them play their customary and “important role as a diversifier in multi-asset portfolios.” While Pimco said the current late-economic-cycle playbook means “we prefer equities versus duration and corporate credit,” they added, “if there are further signs of an economic slowdown, we expect duration will become more attractive.”

Among other key points, Pimco said: 

• They favor being “modestly underweight developed market duration” with a preference “to engage in relative value trades in emerging markets,” dependent on how far EM central banks have tightened policy.
• “More muted returns and higher volatility across the board,” are likely from sticking with a late-cycle mix of favoring equities and commodities versus long-dated bonds.
• Holding “cash can serve as dry powder to capitalize on dislocations” in markets.
• Advocating “multiple sources of inflation risk mitigation,” a mix that includes “a diversified basket of commodity-linked currencies” alongside owning “real assets, such as commodities.”

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