Chris Brightman, Research Affiliates’ chief investment officer, discusses the 2018 outlook across a global opportunity set, while Research Affiliates’ asset allocation and research specialists offer insights into key asset classes. Jim Masturzo (equities), Shane Shepherd (bonds), Michael Aked (real return assets) and Omid Shakernia (alternative strategies) discuss the opportunities they’re seeing as we start the year. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: Let’s begin with a discussion of your outlook across global asset classes. What are your return estimates spanning the global opportunity set as we enter 2018, and where are you finding opportunities for attractive multiyear returns?
Brightman: Developing asset class return forecasts (as well as estimates of risk and cross-correlations) is central to our tactical management of the All Asset portfolios. We continually reposition the All Asset portfolios in response to changes in capital market prices to seek high long-term real returns, but in a way that also aims to help investors diversify away from mainstream equity risk and protect against rising inflation. Objectively forecasting returns using our disciplined, value-oriented modeling techniques enables us to systematically employ contrarian rebalancing – essentially seeking to buy assets that have fallen in price, sell assets that have appreciated and repeating this essential practice over time.
By contra-trading against the market’s excess volatility across a widely diversified collection of asset classes, we seek to create a long-term source of incremental wealth accumulation that goes beyond a simple buy-and-hold allocation.
Our approach to forming long-term return forecasts is undergirded by our “building block” model of capital market returns. This model provides long-term asset class real return forecasts by summing the fundamental components of all capital market returns: yield, real growth and changes in valuations. Because we believe today’s yields provide more information about future returns than do predictions of future price changes, we employ only a mild valuation reversion assumption: We assume a 50% reversion to equilibrium valuation within 10 years (or, equivalently, a 50% chance of full mean reversion and a 50% chance of none). Within our All Asset investment process, we further condition these valuation reversion assumptions for the current strength of the economy (i.e., accelerating growth or decelerating growth), which helps calibrate our longer-horizon views for near-term expected fundamentals.
As we scan capital markets today, we find that even after the strong returns of 2017, Third Pillar markets (diversifying markets – including real assets, emerging markets and high yield bonds) remain compelling opportunities, especially in contrast to lower-yielding mainstream stocks and bonds. Figure 1 provides our annualized 10-year real return outlook as of 30 November 2017 across a wide array of asset classes. The red band includes all markets with an estimated real return of 1% or less. A casual glance reveals this lowest band of estimated returns is home to most mainstream asset classes. Unsurprisingly, the conventional 60/40 portfolio (with 60% equities proxied by the S&P 500 and 40% bonds by the Bloomberg Barclays Aggregate Bond Index) is priced to yield a real return of only 0.5%, by our calculations.
As we move up the graph, the yellow band represents asset classes with real return forecasts of 1%–3%, and the green band, of 3% or more. Note that these higher-return areas are dominated by Third Pillar asset classes, trading at prices that provide high relative yields, which in turn position them for relatively attractive forward-looking rates of return. Over a span of 10 years, we forecast an equally weighted Third Pillar portfolio1 to deliver returns in excess of 2% per annum greater than that of 60/40.
Even after emerging from a modest bear market in 2013–2015, Third Pillar asset classes still reflect what we view as compelling valuations today. Let’s now turn to our colleagues, who provide more detailed discussions of our forecasts by major asset class category.
Masturzo: The past year was very strong for global equities, with all 25 of the markets we model yielding positive returns and emerging markets (EM) posting a 29.5% aggregate return through November 2017, net of inflation (see Figure 2). The ordinal ranking of returns in 2017 by market also aligned with our expected returns entering the year, as well as with our positioning in the All Asset Fund portfolio at the outset of 2017. As the equity markets rallied across all regions, the funds benefitted and we reduced exposure in both EM and EAFE (Europe, Australasia and Far East); our U.S. equity exposure did not change given its small starting weight.
Looking forward, our long-term models still show favorable estimated returns in both developed non-U.S. and emerging markets, but less so than a year ago – not that 10-year annualized return estimates of 5.9% and 4.5%, net of inflation, are anything to sneeze at. (Asset classes are proxied by the indexes listed below Figure 2.) From a risk-adjusted perspective, we view these markets as equally attractive entering 2018 given their similar forecasted Sharpe ratios, owing to the higher volatility in emerging markets.
From a valuation perspective, based on the cyclically adjusted price/earnings (P/E) ratio, we see emerging markets as now only slightly undervalued, with a 30 basis point (bp) annual tailwind in forecasted return from mean reversion – down from 1.4% a year ago. However, estimations in the undervaluation of EM currencies provide a further, and meaningful, tailwind to these assets, and serve as a reminder that hedging EM currencies has often been a costly mistake.
