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William R. Benz
If we talk a lot about our secular (three- to five-year) outlook, it is because we feel it’s really important. First and foremost, it forms the cornerstone of our investment process and provides the key structural themes behind our cyclical positioning and bottom-up, relative value strategies in our clients’ portfolios. Our longer-term views also drive our business strategy, helping us to better anticipate and prepare for the changing needs of our clients. We believe there are wider implications for investors as well, not just in terms of strategic investment positioning but in broader positioning of investment portfolios.
We can sum up our secular outlook as follows: a world operating at multiple speeds, with relative strength in the emerging economies vs. worsening debt dynamics in the developed countries; growing income inequalities; political polarization, financial repression (i.e., governments seeking to impose negative real rates of return on savers) and experimental policy measures; continued bumps and fat tail risks; and a prolonged period of low or potentially negative real returns. We believe getting the proper investment positioning in this type of environment is critical.
Proper business positioning is also important. We have seen a movement toward more bespoke “outcome-oriented” solutions in recent years – ranging from absolute return to yield, income, liability matching, inflation protection, tail risk hedging and “smart” beta using improved benchmarks – with the current secular environment likely to only further the trend. This need for outcome-oriented solutions is the key driver behind PIMCO’s evolution beyond fixed income into asset allocation and other asset classes, including active equities. It informs other parts of our business strategy as well, such as our plans for more local talent resourcing and an even greater emphasis on providing solutions.
As for the broader investment implications, we have identified five main areas that we believe will continue to challenge conventional wisdom and historical precedent, compelling investors to rethink their traditional approach to managing and positioning their investment portfolios.
Implication #1 – Rethink ‘risk-free’ and ‘risky’ If you were asked three years ago to identify which two countries with similar economic fundamentals and initial conditions– Spain or Brazil –carried a greater degree of sovereign risk, you would probably have said Brazil without much hesitation. Spain, as part of the European Union supported by wider European policy measures, would surely have been considered “risk-free” – or at least relatively low risk. Brazil, on the other hand, as an emerging market country, would surely have been considered “risky” – at least relative to Spain. But fast-forward to today and most people would say the opposite – that Spain is clearly risky and Brazil, while not risk-free, certainly appears less risky than Spain and many other sovereigns. This is pointedly reflected in current credit default swap (CDS) spreads where the cost of buying protection for Spain today is dramatically higher than it was going into the eurozone sovereign crisis (see Figure 1).
Implication #2 – Rethink interest rate and credit risk Tradition says that emerging market economies have historically been associated with credit risk while developed countries have been associated with interest rate risk. But that distinction is becoming muddled as a growing number of developed economies, especially in the eurozone, are saddled with larger debt burdens and weaker sovereign balance sheets, while emerging market economies continue to exhibit stronger fundamentals. This is best exemplified by Spain, or even more so Greece, vs. Brazil. But there are many other examples on both sides, with perhaps the most striking being the U.S. now under threat of a credit downgrade.
As a firm, we have been de-emphasizing interest rate risk in favor of credit risk and other potential sources of “safe spread” within our clients’ portfolios. PIMCO defines “safe spread” as sectors that we believe are most likely to withstand the vicissitudes of a wide range of possible economic scenarios, given the range of risks. These are securities backed by strong balance sheets and/or high-quality collateral, which we view as being less susceptible to financial repression, policy mistakes and tail events, and which provide additional yield over core (e.g., German, U.S., U.K.) government bonds. Investment grade corporate bonds of issuers with strong balance sheets, high-quality asset- and mortgage-backed securities and covered bonds form the bulk of our “safe spread” holdings. But higher quality emerging market bonds – both hard and local currency – as well as select shorter-maturity high yield bonds are also attractive in our view.
As the lines between interest rate and credit risk become blurred, finding sources of “safe spread” becomes even more critical – with investments based on traditional, broad sector classifications worthy of review (see Figure 2).
In the aftermath of Lehman Brothers’ collapse in 2008, for example, many investors moved aggressively to reduce risk and shunned everything from asset- and mortgage-backed securities to investment grade corporates, banks and financials, emerging markets, high yield – basically anything that had credit or liquidity risk – in favor of what were perceived as “bulletproof” government bond portfolios. This had several effects. First, many investors locked in losses to the extent they were forced to sell high-quality assets at low prices, missing the subsequent recovery. Second, many sold into an extremely illiquid market, further diminishing returns. And worse, many ended up in highly constrained, presumably “risk-free” government portfolios with index-like (or higher) positions in Greece, Portugal, Ireland and the other European peripherals that have since suffered from the eurozone debt crisis. While these investors had good intentions, their move to constrain portfolios worked to limit returns and actually exposed them to more concentrated investment risks.
