Pimco Insights on Navigating Uncertainty with Alternative Investments

Navigating uncertainty with alternative investments can be a daunting task, but Pimco offers valuable insights to help you make informed decisions.

Pimco recommends considering alternative investments as a way to diversify your portfolio and reduce risk. By allocating a portion of your investments to alternatives, you can potentially increase returns and improve overall portfolio performance.

In today's uncertain market, alternative investments can provide a hedge against volatility. For example, private equity investments can offer a stable source of returns, even in times of market downturn.

By incorporating alternative investments into your portfolio, you can potentially reduce your reliance on traditional assets and improve your overall investment strategy.

Fixed income is poised to play a significant role in 2025, making it an attractive option for investors. A diversified, actively managed bond fund can provide consistent income generation through interest rate cycles.

The PIMCO Total Return Fund, PIMIX, is a great example of this, with a current dividend of 6.2% and an effective duration of 4.2 years. This fund has a large allocation to mortgage bonds, which are relatively cheap to Treasury bonds and corporate bonds.

Historically, bonds tend to perform well during soft landings and even better in harder landing scenarios. Recently, bonds have resumed their traditional inverse relationship with equities, offering diversification and hedging benefits for portfolios.

In the past, a portfolio of alternative fixed-income exposure via bank loans, AAA-rated CLOs, and income-oriented mutual funds has outperformed a traditional passive portfolio of Agency mortgages, Treasuries, and corporate bonds. This alternative portfolio had a 3.6% volatility and a 6.1% maximum drawdown compared to the popular aggregate benchmark bond ETF, AGG, which had a 7.1% volatility and 17% maximum drawdown.

The yield to worst on core bonds currently exceeds the Fed Funds rate, making it an attractive time to invest in core bonds. Historically, when core bonds out-yield short-term rates, they have delivered attractive returns.

Here are some key differences between EM debt and U.S. corporate debt:

Core bonds can offer attractive returns when they out-yield short-term rates. The current yield to worst on core bonds exceeds the Fed Funds rate, making it a favorable time to invest in core bonds.

EM debt scores better than most assets due to favorable correlation characteristics, not solely because of higher yields. This is because the correlation between EM debt and U.S. corporate debt is about 0.63 over the past 10 years, using J.P. Morgan data.

Investors can treat EM debt as a structural allocation to de-concentrate from domestic sources of credit risk. They can size the allocation based on its effect on the Sharpe ratio of their overall portfolio.

Many clients, ranging from insurance companies to pension funds, typically have chosen an allocation of 2% to 8% for EM debt in their strategic asset allocations.

Investing in emerging markets (EM) can be a rollercoaster ride due to general asset class volatility and poor sizing of the asset class in broader portfolios. Many investors have been exposed to imprudent risk scaling within the EM debt allocation.

The correlation between EM debt and U.S. corporate debt is relatively low at about 0.63 over the past 10 years. This is a favorable characteristic that contributes to EM debt's ability to score well in strategic asset allocations.

Diversification is a key objective, and EM debt's correlation with other assets should be carefully considered. An asset inclusion test can help optimize portfolio construction, maximizing the Sharpe ratio subject to risk, return, and correlations constraints.

Typically, clients, such as insurance companies and pension funds, choose an EM debt allocation of 2% to 8%. This range is based on a sober assessment of sizing in strategic asset allocations, taking into account the asset's risk, return, and diversification properties.

Fixed income becomes increasingly compelling as cash yields dwindle. This shift can create a favorable environment for active fixed income investors, especially with falling interest rates providing a tailwind for bonds.

Historically, bonds tend to perform well during soft landings and even better in harder landing scenarios. Recently, bonds have resumed their traditional inverse relationship with equities, offering diversification and hedging benefits for portfolios.

We've partnered with the Roman Family Center for Decision Research at the University of Chicago Booth School of Business to advance our understanding of human behavior and decision-making.

This innovative partnership has the potential to make us a better active manager and stewards of our clients' assets by providing world-class insight into behavioral analysis and trends.

We're committed to supporting diverse and robust research that contributes to a deeper understanding of human behavior and decision-making, empowering leaders to make wiser choices in business and society.

Our goal is to build on PIMCO's strong culture of investing excellence and create a diverse, engaging workplace by challenging our ideas and assumptions about investing and risk.

The RF-CDR team's expertise will help us make wiser choices and provide better outcomes for our clients.

The U.S. economy has been outperforming its DM peers since 2023, achieving growth rates of 2.5%–3%, while others stagnated at 0%–1%. This is largely due to a larger cumulative fiscal stimulus since 2021, which has led to greater private wealth accumulation in the U.S.

Fiscal policy has been a key driver of this growth, with the U.S. experiencing a slower pass-through of higher interest rates to households, thanks to existing low-rate, long-term mortgages. This has helped keep financial conditions more accommodative in the U.S.

The U.S. has also been less affected by international spillovers from Chinese economic weakness, unlike European countries, which have been hurt by weaker trade with China and greater Chinese import competition.

