October 2012 Fund Update: PIMCO TOTAL RETURN FUND
We recently spoke with Saumil Parikh, a member of PIMCO’s Investment Committee who manages portfolios in the firm’s Total Return strategy and is responsible for leading PIMCO’s cyclical economic forums. During PIMCO’s most recent cyclical forum, which took place in mid-September, key topics of discussion included the extent to which the widely anticipated fiscal cliff will impact U.S. economic growth, whether the U.S. housing market is in the process of bottoming, and whether recent fiscal/monetary policy actions have meaningfully altered the downside risks of investing in Europe. The conclusions stemming from these deliberations have impacted the positioning of PIMCO Total Return, as manager Bill Gross has substantially reduced the fund’s weighting in U.S. Treasury securities and has continued to lower its duration (a measure of interest-rate sensitivity).
In evaluating the U.S. fiscal cliff, Parikh explains the discourse was less about whether it will occur than what the magnitude of the economic friction is likely to be. PIMCO’s baseline view, that fiscal drag of somewhere between 1.25% and 1.5% of GDP will be realized over the next 12 months, is the result of detailed analysis of many permutations of potential election outcomes. Another critical consideration, he says, is whether the effects will be transparent and predictable, because “the path of how we get there is actually very important for markets and for how we might position [the fund].” According to Parikh, the best outcome is for Democrats and Republicans to map out a clear agreement during the “lame duck” session following the elections, in which case “most real economic actors will be able to plan around the fiscal drag, if they have some certainty as to the quantity [and what is impacted].” At the other extreme is a scenario in which legislators decide to tackle each sunset piecemeal, without a cogent and transparent plan. “If it turns out to be a multi-committee affair, where [they] go through a sequential process of dealing with each and every stimulus measure individually,” Parikh warns, “then the possibility of the process becoming path-dependent and one that might lead to a much larger fiscal drag, unintentionally, could become much larger.” The multiplier effects of indecision among consumers and business leaders would present significant downside risks to the U.S. economy.
Another subject of vigorous debate is whether U.S. home prices have found a secular bottom and, if so, what this would mean for residential investment, consumer wealth effects, and the ability to continue growing via consumption and credit creation. Based on evidence presented during the cyclical forum, Parikh says most at PIMCO agree that the average U.S. home has cheapened significantly in value “both from an absolute perspective as well as from a relative perspective, compared to other financial assets,” especially in the context of residential rental yields versus the earnings yield for stocks and real yields across a wide range of fixed-income sectors. The real question, he explains, is whether this creates a secular valuation floor that will remain unaffected by future economic decisions or whether it is “simply a contingent bottom that is still subject to the degrees of how the U.S. economy will perform going forward.” The forum participants are much more divided on this issue, as housing has become even cheaper during localized boom-bust cycles in the past, according to PIMCO’s analysis. Parikh says the consensus among members of the Investment Committee, who aren’t yet ready to declare a secular bottom in housing, is that housing will outperform stocks and bonds on a total return basis, at least over PIMCO’s cyclical time horizon of the next 12–18 months. Considering the growth implications of a cyclical bottoming, PIMCO anticipates that an increase in residential construction, along with a multiplier of “at least 1.5x” on new construction and the ancillary effects of price stabilization, will add roughly a half percentage point to U.S. economic growth in 2013. Combining the impact of the U.S. fiscal drag with the positive contribution from housing produces a net growth estimate of “somewhere between 1% and 1.5%” for the United States, which Parikh warns is “awfully close to historical stall-speed levels, where we begin to worry about corporate profits [and] mid-capital structure assets.”
