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Real assets and the net-zero pathway
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The sustainable forces driving change in real assets
The real asset green premium explained
s the economic recovery from the coronavirus pandemic begins, income investors must navigate a raft of challenges, including rising inflation in a low
interest rate environment, the potential for the economic recovery to take longer than anticipated, and the effects of overarching global risks such as climate change. While the prices of many traditional income generating assets have been inflated by unprecedented fiscal and monetary stimulus, investors must also be wary of going up the risk spectrum in search of returns.
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“Net zero commitments are set to revolutionise the world of long-dated real assets”
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Fixed Income
Disclaimer
Income generation in a global landscape
Mark Meiklejon on the Aviva Investors’ Climate Transition Real Assets Fund
How can pension funds use ESG to futureproof portfolios?
Professional Investors Only
Featured in this Spotlight
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Ketish Pothalingam Portfolio Manager, EVP
Ketish is a member of PIMCO’s ESG team, focusing on corporate credit and global bond ESG portfolios
Samuel Mary ESG Research Analyst, SVP
Samuel focuses on the integration of ESG factors into PIMCO's portfolio management and credit research
Opportunities and Trends in ESG
Age of Transformation
Spotlight on: PIMCO GIS Income Fund
SPOTLIGHT ON: PIMCO GIS Income Fund
Can we build resilient income in the post-pandemic world?
In this Spotlight guide, Alfred Murata, managing director and portfolio manager at PIMCO – one of a team of three leading the GIS Income fund – reveals the strategies his team employs to try to generate attractive income while seeking to protect assets on the downside. In addition, this guide includes a 2022 outlook from PIMCO’s wider team, outlining some of the biggest global uncertainties as well as three broad trends that seem to be driving secular transformations.
“Income generation is important in this environment, but it is critically important to focus on risk management as well”
PERFORMANCE AND FEES Past performance is not a guarantee or a reliable indicator of future results. Performance figures are presented net of management fees commissions, other expenses, and the deduction of actual investment advisory fees; but do not reflect the deduction of custodial fees. The "net of fees" performance figures also reflect the reinvestment of earnings. All periods longer than one year are annualized. Separate account clients may elect to include PIMCO sector funds in their portfolio; sector funds may be subject to additional terms and fees. BENCHMARK Unless referenced in the prospectus and relevant key investor information document, a benchmark or index in this material is not used in the active management of the Fund, in particular for performance comparison purposes. CHARTS Performance results for certain charts and graphs may be limited by data ranges specified on those charts and graphs; different time periods may produce different results. GIS FUNDS PIMCO Funds: Global Investors Series plc is an umbrella type open-ended investment company with variable capital and is incorporated with limited liability under the laws of Ireland with registered number 276928. The information is not for use within any country or with respect to any person(s) where such use could constitute a violation of the applicable law. The information contained in this communication is intended to supplement information contained in the prospectus for this Fund and must be read in conjunction therewith. Investors should consider the investment objectives, risks, charges and expenses of these Funds carefully before investing. PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Europe GmbH Irish Branch (Company No. 909462) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institution Act (WpIG). The Italian Branch, Irish Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; and (3) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2). The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.