The economic outlook is shifting, and it's essential to understand the changes happening in the market. The U.S. economy has distinguished itself in 2023 and 2024, achieving growth rates of 2.5%–3%, while DM peers largely stagnated at 0%–1%.

Fiscal policy has played a significant role in this growth, with a larger cumulative fiscal stimulus since 2021 leading to greater private wealth accumulation in the U.S. This wealth has taken longer to dissipate, contributing to the country's economic resilience.

Monetary policy has also been a factor, with the pass-through of higher interest rates to households being slower in the U.S. This is largely due to the existing stock of low-rate, long-term mortgages.

One key driver of the U.S. economic growth has been the prominence of U.S. private credit markets, which has kept financial conditions more accommodative. This has led to an influx of investor capital in lower-quality corporate lending, intensifying competition for deals.

A notable difference between the U.S. and other DMs is the impact of international spillovers from Chinese economic weakness. The U.S. has been less affected, while European countries, particularly Germany, have been hurt by weaker trade with China and greater Chinese import competition.

The U.S. has also been a beneficiary of the growth in generative artificial intelligence (AI), which has provided financial gains and capital accumulation.

Normalization of monetary policy is underway, with the Federal Reserve and other central banks gradually reducing interest rates to more neutral levels. This shift is largely driven by resilient U.S. growth and inflation, which delayed the Fed's rate-cutting cycle compared to other central banks.

We can expect DM central banks to cut rates by 175-225 basis points in 2025, with the Fed focusing on returning monetary policy rates to neutral levels. This will help to moderate growth and inflation, and prevent overheating in the economy.

The Bank of Japan, however, remains an outlier, with a policy rate below neutral estimates. Despite recent market volatility and yen strength, the BOJ is expected to continue with gradual rate hikes to combat elevated inflation and firm wage inflation.

Inflation expectations are rising in Japan, driven by elevated inflation, and labor market indicators are also pointing to a strong economy. This suggests that the BOJ's rate hikes will be necessary to keep inflation in check.

The world of asset classes is vast and diverse. Over the past 20 years, the number of investable emerging market countries has more than doubled, now totaling around 200 individual macro risk factors across 85 countries.

This increased diversity is a positive trend, as it allows for more granularity in understanding country-level macro risk factors. In fact, correlations across this matrix range from 0.8 to -0.7, according to data going back 20 years.

Some factors are "risk-on" while others are "risk-off", meaning they're positively or negatively correlated to global systemic factors like oil or equities. This is significant, as it creates opportunities for investors to hedge against risk.

A basket of emerging market local bonds hedged to U.S. dollars has generated higher returns than comparable U.S. Treasuries over the past 15 years. This is a notable shift from the past, when EM debt was characterized by fat tails – a higher distribution of more extreme outcomes.

The rise of available instruments has been staggering, growing nearly 20-fold in the past two decades. This increased accessibility is a boon for investors, who can now disaggregate country-level macro risk factors into fine granularity.

The shift from bank-dominated lending to a diversified financing ecosystem is also creating opportunities for private credit investors.

Risk management is crucial for investors, particularly in today's volatile markets. PIMCO's research highlights the importance of managing risk, especially in the face of rising inflation and interest rates.

A key aspect of risk management is diversification, which PIMCO emphasizes as a way to reduce portfolio volatility. By spreading investments across different asset classes, investors can minimize their exposure to any one particular market or sector.

Investors should also consider hedging strategies, such as using options or futures to protect against potential losses. PIMCO's experts recommend using these tools to mitigate risk, particularly in times of market uncertainty.

Inflation is a significant risk factor that investors should be aware of, particularly with the current economic environment. PIMCO notes that investors should consider inflation-indexed bonds, such as Treasury Inflation-Protected Securities (TIPS), as a way to protect their portfolios.

A well-diversified portfolio can also help investors navigate market downturns. By spreading investments across different asset classes, investors can reduce their risk and potentially ride out market fluctuations.

Behavioral science is a key component of our investment approach at PIMCO, helping us give our clients an edge and achieve the best possible outcomes.

We believe that behavioral science can make us better investors and help our clients make better investment decisions. PIMCO advisors can provide valuable guidance to reduce the negative consequences of emotional decision making, especially during periods of extreme market volatility.

Normalcy is a relative term, especially when it comes to economics. The concept of "normal" monetary policy is a moving target, influenced by various factors such as government debt levels and investment needs.

Higher government debt levels and stronger private sector balance sheets could support a higher neutral rate than in the past. However, demographic trends and wealth disparity may offset these gains.

Central banks are taking a cautious approach, cutting rates to see how their economies respond. Market pricing has moved in line with expectations, suggesting a neutral policy rate in the range of 2%–3%.

A neutral nominal policy rate of 2%–3% is a reasonable estimate, given the uncertainty around the level of neutral policy rates. There is room for central banks to cut rates further if growth plummets or employment falters.

We always strive to give our clients an edge and achieve the best possible outcomes by leveraging behavioral science. Behavioral science can help investors make better investment decisions.

During periods of extreme market volatility, investors often focus on short-term returns, not long-term goals. Advisors can help reduce negative consequences of emotional decision making by providing valuable guidance.