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PIMCO's Worah: TIPS, Commodities Look Attractive

Stock valuations are reasonable, but with valid inflation fears investors should mind their downside risk, says PIMCO's Mihir Worah.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Mihir Worah. He's the CIO of asset allocation and real return and also a managing director at PIMCO. 

Mihir, thanks so much for joining me today.

Mihir Worah: It's a pleasure, Jeremy.

Glaser: I wanted to start by talking about inflation, a topic that's obviously been top of mind for the market in this last week or so. Do you think that the threat of inflation is real now? Should we be worried about price levels rising?

Worah: I think price levels are going up. They have been moving up and whether they keep moving beyond central bank targets and how central banks respond to them is a big worry for markets right now. We expect core inflation, in the U.S., is running at around 1.7% year over year. We think by the end of 2018, the base case is it should get to around 2.2%, which is right around the Fed's target. I think what the market's worried about is with inflation finally moving up toward the central bank's target, at the same time, you're getting this big fiscal boost. We're starting to see some signs of wages going up. We're starting to see inflation go up and at the same time, you've got the big $1.5 trillion tax cut that's over 10 years and now we're just hearing of the budget deal, which adds about another $100 billion, $150 billion per year to the deficit for the next couple of years. People are concerned about what this will do at a time when inflation is already starting to move up.

Glaser: What are your expectations of how aggressively central banks globally would react to this?

Worah: I think central banks are already on the move as they see economies healing and no need for the emergency measures that we had in place for so many years post-crisis. We know the Fed has already hiked five times and expectations are for another three hikes this year. The Bank of England, just today, started guiding toward perhaps an earlier hike and a repricing of hiking expectations. Economies are healing. Central banks are taking away emergency levels of liquidity. I think at the first stage, central banks have told us that they will accommodate, they do want inflation to go higher and in fact, the Fed has hinted several times that a little bit of an overshoot of inflation above its target wouldn't affect it.

I don't think central banks react very aggressively to inflation moving toward target and maybe slightly above target, but at the same time, that's the worry for markets. If central banks accommodate this rising inflation, perhaps we get an overshoot and we have to come down aggressively later on. In 2018, I don't think central banks react aggressively. We still get the three hikes from the Fed, maybe four. The concern is further out, we're getting late in the business cycle and what central banks do in 2019 and 2020 is getting to be a concern.

Glaser: You talked about rate hikes there. What about the balance sheet normalization of the Fed. Do you think that's having a big impact on the market?

Worah: That's having an impact on the market right now. I think what the market's focused on, rightly, is frankly neither so much the rate hikes or the balance sheet reduction. It's the combination of those with the huge fiscal deficits that we see coming down the pipe. The central bank's going to buy, the Fed's going to buy $200 billion less of Treasuries than it did last year. At the same time, the U.S. Treasury is going to issue $400 billion or $500 billion more of U.S. Treasuries. What the market's going through right now is with all of this excess supply, what is the clearing level? What are the yields where demand equals supply? The market's concerned about the Fed, but it's exacerbated by the fact that we're significantly increasing our fiscal deficits and Treasury supply.

Glaser: Let's look at what this could mean for investors. On the inflation front, does it make sense to have an allocation to an explicit inflation protection, something like TIPS, or do those look expensive today?

Worah: No. I think an explicit allocation either to TIPS or even to commodities makes sense today. TIPS are pricing about 2.1% per year for the next 10 years, which, given our base case and the risks to the upside, looks fairly attractive. It's not as attractive as three months ago when the market was pricing 1.9%, 1.8% per year for the next 10 years, but they're still attractive, especially as in the Treasury market, TIPS, at the end of the day, are U.S. Treasuries, full faith and credit. In the Treasury market, there's going to be a bit of a supply-demand imbalance in favor of TIPS. We told you, the Treasury's told us, we expect supply to go up by $400 billion or $500 billion this year relative to last year and as of now, none of that increase is going to be in TIPS for the next several months.

Sure, as Treasury supply goes up and fiscal deficits are here, TIPS supply is going to go up too, but for the next six months or so, all of the extra supply is going to be in regular, nominal Treasuries and none of that in TIPS. You've got something favoring TIPS. Then commodities, we know historically commodities do well in the late stages of an expansion as supply bottlenecks fail to keep up with demand growth. Moreover, the crude oil curve is in backwardation right now, so if nothing changes, you'll make 8% to 10% per year just owning crude oil futures. Both TIPS and commodities seem to be attractive investments right now.

Glaser: Looking at the diversification benefits of those nominal bonds, we saw this last week that bonds and stocks were kind of trading together. Is that, you think, a sign that we might not see the diversification benefits, or is there still a case to hold those long-term government bonds?

Worah: No. There's a strong case to hold long-term government bonds. I do caution that some of the correlations and historical relationships that we've seen over the last few years and that lots of people depend on may not be as reliable over short-term horizons, but if there's an event, if there's a recession, if there's a hit to equity earnings, if there's a geopolitical event and stocks are going down, for sure, bonds will be going up at that time. The defensive diversification benefits of Treasuries and government bonds isn't diminished. As a tail risk hedge, on the tails, when you get an event, when you get a bad event for something that's bad for the economy, bonds will do well and stocks will do poorly, so there's no change to that.

It's around the middle of the distribution, like I said, where volatility's going up and central banks are buying less bonds, yields are slowing rising, in this slowly rising yield environment, it starts hurting the discount factor and hurting valuations on equities. To put it, again, in a normal environment, if bond yields go up, you could see stocks going down at the same time as bond yields go up. But in the big picture, the defensive risk of hedge, bonds haven't lost their value at all.

Glaser: And finally, I did want to touch briefly here on equities and where you see the stock market today. With some of the volatility we've seen and a little bit of a sell-off here, where do you see valuations?

Worah: Valuations, where we are for the S&P, 2650, the forward P/E's obviously come down compared to its peak at 2850, so in 2018, 2019, P/Es are around 17 or 18, I think that's reasonable. The stock market is reasonably priced, it's just that we need to work through this volatility of either people overpositioned in the stock market, people expecting low volatility forever, this volatility around finding a new clearing yield, for bonds, given all the excess supply we're going to see--we need to work through all of these issues, which should work to some medium-term volatility, but for long-term investors, 2650 on the S&P, I think it's a fine level to be invested.

Glaser: Mihir, I really appreciate you taking the time today.

Worah: Thanks a lot, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.