All Asset All Access

All Asset All Access, August 2017

In this issue, Research Affiliates offers insight into its inflation outlook, subjective adjustments to its model-driven approach and why incorporating macroeconomic volatility into standard valuation models may help in predicting equity market returns.

Chris Brightman, Research Affiliates’ chief investment officer, discusses the inflation outlook and its implications for the All Asset strategies’ contrarian approach; Rob Arnott, founding chairman and head of Research Affiliates, discusses how subjective adjustments enter into the All Asset strategies’ largely model-driven decision-making; and Shane Shepherd, head of research, discusses why incorporating macroeconomic volatility into standard valuation models may improve equity market return forecasts. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: What is your outlook on inflation? Could the real-return-oriented All Asset strategies deliver meaningful returns when inflation is tame or even falling?

Brightman: As we’ve explained in previous publications, returns for the All Asset strategies are managed to be strongly correlated to changes in breakeven inflation (over rolling 12 month periods). We aim for this positive correlation with rising inflation to provide diversification from allocations to mainstream stocks and bonds, which tend to fare poorly with material increases in inflation. To achieve this outcome, we emphasize real return assets, which tend to excel in periods of escalating inflation expectations.

Before going into our inflation outlook, let’s start by addressing the second part of the question. Does our positive correlation with changes in inflation expectations mean that our strategies require rising inflation to produce respectable returns? No. Consider the following: Since 1914, the U.S. inflation rate, as measured by the Consumer Price Index (CPI), has averaged 3%. Since the launch of the All Asset strategy 15 years ago, CPI has run at less than 3% nearly three-quarters of the time. Despite the tame inflation environment, the All Asset strategy has still delivered an average rolling 12-month excess return of 5.43% over three-month Libor during this period (through 30 June 2017).

For the most recent quarter-end performance data for each fund, please click on the link below:

Figure 1 is a table showing the annualized returns after fees for the institutional share class of the PIMCO All Asset Fund (PAAIX), for five different trailing periods, ranging from one year to since inception. The returns are compared with the Bloomberg Barclays U.S. TIPS 1-10 Year Index, and the Consumer Price Index plus 5%. Data as of 30 June 2017 is detailed within.

This outcome doesn’t surprise us. Our strategies are designed to flexibly rotate across major global markets to seek the highest real return potential, regardless of the inflationary regime. Yes, we get a tailwind with rising inflation and face a headwind with falling inflation, in line with the underlying assets’ diversification from mainstream stocks and bonds. Yet we aim for strong returns even during periods of low and stable inflation.

Turning to our outlook for inflation, we believe that a prolonged period of low inflation is unlikely. The economy is operating at full employment, yet real interest rates remain near zero. Recent readings below the Federal Reserve’s inflation target of 2% have been attributed to temporary, one-off factors, such as sharp price declines in wireless phone services and prescription drugs, which have little to no bearing on long-run inflation. The U.S. dollar has fallen by 7% this year, and history and common sense both teach that a weakening currency puts upward pressure on the prices of goods and services.

All fiat currencies inevitably experience periods of high and volatile inflation over the longer term, as Carmen M. Reinhart and Kenneth S. Rogoff document in their 2008 paper, This Time is Different. These nasty inflation surprises are typically preceded by rising debt burdens and stresses on governmental finances of the sort we’re now seeing across developed world economies.

We don’t need to predict the precise inflection point for inflation – the time to acquire real return assets is when valuations suggest they’re cheap because rising inflation is not yet apparent. If a low inflationary environment persists, the All Asset strategies aim to continue delivering decent returns, as they’ve done over the past 15 years. And in the probable scenario that inflation rises from today’s low levels, we believe that their performance could be even more compelling.

Q: Given the All Asset strategies’ largely model-driven approach, could you discuss how subjective adjustments enter into your allocation decision-making process?

Arnott: We launched the All Asset strategies nearly 15 years ago with the aim to provide a differentiated and contrarian global asset allocation solution that would stand the test of time. While global asset allocation was already a well-established field, the All Asset Fund was arguably one of the first to offer a real-return-centric approach to investing – one that uses mainstream stocks and bonds (which we later came to describe as the first and second “pillars” of a three-pillar approach to investing) not as core assets, but rather in a limited, tactical way. In addition, our decision-making is largely model-driven, for a very simple reason: It allows us to be steadfast in implementing our contrarian asset allocation discipline of seeking to buy low (and buy even more should prices continue to move lower) and sell high (regardless of how comfortable or popular that profitable position has been).

A model-driven strategy removes emotion from the decision-making process. Studies spanning fields as diverse as management, science, investing and medicine show that model-driven decisions are generally superior to individual human judgments.1 Why? Humans tend to anchor on irrelevant information or inject short-term emotion into the decision-making process, which can lead to poor choices that may have value-destroying outcomes. Model-driven investing may add value over the long run by consistently seeking to exploit anomalies in capital markets, which often arise from these types of investor behavioral pitfalls.

Does this mean we entirely dismiss intuition and human judgment? Not at all. When current events or issues are not captured in our historical data set, we may consider subjective adjustments to refine the models’ output. We strive to be thoughtful and deliberate when considering the inclusion of such adjustments, which we would hash out during our regular monthly discussions between senior investment professionals at PIMCO and Research Affiliates (or more frequently during tumultuous times).

