All Asset All Access

All Asset All Access, August 2019

In this issue, Research Affiliates discusses its inflation outlook, how the All Asset strategies have performed during inflation surprises, and potential benefits of these strategies for defined contribution plans.

Chris Brightman, chief investment officer of Research Affiliates, discusses the inflation outlook and why Research Affiliates believes investors should be prepared for higher inflation outcomes, while Brandon Kunz, partner and multi-asset strategist at Research Affiliates, examines the All Asset strategies’ performance during past inflation surprises. John Cavalieri, asset allocation strategist at PIMCO, discusses the potential benefits of All Asset for defined contribution plans in light of these considerations. 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?

Brightman: Capital markets are not adequately pricing inflation risk, in our view. Yes, cyclical economic indicators currently suggest a rising probability of slowing global growth, and perhaps a pending recession in the U.S. And for this reason, we understand the recent decline in market expectations for the near-term path of inflation and interest rates. Nonetheless, we see reasons why today’s regime of low and stable inflation may not last and think investors should consider portfolio allocations to deal with that contingency.

The All Asset strategies aim to provide active inflation positioning for both the cyclical (six- to 12-month) and secular (three- to five-year) horizons. For the cyclical horizon, All Asset’s structural emphasis on diversifying and inflation-sensitive “Third Pillar” asset classes (including real assets, emerging markets, and high yield bonds) provides a base level of elevated inflation hedging relative to mainstream stocks and bonds. From there, PIMCO’s active positioning within the underlying funds helps further tailor short-horizon exposures for potential near-term inflation surprises. Complementing this, Research Affiliates focuses on positioning the All Asset strategies to capitalize on intermediate- to longer-term inflation dynamics, informed by models that estimate regime-dependent asset class returns, volatilities, and correlations.

Our model for secular inflation centers on assessing the probability that each key central bank will achieve its stated target. For each of the world’s important currencies, we compare the relevant central bank’s stated inflation target with the historical average inflation rate for that currency. We then assess how closely inflation has tracked the central bank target. A trailing inflation rate that is consistently close to the bank’s target inflation lends increased confidence that future inflation will be aligned with the target level, and vice versa.

For example, because the U.S. Federal Reserve has undershot its stated inflation target of 2.0% core PCE (personal consumption expenditures, equivalent to about 2.4% headline consumer price index (CPI) inflation) in all but a handful of months since the Fed introduced the target in 2012, our model modestly reduces expectations for future inflation. As of 30 June, our model estimates a 10-year U.S. headline CPI inflation rate of 2.1%, which is lower than the Fed’s implicit target but higher than the market’s expectation of 1.7%, as evidenced by 10-year breakeven inflation (BEI). Accordingly, we favor Treasury Inflation-Protected Securities (TIPS) over nominal Treasuries.

While these range-bound cyclical movements within a regime of otherwise low and stable inflation likely present little risk to investors’ long-term wealth accumulation goals, a period of high and volatile inflation could pose a more significant threat.     

We think such a scenario is worth considering for several reasons, including the increasing attention Modern Monetary Theory (MMT) and similar unconventional monetary and fiscal policies are receiving. Notwithstanding the merits of potentially achieving broader societal goals, we believe adoption of these policies would raise the risk of a high and volatile inflation regime.1 Policies similar to MMT have led to periods of high inflation historically, as with the Great Stagflation of the 1970s and the resulting painful repair of the damage in the early 1980s. Using history as our guide, if extreme deficit spending policies are pursued, we could see a future bout of unexpected high inflation that leads to negative real returns for mainstream stocks and bonds.

Given that inflation may arrive with little warning, investors may want to consider allocations to diversifying sources of real-return-oriented, inflation-fighting asset classes. A strategic allocation to such diversifiers can complement existing holdings of mainstream stocks and bonds, whose prices may be particularly vulnerable to inflation given their currently low nominal yields. We believe putting inflation protection in place when the need does not seem self-evident may help investors avoid being caught off guard (and potentially avoid paying high prices) after the market turns.

Q: How have the All Asset strategies performed during past inflation surprises?

