Late‑Cycle Strategies

A portfolio can be overweight quality without giving up on growth opportunities. But investors should expand their focus beyond headline growth rates and also focus on the quality of the earnings expansion. This can differentiate truly cash-generative businesses from those whose earnings-per-share (EPS) growth is mere accounting craft.

In PIMCO portfolios, we begin with a quantitative systematic screen that selects companies based on their valuation adjusted for cash generation. This allows us to find not only companies of high quality but also those with high growth that trade at a discount on adjusted multiples. We use three additional criteria: 1) low level of debt, as a clean balance sheet should help companies navigate uncertain environments due to greater flexibility; 2) high and stable margins, as companies that have a historical track record of maintaining or expanding their margins tend to be able to replicate such performance in more difficult parts of the cycle; and 3) high free cash flow generation, as companies able to generate cash can deploy it into dividends, buybacks, or new investments to fuel growth.

Our next step is more qualitative: We evaluate companies to ensure favorable industry dynamics, fit with our macro and thematic views, and absence of red flags. Looking across equity sectors, we find a wide range of average quality scores of the companies within them, underscoring the importance of analysis at the macro, sector, and company levels (see Figure 2). This framework can help investors navigate late-cycle environments as they pivot toward quality in their equity allocations.

Credit and rates

We see select opportunities in credit markets, and we are focused on companies that should benefit from strong balance sheets and healthy liquidity. Recent widening in spreads has created value in sectors such as financials, which we believe are default remote. Meanwhile, resilient credits in travel and leisure have upside due to the continued economic reopening but still trade wide to pre-pandemic levels.

The rapid monetary tightening priced in by markets has created more value in fixed income markets, but the asset class still faces the headwinds of high inflation, robust growth, and increasing government bond supply as central banks begin to unwind their balance sheets. Nonetheless, bonds have long played an important role as a diversifier in multi-asset portfolios and higher rate levels should bolster their ability to do this going forward. We are modestly underweight developed market duration and prefer to engage in relative value trades in emerging markets (EM) where we see greater dispersion among countries well along in the hiking cycle versus those that are still behind the curve. But if there are further signs of an economic slowdown, we expect duration will become more attractive.

Real assets and currencies

Inflation mitigation is another essential ingredient for multi-asset portfolios in a late-cycle environment, especially when the world faces wartime price pressures as it does today. We favor multiple sources of inflation risk mitigation, and in our portfolios, we are long a diversified basket of commodity-linked currencies and also own real assets, such as commodities.

We find emerging market commodity-linked currencies particularly attractive as they offer decade-high levels of carry while being primed for appreciation. For instance, our select basket of EM currencies currently earns a yield north of 6.5%, according to Bloomberg data (see Figure 3). Unlike stocks and bonds, which tend to be challenged in a rising rate environment, select EM currencies may benefit from higher interest rates. This is partially because many EM countries started their hiking cycles ahead of developed market counterparts and, in our view, should retain an attractive yield advantage even as developed rates rise. In addition to the compelling yield profile, valuations of many EM currencies are at their most attractive levels in a decade. For instance, some currencies we hold are trading at discounts to fair value as high as 50%, according to PIMCO’s internal valuation model.

The war in Ukraine represents a massive supply shock to the commodities market. As sanctions and other restrictions limit transactions with Russia, importers need to find alternative sources of energy, metals, and agricultural products. Sanctions are likely to last for some time, in our view, so major commodity exporters should be in a position to benefit from steady demand and higher prices for the foreseeable future and their currencies should benefit as well.

Most of the currencies in our multi-asset portfolios are those of large commodity exporters in both emerging and developed markets, and each country plays an important role as a source of supply for displaced Russian raw materials (see Figure 4). For example, we like the currencies of certain Latin American countries who combine to export oil, metals, ores, and soft commodities.

The Ukraine conflict has likewise added further strain to the world’s green energy transition, with energy independence now also a priority. Russia makes up 14% of the world’s oil supply and is the second-largest producer of natural gas. Russia is no longer considered a reliable supplier, and Europe, which imports 40% of its natural gas from Russia, is attempting to pivot to other sources of energy, which are hard to find. Globally, capex has lagged and inventories in energy and industrial commodities are low, setting the stage for a market that may be in structural deficit for a prolonged period.

These dynamics should keep commodity prices elevated for the foreseeable future, and in our multi-asset portfolios we have added tactical exposure to commodities such as oil. Long term, the case for green energy has only been strengthened by this geopolitical conflict, and we continue to see many attractive opportunities to invest in sectors that will benefit from that transition over the secular horizon.

Investment takeaways

At PIMCO, our conviction is that the economy is in the later stages of expansion, and we are investing accordingly. While it’s always challenging to forecast when the cycle will turn, we believe there is a playbook investors can follow to help build multi-asset portfolios. In a world of slowing growth, tighter financial conditions, rising inflation, and heightened geopolitical tensions, investors should focus on higher-quality companies, both in equity and debt markets, whose business models can withstand the bumps in the road. Investors should also seek exposure to assets that can mitigate further price pressures, such as commodities and EM currencies. Lastly, investors can prepare for further market volatility by retaining exposure to assets that tend to diversify portfolios during flight-to-quality events, such as duration, and that can serve as dry powder to capitalize on dislocations, such as cash. This late-cycle playbook requires careful portfolio construction and the ability to stay nimble as risks and opportunities evolve.

Download our investor handout for details on how we are positioning portfolios across global asset classes.