Before we’ll consider a subjective adjustment, it must clear a few critical hurdles. Is the issue at hand not addressed by the model? Have market participants already assimilated the information we’re considering and priced it in? Would the adjustment go with or against a trend? Our experience and research suggest that contrarian adjustments – those that buck recent trends – are far more successful than adjustments that follow recent trends. The reason is not surprising: Trend-following adjustments tend to detract from returns because the markets have already priced in or even overreacted to the opportunity. By contrast, we believe contrarian adjustments stand a much better chance of adding value because, by definition, they are exploiting an underappreciated or overlooked opportunity for which prices have not yet adjusted.

It bears mention that given these stringent criteria, we seek not to introduce subjective adjustments frequently (for instance, we have none in place today). Even when we do, these adjustments tend to be expressed as modest tilts or refinements to the final model-driven allocation output.

Q: Based on your recent findings, can including real interest rates and macroeconomic volatility alongside equity valuations improve forecasts of market returns?

Shepherd: A common refrain among investors is that low Treasury yields help explain today’s elevated equity valuations. The underlying rationale is generally that a) the lack of a satisfactory return from bonds leads investors to divert capital into equities, or b) low yields can explain higher valuations through reduced discount rates on future cash flows. A related market narrative suggests that low levels of macroeconomic risk in the economy support high equity valuations. Historically low levels of the CBOE Volatility Index (VIX, one readily observable measure of market risk) would seem to corroborate that narrative.

While these suggestions are theoretically sensible, they deserve close empirical investigation to validate and quantify their efficacy in improving forecasts of market returns.

As we’ve highlighted in previous research, valuation metrics – such as the 10-year cyclically adjusted price-to-earnings (CAPE) ratio – are key predictors of equity returns.2 Can we improve upon these forecasts by including additional information beyond starting valuations? Our work suggests yes. We do find that including the level of real interest rates along with starting valuations improves return forecasting accuracy, but only marginally. A more powerful source of information comes from including estimates of macroeconomic risk. Specifically, the level of inflation, its volatility and the volatility of the real economy are highly correlated risks faced and priced by investors.3 We find that these risks not only help explain current valuation levels but also significantly improve forecasts for future market returns.

In seeking to quantify this effect, our regression results show that adding macro volatility into the standard CAPE ratio model improves the predictive power for forecasting equity returns nearly threefold, and the regression results show strong statistical significance for the macro risk variable. Adding the real interest rate to the CAPE model results in a minor improvement. Including all three variables at once changes the results very little, which suggests that the combination of the CAPE ratio and macroeconomic volatility already picks up much of the information contained in the level of interest rates.

How can we think about these findings? Lower levels of macroeconomic volatility tend to make investors more complacent about taking on risk, or, said differently, more willing to accept a lower return for equity volatility. This, in turn, translates into support for higher equity valuations. Changes in the level of macroeconomic risk have a powerful impact on not only contemporaneous but also future market returns through this risk aversion effect.

One might also ask why, if lower interest rates imply lower discount rates, the data show that including the level of real interest rates with starting valuations provides just a marginal improvement on return predictability. While the intuition appears sound at a high level, when we push it a step further, we see a multifaceted relationship. The level of interest rates is correlated with not only discount rates but also economic growth and future cash flows. If lower rates are due to structurally slower economic growth, then we must consider the impact on both the numerator (cash flows) and denominator (discount rates) of the dividend discount valuation model. Slower growth in future cash flows diminishes equity returns and offsets the impact of lower discount rates, and therefore the real interest rate has a lower-than-anticipated impact on future expected returns.

Predicting the movements of equity markets is not an easy task. The CAPE ratio provides a strong basis for predictions over longer horizons. Our rigorous examination of the data shows that incorporating measures of macroeconomic volatility provides the most powerful improvements to these forecasts.


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.

Further reading

Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:

  • Outlook for credit markets, plus a framework for creating long-term asset class forecasts (July 2017)
  • The case for diversification amid an aging bull market for U.S. stocks (June 2017)
  • Continued opportunities in emerging markets (May 2017)
  • Benefits of active investment management in “third pillar” assets (April 2017)
  • Where conventional wisdom may be making mistakes in today’s market (March 2017)
  • Contrarian strategies to enhance real return (February 2017)

1 Grove, W., D. Zald, B. Lebow and B. Nelson, 2000, “Clinical vs. Mechanical Prediction: A Meta-Analysis,” Psychological Assessment 12, p. 19–30.
2 For more information, see the Research Affiliates papers “CAPE Fatigue,” published in June 2017 by Jim Masturzo, and “Negative Rates Are Dangerous to Your Wealth,” published in April 2016 by Chris Brightman.
3 See the Research Affiliates paper “Quest for the Holy Grail: The Fair Value of the Equity Market,” published in March 2017 by Michele Mazzoleni, Omid Shakernia and Michael Aked.
The Author

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates

Robert Arnott

Founder and Chairman, Research Affiliates


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The fund invests in other PIMCO funds and performance is subject to underlying investment weightings which will vary. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.  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. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors.  Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. 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. Investing in securities of smaller companies tends to be more volatile and less liquid than securities of larger companies.  Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives and commodity-linked 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. Commodity-linked derivative instruments may involve additional costs and risks such as changes in commodity index volatility or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Investing in derivatives could lose more than the amount invested.  The cost of investing in the Fund will generally be higher than the cost of investing in a fund that invests directly in individual stocks and bonds.  Diversification does not ensure against loss.

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