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There are ample signs of change in the wind for investors. The Federal Reserve is raising short-term interest rates, and U.S. inflation is at target for the first time since 2012. The global trade order that has existed for decades is being disrupted. Several economic indicators are running hot (see Figure 1) even as the current U.S. expansion has begun its tenth year. Volatility is higher as some investors price a dire outcome while others are more sanguine, creating relative value opportunities.

In this midyear update to our outlook, detailed in our paper “Singles and Doubles,” we discuss some medium- to longer-term themes relating to late-cycle investing as well as some shorter-term opportunities arising from current market dynamics.

Figure 1 is a table showing 15 economic indicators and their percentile rank upon the last third of business cycle expansion. Indicators are listed in a column on the left, and horizontal scales to their right are used to indicate percentile rank. 13 of the indicators are above the 50th percentile, and six are at 75 or higher. Two are below 50. Indicators are listed inside the table.

Four key themes


We see significant risk of an uptick in inflation, as detailed in our paper, “Inflation Awakening.” We believe investors should understand the inflation sensitivity, or “inflation beta,” of their portfolios. Traditional stocks and bonds tend to respond negatively to inflation surprises (see Figure 2), while real assets not surprisingly tend to respond positively; investors should verify and be comfortable with the inflation betas of their portfolios. In our view, many investors are underexposed to real assets – such as commodities and inflation-linked bonds – and that strategy has generally worked well over the last several years as shocks to risk assets were accompanied by fears of deflation, vastly diminishing the diversification properties of real assets. However, this may not hold true going forward.

Figure 2 is a bar chart showing inflation beta of equities, bonds, REITs (real estate investment trusts), TIPS (U.S. Treasury Inflation-Protected Securities) and commodities over the time period March 1974 – June 2018, with proxies noted below the chart. Commodities has an inflation beta of 5.4, TIPS is at 0.8, and REITs, at negative 0.1. Conversely, equities are shown to have an inflation beta of negative 1.2, and bonds, negative 1.1.

Stock-bond correlations

When above-average inflation starts being a bigger risk than below-average inflation, bonds become a less reliable diversifier for equities and other risk assets. To be sure, high-quality bonds remain a crucial component of a portfolio allocation, in our view, because they are likely to be the best-performing assets in a recession. Also, as mentioned above, inflation-linked bonds are attractive before inflation accelerates. However, investors who count on large bond overlays to damp volatility of portfolios of risk assets may be in for some surprises. (See Figure 3. Also, recent PIMCO research focuses on the underlying mechanisms of the stock-bond relationship. For more, read “Treasuries, Stocks and Shocks.”)

Figure 3 is a scatter plot of 3-year stock-bond correlation on the Y-axis, against 3-year annualized inflation, for each month from 1970 to 2018. For the period 1970 to 1999, most of the plots are above the zero line, meaning a positive stock-bond correlation up to roughly 0.8%, with inflation ranging roughly from 2% to 12%. For the period 2000 to 2018, most of the plots are below the zero line, meaning a negative stock-bond correlation, as low as negative 0.8, with inflation ranging between 1% and 4% over the time period. The average of the plots shows a curve bending upwards, crossing the X-axis around 2.2, with its slope moderating at higher inflation rates.


For the last several years, investors have been paid for being long just about any asset (other than commodities) as the exceptional influence of central bank liquidity and lower long-term rates boosted valuations. At this stage in the business cycle, however, with the Fed actively hiking rates and reducing the size of its balance sheet, valuations have become stretched and we should start to see greater dispersion in returns across sectors, regions and factor styles. As is well-known in equity markets, the momentum factor tends to underperform and the quality factor outperform late in the cycle. Similarly, credit spreads tend to underperform equities on a risk-adjusted basis and commodities tend to do well overall as demand starts to outstrip supply. Some of these themes have already begun to play out. Investors should, in our view, stress-test their portfolios at the factor level rather than asset class level to truly understand how it is likely to behave as this cycle plays out. This also underscores the importance of rigorous global research capabilities to pinpoint attractive opportunities in any sector while managing risks. The ability to better analyze the relative value between assets, countries and factors becomes more important than large beta bets.

