"Those running money today must be positioned for an environment with greater potential for extreme events in terms of risk aversion than they have seen in the past," says Emanuele Ravano, Pimco's London managing director. "The consequence must be a flatter distribution of returns."
Ravano has been shifting both the composition and the structural principles of its bond strategies in recent months to align with a macroeconomic outlook of informed pessimism, underpinned by three defining structural weaknesses in developed markets.
The first is the "super-debt" cycle lead by the US and now followed throughout Europe, following the private-sector borrowing binge that helped precipitate the financial crisis.
The second, related, principle is the plight of European governments, which Ravano believes are being forced to provide a short-term liquidity solution to the long-term problem of economic solvency. "In Europe, neither currency nor fiscal measures can change the dynamic of growth," he says. "When the liquidity measures in Greece run out in three years' time, for example, the country will be in no better shape to repay its debt."
Europe is repeating the mistakes made by emerging markets a decade ago, argues Ravano. Just as Argentina -- supported by the IMF -- used liquidity measures to deal with a more fundamental problem of solvency during its debt crisis in the late 1990s and early 2000s, Europe will remain saddled with it current debt pile for as long as economic growth falters.
The fact that many European banks have passed stress tests, for example, is less significant when one considers that the governments that provide their safety nets face such major long-term solvency issues.
The third structural weakness, says Ravano, is the clear trend towards structural deflation in countries such as Japan. "Deflation in Japan is embedded; there is a lot of non-discretionary spending [that cannot be cut] in their fiscal plans," he says. Add in an ageing population, sluggish wage inflation and an overall economy still in decline, and it is hard to see a government in any position to provide stimulus for a long time.
This cautious macroeconomic view has significantly changed the principles of Pimco's fixed-income allocation in recent weeks and months. Structurally, it has shifted towards fewer -- and more liquid -- positions. Part of the liquidity strategy has been to replace market liquidity risk with self-liquidating risk.
"If we like sovereign risk, for example," says Ravano, "instead of buying five-year Brazilian government bonds, we will sell two-year credit default swap protection on Brazil -- a position that liquidates itself after two years."
A second effect of Ravano's outlook is that he is more bullish than many peers on financials. "We think governments are re-regulating the financial system into something that's closer to utilities," he says. "We feel the market has not yet priced into financials the fact that re-regulation will make it safer to be a bank." He points to a similar strategy the firm carried out during the Enron crisis, buying pipeline providers when the industry was in the throes of government re-regulation.
Meanwhile, Pimco now has its largest ever position, both proportionately and in absolute terms, in emerging markets. Here Ravano points to strong balance sheets, healthy growth dynamics and the absence of repayment concerns over debt, as key benefits.
On the product side, he says, Pimco is moving away from the traditional practice of owning indices. "All indices are long-duration and market weighted, so will not protect investors against rising yields," he says.
Market weighting also skews indices towards those countries that issue more debt, whereas the GDP-weighted indices now favoured by Pimco have controls for concentration on governments that may be issuing excessively. A strong preference for emerging markets means global indices should not exclude developing G20 countries -- notably the Bric block.
Finally Ravano places a growing emphasis on the equity risk that is inherent in non-equity products such as high yield, where, during a crisis, the bond risk converges with the equity risk as a corporate approaches default.