Turning to Europe, Parikh says they expect the region’s recession to continue and in fact deepen over the next 12 months. However, an important caveat is that the probability of a Lehman-type event has declined significantly due to the increased willingness and political ability of the European Central Bank to serve as a conditional lender of last resort to sovereigns. “The conditionality that is going to be applied [by the ECB] is, for all intents and purposes, a political straw man,” though Parikh stresses, “It is not a sufficient policy action to return the eurozone economy to growth.” What remains unclear is whether the policy will be sufficient to last beyond PIMCO’s cyclical time horizon. However, Parikh says the ECB’s support makes the Investment Committee more confident that European bond markets are suitable for investment now, “as opposed to 12 months ago, when we thought they were completely uninvestable, because the risks were not definable and the downside was very, very large in that space.” Today, they believe selected investments in the periphery offer excess returns, provided that the ECB’s policy remains in place. PIMCO Total Return has recently purchased short-dated sovereign and quasi-sovereign obligations of Italy and Spain. Parikh explains, “We don’t think these countries are going to jump to default” during PIMCO’s cyclical time frame, while acknowledging that “they may slowly creep to default over a secular horizon.” The reason PIMCO is so confident in the stability of the ECB’s stance over the next 12 months, he elaborates, is because it really won’t be contested in German politics until their election cycle next year, which is likely to become a referendum on monetary policy (which is why they aren’t buying longer-dated bonds). Parikh adds that the fund’s contrarian position—primarily in cash bonds, not derivatives—is an example of its ability to profit from providing liquidity to the markets.
On a secular basis, Parikh ultimately believes the United States is more likely to be successful than Europe in its effort to buy sufficient time for appropriate fiscal adjustments and structural reforms to take root and set the stage for real growth. He thinks there is “better than [a] 50/50 chance that as long as fiscal and monetary policy is coordinated and the politics of running deficits is put into its proper context, [and] the innovative and creative destruction elements of the U.S. economy that we are so famously dependent on for higher productivity and higher growth rates are being allowed to work without disruption, then I think the U.S. has a genuine probability of reaching—over time—a real [growth] outcome.” The fact that we haven’t returned to a higher growth rate by the fourth year of recovery is properly viewed as a failure, he notes, “But at the end of the day, we’re making progress, right?” Parikh points to several reasons for American optimism: deficits that have come down, growth and productivity rates which remain higher than most developed nations, and potential for a self-feeding recovery in housing. In contrast, he says the eurozone “still has to be viewed with initial design flaws” that do not allow for cross-border investment and labor mobility needed to engender productivity and growth. “So with Europe, we’re much more skeptical that the destination can be reached.”
With respect to emerging markets, there is broad agreement at PIMCO that these economies are going through both cyclical and secular slowdowns, the former resulting from a global inventory recession and the latter due to their need to shift away from investment-based models toward economies with greater balance between consumption and investment.
Due to the ongoing threat of weak and slowing global growth, PIMCO expects little movement in the Treasury yield curve up to the five- to seven-year point over the next several years. Beyond the effects of near-zero Fed funds and quantitative easing, rates are further suppressed by the lack of credit creation from the private sector. Regardless of political posturing, PIMCO assesses the risk of an abrupt post-election change in Fed policy as “trivial” since an unassisted deleveraging would be painful to the true creditors of the nation, which are corporations and higher-income households. “So the demand/supply dynamics for duration risk in the market are very heavily skewed toward low interest rates remaining low for an extended period,” Parikh says. The longer end of the yield curve (beyond 10 years) is much more susceptible to inflation expectations, which he says will be driven not only by monetary actions but also by realized inflation. Over the cyclical horizon, he sees the demand/supply imbalance moving to the favor of supply, and therefore “price inflation is actually on the down trend.” To Parikh, this means the possibility of a currency or externally driven event is the most likely source of a major shift in inflation expectations during the next few years.
Over the past 15 months, Gross shifted the fund’s net exposure to U.S. government securities (including futures and other interest-rate derivatives) from approximately 0% as of June 30, 2011, to a peak of 41% on January 31, 2012, and back down to 21% at the end of August. During the latter half of 2011, he increased the fund’s stake in high-quality (mostly Fannie Mae) mortgage-backed securities from 21% to 50% of the fund and has maintained the allocation around this level throughout 2012. This decision has boosted the fund’s year-to-date performance, as mortgage-backed securities have significantly outperformed Treasurys in 2012. Most recently, the Fed’s latest announcement of bond purchases includes an open-ended plan to directly target the mortgage market, committing to buy at least $40 billion of mortgage-backed securities monthly in addition to the reinvestment of proceeds from maturing holdings. In the third quarter, Gross substantially reduced the fund’s weighting in nominal U.S. Treasurys while maintaining its allocation to U.S. Treasury Inflation-Protected Securities (TIPS).