Kunz: The All Asset strategies have tended to deliver their best performance in periods of rising realized or expected inflation and amid “inflation surprise” environments, which we define as unanticipated moves in quarterly inflation relative to what was expected at the beginning of each quarter. This tendency is largely due to the strategies’ structural diversification away from disinflation-oriented mainstream stocks and bonds and into diversifying and inflation-sensitive “Third Pillar” markets ­– the real asset, emerging market, and high yield bond categories that make up the “home base” exposures around which we tactically navigate. Before diving into the results of the All Asset and All Asset All Authority funds during inflation-surprise regimes, let’s first look at a longer history of U.S. stocks and bonds versus an equally weighted mix of these inflation-sensitive Third Pillar markets, going back as far as relevant comparative data  allow: the early 1970s. In Figure 1, we’ve calculated the beta of each asset class exposure to inflation surprises in order to assess their historical inflation-hedging potency.

Figure 1 shows a bar chart of beta to changes in the rate of inflation surprises, over the period 1974 to 2019. The graph shows a bar for each of four assets: stocks, U.S. core bond funds, a 60/40 stock and bond portfolio, and Third Pillar asset classes (Third Pillar encompasses high yield, real return, and emerging markets). Asset class proxies are named below the chart. The chart shows Third Pillar assets have a positive beta of 0.2% return for every 1% increase in inflation surprise. By contrast, the other asset classes have negative returns for every 1% increase in inflation: negative 1.4% for stocks, negative 1.8% for bonds, and negative 1.5% for the 60/40 mix.

Importantly, U.S. stocks and bonds have exhibited starkly negative betas to upside inflation surprises, while a mix of Third Pillar assets has shown a positive beta. Translation? These diversifying and inflation-sensitive Third Pillar markets, with their 0.2 beta to inflation surprise regimes, have historically experienced an average 0.2% return for every 1.0% increase in inflation surprise, while a U.S. 60/40 portfolio has seen an average 1.5% decline. (Of course, the opposite is true in downside surprise environments, which we’ll get to shortly.)

Now let’s take a look at the performance of the All Asset and All Asset All Authority funds versus a U.S. 60/40 mix (proxied by the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index) using a similar inflation-surprise analysis. In Figure 2, we compare the net-of-fee performance of the All Asset funds since inception to that of a U.S. 60/40 portfolio  and in upside and downside inflation-surprise regimes.

Figure 2 has two bar charts showing the returns of the All Asset and All Asset All Authority funds compared with a 60/40 equity portfolio. Each fund outperforms a 60/40 portfolio during periods when inflation surprised higher. All Asset outperformed when inflation surprised higher, with a return of 7.77%, 35 basis points better than a 60/40 portfolio, while All Asset All Authority had a 7.28% return, 17 basis points higher.

For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:

A table shows the performance as of 30 June 2019 of the two funds and benchmarks for one year, three years, five years, 10 years and since inception. Data is detailed within.

As the realized betas from Figure 1 would suggest, both the All Asset and All Asset All Authority funds, with their explicit emphasis on diversifying and inflation-sensitive Third Pillar markets, have indeed delivered better absolute returns during upside inflation surprises than in other periods. More importantly, they have outperformed a U.S. 60/40 portfolio in upside-surprise environments.

However, two observations are worth addressing:

First, while the All Asset funds have historically outperformed during inflationary environments, the magnitude of their outperformance versus a U.S. 60/40 portfolio is not as pronounced as the inflation betas from Figure 1 would suggest. In fact, the conventional 60/40 portfolio has done almost as well during inflation-surprise environments over the last 17 years (since All Asset’s inception). Why has the U.S. 60/40 portfolio done so well, if rising inflation is supposed to be a headwind for these mainstream assets?

One key element is that inflation over the last two decades has largely remained in the “Goldilocks” zone of 1%­–3%. When overall inflation is contained, cyclical rises in inflation tend to reflect rising cyclical economic strength, which in turn can support higher price/earnings (P/E) ratios, as Figure 3 shows.  However, when inflation moves above this zone, the rising price level increasingly taxes economic growth, causing equity valuations to fall.2 So investors should not get lulled into assuming that the recent positive correlation of U.S. equity returns with modestly rising inflation will persist if inflation materially rises. And as Chris discussed above, we believe the growing prominence of unconventional monetary and fiscal policies such as MMT has increased the probability of high and volatile inflation, which in turn could stress U.S. stock markets (and, by extension, a conventional U.S. 60/40 mix) – bolstering the case for diversifying and inflation-sensitive allocations.

Figure 3 is a chart showing median CAPE (cyclically adjusted price-to-earnings) ratios and various ranges of three-year CPI (Consumer Price Index) inflation, represented by the bars. The CAPE ratio peaks at 20 when inflation ranges between 2% and 3%. At higher ranges, CAPE Is lower: about 18 when inflation is 3% to 4%, 16 when the range is 4% to 5%, and less than 15 when inflation is 5% to 6%. When inflation is above 6%, the CAPE ratio is 8.5. The chart also shows when inflation ranges from below negative 1% to positive 2%, CAPE ratios range from about 16 to 19.