Disclaimer Past performance is not a guarantee or a reliable indicator of future results.The Fund will be actively managed in reference to the Bloomberg Barclays MSCI Global Green Bond Index as further outlined in the Prospectus and Key Investor Information Document. Performance and fees Past performance is not a guarantee or a reliable indicator of future results. Performance figures are presented net of management fees commissions, other expenses, and the deduction of actual investment advisory fees; but do not reflect the deduction of custodial fees. The "net of fees" performance figures above also reflect the reinvestment of earnings. All periods longer than one year are annualized. Separate account clients may elect to include PIMCO sector funds in their portfolio; sector funds may be subject to additional terms and fees. Charts Performance results for certain charts and graphs may be limited by data ranges specified on those charts and graphs; different time periods may produce different results. ESG Socially responsible investing is qualitative and subjective by nature, and there is no guarantee that the criteria utilized, or judgment exercised, by PIMCO will reflect the beliefs or values of any one particular investor. Information regarding responsible practices is obtained through voluntary or third-party reporting, which may not be accurate or complete, and PIMCO is dependent on such information to evaluate a company’s commitment to, or implementation of, responsible practices. Socially responsible norms differ by region. There is no assurance that the socially responsible investing strategy and techniques employed will be successful. Past performance is not a guarantee or reliable indicator of future results. For professional use only The services and products described in this communication are only available to professional clients as defined in the Financial Conduct Authority's Handbook. This communication is not a public offer and individual investors should not rely on this document. Opinion and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness.The services and products described in this communication are only available to professional clients as defined in the MiFiD II Directive 2014/65/EU Annex II Handbook and its implementation of local rules. This communication is not a public offer and individual investors should not rely on this document. Opinion and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. PIMCO Europe Ltd (Company No. 2604517) is authorised and regulated by the Financial Conduct Authority (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963), PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E) and PIMCO Europe GmbH Irish Branch (Company No. 909462) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institutions Act (WpIG). The Italian Branch, Irish Branch and Spanish Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; and (3) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) in accordance with obligations stipulated in articles 168 and 203 to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication.| PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2) . The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser.
ast year saw record issuances of green, social and sustainability (GSS) bonds. 2021 has been similar, reaching several new records. At the
same time, climate risk has become a key consideration to ensure stability of financial returns going forward as issuers and investors alike grapple with physical and transition risks.
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monetary and fiscal support during the pandemic has left many traditional income-generating assets with high valuations, making it harder for investors to find reliable income sources at a reasonable price.
he economic shock of Covid-19 has left the world’s largest economies grappling with rising inflation on the one hand and lower-for-longer interest rates on the other, as governments strive to control high levels of debt. At the same time,
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“You have to work harder to generate attractive returns in this environment”
PIMCO’s Alfred Murata on the balancing act facing today’s fixed income investors
According to Alfred Murata, managing director and portfolio manager at PIMCO, fixed income investors today find themselves in a more difficult position than during the spring of 2020, when credit valuations were at attractive levels. In contrast, the current environment requires a delicate balancing act between achieving an attractive level of yield and going too far up the risk spectrum.
PIMCO’s GIS Income fund, managed by a team led by Dan Ivascyn, Alfred Murata, and Josh Anderson, employs a flexible approach that allows it to take advantage of the global opportunity set in the entire $123trn fixed income market. (1)
The ‘bend but not break’ approach
The EU Sustainable Finance Disclosure Regulation (SFDR), which came into force in March 2021, aims to improve financial industry transparency and consistency on sustainable investments and associated processes, discourage misleading claims about an investment’s sustainability credentials, and encourage the integration of financially material sustainability risks into the investment process. It obliges certain financial market participants to make what can be complex sets of disclosures. It is one of several measures the EU is using to create a common framework for sustainability and to reorient capital flows, with the aim of easing the transition to a more sustainable economy.
“Income generation is important in this environment, but it is critically important to focus on risk management as well,” he explains. The fund pursues this through a robust risk diversification process. This involves making investments in a wide range of eligible sectors and securities, with the aim of helping the fund to achieve its objectives even if some investments don’t perform well during a particular year.
“It’s very important to focus on the details of the securities themselves”
According to Murata, one of the key challenges investors are facing today is the risk of the economic recovery from the shock of the pandemic taking longer than anticipated, leaving industries reeling and markets volatile. In addition, as fiscal and monetary stimulus recedes, investors must be prepared for tougher times ahead.
Rising to the challenge
To mitigate against this uncertain outlook, the GIS Income fund team seeks out positions that could deliver a high level of yield while offering an element of downside protection. An example of a sector where they are finding such opportunities is the airline industry, which has been heavily hit by the pandemic. As a result, airlines have resorted to leverage, but Murata says the sector is looking more attractive due to its fast deleveraging efforts. In addition, the fund is able to pick positions in airlines that are backed by collateral, such as planes; Slots, Gates and Routes (SGR) assets; or frequent flyer programmes, which should provide an element of downside protection during negative economic scenarios.
