Financial market volatility will increase amid growing economic deterioration over the next year, although the positive impact of that will be fiscal union in the eurozone, argues Pimco.

Marc Seidner, generalist portfolio manager for the US house, believes such integration is only achievable after conditions get worse, forcing European politicians to make difficult choices.

“Our base case is that volatility increases and financial markets and economic conditions worsen amid the deepening crisis,” he says. “But we will likely see movement towards a more positive outcome of greater fiscal and monetary union.”

The firm recently downgraded growth expectations for the US to 1-2% this year given that issues surrounding the overhanging “fiscal cliff” will remain unresolved in the run-up to the presidential election this November.

Thereafter the understanding is that tax increases and spending cuts need to be introduced next year, with Bush-era concessions and stimulus programmes amounting to 3.5% of national GDP set to expire at the end of 2012.

“Whether you are optimistic or pessimistic on US growth, unless the next president and new members of Congress can agree philosophically on how best to stimulate the economy, US GDP growth will shrink close to zero, and if not into recession, in 2013,” Seidner says.

Last week the Federal Open Market Committee announced it intended to keep interest rates low until at least 2014, while keeping Fed funds rates unchanged at 0%-0.25%. Yet it has raised market expectations it is ready to act aggressively if the eurozone crisis spills into the US.

Seidner notes that given the slowness of US economic growth there is limited scope to use fiscal policy to stimulate economic activity, leaving monetary policy as the only viable option and likely to be introduced over the next six to 12 months.

“We think the Fed will continue to seek opportunities to use the tools and policies they have been utilising, be it another round of quantitative easing, maturity extension programme or ‘operation twist’ to try to continue stimulating the US economy,” he adds.

Operation Twist is a stimulus programme under which the Fed buys long-term Treasuries while simultaneously selling shorter dated issues it was holding. The aim is to lower longer-term yields so banks can make loans more cheaply and drive economic activity.

“This is not the type of environment to reach for yield and take excessive risk, the focus should be on preserving principal and be cognisant of the downside risks,” reflects Seidner.

He and his team, who are based in Newport Beach, translate macroeconomic and financial market views into portfolio management for Pimco’s global clients.  

They have been focused on derisking portfolios, investing in sovereign bonds of countries such as Canada, Australia, Brazil, Mexico and the US.

Pimco has also entered segments of the US bond market such as agency mortgage-backed securities and high-quality US municipal bonds. For corporate bonds, his team prefers issuers with strong balance sheets and a global footprint.

Seidner’s preference is for debt over equity. But for stocks he chooses dividend yielding over growth companies, and prefers exposure to real return assets.