Second, we’d note that the U.S. 60/40 mix has outpaced both All Asset funds since their inception. Does this represent a structural outperformance advantage? We don’t believe so. Two related factors are at play here. Of course, the trailing return comparison is influenced by the fact that we are making the comparison after a prolonged U.S. equity bull market. Doing the same after a bear market would likely yield markedly different results. In addition, inflation surprises to the downside have dominated this trailing period, occurring 78% of the time. That provided powerful return tailwinds to a U.S. 60/40 mix while creating return headwinds for inflation-sensitive Third Pillar assets. Looking ahead, not only do we forecast higher inflation than the markets expect, but we also believe the risks of high inflation have risen with the growing popularity of unconventional fiscal and monetary policies. As such, we expect diversifying and inflation-sensitive Third Pillar markets, and by extension the All Asset strategies, to be in a position to potentially deliver attractive forward-looking returns. Moreover, we would expect these strategies to perform well amid U.S. equity bear markets and high-volatility regimes.3 Should any of these environments materialize, we would expect the All Asset strategies to outperform a conventional U.S. 60/40 mix.

Q: Given All Asset Fund’s design as both an equity diversifier and an inflation-sensitive strategy, what role can it play in defined contribution/401(k) plans?

Cavalieri: Defined contribution (DC) plan sponsors face multiple challenges in helping plan participants achieve their long-term wealth accumulation goals. Central among these is how to assemble a sufficiently diversified mix of investment options designed to respond to the range of potential future market conditions, while also retaining a simple structure – easy for sponsors and participants to navigate and not overpopulated with a paralyzing amount of choice or complexity.

Historically, DC plan sponsors have sought to balance these competing goals by centering plan investments on traditional, mainstream asset classes: core stocks (often segmented into the 3x3 “equity style box”4), core bonds, and capital preservation strategies. However, over the last decade, we have seen plans evolve this approach toward greater diversification. Recognizing that the equity styles tend to be highly correlated to each other and to the broad market, plan sponsors have been collapsing core equity options, freeing up valuable, though limited, space for new diversifiers.

The ideal diversifiers should provide return diversification across two key dimensions: risk factors and macroeconomic factors. Risk factor diversification is critical because different asset classes can share common underlying risk factor exposures (such as equity beta across global stocks and credit sectors, or interest rate duration across bond categories).

Diversifying across factors is also critical. Different asset classes respond differently to varying macroeconomic regimes (see Figure 4). For example, mainstream stocks tend to perform very well in a disinflationary economic expansion. Core bonds typically perform well in disinflationary contractions. But both may be challenged amid stagflation (rising inflation, falling real growth) or an inflationary growth regime.

Figure 4 shows a two-by-two array of four squares, marking the macroeconomic regimes. The Y-axis represents GDP growth, and the X-axis measures changes in inflation expectations. The macro regime of inflationary expansion is in the upper right-hand box, marked by positive real GDP growth and positive changes in inflation expectations. Disinflationary expansion is up top, on the left, showing a condition of positive GDP growth, but negative inflation expectations. For inflationary contraction, GDP growth is negative and inflation expectations are positive. For disinflationary contraction, in the lower left-hand corner, both variables are negative. 

Interestingly, the inception of the modern-day 401(k) plan in 1981 came shortly after a dramatic peak in domestic inflation and the start of a multi-decade disinflationary regime. U.S. inflation peaked at nearly 15% in 1980, while stock and bond yields also reached peak (cheap) levels soon thereafter (based on S&P 500 dividend yields and U.S. 10-year Treasury yields, respectively). While the long climb toward these peak levels challenged market returns in the 1970s, it set the stage for a supersecular stock and bond bull market in the ensuing decades. As the Federal Reserve gradually contained inflation, falling stock and bond yields generally delivered capital gains that paired with elevated starting yields to drive attractive, sustained returns … and a perception that investing in core stocks and bonds alone was sufficient.