The 'bend but not break' approach
“The more generic, plain vanilla assets have seen a lot of support from central banks over the past year, so the valuations of these assets are not as compelling today,” explains Murata. “You have to work harder to generate attractive returns in this environment.”
A flexible approach is therefore key to be able to take advantage of any potential dislocations in the market. However, this must be coupled with strong risk mitigation tactics to protect the portfolio on the downside in a market where the risk of rising volatility looms large.
The fund’s aim is to deliver an attractive level of income while protecting investors against the downside. That means looking beyond interest rate duration and credit risk, to try to construct a portfolio that can weather a range of economic backdrops. Murata calls this process the “bend but not break” approach.
“It’s important to focus on the details of the securities themselves,” says Murata, “and to try to focus on positions where not only can you obtain an attractive level of income, but also benefit from some downside protection.”
In addition to such higher-yielding sectors, a portion of the portfolio is also invested in higher quality assets, like US agency MBS, that the team believes can add an extra element of downside protection, consistency and diversification.
Another key risk for fixed income investors is rising inflation, which remains elevated in the UK and higher in other countries, such as the US.
Inflation protection
PIMCO believes this inflationary spike is likely to be contained and transitory, but Murata says “it still bears watching, given how low interest rates are today”. If inflation remains elevated for longer, this could prove challenging for income investors, especially when it comes to longer duration assets.
To mitigate this risk, the PIMCO GIS Income portfolio maintains low interest rate duration, which is intended to limit the effect on the assets within it if interest rates were to rise. In addition, the fund is invested in Treasury Inflation Protected Securities (TIPS), which benefit from rising inflation.
In an environment where income is harder to come by, Murata also sees advantages in the fund’s global approach, which allows the team to look across the entire fixed income spectrum for investment opportunities. For example, the team invests in non-agency mortgage backed securities (MBS), which are backed by residential loans.
“This is an asset type that we think is very attractive in today’s environment,” Murata says. “If there is an increase in inflation, it is likely that housing prices could increase, which would be positive for these non-agency mortgage backed securities in the portfolio.”
The portfolio tends to be invested in bonds backed by mortgages issued before the financial crisis where borrowers have been making payments for more than 15 years. These have also benefitted from the significant increase in home prices over the past decade. As a result, many of the mortgages have loan to value ratios of less than 50% as the sector continues to deleverage.
A global landscape
This sub-sector sits in stark contrast to the corporate debt space, where leverage has been rising for the past decade, and more so as a result of the Covid-19 crisis. Though the fund does not outright avoid highly leveraged industries, the team takes a selective, bottom-up approach to finding resilient corporate names, leveraging PIMCO’s team of credit analysts around the world. Within the corporate debt space, the team likes financials, given the high levels of capital and strong balance sheets held by banks today compared to 2008.
Murata says: “We really like the fundamentals of this space. In terms of valuations, corporate credit in general is trading at tighter levels than before the Covid-19 crisis, whereas non-agency MBS were not included in the Federal Reserve’s purchase programme, so they haven’t benefitted from as much government support and are trading at wider levels than before the crisis.”
The non-agency MBS opportunity also highlights the advantages of an active approach to fixed income investing. PIMCO’s size, with more than 200 portfolio managers involved in the idea generation process for the fund, allows it to engage with issuers on a variety of topics. Murata says PIMCO’s global reach allows it to work directly with larger companies to take advantage of opportunities before they enter the wider market.
Similarly, an active approach allows PIMCO to try to maximise value, even when a company that they are invested in is experiencing financial difficulties, such as during the coronavirus pandemic. While passive funds would likely be forced to sell their positions in this situation, PIMCO can work with these companies, for example by becoming a member of a firm’s credit risk committee.
In the current economic climate where yields are challenged and anticipated volatility remains elevated, the expert team behind the PIMCO GIS Income fund aims to bridge the gap for investors seeking attractive income without too much volatility.
An active approach
“The GIS Income fund team seeks out positions that could deliver a high level of yield while offering an element of downside protection”
Sources.
