By Sinead Cruise
LONDON (Reuters) - PIMCO, the world's largest bonds house, is weighing up a fresh sell-off in "expensive" euro zone debt, fearing policymakers could ask investors to forgive more sovereign debt.
Sketching out a three- to five-year investment outlook this week, managers at the $2 trillion fund firm said they believed the European Central Bank was reviewing its Fairy Godmother role in money markets after months of stubborn recession, a switch PIMCO says could herald painful losses for complacent investors.
"Investors and financial markets are very confident that the ECB, in extremis, will be the lender of last resort, that they won't let things fall apart. We are less so," Andrew Balls, head of the firm's European portfolio management said.
"We think the ECB is likely to swing between periods of 'whatever it takes' activism and periods of refusal to act."
Reflecting this caution, PIMCO has steadily reversed small overweight positions on Spanish and Italian government debt in most of its accounts since March.
The firm is now broadly underweight on euro zone sovereigns, euro zone credit and the European banking sector and is recommending gradual movement into assets with 'real' returns, including inflation-linked bonds, commodities, real estate and emerging market currencies.
While it sees little chance of a big bond market exodus in the near term, PIMCO said this strategic change should help to protect portfolios against the feeble 0.5 percent annual economic growth it expects in the euro zone over the next three to five years.
Investors have gorged on euro zone risk assets ever since ECB Chief Mario Draghi made his vow last summer to defend the euro concept, sending stocks soaring and driving down yields on bonds once shunned by all but the bravest of buyers.
But PIMCO is preparing for more 'tough love' policies from Frankfurt, including more defaults and debt haircuts, as it becomes clearer that record low interest rates and the billions of euros of cheap cash the ECB has pumped into the system have failed to shock-proof banks or spur growth.
"You can see why the ECB might be forced to act in this way. Ever since the Draghi pledge, you've seen very limited progress on the various reforms Europeans were meant to make. The notion that the ECB will be a very certain, predictable stabiliser is possible but remains untested," he said.
The surprising calm in which markets greeted Italy's election and the Cypriot financial meltdown has given the ECB greater freedom to experiment with these more aggressive and less investor-friendly measures, Balls argued.
While most competitors have read the fall in contagion risk as a buying signal for euro zone sovereign debt, PIMCO believes the probability of large debt restructurings in the medium term is actually increasing.
Pension funds and other institutional investors have slashed cross-border holdings in favour of domestic government debt since the most acute phase of the crisis, meaning that any haircut would be a more country-specific issue than a sweeping systemic event capable of fracturing the monetary union.
"We thought Cyprus was a pretty big event but the markets looked through it," Balls said. "If you are prepared to sign off haircuts on insured depositors in Cyprus, then it makes us think that everything is on the table."
Balls advised investors against chasing assets that depended on positive central bank intervention for growth and questioned the wisdom of selecting assets based on relative, rather than absolute returns.
"Having something that offers an okay spread against some very expensive Bunds is not good enough ... it's just a relative view against what we see as pretty rigged government interest rate markets," he said.
(Editing by Ruth Pitchford)
