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PIMCO Sees More Muddling, Higher Rates Ahead

Eric Jacobson

Eric Jacobson: Let's carry forward on the macro theme. Obviously we talk all the time about what PIMCO's macro views are. But things have been moving fast and furious over the last few months. Take us up to date if you would, sort of on where we are right now and then I'll follow up with another question about TIPS in relation to that.

Mihir Worah: There are two things going on the macro framework. As you know we just, the reason I talked about that is just we went through our secular three- to five-year outlook, that's on the margin starting to influence. It's a long-term view. It doesn't influence what do we do week-to-week. But it's starting to influence how we think about portfolio construction.

So big picture we think the base cases for the next year, the U.S. and the global economy muddles along. We don't get a hard landing in China. We've positioned and we've talked about it for commodity prices being stable, crude oil in the $50s, which is kind of what led to our positioning in certain parts of the credit spectrum and also in TIPS when everyone thought crude oil prices would go to zero. We had the view that they'd go to $50, and we are there.

The other two big factors guiding the macro positioning near term is our view on the Fed. We thought that the Fed would hike one or two times this year, and that's not changed. The probability of June went up, then it went down as we got the weak labor numbers for May and the Brexit. But we still think the Fed's likely to hike one or two times a year and so most of our interest-rate positioning is based around what the Fed is likely to do in the front end of the curve. In the back end of the curve we still hold both Treasuries, but in particular long-term TIPS to position us against the risk off move and our underweights are up, our anti-Fed kind of positions are all localized on the front end of the curve.

The second change in the portfolio from say year ago, is we don't have that structural long U.S. dollar position that we've carried for a couple of years and that have made money for our clients. We think that this U.S. dollar strength, yes the Fed is likely to hike, yes the U.S. economy is growing better than the rest of the world. But the rest of the world can't afford a stronger U.S. dollar. It tightens financial conditions globally and the Fed has to be aware of that. So we have less of a currency or long U.S. dollar position than we've had in the past. That's the near-term positioning.

One of the things coming out of our secular forum is we are getting more cautious, longer term. While our view is that this low-growth world continues and is stable for a while, we think it's not very secure, because this low growth is really a result of central bank, very aggressive central bank actions, and we are seeing diminishing returns from these central bank actions. So we are starting to get slowly, we are starting to get more defensive move up the capital structure and get more conservative in our investing. You won't see that this week but you'll see that as a bias over the next one or two years in the total return fund.

Jacobson: That's interesting obviously in the context of TIPS which I said I am going to ask you about. More broadly we've talked about this before that a lot of investors still have some confusion about what to expect in terms of performance from TIPS given the way that they are structured and so forth. Given what you said about your macro expectations maybe you can take, maybe one or two most likely paths or scenarios that PIMCO thinks we might be on and just use that as a springboard to talk about how one should expect TIPS to respond given those kind of conditions.

Worah: Our base case and one of the likely paths we think the U.S. economy and markets go through is that as we've reached full employment, as we've reached a stability in commodity prices, as we've reached what I said is probably the eighth inningof dollar strength, all of these factors point to higher inflation going forward. So, while the world has been worried about deflation, and TIPS are pricing in very low inflation for a very long time, we think this is something that's likely to change. As this changes, you should see inflation expectations go up and you should see regular Treasuries also sell off. You are not going to get a large sell-off and we've talked about the new neutral how long term rates and short end rates, because productivity is lower, because the amount of debt in the global economy, long-term rates are likely to be lower than they have been in the past we call this a new neutral.

So you won’t see an aggressive sell-off in rates. But you'll see a small sell off in regular long term Treasuries. And being in TIPS you should benefit because much of this sell-off is likely to be from inflation expectations widening. So to us we think TIPS at current valuations are attractive because not only are they cheap in the context of inflation expectations being too low 30-year inflation expectation at 1.6% per year for the next 30 years. We think the U.S. is likely to see higher than that. Not only are inflation expectations narrow, but we think real interest rates because TIPS are cheap, real interest rates, which is the part of TIPS that respond to changes in interest rate, are probably reasonably fair. So when you see inflation come back, if you see the global economy recover and you see interest rates start to rise you probably won't see much of a rise in long-term TIPS interest rates.

So long term TIPS, 30-year TIPS we think protect you from a bad scenario, where you want U.S. Treasury exposure, they are U.S. Treasuries after all, and in a good scenario where inflation comes back they won't sell off as much as regular bonds. So we think one of our themes coming out of our secular forum is look for bonds that will bend, but not break. So you can take some market-to-market volatility, but they are going to preserve your capital after all, and TIPS to us fit into that. Yes, if oil prices go down, TIPS will underperform for a short while. But they are U.S. Treasuries after all you are going to get your money back. So to us TIPS play two roles in a portfolio. They are government bonds, so they are defensive. But they are also cheap and to the extent that we think people are mispricing inflation expectations they could tend to give you reasonable returns going forward. So we find TIPS quite attractive right now.

Jacobson: Well, again thank you very much for joining us, Mihir. We really appreciate it.

Worah: Thanks, Eric. It's a great conference. Always good to be in Chicago at the Morningstar conference.