Parikh explains that TIPS are an efficient vehicle through which to express PIMCO’s conviction that the “rickety bridges” of monetary policy are far more likely to produce inflationary outcomes than to restore strong, self-sustaining economic growth, “discerning between the composition of nominal growth [being tilted] more toward inflation and less toward real growth.” Over the next three to five years, PIMCO expects to earn nominal returns of 3%–3.5% from the TIPS they hold today, primarily longer-duration issues. Parikh says this comes “from the inflation carry as well as from the roll-down in the real interest rates of the TIPS curve,” which is very steep at present. He likens this to a strategy PIMCO has used in the past with intermediate-term nominal Treasurys: buying a bond with a seven-year maturity, for example, and clipping its relatively higher interest coupons for several years before selling it closer to maturity, then reinvesting the proceeds in another seven-year bond. Parikh says this is a significant mispricing, calling it “a gift to get the same roll-down characteristics in the real yield curve as in the nominal yield curve . . . because in the real yield curve you get the additional upside convexity of inflation surprises, which in the nominal curve you get punished for.” Taking a long-term perspective, PIMCO expects inflation to surprise on the upside rather than the downside.
Parikh says they are finding similarly steep roll-down characteristics in certain emerging markets, such as Brazil and Mexico. While Mexico’s economy is tightly linked to the U.S. economy and the country faces political uncertainties such as the drug war, PIMCO believes Mexican bonds represent a more attractive form of duration because their higher real interest rates offer fair compensation for these uncertainties and price volatility. In general, Parikh says they view emerging-market central banks as more likely to cut rates than to raise them over a cyclical time horizon as growth slows down. PIMCO believes the secular trend of outperformance by emerging-markets currencies will remain intact, but Parikh cautions, “As the rest of the world adjusts to the reality of lower growth rates and lower [currency yields], we would expect volatility and [downward adjustments to] the valuation of emerging-markets currencies.” For the time being, this has led Gross to hedge most of the currency risk of positions in emerging-markets bonds which are not denominated in U.S. dollars.
Litman Gregory Opinion
During an unusually disappointing 2011 (request our October 2011 update for details) in which PIMCO Total Return trailed the Vanguard Total Bond Market Index by 3.4%, Gross assured shareholders that he and the entire PIMCO team were as focused as ever on delivering exceptional performance. The fund has in turn provided strong year-to-date performance of 9.1% compared to a return of 3.9% for the benchmark. Across the 12-month period ending August 31, 2012, which includes the worst month (September) of relative performance during last year’s rough patch, the fund still managed to beat the benchmark by 2.9%. Over the long term, Gross has outperformed the benchmark by wide margins on a trailing basis and with remarkable consistency in rolling periods. The fund has outpaced Vanguard Total Bond Market Index in 75% of 12-month periods, 91% of 24-month periods, and has never trailed the benchmark over a three-, five-, or 10-year span since inception of the Total Return strategy.
Beyond our confidence in Gross’s experience and his distinguished track record, we like the relentless passion he continues to display in spite of his well-documented success. We are also impressed by his supporting colleagues, in particular the other members of PIMCO’s Investment Committee, who have consistently demonstrated a deep knowledge of their respective fixed-income markets. As the roles of these committee members have expanded, we have spent increased time in conversations with them, and we find them to be engaged, insightful, and intellectually honest. PIMCO’s risk-based approach to portfolio management is also an advantage in an increasingly uncertain economic environment. The firm will not be correct in every investment decision, but Gross and his team have shown an ability to quickly assess and recover from short-term mistakes. We believe they have the talent and disciplined processes in place to continue delivering long-term performance that meaningfully exceeds the benchmark, so we continue to Highly Recommend PIMCO Total Return (as well as funds managed in the same strategy by PIMCO).
—Chris Sawyer, CFA, Senior Research Analyst
This research report is provided for informational purposes only and on the condition that it will not form the sole basis for any investment decision. The fund’s prospectus contains its investment objectives, risks, charges, expenses and other important information and should be read and considered carefully before investing. Past performance is no guarantee of future results.