(1) SIFMA Global Fact Book, p.48. End of 2020.
“We see this as totally consistent with the way our credit analysts think”
“PIMCO’s scale allows it to drive positive change”
Active approach
Pothalingam adds that “a label doesn’t confirm virtue”, which means the ESG fixed income investment process is highly active. PIMCO’s proprietary methodology allows it to “say ‘no’ to many labelled bonds, since a label doesn’t necessarily mean it is aligned with ESG goals”, he explains.
One of the ways to ensure an issuer is aligned with climate transition goals is via sustainability-linked bonds where the coupon is contingent on the company meeting specific interim targets. According to Pothalingam, companies that don’t want to make climate commitments will find that over time the cost of their debt might increase. This incentivises businesses to create ambitious targets and meet them within the specific timeframe to avoid having to pay more for their debt.
But like many asset managers, over the last decade, PIMCO has been intensifying its focus on ESG issues. A decade ago, it became a signatory of the UN Principles for Responsible Investment (UN PRI) and established a dedicated ESG team. From 2017, PIMCO began launching dedicated ESG-labelled bond products and now offers a full suite, including the GIS Global Bond ESG Fund, the GIS ESG Income Fund and the GIS Climate Bond Fund.
the world of investing for several years, but the concept is not new for PIMCO. The bond house first offered clients a socially responsible version of one of its key funds as far back as 1991.
he idea of investing with environmental, social and governance (ESG) principles in mind has been gaining traction in
According to Ketish Pothalingam, portfolio manager and member of PIMCO's ESG team, today the group has ESG integrated in its investment thinking, with sustainability metrics integrated into the way teams consider risk.
Risk assessment
For PIMCO there are two key types of climate risk that must be considered: transition risk, which includes the risk posed by increasing climate regulation and reporting standards globally, and the physical risks from climate change, such as wildfires and floods. To measure these risks, the firm is constantly working on developing proprietary analytical frameworks and scoring methodologies.
Physical risks from climate change include wildfires and floods.
Source.
Source: As of 31 October 2021. PIMCO, Bloomberg. The chart's starting time period is since inception of the GIS Income Fund, which was incepted on 30 November 2012. Past performance is not a guarantee or a reliable indicator of future results. Index and ETFs shown are: U.S Agg = the Bloomberg U.S. Aggregate Index, U.S High Yield ETF = iShares iBoxx$ High Yield Corporate Bond ETF, EM External Debt ETF = iShares J.P. Morgan USD Emerging Markets Bond ETF, U.S IG Corporate ETF = iShares iBoxx $ Investment Grade Corporate Bond ETF. Periods longer than 1Y are annualized. Please note that the above indices are not used in the active management of the Fund, in particular for performance comparison purposes. They are used for information purposes only. Performance is shown for the institutional class, accumulation shares. Refer to the relevant sections of the Fund prospectus for additional performance and fee, benchmark, chart, GIS funds, index and risk information.
The primary investment objective of the Fund is to seek high current income, consistent with prudent investment management. Long-term capital appreciation is a secondary objective.
Strong performance since inception
Fund Positioning
The Fund is diversified across a variety of income-generating ideas. The fund’s assets fall into two broad categories: higher yielding sectors and higher quality sectors.
PIMCO GIS Income Fund (% Bond Exposure)
Fund overview
Portfolio management team
Dan Ivascyn Group CIO, Managing Director 23 years at PIMCO
Alfred Murata, J.D., Ph.D. Managing Director 20 years at PIMCO
Joshua Anderson, CFA Managing Director 18 years at PIMCO
Fund Performance
• 0-8 years duration band
Higher yielding sectors
Higher quality sectors
Selective in emerging markets: Key exposures are in countries with strong balance sheets, such as Mexico, Russia and Brazil. PIMCO believes these investments can help boost yield and diversification, but notes it is important to be selective and scale these positions to mitigate volatility.
High conviction in non-agency mortgages: PIMCO sees attractive risk-adjusted yield levels and strong mortgage credit fundamentals in this area of the market. The firm expects the sector to be resilient through a range of economic scenarios.