On the home front, the bull market in U.S. stocks continued in 2017, buoyed by optimism and high corporate profits. Even when including results from the global financial crisis, average corporate profits since 2006 are roughly 4 percentage points higher than they were over the previous 60 years, as Figure 3 shows.
Will tax reform drive profits even higher? In the short term, we think it’s entirely possible, although not to the extremes some may expect. According to a recent CNBC report, the average effective tax rate among S&P 500 companies is about 24%, significantly lower than the topline corporate rate of 35%.2 In addition, as Figure 3 shows, while wages have been trending down as a percentage of GDP for 70 years, they have historically hit periods where they pop back up. Additional profits accruing to corporations could be a catalyst for such a bump, and any bounce-back without an associated increase in productivity could eat into profits.
We thus remain tilted away from U.S. stocks and toward foreign markets; however, in a departure from the past, our preference for the latter is now less about undervaluation in those markets and more about the benefits of currency and income against the backdrop of what we view as rich U.S. equity markets.
Shepherd: Our 10-year outlook for core fixed income strategies is rather unexciting, reflecting the current environment of low starting yields and expectations for modestly rising rates, which will create headwinds for longer-duration assets. That said, we do see pockets of opportunity outside of core fixed income.
The U.S. yield curve has flattened significantly over the course of 2017, with the short end energized by three hikes in the fed funds rate. However, on the long end, the 10-year rate actually declined slightly, and the 30-year fell by more than 25 bps over the course of the year. As such, the slope of the curve (represented by the 10-year minus the three-month rate) flattened from 1.9% to 1.0%, leading to a much poorer risk premium for taking on duration.
Our interest rate models forecast a rise in equilibrium real interest rates to about zero over the next decade (roughly a 2.3% short-term nominal yield) and the slope reverting back toward our 1.6% estimated equilibrium rate. As such, we estimate short bonds returning about 0.2% annualized on a real basis over the next 10 years, with intermediate Treasuries providing 0.6% and long bonds delivering -0.8%. We therefore allocate small positions to U.S. duration, solely for the hedging properties. (All asset classes discussed here are proxied by the indexes listed below Figure 1.)
We similarly see limited opportunities for generating attractive real return in credit sectors. Investment grade (IG) credit spreads have become tight, leading to our estimated real return of 1.0%, only 0.4% greater than that of intermediate Treasuries, as eventual widening of IG credit spreads toward average levels will create headwinds. Farther down the credit spectrum, the story is similar. We estimate high yield bonds are priced to deliver 1.5% on a real basis, also reflecting tightened credit spreads that are likely to widen going forward. Improving economic conditions reflected in our business cycle model are expected to keep defaults in check for the short term, although a recession and subsequent defaults sometime in the next 10 years remain highly likely. Bank loans provide perhaps the best opportunity within the credit space, as we see them priced to deliver a 1.7% real return over the next 10 years. They offer similar credit risk but less volatility than high yield bonds and their floating rate characteristic provides an inherent hedge against rising interest rates.
Our largest fixed income positions remain in emerging market local bonds and local currencies. We view these assets as attractive due to their high real yields and the potential for currency appreciation, and their foreign currency denomination insulates them against inflation in the U.S. dollar. Our 10-year estimates for EM local currency returns are 3.5% net of inflation. This is driven by a weighted average real yield of 1.8% – a considerably better starting point than the negative real yields provided by U.S. and other developed market yield curves. On top of this, we estimate a 1.7% annual appreciation in emerging market currencies over the longer run. This reflects two factors: First, the U.S. dollar remains overvalued on a real purchasing power parity (PPP) basis compared with most currencies; and second, we model a gradual appreciation in relative PPP for emerging markets as their productivity rises (as described by the Balassa-Samuelson effect3).
These twin tailwinds should continue to drive stronger returns for all assets denominated in EM currencies. As such, our 10-year real return estimate for EM local currency bonds is also attractive, at 3.8%. However, the incremental return provided by this additional duration exposure relative to the 3.5% estimated local currency return is not large. We have reduced exposures to these assets given their high volatility relative to currency rates. However, we still prefer them to hard-currency EM bonds, whose strong tie to the U.S. dollar and U.S. yield curve leads to less compelling starting yields, and the lack of potential currency appreciation further limits their return potential in the current environment.
Real return assets
Aked: We define traditional real return assets as those that provide an explicit hedge against inflation – for instance, a direct indexation of value to a price level, such as the consumer price index (CPI) for Treasury Inflation-Protected Securities (TIPS), the price of commodities for various commodity futures or the value of property for a real estate investment trust (REIT). The surprise outcome of the U.S. presidential election in November 2016 and resulting policy uncertainty drove medium-term breakeven inflation rates4 back above 2%. But at least for 2017, the risk of rising inflation from continued expansionary policies proved to be more bark than bite.
