NEW YORK, Feb 28 (Reuters) - Risks of both rising stock market volatility and inflation coupled with substantial underpricing on both fronts make both areas compelling investments for 2017, Pacific Investment Management Co said on Tuesday.
"Today's cheap implied volatility may allow for the use of option strategies in an optimal way, either to hedge downside - bearish - risks or to express bullish views in a cost-effective and risk-managed fashion," Mihir Worah, Pimco's chief investment officer of asset allocation and real return, said in remarks posted on the firm's website. "Either way, we feel the current price of the volatility trade is attractive."
Stock market volatility is near its lowest levels of the past decade for fundamental and technical reasons.
Pimco, which oversees more than $1.5 trillion, said many investors are focusing on potential outcomes of deregulation, tax reform and fiscal stimulus under the new Trump administration while ignoring potential outcomes of trade wars, geopolitical flare-ups or policy errors.
"We now have some winners and some losers rather than a market where all stocks move up or down in unison," Worah said. "This greater dispersion among the components of an index – with winners and losers often offsetting each other – tends to decrease overall volatility at the index level."
In addition, the pricing of certain financial instruments suggests investors do not believe U.S. inflation rates will rise as quickly or as high as Pimco believes is likely.
"What we find surprising is that many of the new U.S. administration’s suggested policies – tax cuts, infrastructure spending, tariffs on imports, reduced immigration – would all tend to increase inflation, yet the market for Treasury inflation-protected securities (TIPS) seems to imply that the Fed will not achieve its inflation target," Worah said.
The Federal Reserve has an inflation target of 2 percent.
Pimco said investors are demanding a liquidity premium for investing in TIPS rather than Treasuries. "Investors have been conditioned by the experience of the past several years, when deflation was the bigger risk than rising inflation, and they are not yet ready to price a positive inflation risk premium in the market," he said.
Given current valuations and the increased possibility of higher inflation, Pimco said TIPS improves a portfolio's resilience and performance potential over a greater set of economic outcomes. "In a world where many assets are priced for perfection - whether overpriced or just fairly priced at best - we feel volatility and inflation hedges are still currently attractively priced or cheap." (Reporting by Jennifer Ablan; Editing by Leslie Adler)