Q: Are the markets likely to remain volatile and how should investors position their portfolios?
Scott Mather: While the volatility this past week has been extreme, it has been a feature in the markets over the past eight months and will likely continue – especially with continued divergence in global monetary policies. Investors should position their portfolios with this higher volatility in mind, and make sure, for example, that they’re taking risk only where they are being properly compensated for it. Risk premiums across all financial assets are relatively compressed at the moment, so it’s time to think about taking less risk than over the past several years across many sectors and asset classes.
Investors who focus on short-term horizons will likely have a difficult time in markets like this, but long-term investors should keep in mind that volatility can create opportunities. At PIMCO, we’ve been positioning portfolios with an eye to making volatility work for us, and in the quarters ahead we expect there to be plenty more opportunities to take advantage of risk assets selling at favorable prices.
Q: Has PIMCO changed its outlook for when the Fed will begin raising rates?
Mather: Throughout the first half of the year our outlook was that the Fed would initiate its tightening cycle sometime during the second half of 2015, focusing in particular on the Fed’s September announcement – scheduled to be released on September 17 – as our “base case” for the first small step away from zero.
Macro events in July and August have caused us to adjust that outlook. The underlying fundamentals of the U.S. economy remain solid. However, with the world as unsettled and volatile as it’s been lately, Fed officials don’t want to be seen as contributing to the uncertainty. As a result, while there is still a possibility that the Federal Open Market Committee (FOMC) could raise rates in September or October, our base case is now that they will hold off until the December meeting.
Q: What would a later start to the tightening cycle mean for investors?
Mather: In the short-term it would mean marginally less upward pressure on the very front-end of the yield curve. That should benefit strategies that invest there. It might also mean we wouldn’t see as much Fed-induced volatility in the financial markets in September, though, of course, one reason for the volatility is market uncertainty regarding the timing of Fed liftoff. In that sense, once the Fed starts the process of normalizing policy some of the uncertainty may abate.
More important than the exact date of the first Fed hike, however, is the composition of the cycle. This means how quickly the Fed will raise rates, how much it will raise them each time and where and when it will stop. These factors will ultimately have a more profound effect on an investor’s long-term investments than whether the first increase is in September, December or 2016.
With this in mind, I’d mention that PIMCO remains committed to our two- to three-year outlook for rates. We continue to see a multi-speed world of economies converging to modest trend growth rates in the context of inflation rates that, while perhaps somewhat higher than current levels, remain relatively contained. In this environment we see the equilibrium nominal level of the Fed funds rate, which is the level where the Fed isn’t tightening or easing, being between 2.0% and 2.5%. This is roughly 0% in real terms, or about 2% lower than the neutral rate that has applied in the last few hiking cycles. So while the members of the FOMC may be eager to move the policy rate away from zero, they are likely to keep it much lower over time than it has been in the past. We also think the Fed may allow more time between hikes than it did in previous cycles. In short, our New Neutral call stands: rates lower for longer.
