PIMCO's Worah: Own TIPS, Financials

Trying to time the Federal Reserve has been a challenging task for portfolio managers across the country. And perhaps the biggest difficulty has been separating the “signal” from the “noise,” Mihir Worah tells us.

Worah, Pimco’s CIO of Asset Allocation and Real Return, and managing director, says portfolio construction is as challenging as ever as all eyes focus on the Fed. Ahead of his keynote at ETF.com’s Fixed Income conference this week, he shares with us what assets he likes for 2016 and what worries him the most these days.

ETF.com: You follow the Fed closely. For more than a year, people have been calling for higher rates, but that has yet to happen. Is there a point in trying to time the Fed?

Mihir Worah: There's a couple reasons why it's been so difficult. Part of it is because the Fed has been sending out signals on when it’s likely to move, and it’s often hinted that the first hike is likely to be some time in 2015. But then a couple of factors got in the way.

The two biggest factors are: inflation, or the fact that inflation in the U.S. is low. That’s due to two things—the drop in oil prices, which the Fed doesn't control; and the stronger dollar, which the Fed has an impact on.

The second thing stopping the Fed is that the world is more globalized. Even if the U.S. had decent growth, the fact that Chinese growth is slowing down has an impact on the U.S. The U.S. is not an island.

Low inflation, and slower growth overseas have meant that even though growth in the U.S. was OK, and employments gains were OK, it's been very difficult for the Fed to move.

There’s still a chance that the Fed will move this year. The market is pricing in a 50 percent chance that the Fed will raise rates this year, but we think it could be higher, at 60-70 percent.

ETF.com: Do you think the government does an accurate job at measuring inflation?

Worah: I don't have a big complaint on how the government measures inflation. But there's one factor I think that's important right now in terms of its going up, and impacting people.

To set the stage: Gasoline prices are down because oil prices are down. Food prices are flat. When you look at the commodity-sector part of inflation—and this is the most volatile part of inflation—the consumer is paying less at the gas station than they did last year, and they're paying about the same at the grocery store as they did last year. With Obamacare, medical costs are growing slower than they did last year, too. That's all good news on inflation, and the government captures these pretty well.

What the government misses is what it costs to put a roof over your head. Rents are rising fairly fast. The consumer is paying 5-6 percent higher rents this year than last year. Home prices are going up faster than that. But the government doesn't include the price of homes in its inflation survey.

So, there're large parts of the inflation basket that are well-captured, and in fact are going down: gasoline, medical costs, food. But there are some parts that the government doesn't capture that well, which are going up. This leads to a dichotomy, and people focus too much on the prices that are going up and less on the prices that are going down.

ETF.com: How much lower can 10-year Treasury yields go before we actually see a Fed rate hike? And does that even matter since, relative to other safe assets globally, U.S. Treasurys are still the higher-yielding choice?

Worah: U.S. Treasurys are a higher-yielding choice on a relative basis. In fact, U.S. Treasurys are important not only for bond investors, governments, sovereign wealth funds and endowments, but also as a hedge in a diversified portfolio against your stock market and other risky investments. That means people have flocked to U.S. Treasurys for two main reasons: one being to generate income; and the other being to protect against other parts of a portfolio that may go down in recessionary times.

We don't see them going significantly lower from where yields are today around 2 percent unless there's a surprise, such as a hard landing in China, which is not our base case, or a surprise recession in the U.S., or oil prices drop into the $20s, and go down another 50 percent from here—none of those are our base case.

ETF.com: What’s your base case for oil? And what asset classes will be more in the line of fire if oil surprises on the upside or downside?

Worah: Our view for oil is that a year from now, oil prices will be about 20 percent higher than they are today. Oil prices are somewhere in the high $40s now; we think a year from today, oil prices will be in the low $60s.

It’s basically a supply-demand situation. Oil demand is going up as the global economy grows. And we expect it to go up by about 1 million barrels a day. That extra million barrels has to come from somewhere. At these prices, they’re not going to come from the U.S. shale patch, because at these prices, U.S. shale oil production is going down.

The Saudis, on the other hand, are pumping as much oil as they can, and with global demand going up, we think oil prices should rise.

Based on that, the one investment that has the best risk/return characteristics—to the extent that you own government bonds in a portfolio—is to own TIPS rather than regular government bonds. For the TIPS market to underperform regular government bonds, you need oil prices to go down somewhere to the $30s. We don't think that's likely.

The one sector that we're still avoiding—even though our view is that oil prices will be higher—is some of the high-yield energy-oriented bonds. Our base case is that oil prices are going higher, but you've got to take into account risk and return, because if you're wrong and oil prices stay here or go down, some of those bonds could default. So, we're not committing a lot of capital to the exploration, drilling, energy-oriented sectors of either the bond or the equity markets. We're focusing on safer views of high oil prices, like TIPS or buying options in crude oil.

ETF.com: Beyond TIPS, where do you see most opportunity going into 2016? What assets do you like?
Worah: The market is very pessimistic and pricing a very dire outlook for inflation in oil prices over the next year. In this world of low yields in the bond market, you've got to see if you're being compensated in terms of some risk premia or something that's causing prices to deviate from where they should be.

So, we like TIPS. We also like bonds issued by U.S. banks—Citibank, J.P. Morgan, Bank of America, Goldman Sachs, Morgan Stanley. All of the banks are well-capitalized. Defaults are very unlikely.

And because the Fed is raising capital regulations, these banks have to issue more debt, so spreads are widening. You have a situation where there's a sector with spreads that are wide and widening. Yet the credit risk or the default risk is getting safer in that sector. We find that attractive.

And something that we have found attractive at Pimco for several years—and still do—are bonds related to the housing sector in the U.S.; the so-called nonagency mortgage-backed securities or the mortgage-based securities not protected by Fannie or Freddie. We still expect home prices to go up 3-4 percent per year for the next couple of years. These bonds in a world of 2 percent Treasury yields should give you attractive risk-adjusted returns.

Given the underperformance and volatility, we're also looking at certain emerging markets, like Brazil and Mexico. They might give you attractive returns in 2016 as well.

ETF.com: What's your biggest concern today? Anything keeping you up at night?

Worah: Being an active manager in the bond markets, one of the things that keeps us up is the correlations. Over the last several years, while you can analyze the fundamentals of the economy, of specific bonds, of specific sectors of the markets, as interest rates have been low, and volatility has been low, a fair amount of correlated positions have been built up by managers.

I have portfolios that worked over the last five years, but will not work over the next five years. We're being very careful in our portfolio construction. What keeps us up is that even if you do the right analysis and the right security selection, the bonds and sectors you own might get tainted by systematic selling, forced selling by other investors.

Liquidity is low. Correlations are high. You have to be mindful and more careful than ever in separating the signal from the noise. There's a lot of noise. There's lot of daily volatility in the markets. And you've got to have your conviction and make sure you've got a well-constructed, well-diversified portfolio to see you through the volatility.

Contact Cinthia Murphy at [email protected].