Exposure to US Agency MBS: Although valuations have tightened since their initial widening last year, PIMCO still has exposure to these assets in the higher quality portion of the portfolio.
Cautious on generic credit, but opportunistic in financials: PIMCO believes the fundamentals in the financial sector are strong, as banks are operating with the highest levels of capital since the financial crisis.
Max 50% in high yield securities rated below Baa3 or equivalent (excluding MBS and ABS securities)
• Max 20% in emerging markets
• Max 30% in non-USD
For the GPB hedged share class, the fund is actively managed in reference to the Bloomberg U.S. Aggregate (GBP Hedged)
•
The concentric circles model
PIMCO models relative risk of different sub-sectors within the fixed income asset class using this concentric circles approach. Based on this, investments that are closer to the core represent the lowest level of risk, while those at the periphery face more cash flow uncertainty. Therefore, moving out from the core involves taking on a greater level of risk, but investors should earn increasing risk premia in return.
By applying its two-pronged approach of investing in higher yielding and higher quality sectors, the investment team can combine investments based on their risk characteristics.
Preserve Capital
Generate Yield
Fed funds O/N repo
3-month T-bills + commercial paper + 2-year T-notes
Intermediate + long Treasuries
GSE mortgages + swaps + government futures + TIPS + agencies
Bank debt + bank capital + national champions + AAA asset-backed
High quality EM + munis + investment grade
High quality CMBS
High yield + bank loans + subprime mortgages + low quality EM
Equities + real estate
PIMCO GIS Income Fund: 6.14% p.a.
US HY ETF: 4.58% p.a.
US IG ETF: 4.31% p.a.
US AGG: 2.76% p.a.
Taper Tantrum
U.S. High Yield down - 12%
Risk Asset Selloff
Covid-19
Growth of $100
Cash/other
Government related*
Agency MBS
Non-U.S. Developed*
ABS
CMBS
IG Credit
Non-agency MBS
Emerging Markets
Bank Loans
High Yield
5%
13%
12%
1%
7%
9%
15%
3%
Source: PIMCO. As of 30 September 2021. *”Government related” and “Non-U.S developed”: excludes any interest rate linked derivatives used to manage our duration exposure in the following countries: U.S, Japan, United Kingdom, Australia, Canada and European Union (ex-peripheral countries). Derivative instruments may include interest rate swaps, futures and swap option. All other government related and non-U.S government related securities such as government bonds, Treasury inflation protected securities, FDIC-guaranteed and government-guaranteed corporate securities are included. Bond exposure is defined as the market exposure inclusive of notional values.
Source: PIMCO
Source: As of 31 October 2021. PIMCO, Bloomberg. The chart's starting time period is since inception of the GIS Income Fund, which was incepted on 30 November 2012.
1. Fed funds O/N repo
2. 3-month T-bills + commercial paper + 2-year T-notes
3. Intermediate + long Treasuries
4. GSE mortgages + swaps + government futures + TIPS + agencies
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2
3
4
5
6
7
8
9
5. Bank debt + bank capital + national champions + AAA asset-backed
6. High quality EM + munis + investment grade
7. High quality CMBS
8. High yield + bank loans + subprime mortgages + low quality EM
9. Equities + real estate
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Past performance is not a guarantee or a reliable indicator of future results.
Index and ETFs shown are: U.S Agg = the Bloomberg U.S. Aggregate Index, U.S High Yield ETF = iShares iBoxx$ High Yield Corporate Bond ETF, EM External Debt ETF = iShares J.P. Morgan USD Emerging Markets Bond ETF, U.S IG Corporate ETF = iShares iBoxx $ Investment Grade Corporate Bond ETF. Periods longer than 1Y are annualized. Please note that the above indices are not used in the active management of the Fund, in particular for performance comparison purposes. They are used for information purposes only. Performance is shown for the institutional class, accumulation shares. Refer to the relevant sections of the Fund prospectus for additional performance and fee, benchmark, chart, GIS funds, index and risk information.
nvestors and policymakers alike will have to come to grips with a radically different macro environment over the secular horizon as the post-financial-crisis, pre-pandemic New Normal decade of subpar-but-stable growth, below-target inflation, subdued
I
volatility, and juicy asset returns is rapidly fading in the rearview mirror. What lies ahead is a more uncertain and uneven growth and inflation environment with plenty of pitfalls for policymakers. Amid disruption, division, and divergence, overall capital market returns will likely be lower and more volatile. But active investors capable of navigating the difficult terrain should find good alpha opportunities.
