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Global Investing in 2013: Policy Dominance, Active Management, and a New Paradigm in Currencies

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An interview with Scott Mather, head of global portfolio management at PIMCO.

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With policies and politics driving markets more than fundamentals, active management is critical, argues Scott Mather, head of global portfolio management at PIMCO. In the following interview, he surveys the landscape for bonds and currencies, identifying the developments that we believe may spell opportunity, and risk, for investors.

Q: What do you see as the main challenges in today's investment environment?

A: Debt dynamics are the most important issue facing global investors. As we often hear, there is simply too much debt, particularly in the developed world, and it is constraining growth, as well as fiscal and monetary policies.

It was not that long ago that we accepted the notion of central bank independence. But, ultimately, each central bank reports, to some degree, to a political body, and the political pressure to address unemployment and lackluster economic performance has belied the concept, some might say façade, of independence.

Meanwhile, legislators have generally not engaged in intelligent fiscal planning that meaningfully addresses economic issues in the US or other developed economies.

Thus, central bankers have implemented experimental policies to fill the gap, pushing many investors to take on risk and subsequently divorcing asset values from fundamentals, as well as increasing inflation risk.

We anticipate that the impact of ongoing global policy experimentalism on real economic growth and financial markets will likely vary substantially from country to country. That variance creates both risks and opportunities, and it may very well be unwise for investors to passively float through this environment.

Q: Could you elaborate on why passive management may be such a risk for global investors?

A: Passive investing may cause investors to miss opportunities and be exposed to risks that an active manager might mitigate.

Take sovereign bond exposure. If investors passively rely on market capitalization-weighted indexes, they could end up owning more and more debt from countries that are less and less creditworthy or countries in which inflation risk is rising. Overexposure to peripheral Europe has been and may continue to be a significant investment risk.

Although spreads have tightened in Italy and Spain since the ECB committed to "do whatever it takes" last July, we believe the underlying issues are far from solved. For that matter, debt and employment issues in the US are not solved and we see long-term inflation and currency debasement risks emanating from policy measures. To varying degrees, circumstances are similar in Japan and the U.K.

All these factors could lead to shifts in global bond and currency markets. When global events and credit quality are moving quickly, investors should consider a manager who can actively respond to these changes. Indeed, we see investment opportunities from anticipating how policies may play out in different countries. With flexible, active, global strategies investors can potentially benefit from a broader opportunity set and the ability to go off benchmark in an effort to both avoid risks and tap opportunities.

Q: Speaking of opportunities, do you believe it has become more difficult to generate alpha with yields so low? Where do you see compelling opportunities to potentially add alpha going forward?

A: We have lowered our general expectations for total return given the lower-yielding environment, but not our alpha targets. In fact, we see more potential alpha opportunities than one might expect in a "normal" environment as we expect countries will choose different paths to address issues with debt, growth and inflation. And because we think the market reaction to economic events and policy responses could also vary greatly, we anticipate a period of "rolling crises" until debt loads are brought down from the danger zone. In this regard, we believe now is a good time to consider tapping the global investment opportunity set and seeking to compensate for that low beta.

I would highlight three key areas from which to seek alpha – yield curve, country selection and sector.

In the developed world, many central banks are keeping policy rates at zero. Such policies have contributed to a significant slope in the yield curve, and that creates opportunities for investors focused on risk-adjusted returns. Additionally, some central banks (including those in Australia, the eurozone, Japan, the UK, and the US) will likely deploy additional monetary stimulus through rate cuts and/or balance sheet expansion in the year ahead, providing opportunities for active positioning.

In our opinion, country differentiation is critical when investing in global regions. We anticipate greater variation between countries as the limits of debt sustainability and monetary and fiscal policies are tested to varying degrees. Ultimately, this may lead to quite a bit more bond market volatility and changing correlations across the globe. For example, the spread between Spanish and German yields at the end of 2012 was only 50 basis points higher than at the start of the year. Any appearance of calm, however, would be deceptive given that spreads oscillated substantially by up to 300 basis points throughout the year. We expect volatility, and the potential for alpha, to continue as long as the markets question Europe's ability to address its problems.

To be sure, when investing in foreign securities, investors should carefully consider whether or not to take on currency exposure, which can heavily influence both returns and volatility. We anticipate a period of increasing currency volatility as a result of the aggressive monetary policies being pursued around the world – again presenting new opportunities for the active manager.
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