Figure 4 is a bar chart showing aggregate risk factor returns in terms of Sharpe ratio over the business cycle from 1955 to 2017 for U.S. equities, investment grade credit, and 10-year Treasuries. For the full sample, equites have Sharpe ratio of 0.4, compared with roughly 0.2 for IG credit and U.S. Treasuries. In the first half of an expansion, U.S. equities show a Sharpe ratio of 0.9, compared with 0.5 for IG credit, and 0.4 for Treasuries. For the second half of expansion, U.S. equities show 0.2, compared with roughly negative 0.1 for IG credit, and negative 0.4 for Treasuries. In a recession, Treasuries have a Sharpe ratio of about 0.6, compared with negative 0.25 for equities and about negative 0.1 for IG credit. Proxies and definitions are listed below the chart.


Market volatility has been increasing for a number of reasons. To begin with, there is general uncertainty around a possible turn in the cycle. Another reason is the potential for implicit portfolio hedges (such as bond overlays) to become less predictable amid greater inflation risk, leading many investors to de-risk by selling assets and reducing leverage. In addition, the Fed is normalizing policy and perhaps re-striking the put (i.e., reassessing the state of economic downturn that would warrant a shift to easier policy or extraordinary measures). And all this is accompanied by something new: a potential change to the framework for global trade that has been in place for decades. These reasons suggest reducing portfolio volatility either explicitly or implicitly by going up in quality, reducing leverage, raising liquidity or purchasing downside hedges. Many investors avoid these strategies in the belief that they all mean reducing yield and giving up potential returns. However, in light of the uncertainties across many markets, we believe return potential over a two-year horizon will likely be better if these strategies are judiciously employed.

Five investment opportunities

With market dynamics shifting and the potential for greater change ahead, investors may find it difficult to determine optimal portfolio positioning. Here are five investment opportunities we see.

Shorter-maturity bonds

Taking a simplified view, yield curves tend to flatten late in the cycle as the Fed hikes more than expected and then steepen in a recession as the Fed cuts rates. The yield curve has been following this playbook during this Fed hiking cycle, but for a number of reasons we think the flattening is overdone and the risk/reward trade-off favors fading this move.

Figure 5 is a table and line graph showing historical performance of the 1-year forward 5s30s swap curve from roughly 1994 to June 2018. The graph shows the level at zero in mid-2018, about its low over the period. The level had four peaks at around 1.75 from 2010 to 2015. Its other high is around 1.5 in the early 2000s, and its lows are around zero, in the years 2000, 2006, and 2009.

Three main reasons for the flattening (in addition to late-cycle Fed hiking) are the U.S. Treasury’s decision to stop extending the weighted average maturity of its issuance, the anchoring effect of low long-term global rates, and the ability for U.S. corporations to currently deduct pension contributions at the 2017 tax rate of 39% rather than the new 20% tax rate, leading to a rush to buy long-dated bonds. We feel all of these are likely to reverse as the large U.S. deficit combined with the Fed’s balance sheet unwinding will supply plenty of long bonds to the market, the European Central Bank is expected to end its own quantitative easing program by the end of this year, and the Bank of Japan signals possible flexibility in its pegging of the 10-year rate at 0%. Finally, the window for the higher deduction rate for pension fund contributions ends in September.

“Shorter-term U.S. corporate bonds are offering more attractive yields than they have in years.”

A simpler expression of this trade is to simply invest in shorter-term U.S. corporate bonds, which are offering more attractive yields than they have in years due to a combination of Fed rate hikes, accompanied by wider Libor and credit spreads. Their shorter maturity not only makes them less sensitive to higher rates, but they may also be more defensive in the event of a slowdown or recession.

Basket of EM currencies

Emerging market (EM) assets came off a torrid 2017, but have had a tough run in 2018 as Fed hikes, fears of tariffs and trade conflicts, and political uncertainty in Mexico, Brazil, Turkey and Argentina have weighed on the market. Emerging markets are indeed highly geared to global growth and global trade. Moreover, institutions often aren’t mature enough to handle political change. Any unanticipated slowdown could lead to further underperformance. However, we feel the underperformance is overdone given current risks, and there are pockets of value in EM that rigorous research and an active management approach can uncover. As we discuss in the sidebar, there appears to be an unexplained risk premium associated with EM currencies, which leads us to conclude that a diversified and appropriately sized investment should be part of any long-term asset allocation.


