PIMCO recently introduced the PIMCO Inflation Response Multi-Asset Strategy, a comprehensive approach to hedging global inflation risks with an additional focus on “playing offense” to take advantage of inflation dynamics. The strategy tactically allocates across a wide opportunity set of inflation-related assets, including Treasury Inflation-Protected Securities (TIPS), commodities, real estate, currencies, gold and floating-rate issues. In the following interview, portfolio manager Mihir Worah discusses the strategy’s investment process, the company’s outlook on inflation and how the strategy uniquely applies PIMCO’s real return expertise and risk-factor approach to asset allocation.
Q. What is the PIMCO Inflation Response Multi-Asset Strategy?
Worah: We see this strategy as an inclusive solution for investors seeking to hedge inflation, utilizing more assets than simply stocks, bonds and real estate. The PIMCO Inflation Response Multi-Asset Strategy is designed to enable investors to access PIMCO’s real return expertise – which stems from our intense analysis of drivers of inflation and return in each asset class – as well as our risk factor-based allocation model. And the strategy will focus on delivering attractive return potential even if inflation is low or we see inflation as more of a long-term risk.
Q. What motivated the development of this strategy? Is PIMCO bullish on inflation?
Worah: We believe that investors should always be prepared for the risk of rising inflation, and yet many portfolios may be inadequately allocated to assets with the potential to generate attractive real returns (returns after accounting for inflation). Traditional inflation hedges, such as TIPS or real estate, are often limited in scope and may not provide an effective response to the wide-ranging drivers of inflation. Further, we believe portfolios that rely on a mix of stocks tend to be best-suited for mild inflation, while bonds may be better suited for a flat or disinflationary environment.
The Inflation Response Multi-Asset Strategy is a comprehensive approach designed to arm investors with exposure to key inflation-sensitive assets, while letting us use our expertise and resources to decide how much of each asset to purchase in a given environment. Investors may not only gain a potentially attractive way to tackle inflation risks in their portfolios, but may also enhance risk-adjusted return potential.
In terms of our outlook, yes, we do see inflation risks ahead, though we have forecast gradually rising global inflation over the next few years. In emerging markets, we anticipate inflation increasing due to healthy growth dynamics and commodity prices that are likely to rise in the long term, with intermittent volatility expected. In developed markets such as the U.S., we see more muted growth but still a potential for inflation, and perhaps strong inflation in certain scenarios.
Q. What about some market watchers, including the Federal Reserve, who point to signs that slowing economic growth has eased inflation potential?
Worah: That’s a fair question. We agree with the Fed that growth is likely to be modest, but where we differ is on how we view inflationary pressures. Our view for the U.S. economy is that what is occurring now is more than a cyclical slowdown – the economy has experienced capacity destruction (equipment and human skills have become obsolete), meaning there may be capacity constraints as the economy recovers and that the output gap is not as wide as the Fed may think. Also, despite some recent easing in commodity prices, we anticipate they will generally rise over a three- to five-year horizon as emerging markets continue their long-term growth trends.
Further, the Fed, in our view, has an inflationary bias, which could not only truncate any possibility of deflation that derives from slow growth, but may also beget a chance of error toward higher inflation. Finally, although Fed and U.S. Treasury officials do not say this publicly, all signs indicate to us that they may be comfortable with a falling dollar as a means to support domestic manufacturing. A weak dollar is potentially inflationary.
Q. What is the investment approach underpinning the strategy? And how does PIMCO’s macro investment process inform that approach?
Worah: PIMCO’s macro investment process includes an outlook on how risk factors tied to certain assets are evolving. These factors include inflation risk, as well as currency, equity and interest rate risks, among others.
Our investment committee generates the broad views on these risk factors, and the asset allocation committee, led by Chief Executive and co-Chief Investment Officer Mohamed El-Erian, provides guidance on how those views on risk translate into asset allocations.
I will incorporate these inputs into actively positioning risk-factor exposures, along with relative value and quantitative analysis from the real return team that I lead and discussions with the risk management group at PIMCO. With this collective intelligence, I will potentially make adjustments to a baseline allocation that may include TIPS, commodities, currencies, gold and real estate investment trusts (REITs). I also may allocate to floating-rate notes. So a lot of resources are brought to bear on the asset allocation.
Q. Could you expand on how the strategy may approach a variety of potential inflationary environments, and how investment allocations are determined?
Worah: In different inflationary environments, investors may benefit from varying their approach to inflation hedging. For example, let’s consider a scenario not unlike today’s, with mild current inflation but expectations that it may accelerate and real interest rates could decline as investors purchase investments that can be used as potential hedges (i.e., as the price of these investments are bid up, their yields drop). In such a hypothetical situation, some investors may wish to increase exposure to TIPS and gold, two asset classes that have historically performed well in this environment.
By contrast, if we reach a steady state of economic growth and the flight to U.S. Treasuries fades, we could see real interest rates rise, the potential for TIPS to underperform and demand decline for the U.S. dollar. In such a scenario, investors might benefit from underweighting TIPS and the U.S. dollar, and having greater exposure to emerging market (EM) currencies. This could not only cushion investors from potentially rising inflation in the U.S., but also provide an opportunity to enhance returns if, as we anticipate, emerging economies allow some currency appreciation in an effort to offset the inflationary pressures we see building there.
These hypothetical scenarios illustrate that there is a toolkit of assets that can be used to respond to inflation in different ways. PIMCO has a track record managing each of these inflation-related assets, which we believe will translate well into our active management of this strategy.
Q. How do you evaluate and monitor risks in the strategy?
Worah: We appreciate that certain asset classes – whether they are commodities or EM currencies – can be volatile and there are times when they could experience large drawdowns. In the Inflation Response Multi-Asset Strategy, we focus on building the risk hedging from the bottom up, as an integral part of our investment process.
As with our other multi-asset strategies, however, this strategy goes over and above PIMCO’s risk management framework by having a budget allocated to hedging against the possibility of severe downside scenarios. Finding effective, and cost-effective, ways to embed tail-risk hedging is a key goal of the strategy and arguably another strength unique to PIMCO. (Tail risk refers to the possibility of an event occurring on the extreme end of a bell-shaped probability curve.)
Q. How can clients utilize the PIMCO Inflation Response Multi-Asset Strategy?
Worah: We created this strategy because our clients often come to us with questions about how to construct a portfolio that could be positioned for all inflation scenarios. For example, they may ask, “I want to be in TIPS, I want to be in commodities, I want to be in gold, but how much should I allocate to each?” Or similarly, “I want to be in REITs and I am worried about inflation, but how much should I allocate?” What this strategy seeks to do is provide solutions for these types of questions.
We believe investors generally should have some exposure to a variety of these different asset classes, if they want a comprehensive hedge against inflation. And we are offering a vehicle that provides actively managed exposure to these asset classes, using PIMCO’s expertise and resources to help determine an appropriate allocation for any given environment, while potentially generating an attractive return along the way.
Thank you, Mihir.