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PIMCO's Worah: We See Higher Inflation Longer Term

Our expectation is for inflation to be somewhat higher than the 2.0%-2.5% rate that we have gotten used to over the last 20 years, says PIMCO Real Return manager Mihir Worah.

Jason Stipp, 07/20/2011

Mihir Worah is head of PIMCO's Real Return portfolio management team and manager on the PIMCO Real Return PRRIX and PIMCO Commodity Real Return Strategy PCRDX funds. He recently answered our questions about his outlook for near-term and longer-term inflation, recent dynamics in the TIPS market, and the importance of managing and diversifying a portfolio's inflation protection.

1. We've seen inflation heat up in 2011, but we also see continued high unemployment and a sluggish economy, which would tend to keep a cap on rampant price increases. What expectations about inflation are you incorporating into your investment process? Do you have different expectations for near-term versus longer-term inflation?
You are correct that our sluggish economy can help contain U.S. inflation, especially the domestic drivers of inflation, such as wage rates. However, we would point to particular price pressures such as tightness in the rental market and anecdotal evidence of rising rents nationally. This is important, because the cost of shelter is over 30% of the average U.S. consumer's spending.

In addition, some components of inflation, such as food and energy, are driven by global, not just U.S., supply and demand factors. So our investment process does not look just at inflation in the aggregate, but rather decomposes inflation into key components. This is most easily thought of as "core" and "headline" for the U.S. CPI. We expect core inflation to rise at a 1.5% to 2.0% rate over the next year, and headline inflation to be on average somewhat above that not just this year, but also going forward.

In the longer term, our expectation is for inflation to be somewhat higher than the 2.0%-2.5% rate that we have gotten used to over the last 20 years. Some of the reasons for this are: 1) a shift by developing economies from exporting disinflation to exporting higher prices. This is likely due to the effect these nations are having on commodity prices as well as the likelihood that their currencies appreciate relative to the dollar; 2) the buildup of monetary stimulus that might eventually be coupled with increased velocity of money resulting in too much money chasing too few goods; 3) a tolerance by governments for higher inflation in order to maintain low or even negative real borrowing costs in order to "grow" out of debt.

2. We've seen some real yields on TIPS dip into the red, which has concerned some market-watchers. As a TIPS manager in the Real Return Fund, do you think that TIPS investors' expectations about inflation are overblown (and thus TIPS are over-bought)? When we last spoke with you, you had mentioned that some areas of the TIPS market looked more attractive than others. Is that still the case?
We don't think that TIPS are "over bought" relative to nominal Treasuries. We believe that the negative real yields, especially at the front end, are more the result of Fed action than investors' inflation concerns. The nominal Treasury market is rich as the Fed keeps the short end anchored at 25 basis points for the foreseeable future. Meanwhile, if inflation comes in at, say, 2.5% in line with our expectations, then mechanically short-dated real yields are actually -2.25%. We think that a fed funds rate lower than the rate of inflation is likely to persist into the foreseeable future.

The bottom line: Although negative real yields on lower maturity TIPS may not be particularly attractive, they are here to stay for a while. At different times there are different parts of the TIPS curve that offer better value, which an active manager can exploit. Early this year, for instance, we saw value at the front of the curve where we could capture some inflation accruals that were higher than the market had been expecting. At the moment we see value at the longer end of the curve due to its steep nature, giving us higher returns and some potential "rolldown" returns.PAGEBREAK

3. PIMCO as a firm has released several commentaries that expressed deep concern about the U.S. Treasury market's prospects. Although PIMCO Real Return is a TIPS fund, you also can invest up to 20% of your assets in non-TIPS holdings. What percent is currently invested outside of TIPS, and where is it invested? How do you identify securities outside of TIPS that have the potential to offer real (inflation-beating) income?
Our expressed concern about U.S. Treasuries was not a prediction of imminent decline in the worth of Treasuries. Rather, it addresses value relative to other places where an investor might put his or her money. This same philosophy applies to U.S. TIPS, which means that we see better relative value in some ILB [inflation-linked bond] markets other than the U.S., such as Australia, or some developing markets, and also see better value in some nominal sovereign debt. We have also seen some value in high-quality corporate debt, where the nominal returns, adjusted for credit, are expected to outpace the inflation accruals of U.S. TIPS.

4. If you consider inflation protection as a kind of insurance in your portfolio, and there are several different types of policies available (e.g., commodities, TIPS, exposure to foreign currencies), do any of those policies look particularly attractively priced right now?
You are right that there are different ways to respond to inflation, depending on the overall structure of investors' portfolios, their risk tolerance, and the kind of inflation they expect. For instance, TIPS can provide low-risk protection from generalized inflation; currencies can provide some protection from the inflationary impact of a declining dollar; and commodities can often protect from the most volatile component of inflation, which is food and energy, while also sometimes offering diversification from stocks and bonds. All three have a role in an investor's portfolio. TIPS should be the bedrock of any inflation-protection strategy, since they have the lowest risk and are contractually tied to the U.S. CPI. Given the current low real yields on offer, investors may also look to commodities--which are more volatile but likely to be the dominant source of near-term inflation. An additional longer-term inflation hedge can be obtained from assets denominated in foreign currencies, particularly the higher-yielding and faster-growing ones like Australia, Brazil, and India, for example.

5. Valuation-conscious investors often recognize the diversification and inflation-resistant qualities of assets like TIPS or commodities, but they may also feel that pricing on these assets may be too high or, in some cases, too volatile to use effectively. How can investors benefit from the fundamental diversification qualities of these assets while minimizing the risk of buying and selling at the wrong time?
As I mentioned earlier, different inflation assets respond to different inflation factors. And even within an inflation category, such as TIPS, currencies, or commodities, there are relative value opportunities that change over time as the market's expectations change. In such a challenging environment, it is important to actively manage the mix of inflation assets in a portfolio and actively manage each particular inflation component.

 

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