However, today’s macro conditions are closer to the opposite of the early 1980s and therefore warrant considering a different investment approach. Bond and money market yields are closer to 2%, not the 15%–20% peak levels of the early 1980s, as measured by the 10-year U.S. Treasury yield and the effective federal funds rate, respectively. The dividend yield for the S&P 500 is comparably low, 1.9%, having fallen 70% from its peak value of 6.2% in 1982. Most central bankers around the developed world are actively trying to create more inflation, not reduce it. Even politicians are contributing to the potential inflationary push by espousing increased deficit spending and, at the extreme, outright money printing as part of the MMT (Modern Monetary Theory) doctrine.

The combination of core stock and bond markets nearing full value (in our view) and the potential for rising inflation means that investors may need to bolster their portfolios for the next supersecular period by adding diversifying and inflation-sensitive assets.

Fortunately, the DC market has taken notice. According to the 2019 PIMCO Defined Contribution Consulting Study, which surveyed 238 consulting and advisory firms, 91% of respondents said they are recommending inflation-protection investment options, and over half recommend a multi-asset approach to inflation hedging. Single asset class options – for example, focusing just on Treasury-Inflation Protected Securities (TIPS), commodities, or real estate investment trusts (REITs) – also remain popular, but this approach comes with trade-offs, since any single asset class may only respond to a subset of inflation drivers, and its stand-alone return and risk attributes may or may not be ideal for inclusion in a DC plan.

By contrast, All Asset’s multi-asset approach includes exposure to core real assets such as TIPS, commodities, and REITs and complements those with other diversifying and inflation-sensitive markets. The goal is to provide a greater ability to hedge against a range of inflation drivers and tap into multiple potential real return sources, while targeting a moderate level of overall risk and volatility. And to  occupy only a single line item in the DC plan.

This is why PIMCO All Asset Fund may offer a compelling option to DC plan sponsors. The attributes that the fund seeks to provide – and has historically delivered – are aligned with the needs of DC plans looking to evolve and diversify their investment offerings for the benefit of participants, while maintaining a streamlined set of investment options. Specifically, All Asset Fund seeks four concurrent attributes:

  • Maximum real returns
  • Diversification away from U.S. equity risk (i.e., low average equity beta to the S&P 500)
  • To act as a hedge against rising inflation
  • Moderate average volatility

It’s been nearly four decades since the start of the great disinflationary bull market in the early 1980s. That backdrop may well be the only investing environment a DC plan sponsor or participant has ever known. So it’s not surprising that DC plans have historically emphasized disinflation-biased assets – mainstream stocks and bonds. But past is not prologue in investing; indeed, markets often exhibit alternating cycles. Does that mean U.S. inflation will inevitably resume a multi-decade march into double digits, like it did throughout the 1960s and 1970s? We think not. But it does mean that a prudent investor should at least consider a more balanced forward-looking risk assessment.

We believe the flexible, real-return-oriented All Asset strategy may be an attractive complement to existing DC investment options by combining the potential for high long-term real returns, risk diversification, inflation hedging, and moderate volatility into a single line item for investors.

Further reading

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

  • A look at some often overlooked potential benefits of the All Asset strategies and insight into Research Affiliates’ approach to trading (July 2019)
  • What an embrace of Modern Monetary Theory could mean for inflation and how PIMCO uses machine learning applications (June 2019)
  • The role of machine learning in quantitative investment models and factors driving current risk tolerance within the All Asset strategies (May 2019)
  • Differences between the All Asset and All Authority strategies, and their underlying allocation infrastructure (April 2019)
  • Assessing investment risk in terms of the likelihood of meeting long-term wealth accumulation goals (March 2019)
  • The potential impact of a bear market in U.S. stocks on emerging markets (February 2019)

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.

1 Interested readers can find more on this topic in my June 2019 piece, “Dismiss MMT at your Peril,” published on the Research Affiliates website.
2 Learn more in Rob Arnott’s October 2017 paper, “King of the Mountain: The Shiller P/E and Macroeconomic Conditions,” published on the Research Affiliates website.
3 See further discussion of this topic in my July 2018 piece coauthored with Amie Ko, “Are Our TDFs Massively Underweight Inflation-Fighting Assets?” published on the Research Affiliates website.
4 The equity style box is a 3x3 matrix of the following attributes: Growth, Blend, Value and Large Cap, Mid Cap, Small Cap.
The Author

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates

Brandon Kunz

Partner, Head of Multi-Asset Solution Distribution, 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. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. The use of leverage may cause a portfolio to liquidate positions when it may not be advantageous to do so to satisfy its obligations or to meet segregation requirements. Leverage, including borrowing, may cause a portfolio to be more volatile than if the portfolio had not been leveraged. 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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