Gold is a real asset that not only serves as a store of value but also a medium of exchange, and that tends to outperform in risk-off episodes. As such, one would expect gold to outperform during the recent period of rising inflation expectations along with rising recession risk. Yet counterintuitively it has been underperforming relative to its historical average (see Figure 6).

Figure 6 is a line graph showing the discount or premium of gold to U.S. real yields, from July 2014 to July 2018. As of 24 July 2018, the level was near its low for the chart at negative, or discount, of 5%. The range over time is from roughly negative 7.5% to a positive 10%, which was reached in the first quarter of 2018. During most of the time period, the ratio fluctuates between negative 7.5% and positive 7.5%.

We believe this is because in the near term, gold’s properties as a metal and as a currency are causing it to drop amid trade tensions and the stronger U.S. dollar, dominating its properties as a long-term store of value. This leads, in our view, to an opportunity to add a risk-off hedge to portfolios at an attractive valuation.

Large cap versus small Cap

Small cap stocks have had a good run, outperforming the S&P 500 by close to 5% so far this year. One of the rationales for this outperformance is that small cap stocks are more domestically oriented and hence less exposed to trade wars and tariffs. While this view has some merits, we feel buying lower quality, lower value, higher volatility small cap stocks is unlikely to lead to outperformance should a real trade war commence. Consistent with the theme for high quality to outperform at this stage of the business cycle, and given attractive entry points, we favor an overweight of large cap relative to small cap.

Figure 7 is a line graph of showing the ratio of the performance of the Russell 2000 (representing small cap U.S. stocks) and the S&P 500 (representing large cap U.S. stocks) from 2000 to 2018. The ratio as of 26 July 2018 was around 2%, meaning the Russell 2000 had outperformed. Yet the chart shows it has fallen from a level of about 5% earlier in the year. For most of the time period, the ratio trades within one standard deviation, between about 6% and negative 3.5%. Its last major peak was in 2016, at around 10%, and its last trough was in 2015, around negative 10%.

Alternative risk premia

Higher volatility and stretched valuations are likely to result in lower risk-adjusted returns from traditional risk premia like equity, duration and credit. While smart beta strategies have been proliferating recently, so far these have mostly focused on equities, an asset class that has been well-mined by academics but where it is still possible to find risk premia and alpha strategies that are uncorrelated to the business cycle.

Meanwhile, there is a rich universe of strategies available in the fixed income and commodity markets that can be combined with equities and currencies to form diversified portfolios that seek to harness the benefits of alternative risk premia. Including diversifying but liquid strategies is important, as many strategies that earn an “illiquidity” premium, such as private equity and venture investing, also have a high beta (correlation) to equity markets, which may not be desirable at the current phase of the business cycle.

“Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment.”

Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment. While recession indicators are not flashing a red warning signal that a downturn is imminent, which would imply a retreat to a defensive position, they are flashing a yellow “caution” signal. This coupled with expectations for higher volatility suggest a regime of careful portfolio construction and opportunistic investments. In this piece we have highlighted four themes to consider when constructing portfolios and five opportunistic investments across asset classes that we believe will position investors for attractive risk-adjusted returns in the uncertain times ahead.

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Asset class views

Here is how we are positioning asset allocation portfolios in light of our near-term outlook for the global economy and markets.

This diagram shows a dial representing overall risk preference with PIMCO’s multi-asset portfolios, showing a neutral rating overall, with an arrow centered straight upwards in the middle.
Under Over


Overall risk

This late in the cycle, with valuations rich, the Federal Reserve raising interest rates, and the potential for recession in the medium term, we are neutral in our overall positioning. The expansion likely still has some room to run, but there is ample reason for highly selective relative value positioning and rigorous research on securities.

