Understand what the Force can and can’t do
The Force can bring sovereign yields down. It can punish depositors for holding cash through negative rates. It can also encourage risk-taking as investors
search for higher yielding assets to escape financial repression. This risk-taking can support prices of assets that central banks are not directly buying.
This asset price appreciation can even support real economic growth through wealth effects. The jury is still out on the sustainability of that growth (we
will leave that to the future historians).
The Force cannot make corporate managers smarter. It does not change the competitiveness of a company. It does not make its products suddenly more
appealing, and it does not make a secularly declining business profitable. In short, it can’t make pigs fly – not for a long time, at least.
Investors should resist the Force and focus on avoiding these (temporarily) flying pigs. PIMCO’s elaborate global credit research process brings our credit
research analysts, sovereign analysts, commodity analysts and global portfolio managers together to identify businesses and companies we believe have
strong earnings potential, improving pricing power, superior asset coverage and high barriers to entry and those that focus on de-levering to generate
value for credit investors. At the same time, it aims to avoid flying pigs. We will not be right all the time, but as history has shown, this process has
been successful in avoiding such issues much more consistently than the aggregate market (Figure 3).
Expect periodic disturbances in the Force
The Force in consideration depends on smooth and flawless execution by central banks. We have seen many disruptions in the Force in the past and will
continue to see them in the future. The next possible disruption comes from when the U.S. Fed will begin hiking rates. Our base case is around Q 3 2015.
The Fed has attempted to reduce some volatility associated with the rate hike by lowering its dot forecasts for 2015 and 2016. Nonetheless, the implication
for us is, first, to keep some dry powder with the aim to take advantage of the volatility or disturbance in the central bank’s Force. And second, be armed
with the fundamental research for when that disturbance creates opportunities in the sectors and credits that pass our rigorous screening process.
Harness the Force but resist the urge to go to the Dark Side
The central bank policies provide a lot of interesting opportunities in the credit markets, but also a number of potential pitfalls. We evaluate credit
using three broad considerations: fundamentals, technicals and valuations.
Broadly, corporate debt levels relative to profits look in line with long-term averages (Figure 4). Additionally, improving economic fundamentals in the
U.S. – as evidenced by the declining unemployment rate and incremental cash in consumers’ pockets through lower energy costs – provide a supportive
backdrop for credit. Similarly, in Europe, stabilizing and improving Purchasing Managers Index (PMI) data support credit fundamentals.
This is where central bank policy, particularly now in Europe and Japan, remains most supportive for high quality global credit. By making deposit rates
negative and/or by buying sovereign bonds, the European Central Bank and the Bank of Japan are pushing investors to look for other sources of high quality
yield. Global high quality credit should benefit from this as investors look for relatively safe but higher sources of yield.
Current credit spread are wider than the long-term average, making for an attractive entry point. Additionally, during prior rate-hike periods we have seen
credit spreads tighten over time, since rate hikes are also associated with improving economic growth, which helps credit fundamentals (Figure 5).
Various areas in global credit look attractive to us given improving fundamentals, favorable technicals and attractive valuations. In the U.S.,
housing-related credits, banks and sectors tied to improvement in the U.S. consumer, like autos, airlines and lodging, look attractive. In Europe, we like
peripheral sovereign spreads, exporters that benefit from weaker currency and subordinated bank securities (see the April 2015 Global Credit Perspectives for more details on opportunities in global credit markets today).
But it is also important to avoid going to the Dark Side – companies whose valuations are not justified by fundamentals but are artificially supported by
central bank policies. To us, these would include select U.S. retail and technology companies that face risks of obsolescence in business models as the
search for yield keeps spreads artificially compressed. Similarly, in Europe, credit spreads of many corporates now trade tighter than the sovereign spread
and, hence, look less attractive. Finally, in Asia-Pacific we expect downside risk to China steel demand to translate into weakness in metals and mining
companies in the region.
May the Force be with you
By virtue of their large balance sheets, central banks today are more powerful than ever before. This creates significant opportunities in global high
quality credit sectors. Instead of being choked by negative or negligible yield on sovereign bonds, investors should look for opportunities elsewhere when
seeking superior returns. But we believe fundamental credit research is now more important than ever. Focus on companies with improving business
fundamentals, high barriers to entry and strong pricing power and those that are de-levering when seeking better risk-adjusted returns. And finally,
recognize that this monetary policy reliance globally will likely lead to increased market volatility. Be prepared to take advantage of such opportunities.