Fri, 19 Sep 2014
As Fed policy tightens over the short term, investors will have to actively manage interest rate exposure while looking ahead to a 'new neutral' in the next three to five years, says PIMCO's Jerome Schneider.
Sarah Bush: Hello, my name is Sarah Bush and I'm at the Morningstar ETF Conference. Today, I'm joined by Jerome Schneider from PIMCO.
Thanks very much, Jerome, for joining us.
Jerome Schneider: Thanks so much for having me. Appreciate it.
Bush: So, I thought maybe we could start out since we had the Fed announcement yesterday just by getting an update on how PIMCO is thinking about rates these days.
Schneider: We're obviously in a transformational phase with the Fed. We're going to potentially have [an end to] quantitative easing, which has now been articulated as finishing in the October timeframe. And as we see, there is an improving job economy. We're, obviously, focused on wage pressures. That's what Chairman Yellen is focused on right now. And that obviously translates into how robust the economic cycle is going be. It's going to be a reflexive positioning for the Fed--meaning, they're going to have to think about how these factors come together and ultimately how they're going to have to tighten rates.
So, we're still thinking it is mid-2015 in terms of rate tightening. For investors, they're going to have to think about how the markets react to this information. And although the language remained markedly the same yesterday, we did get some clarification on what the exit plan was going to be for the Fed, ultimately. And so the stimulus, as we know it--the growing in the Fed's balance sheet--is going to begin to subside and eventually abate. And that's going to obviously have an impact on various markets around the world.
More importantly, it is going to focus on the volatility within the market. That's going to be a primary focus for investors going forward. And what that really means is that you need to find risk attributes within your portfolio to accentuate, to help provide income, to help provide safety and performance, and more importantly, total return--and deaccentuate those that might contribute a little more volatility to the market.
And so, for us, thinking about interest rate exposure is one that you're going to have to actively manage over the short-term horizon--the cyclical horizon--as the U.S. economy improves, which we believe is going to improve over the next year. But ultimately, thinking about what we call “the new neutral” over the next three to five years translates into an investment thesis. And we believe that the ultimate rate will be around 2% at that point in time. But that doesn't necessarily mean that the Fed isn't going to overshoot rates or undershoot rates. That's something that investors are going to have to contend with over the next six to nine months until we ultimately get our first rate hike from the Fed.
Bush: Let's talk a little bit about how you are putting that into practice with portfolios. We noticed that PIMCO's Short-Term (PSHAX) has been run with a pretty short duration relative to where it has been historically. Where are you finding value and how are you thinking about that rate positioning?
Schneider: What I think we have to think about is ultimately the reaction function of the marketplace. For me, short-term investors want to think about two things. They want to see a portfolio that, obviously, has a performance beyond money market funds--so, above zero interest rates. Well, anybody can do that. You could, obviously, go buy a high-yielding asset or a longer-duration asset, which has a yield. But what we really need to think about is total return. Just because you are earning a yield on a security doesn't necessarily mean your total return is the same on the security. You could own a yield in a high-yield bond in 2008 that might offer a very attractive yield, but your total return will be quite negative.
So, we need to be thinking about two things: one, a total-return aspect; and two, thinking about it in terms of what bond geeks call Sharpe ratios, or volatility-adjusted returns. And when doing that, you can find very good opportunities in the short end.
So, for my portfolios, I find better opportunities in credit; the U.S. economy is improving. We can find better opportunities thinking about ways in which demand for liquidity is in the marketplace. And for me, I really focus on the liquidity markets and effectively what I call “alpha generation” or “excess return generation” through collecting liquidity premiums, finding mismatches with liquidity within market and putting those into the portfolio, so that we can basically harvest those excess returns.
Then, the third thing is look globally for opportunities. Look globally to deploy these assets in high-credit, high-quality situations with improving economies. And one of those places in which we have partaken for this year in our portfolio was Korea, as an example. Again, a AA- or A-type of economy--improving metrics, good strong balance sheet. And Korean companies shared that benefit as well. So, we've been able to benefit from that.
So, as we think about our positioning, we want to think about items such as financials or those industries with improving economics to the home industry. For us, that's our focal point for the immediate future.
And then, ultimately, we're going to think about ways to participate in a higher interest rate environment, and that could be looking out the yield curve in terms of roll down and potentially adding duration back in at a future point in time. But until the Fed clearly gives us that delineating factor of that first hike and the market recalibrates to that, duration for us in the short-term portfolios at least is something that we need to be very tactical in utilizing.
Bush: I want to ask you just one more question. Since you're focused on the short-end of the curve, I'm sure you've paid a lot of attention to money market reform. Are there any opportunities that that's opened up for managers in the space?
Schneider: Absolutely. The key point that many investors, whether institutional or retail, have missed over the past 40 years is that liquidity management has remained static. And now, all of a sudden, it has changed. We talk to treasurers and CFOs of Fortune 500 companies who really haven't fully understood that, over the next two years, the constitution of how a money market fund works--moving from $1 par NAV [net asset value] to a floating-rate NAV--is going to change markedly. And there are accounting ramifications and tax implications and, frankly, liquidity implications.
So, for investors moving forward, they used to find safety, and importantly, income in money market funds; that's no longer going to be case. Two reasons: One, money market funds are going to have an increasingly subdued amount of supply that they can invest in. There is going to be an abundance of cash in the short end and fewer and fewer assets they can invest in. So, that's going to create a supply/demand mismatch. So, rates structurally are going to remain lower in money-market-fund types of assets, even once the Fed starts increasing rates.
The second thing is active management. We need to be thinking about how to deploy investment opportunities beyond what the regulatory constraints are of a 2a-7 SEC money market fund. Now, there are valid reasons to invest in money market funds; but for investors thinking about how to tier their liquidity, the money-market-fund segment is only one aspect of liquidity management. Looking to short-term, low-duration types of strategies, such as our PIMCO Short-Term Fund (PSHAX) or our [PIMCO Enhanced Short Maturity ETF (MINT)] or our Low Duration ETF (LDUR), which just launched, we can utilize opportunities with active management that balance risk and reward, and most importantly, offer an active approach to liquidity management. That's the key thing that investors need to think about--that the conditions for managing their liquidity, which they have had for the past 40 years, have distinctly changed and will ultimately change forever, two years from now, once money market regulation is implemented.
Bush: Great. Thanks very much, Jerome. Thanks for joining us.
Schneider: Thanks for the opportunity.