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© Reuters. FILE PHOTO: A man shops for produce at Best World Supermarket in the Mount Pleasant neighborhood of Washington, D.C., U.S., August 19, 2022. REUTERS/Sarah Silbiger/File Photo By Davide Barbuscia

NEW YORK (Reuters) – Equity and fixed income markets may be too optimistic on how quickly central banks will cut interest rates and underestimate the risk of an economic downturn or of inflation reaccelerating, U.S. bond giant PIMCO said on Wednesday.

The asset manager over the past year has shifted out of lower-rated credit into higher-quality, securitized assets that could gain value and prove more resilient in a range of economic scenarios, PIMCO’s group chief investment officer, Dan Ivascyn, said in a note.

PIMCO expects inflation to continue to decline and that central banks, including the Federal Reserve, will cut rates this year, but said markets were too optimistic on how quickly the process will unfold.

“We think the market is rightly suggesting that a soft landing in the U.S. is possible,” Ivascyn said, referring to an economic scenario where the Fed manages to bring inflation down without causing a recession. “However, credit spreads and equity valuations factor in a very low probability to the risk of either a recession or of inflation reigniting.”

PIMCO maintains exposure to U.S. Treasury Inflation-Protected Securities to protect against the possibility of a rebound in inflation.

Bonds rallied late last year on expectations the Fed had reached a peak in its interest-rate hiking cycle. PIMCO’s flagship Income Fund, managed by Ivascyn, posted a 9.32% return in 2023.

“When the Fed begins to cut rates, we believe price appreciation could lift returns above even the high levels achieved last year,” Ivascyn said.

He added he has reduced the fund’s interest rate exposure from its peak last year to maturities ranging between five and 10 years. While it maintains exposure to shorter-dated securities, they appear to be overvalued because of excessive market optimism on how quickly the U.S. central bank will lower rates.

“In our view, when the Fed ultimately cuts interest rates … yields in longer-maturity bonds could rise further, pressuring prices,” he said.

Concerns around U.S. Treasury debt issuance and the long-term sustainability of the country’s fiscal deficits could pressure long-dated bonds further, he said.

“We are beginning to diversify our interest rate exposure into high-quality markets outside the U.S., including in Australia, Europe, and the UK,” said Ivascyn.