PIMCO's Secular Forum 2021 brought together internal experts and a range of invited speakers to explore the post-pandemic outlook for the global economy, policy, politics, and financial markets over the next five years. Here Joachim Fels, Global Economic Advisor, Andrew Balls, Chief Investment Officer, Global Fixed Income and Daniel J. Ivascyn, Group Chief Investment Officer report on the most prominent themes
As such, this year’s secular thesis further develops the themes we highlighted in our 2020 Secular Outlook - Escalating Disruption. We argued then that the pandemic would serve as a catalyst for accelerating and amplifying four important secular disruptors: the China–U.S. rivalry, populism, technology, and climate change.
Developments over the past year have reinforced those expectations. China–U.S. tensions have not only continued but intensified under the Biden administration. Populism and polarization have been on the rise in many countries, further fuelled by politically charged divisions over lockdowns and vaccines. Digitalization and automation have been turbocharged by the pandemic. Extreme weather conditions in many parts of the world have also inflicted severe human and economic losses and contributed to major gyrations in energy markets. In our forum discussions we concluded that each of these secular disruptors will remain active in the foreseeable future.
Initial conditions
Another important initial condition for the secular outlook is the sharp further increase in public and private sector debt caused by the pandemic recession and the policy responses. To be sure, with borrowing costs at or close to record lows, record high debt levels are not an immediate concern. However, higher leverage implies heightened vulnerability of public and private sector balance sheets to negative growth shocks and to positive interest rate shocks, thus increasing the risk of destabilizing runs on sovereign and private borrowers. Moreover, elevated debt levels and highly financialized economies as measured by wealth-to-income ratios will likely constrain central banks’ ability to push interest rates aggressively higher without causing severe economic pain – a financial market dominance theme to which we will return.
In our discussions, we identified three broad trends that are likely to drive a major transformation of the global economy and markets.
Secular drivers
1) The transition from brown to green With increasing voter and consumer focus in many parts of the world, governments, regulators, and the corporate sector are stepping up their efforts to decarbonize and achieve net zero emissions by 2050. This means that both private and public investment in renewable sources of energy will be boosted over our secular horizon and for years to come. While the heavy lifting will have to be done by the private sector, both the U.S. bipartisan infrastructure bill and the EU Next Generation fund will support the transition with sizable spending on “green” infrastructure over the next five years.
Of course, higher private and public spending on clean energy is likely to be partly, but not fully, offset by lower investment and capital destruction in brown energy sectors such as coal and oil. During the transition there is a potential for supply disruptions and spikes in energy prices that sap growth and boost inflation, as recent events in China and Europe have demonstrated. Moreover, as the process creates winners and losers, there is a potential for political backlash in response to job losses in brown industries, higher carbon taxes and prices, or carbon border adjustment mechanisms that make imports more expensive. While the destination – a net zero world – is desirable for many reasons, including economic ones, the path to this destination is unlikely to be smooth.
2) Faster adoption of new technologies In last year’s outlook we expected the pandemic to turbocharge digitalization and automation. This is borne out by the data available so far, which show a significant rise in corporate spending on technology. Similar increases in investment in the past, e.g., during the 1990s in the U.S., have been accompanied by an acceleration in productivity growth. Developments over the past year suggest this may again have been the case as productivity has surged, though the cyclical rebound clearly also played a role. It remains to be seen whether the recent surge in tech investment and productivity growth is a one-off or the beginning of a stronger trend, but the data so far do support the notion that the pandemic served as a catalyst for a faster adoption of new technologies.