In a period of rapid economic and market transformation, we believe investors can benefit from remaining flexible and permitting their managers sufficient scope around their benchmarks. This is of course subject to their underlying investment objectives and confidence in their investment managers’ ability to manage risk. But we feel investors will generally be better served by giving their managers greater discretion to capitalize on potential opportunities, while avoiding sectors and securities that may be subject to financial repression, inflation and/or heightened tail risk. In formulating investment guidelines, more can be better than less.
Implication #4 – Rethink approach to benchmarksWhen I started at PIMCO 25 years ago, almost all of our clients used the same benchmark. Granted, most were U.S.-based pension funds, foundations and endowments, which had similar funded statuses, asset allocations and overall return objectives. They all pretty much used the same benchmark, similar one-page investment guidelines and the general objective of maximizing returns subject to risk. Times were far simpler back then, as today most of our institutional clients have 10- to 20-page guidelines with benchmarks covering every possible combination of market segments, countries, sectors and issuers.
But while the industry has clearly moved toward more bespoke, outcome-oriented benchmarks – which we consider to be a positive trend – most indexes are still backward-looking and reflect past patterns of market development. They are not necessarily structured to help investors seize opportunities created by the dramatic secular shifts taking place in the global economy, nor are they set up to avoid the pitfalls.
Consider the following scenario: Assume you are walking down the street with a pocket full of money and come across two people looking to secure a loan. The first says he has a mountain of debt, which is growing by the day; the second says she has a significant amount of income, which is also growing by the day. Who would you lend to? Hopefully borrower number two! Yet, when it comes to investing, most benchmarks will induce – or, for passive investors, force – you to go with the equivalent of candidate number one. This is because traditional indexes are market-weighted, which means the biggest allocations will be to those countries, sectors and issuers with the largest amounts of debt outstanding, with rising debt burdens and further debt issuance leading to ever-increasing allocations.
Take European bond investors, for example. Many have already suffered through downgrades of Greece, Ireland and Portugal, with growing concerns about Spain and Italy. Yet they may continue to suffer if they invest according to one of the traditional market-weighted European government bond benchmarks, as the indebted countries in the index continue to issue more and more debt and constitute an ever-increasing percentage of the benchmark. Global bond investors face a similar situation with traditional market-weighted global benchmarks, since there is a natural tendency to overweight large and growing debtors such as the U.S., Europe and Japan, rather than the stronger emerging economies that tend to have less debt and higher rates of income growth.
We recommend investors consider more forward-looking benchmarks and indexes as alternatives, to help ensure that lending/investing goes to those with growing income rather than growing debt.
Implication #5 – Rethink asset allocationLet’s go back to the early to mid-2000s, when an increasing number of institutional and retail investors were adopting the Harvard and Yale models for their asset allocation. These were fairly aggressive models, with an emphasis on traditional equity, private equity, hedge funds and alternatives, and typically only a small allocation to long government bonds as a deflation hedge. While Harvard, Yale and many of the more sophisticated players probably knew what they were doing, when it came to understanding and preparing for the tail risk scenarios that did in fact hit in 2008, many others – particularly those with shorter-term horizons and more immediate liquidity needs – were caught by surprise as events unfolded. What happened? Quite simply, while their portfolios appeared to be very well-diversified on paper, they in fact had enormous equity factor risk as their different public equity components (U.S., non-U.S., large-cap, small-cap, value, growth), along with their private equity, hedge fund, alternative, commodity, real estate, high yield and emerging market bond allocations, all became highly correlated and sold off simultaneously. The pain was even more acute for the highly leveraged players who were even less equipped to handle the heightened volatility.
At PIMCO, we have been advising clients for many years to look at underlying risk factor exposures rather than traditional asset class definitions (see Figure 3). And following the global market dislocation in 2008, we have had a growing number of clients ask us to review their existing allocations and subsequent diversification needs. It is amazing to us that portfolios that look fully diversified on a traditional asset class basis contain holdings that remain heavily correlated with total equity risk factor exposure ranging between 70% and 80%. Diversification is still as important as ever, but we believe investors need to look at risk factors rather than traditional asset classes when making asset allocation decisions.
As your global investment authority, we hope to help you navigate the complex transformations over the secular horizon.
A “risk free” asset refers to an asset which has a certain future return. U.S. Treasuries are considered to be risk-free because they are backed by the U.S. government. All investments contain risk and may lose value.
Past performance is not a guarantee or a reliable indicator of future results. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; investments may be worth more or less than the original cost when redeemed. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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