‘Bonds are back,’ Pimco says, as stock market becomes less attractive

“We continue to see a strong case for investing in bonds, after yields reset higher in 2022 and with an economic downturn looking likely in 2023,” wrote Tiffany Wilding, Pimco’s North American economist, and Andrew Balls, chief investment officer for global fixed income, in the money manager’s 6-to-12-month outlook.

Investors were hit with a rare double whammy in 2022 as stocks and bonds sold off simultaneously while the Federal Reserve jacked up the fed-funds rate from near zero to a range of 4.25% to 4.5% by year-end.

That robbed investors of the typical cushion provided by a traditional portfolio divided between stocks and bonds. 2022 saw the worst combined total return for both stocks and bonds dating back to 1872, according to Deutsche Bank.

“Fixed-income markets today can offer broad opportunities to build resilient portfolios with the potential for both attractive returns and mitigation against downside risks,” Wilding and Balls wrote.

See: Trust the bond market, not the Fed, on interest rates, Gundlach says

Pimco expects a “modest recession” in 2023 across developed markets as central banks continue to tighten monetary policy in their effort to rein in inflation.

“Any recession could further challenge riskier assets such as equities and lower-quality corporate credit. But we believe the repricing across financial markets in 2022 has improved prospects for returns elsewhere, particularly in bonds. We are focusing on high quality fixed income sectors that offer more attractive yields than they have in several years,” they wrote.

Equities “have become less attractive amid higher interest rates and recession risk,” they said, with higher bond yields causing a move away from what had been known as a “TINA” market, an acronym for “there is no alternative’ to equities.

Stocks still appear richly priced, they said, while Pimco’s models show a much lower recession probability priced into the S&P 500 stock index than macro indicators suggest, while earnings per share estimates appear overly optimistic.

“A change to our underweight position (in equities) would require stabilization in rates, an ERP (earnings risk premium) reflective of recession, and lower earnings expectations,” they wrote. “Until these criteria are met, we favor defensive sectors and quality companies with reasonable valuations, clean balance sheets, and resilient growth prospects.”

In a section titled, “Bonds are Back,” the pair noted that Pimco’s investment committee discussions focused on asset-price returns across a number of scenarios. For example, corporate credit could perform well in a very mild recession, they said. And while Pimco expects disinflation, U.S. Treasury inflation-protected securities, or TIPS, could perform well due to uncertainty over where core inflation settles versus current expectations.

The pair noted that U.S. core bond funds offer starting yields at about 5.5%, which rises for funds with a larger credit component. “This is attractive given our baseline outlook, and these funds’ more favorable risk profile may offer additional downside mitigation versus outer-circle assets in the event of worse outcomes,” they said.

Pimco expects a yield range of about 3.25% to 4.25% for the 10-year U.S. Treasury note. They aim to be neutral on interest-rate risk.

TIPS pricing “suggests high confidence in the Fed’s anti-inflation credibility and could provide a reasonably priced cushion against more adverse inflation scenarios,” they said.

Pimco remains positive on agency mortgage-backed securities, or MBS. “These are high quality, AAA rated assets with relatively attractive spreads that are inner-core, bend-but-not-break securities,” they wrote. “An expected decline in interest rate volatility would support MBS.”

When it comes to credit and structured products, Pimco continues to strongly favor “up-in-quality and up-in-liquidity positioning in core portfolios.”

Markets that are more sensitive to the economic cycle warrant caution, they said, “especially investments that will bear the brunt of any monetary policy overshoots.”

They cited floating rate, senior secured bank loans as an example. Pimco’s credit team sees material downgrade and default risk even at current policy rate levels, they said.

U.S. stocks were modestly higher Wednesday a day ahead of a reading on the December consumer-price index. The S&P 500
SPX,
+0.68%,
which fell more than 19% in 2022, was up 0.7% and has risen around 2.8% since the start of the year. The Dow Jones Industrial Average
DJIA,
+0.33%
was up 2.7% so far in 2023.

Treasury yields, which move opposite to price, have pulled back to begin the year. The yield on the 10-year note
TMUBMUSD10Y,
3.580%
was off 5.2 basis points at 3.57%.