Digitalization and automation will lead to better economic outcomes overall by creating new jobs and making existing jobs more productive. But it will also be disruptive for those whose jobs will disappear and who may lack the right skills to find employment elsewhere. As with globalization, the dark side of digitalization and automation will likely be rising inequality and more support for populist policies at both ends of the political spectrum.
3) Sharing the gains from growth more widely The third potentially transformative trend underway is the heightened focus by policymakers and society at large on addressing widening income and wealth inequality and making growth more inclusive. The latest case in point is the new focus by China’s leadership on “common prosperity,” aimed at narrowing the private wealth and income gap. As we write this essay, another example is the U.S. Democrats’ proposed $3.5 trillion “soft infrastructure” spending package, which is mainly focused on social safety net programs such as Medicare and includes, among other things, expanded child tax credits for working families, universal preschooling, and free community college. While the size of a package that will pass Congress is likely to be much smaller, the changes would “hard-code” such policies for years to come.
Meanwhile, partly due to pressure from investors increasingly focused on ESG (environment, social, and governance) and partly due to self-interest, many companies are focused on improving working conditions, pay structures, and workforce diversity. Anecdotal evidence suggests that in many companies, the balance of power in the employer-employee relationship has started to shift from the former to the latter, thus improving workers’ bargaining power. It remains to be seen whether this trend continues or whether work from home with the help of technology eventually allows companies to outsource more jobs to cheaper domestic and global locations, thus preserving or even increasing employers’ bargaining power.
In an Age of Transformation characterized by disruptive trends and more interventionist policies, economic cycles may well be shorter in duration, larger in amplitude, and more divergent across countries. It is not difficult to imagine investment booms fuelled by accelerating labour-intensive green investment and efforts to diversify or re-shore supply chains in order to increase resiliency, followed by busts caused by stop-go fiscal policies, energy price shocks, or overly ambitious and abrupt regulatory changes.
Macro implications
Cyclical divergence among regions and countries is also likely to increase as the various transformations progress at different speeds and as fiscal policy, which is often driven by election cycles that are asynchronous across countries, becomes a more dominant driver of demand. Moreover, with China becoming more self-sufficient and its economic growth likely to slow further over the secular horizon due to demographics, deleveraging, and decarbonization, one large common driver of export growth in many emerging and developed economies will likely fade in importance.
Like economic growth, inflation in the Age of Transformation is likely to become more volatile within countries and more divergent across regions. We continue to believe that inflation tails have become fatter, with periods of much higher, and periods of much lower, inflation becoming more probable. Upside risks emanate from the net zero transition and its impact on carbon prices, and from de-globalization, fiscal activism, and potential “mission creep” at central banks. Downside risks stem from companies learning to do more with less thanks to better technology. In addition, record high levels of debt and leverage increase the risk of debt deflation in the case of negative growth shocks.
Taken together, the pre-pandemic New Normal decade of subpar-but-stable growth, below-target inflation, subdued volatility, and juicy asset returns is rapidly fading in the rearview mirror. What lies ahead in the Age of Transformation is a more uncertain and uneven growth and inflation environment with plenty of pitfalls for policymakers.
Last but not least, the pandemic either forced or encouraged many individuals to pause and rethink their lifestyle and the work-life balance. It is still too early to tell if and how preferences will change and how lasting any changes will be. However, it is well possible that we will see significant shifts in preferences for work versus leisure, for working from home versus the office, and for working in certain sectors or locations versus others. Also, consumption patterns may change permanently as many people may no longer be comfortable traveling or participating in mass gatherings even after the pandemic ends. This calls for a larger dose of humility in trying to predict economic outcomes over the secular horizon and strengthens our earlier point about elevated macro uncertainty in the years ahead.
Another important initial condition for the secular outlook is the sharp further increase in public and private sector debt caused by the pandemic recession and the policy responses.
Investors and policymakers alike will have to come to grips with a radically different macro environment.
Summary
Although we see upside risks to interest rates over the short term as economies continue to recover, over the secular horizon we expect rates to remain relatively range-bound, enabling lower but positive returns for core bond allocations. We remain generally constructive on equities, but we expect to see substantial differentiation across regions and sectors. In addition, we expect to see attractive return potential in private credit and real estate as a result of the COVID-19 crisis, and we will look to pursue these opportunities.
