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Pimco warns asset markets 'fully priced,' vulnerable to negative surprises

[NEW YORK] Pacific Investment Management Co, which oversees more than US$1.5 trillion in assets, slightly upgraded its forecast for world gross domestic product, from around 2.5 per cent this year to between 2.5 per cent and 3 per cent in 2017, but cautioned that many asset classes appeared overvalued.

In Pimco's latest Cyclical Outlook released on Wednesday, the firm said its baseline forecast through 2017 is for a continuous global economic expansion, mostly supportive monetary and fiscal policies, and broadly range-bound markets.

With the run-up in the benchmark Standard & Poor's 500 index, high-yield "junk" bonds and global government debt securities, "we are concerned about risks lurking beneath the surface, especially in the context of asset prices that in many cases appear stretched," wrote Joachim Fels, Pimco's global economic advisor, and Andrew Balls, Pimco's chief investment officer of global fixed income.

"Asset markets seem fully priced for a very benign outcome and thus vulnerable to even small negative surprises," Mr Fels and Mr Balls said.

The firm said it will likely favour US bond markets overall versus a number of the global alternatives given that, "in a world of low global yields, higher US yields also enhance the flight-to-quality nature of the US markets during periods of market disruption."

Pimco continues to favor TIPS (US Treasury Inflation-Protected Securities), based on valuation, the forecast of 2-2.5 per cent US CPI inflation in 2017 and the risk that different forms of monetary easing could lead to higher-than-expected inflation outcomes over the secular horizon.

Pimco also expects to run modest positions in agency mortgage-backed securities (MBS), given reasonable valuations.

"While we continue to find opportunities across global spread markets, we have generally reduced overall spread risk in our portfolios and expect to de-risk further with tightening valuations," wrote Mr Fels and Mr Balls.

Pimco also continues to favor non-agency MBS and some other securitized assets.

"We expect to be at benchmark weight or overweight in corporate credit and will favor credit exposures that, while they may weaken during periods of market volatility, tend to have low default risk - and will also demonstrate a preference for short-dated/ self-liquidating positions in investment grade and high yield credit," Mr Fels and Mr Balls said.

They said financial corporate credit continue to offer some good opportunities, as well.

Pimco upgraded its forecast for US growth to between 2 per cent and 2.5 per cent in 2017, following the 1-per cent soft patch during the past three quarters, helped by an expected end of the inventory correction and a revival of business investment amid ongoing robust consumer spending.

All told, Pimco's Mr Fels and Mr Balls said the Federal Reserve will likely raise rates two or three times between now and the end of 2017, "while markets price in only one hike."

Pimco said, while the firm continues to worry about "monetary policy exhaustion," it still appears that the net effects of easing are mostly positive, albeit shrinking. Central banks are now focused on mitigating the negative side effects of low or negative interest rates and flat yield curves on the financial sector with compensating measures.

Meanwhile, fiscal policy could become a bigger source of surprises next year, mostly in the form of more stimulus, particularly in developed markets.

"In the US, any expansionary fiscal measures announced and agreed with Congress by the next president would probably only be implemented in the 2018 fiscal year that starts on 1 October 2017," Mr Fels and Mr Balls wrote.

"However, expectations for more stimulus after the election, irrespective of who wins it, could already lift confidence and thus encourage corporate and consumer spending well before implementation."