Traditional real return assets have caught the attention of a wide swath of investors over the past decade, reflecting in part a desire to hedge against the effects of extraordinary policies by central banks globally. But these traditional inflation hedges come with a significantly lower estimated return. Despite the strong performance of emerging markets in 2017 for both equities and fixed income, we think EM assets – which my colleague Chris Brightman referred to as possibly “the trade of a decade” back in early 2016 – still provide a significantly cheaper inflation hedge than do traditional real return assets for U.S. dollar investors.
TIPS performed well during 2017, both in absolute terms and relative to nominal Treasury securities. The risk of an economic slowdown receded across both developed and emerging markets, and noninflationary growth spurred the return of “Goldilocks market” sentiment. Commodities, particularly oil, rose slightly, but in some cases the gains were not enough to overcome the negative yield implied by the commodities futures’ forward curve. REITs rode the wave of the broader equity market, rising a touch below 10% as of 30 November. (All asset classes discussed here are proxied by the indexes listed below Figure 1.)
We increased our positions in traditional real return assets over 2017 as their estimated returns became more competitive with our nontraditional inflation fighters, such as emerging market debt and equity. While our position in All Asset and All Asset All Authority funds grew around 5%, predominantly in REITs and commodities, we are utilizing them at much lower levels than we did a decade ago when these assets were viewed by many investors as alternative investments, and consequently came with a much larger estimated return. We will continue to scour the global investment landscape to uncover the best real return opportunities, whether traditional or nontraditional, for the benefit of our investors.
Shakernia: The beauty of alternative strategies is in their potential to provide market-neutral, differentiated sources of return with low correlations to the equity and interest rate risk factors. The opportunity set for alternative strategies within the All Asset funds includes PIMCO long/short equity strategies, absolute-return-oriented fixed income strategies and futures-based trend-following strategies.
In light of these strategies’ generally low volatilities and market-neutral risk profiles, we do not expect them to deliver returns above our respective long-term secondary benchmarks of CPI + 5% and CPI + 6.5% for the All Asset and All Asset All Authority funds. Yet these strategies can play a critical role in our portfolios: We deploy them to dynamically adjust the portfolios’ “risk dial,” especially when we believe they are likely to outperform our traditional “dry powder” options (i.e., short-term, core bonds and long-duration bond strategies).
As we’ve noted in a couple of recent commentaries, we view value stocks across global markets as one of the most compelling opportunities for long-term results within the All Asset suite today (see All Asset All Access, October 2017 and “The Fundamentals of RAE: Buying Low, Eyeing the Future” for more of our views). With an extended bear market in value stocks relative to high-flying growth stocks, the PIMCO RAE Fundamental strategies (our primary vehicle for value stock exposure) today are priced at deep discounts relative to their market-cap-weighted benchmarks. In our contrarian viewpoint, this portends high excess return potential for these strategies in the years ahead.
PIMCO’s long RAE Fundamental and short market-cap strategies provide the All Asset funds with equity-market-neutral vehicles by which to harvest sources of potential alpha, giving the funds what we view as the most favorable long-term prospects within the alternatives strategies opportunity set. Given this outlook, it’s no surprise that these strategies represent the bulk of our current allocations within the alternatives category.
The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the sub-advisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
A recap of what drove 2017’s strong performance (December 2017)
A revealing look at why a negative correlation with mainstream assets isn’t required to benefit from diversification (November 2017)
A deep dive into the All Asset strategies’ dynamic risk positioning (October 2017)
A retrospective look at the All Asset Fund’s performance in the 15 years since its launch (September 2017)
Outlook for inflation and real return investing (August 2017)
Outlook for credit markets, plus a framework for creating long-term asset class forecasts (July 2017)
1 Third Pillar consists of an equally weighted allocation to U.S. high yield (Bloomberg Barclays U.S. Corporate High Yield Index), long U.S. TIPS (Bloomberg Barclays U.S. Treasury Inflation Notes: 10+ Year Index), EM local bonds (JPMorgan Government Bond Index-Emerging Markets Global Diversified Index (Unhedged)), EM equities (MSCI EM Index), REITs (Dow Jones Select U.S. REITs Index) and diversified commodities (Bloomberg Commodity TR Index).
2 See “The S&P 500 may not get such a ‘big league’ benefit from Trump’s tax plan after all,” posted 13 February 2016 on CNBC.com.
3 The Balassa-Samuelson effect (proposed by economists Bela Balassa and Paul Samuelson in 1963) identifies that countries with high productivity growth also experience high wage growth, which can lead to higher real exchange rates. This can be used to explain currency appreciation in emerging countries versus developed countries, as the former tend to be characterized by higher levels of productivity per capita.
4 As measured by the Federal Reserve Bank of St. Louis’ 5-Year, 5-Year Forward Inflation Expectation Rate.