 The figure shows a dial representing the preferred weighting for equities, with neutral weighting overall. The diagram breaks down equity weightings for the various regions with a series of horizontal scales, transitioning from brown for underweight, represented with a minus sign, to green for overweight, represented with a plus sign. U.S. equities have a very slight underweight, while those of Japan have a very slight overweight. Europe and the emerging markets are neutral.
Under Over





Emerging markets


While we are more constructive on equities relative to other risk assets, in light of the recent rally we are maintaining an underweight to U.S. equities. Given valuations and in view of the late stage expansion, in the U.S. we have an overweight to banks and underweight to small cap stocks. We are modestly overweight Japanese equities given positive earnings, low leverage and still supportive Bank of Japan.

The figure shows a dial representing the preferred weighting for rates, with slight underweight overall. The diagram breaks down weightings for various regions with a series of horizontal scales, transitioning from brown for underweight, represented with a minus sign, to green for overweight, represented with a plus sign. The U.S. and emerging markets are neutral, while Europe and Japan have slight underweights.
Under Over





Emerging markets


We remain defensive on interest rate exposure. However, in contrast to our views on equities, we find U.S. rates the most attractive in developed markets. Beyond the U.S., we find U.K. gilts and Japanese government bonds rich, and we believe valuations of eurozone peripheral bonds are suspect without continued ECB support. We favor the front end over long duration Treasuries and have a steepening bias in U.S. rates.

The figure shows a dial representing the preferred weighting for credit, with very slight overweight overall. The diagram breaks down weightings for various regions with a series of horizontal scales, transitioning from brown for underweight, represented with a minus sign, to green for overweight, represented with a plus sign. The securitized market has a strong overweight, while investment grade has a very slight overweight. High yield has a slight underweight, and emerging markets are neutral.
Under Over



Investment grade

High yield

Emerging markets


At this later stage in the business cycle, investors should appreciate the limited spread-tightening potential of corporate bonds as well as the downside potential for defaults or spread widening. Our credit allocation is focused on non-agency mortgage-backed securities, which should continue to benefit from an ongoing recovery in the U.S. housing market and remain well-insulated from many global risks. Our allocation to investment grade credit is focused on shorter-dated high quality corporates that now offer yields close to 3% without a lot of duration or credit risk.

The figure shows a dial representing the preferred weighting for real assets, with an overall slight overweight. The diagram breaks down weightings for various regions with a series of horizontal scales, transitioning from brown for underweight, represented with a minus sign, to green for overweight, represented with a plus sign. Inflation-linked bonds and commodities have equal and slight overweights. Gold is overweighted, but less so, and REITs are almost neutral, with the slightest of overweights.
Under Over


Inflation-linked bonds




Real assets

We maintain an overweight to real assets, with a focus on U.S. Treasury Inflation-Protected Securities (TIPS). Inflation expectations have risen recently, yet we believe there is still value in TIPS as the market is underpricing U.S. inflation risk. While we expect U.S. inflation to rise modestly above the Fed’s target in the near term, longer-term risks remain. We find gold attractively priced as not just an inflation hedge but also a diversifier in the case of a financial crisis.

The figure shows a dial representing the preferred weighting for currencies, with a neutral weighting overall. The diagram breaks down weightings for various regions with a series of horizontal scales, transitioning from brown for underweight, represented with a minus sign, to green for overweight, represented with a plus sign. The U.S. dollar, euro and yen are neutral. Emerging markets ex-Asia has a slight overweight, while emerging markets Asia has a slight underweight.
Under Over





EM ex Asia

EM Asia


We continue to favor small tactical positions in some of the higher-carry “commodity currencies” given still-attractive valuations and an embedded risk premium that should benefit long-term investors. Asian economies have benefited inordinately from global trade, but are likely to weaken in the face of slowing Chinese growth.

Investor Summary

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Asset Allocation Views


Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Investments in private assets could be volatile; an investor could lose all or a substantial amount of its investment.  Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.

Management risk is the risk that the investment techniques and risk analyses applied by the investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

Smart beta refers to a benchmark designed to deliver a better risk and return trade-off than conventional market cap weighted indices.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.