In the next five years the global economy will likely experience more uncertain, volatile, and divergent growth and inflation than in the New Normal decade leading up to the pandemic.
Three broad trends should drive major secular transformations: the transition to green energy, the faster adoption of new technologies, and an increasing tendency to share gains more widely.
Returns across asset classes will likely be lower and more volatile over the secular horizon given starting valuations today and the outlook for disruption, division, and divergence. But active investors capable of navigating change should find good alpha opportunities.
To explore the investment implications, view PIMCO's full Secular Outlook; Age of Transformation (October 2021).
This is particularly the case when it comes to one of the most hotly debated and researched sustainability topics of the year: climate change.
“We have been developing certain tools that are evaluating not only the current carbon emissions associated with a portfolio, but the glide pathway for future portfolio carbon emissions or exposure to green bonds that will be bringing down carbon emissions, consistent with the Paris Agreement 1.5-degree objective,” says Mary.
The significant capital (political, financial, and human) required to facilitate these objectives has the potential to be highly disruptive to the global economy. Capital deployment by public and private actors will be meaningful given the commercial potential for scalable solutions, resulting in investment opportunities across a range of asset classes. Capital reallocation to cleaner sources of energy by governments and investors has long-term merits but also has the potential to cause short-term dislocations over the course of the transition.
actions necessary to meet such ambitions remain insufficient.
he world remains far from meeting the maximum global warming limit of 1.5 to 2.0 degrees Celsius established by the Paris Agreement adopted in 2016. Pledges and targets for decarbonization have notably increased, but the
PIMCO’s annual Secular Forum addressed macroeconomic and geopolitical considerations arising from the energy transition, as well as regulatory developments for ESG investing. Here, Joachim Fels, Global Economic Advisor, Andrew Balls, Chief Investment Officer, Global Fixed Income and Daniel J. Ivascyn, Group Chief Investment Officer report on some key findings
Climate disclosure requirements are expanding across geographies through a range of regulatory initiatives, while an increasing share of investors consider climate to be a material driver of performance. Climate change adaptation and mitigation are likely to be a major focus of policymakers and regulators over the secular horizon. Carbon pricing, and concepts such as the Carbon Border Adjustment Mechanism, will continue to gain momentum in many economies. While a carbon pricing policy is a remote political possibility in the U.S. at the federal level, certain state governments will continue to move ahead with such efforts in their jurisdictions with considerable impact.
Carbon innovations
Energy transition represents a capital deployment event of historic proportions
“Climate change adaptation and mitigation are likely to be a major focus of policymakers and regulators over the secular horizon”
The trajectory for fossil fuel demand peaking in parallel with tightening regulatory and ESG pressures on fuel exploration and production increases the risk of energy price volatility over the secular horizon and can translate to broader upward pressure to inflation.
Energy and materials volatility
Furthermore, the concentrated sources for the underlying minerals and raw materials needed for clean energy technologies cause overreliance on certain countries and supply chains, resulting in a trade-off between diversifying supplies and achieving a cleaner energy future over the shortest possible time frame. A concerted effort to reach the well- below 2.0 degrees Celsius goal would mean a quadrupling of mineral requirements for clean energy technologies by 2040. How the world ensures supply and demand remain relatively balanced for both old and new energy will be of critical importance to maintaining stability in financial markets and confidence in policymakers.
Overall, the energy transition represents a capital deployment event of historic proportions. Measuring the risks and opportunities for the transition directly, and indirect implications across asset classes, will be increasingly critical for investors. In 2020, 80%+ of PIMCO’s firm-wide holdings of corporate issuers were engaged on ESG Topics. PIMCO is committed to ongoing engagement with policymakers and international organizations to help develop the best frameworks, tools, and solutions to enable investors to analyze the risks and opportunities in this rapidly evolving space.
Ongoing engagement
Learn more about PIMCO’s approach to ESG investing here
