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It's a goodbye slow at the right times. A year ago, Pimco chief economist, Joachim Fels, announced that the bond investor was gearing up for the next correction. However, it does not expect a recession, at least not next year.
Mr. Fels, the stock markets have been exceptionally nervous in recent weeks. Is this the beginning of a major correction?
No, this is not yet the big correction on the stock market. The big bear market usually occurs just before or during a recession. I think we are in a late phase of the economic cycle. But the next recession is not imminent. At the present time, there is still no typical imbalance or tension in the economy that has made a recession necessary.
The US Federal Reserve is not yet restrictive, which has often led to recessions in the past. It is currently moving towards a neutral monetary policy. In the United States, fiscal policy is also supportive of this and a good part of next year. In that sense, I think the next recession will be in 2020 at the earliest.
Will the markets calm down here?
There will always be corrections, as we see them at the moment. Generally, at an advanced stage of the cycle, volatility increases. But normally, stock markets are still doing well in this phase. The break then only when it is clear that the recession is imminent or even started.
What is the situation in Europe?
Europe is a little behind in the economic cycle because we have meanwhile approved a new recession in 2012 and 2013. The problem is that if the recession occurs in the United States, it is unlikely that the recession will occur in the United States. Europe is decoupled. If this happens in the United States, it will also be in Europe. This is because monetary policy in Europe has relatively little room for maneuver.
What does this mean for investors?
The time has not come yet to sell everything and go in cash or safe state bonds. Because you can leave a lot of back on the table. But at the end of the cycle, investing becomes more difficult. On the one hand, because volatility increases and, on the other hand, because we can no longer generate such high returns with high valuations.
How is Pimco positioned in such a phase?
At this advanced stage, there are some typical behaviors. First, corporate bond spreads are widening, while the stock market continues to perform well. This is why we are slightly underweighing corporate bonds in our multi-badet funds. As far as equities are concerned, we have a neutral weighting.
Commodities also work well in the last phase of the economy, not least because inflation is beginning to be felt. In the United States, inflation-indexed bonds have a meaning. In addition, we believe that short- and medium-term government bonds in the United States make sense. Yields have already increased significantly. We are almost three per cent in term of two to five years. And if the recession happens earlier, then these sovereigns have a lot of upside potential. You can diversify your portfolio.
In Europe, however, there has been no increase in yields.
This is true. This means that if there was a recession, there would not be much upside potential. Because prices are already so high or yields are still so low.
What are the factors that could trigger a recession?
First of all, there is the risk that this trade war will worsen significantly. What has happened up to now is not so dramatic. But if President Trump and President Xi fail to reach an agreement quickly, but continue to skyrocket, higher tariffs are threatening more and more imports and a further devaluation of the Chinese currency. And we could then face a recession next year.
And the second risk?
Inflation will accelerate and the Fed will again raise interest rates. Thus, the growth phases in the past have always been strangled.
And what could trigger inflation after a long period of weakness?
Strong demand fueled by fiscal policy. Economic growth in the first two quarters is just under four percent. Added to this is the overheating of the labor market. This is not our basic scenario. But we can be wrong.
Are you worried about the situation in Italy?
That really worries us. It's a market that we have clearly underweighted.
Could Italy trigger a crisis in Europe and, hence, a crisis in the United States?
Yes it is possible. If there is a crisis in Europe, triggered by Italy, the overall impact. For we must not forget: Italy is the third largest bond market in the world after the United States and Japan. The crisis might not be as serious as the first crisis of the euro, as banks are more cautious and the portfolios of international investors have returned to Italy, either in the bank books of Italy, in the books of Italian banks. In this sense, the risk of infection is not so great.
At the end of 2017, Pimco started to reduce risks. Are you still there or are you buying slowly again?
We have a structured investment process and every quarter we test our economic and market valuations. In September, we strengthened our cautious positioning. We underweight corporate bonds, including high yield bonds. In emerging markets, we are cautious.
But: we are always invested. However, in each badet clbad, we make sure to invest more liquid and secure investments. If there are course corrections, this can also be an opportunity to buy and increase the risk.
Mr. Fels, thanks for the interview.
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