All Asset All Access

All Asset All Access, February 2020

Research Affiliates examines how different asset classes perform across full market cycles, and discusses how macro forecasts inform its investment strategies.

In this issue, Rob Arnott, chairman and head of Research Affiliates, discusses how stock markets and other asset classes tend to perform across market cycles over the long term, and looks at what this means for contrarian investment strategies. Jim Masturzo, head of asset allocation at Research Affiliates, discusses how macroeconomic models to forecast growth and inflation inform investment positioning. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: How do you define a full market cycle, and what gives you confidence in the All Asset strategies’ long-term return prospects across cycles?

Arnott: Market cycles are often difficult to identify until after the fact. What’s more, there are multiple approaches to identifying the beginning and end points of a cycle. At Research Affiliates, we use a simple, sensible definition of a full market cycle: the span from one previous peak in cumulative total market return, to a subsequent higher peak, with an intervening decline of at least 20%. This approach generally ensures that a complete cycle captures both bull and bear market conditions. Using monthly U.S. equity returns since 1926 (as measured by the S&P 500 and, prior to 1957, the S&P 90), we identify seven peak-to-peak spans that include a total return drawdown of at least 20% from the previous market peak and that are followed by a rebound leading to a new, higher peak.

Before we turn to our All Asset strategies’ prospects today, let’s first examine U.S. stock market cycles over the last 95 years, and compare the latest cycle with that long-term history. Figure 1 shows the cumulative performance of the S&P 500 Index and a basket of Third Pillar assets1 (where available) over each of the full market cycles since 1926. Panel A displays the entire peak-to-peak span. We then dissect the full cycle period into its two component phases: the initial drawdown period from the first peak to the trough (Panel B), and the subsequent rebound from the trough to the new peak (Panel C).

 Figure 1 chronicles eight market cycles in a table format, showing returns for S&P 500 and Third Pillar assets (as defined below chart). The first full cycle period highlighted is September 1929 through May 1946. The last period of the series is the current cycle of November 2007 to December 2019. On average since 1973, the earliest records available for Third Pillar assets, they tended to outperform S&P 500 during full stock market cycles (peak to peak) and during drawdowns, while underperforming during the rebound, as discussed in the text related to this table. 

Over full peak-to-peak cycles since September 1929 (the first peak of the measurement period), U.S. stocks as measured by the S&P index delivered annualized returns ranging from 2.0% (September 2000 – October 2007 cycle) to 15.4% (September 1987 – August 2000 cycle). On average, U.S. stocks returned nearly 9% per annum over a full cycle, which typically lasted 11 years.

Now let’s consider how Third Pillar assets generally fared over these cycles. Bear in mind that our observations begin in 1973, the first year when returns are available for at least three of our Third Pillar markets: high yield bonds, commodities, and real estate investment trusts (REITs). In market cycles over the last 46 years, a basket of Third Pillar assets on average returned 12.4%, exceeding U.S. stocks by approximately 2.5% per annum.

When we consider patterns of Third Pillar outperformance over market cycles, it’s evident that these diversifying assets tend to win when mainstream stocks falter. In Panel B, notice that from the peak-to-trough levels of past cycles, U.S. stocks fell around 20%–30%. Concurrently and relative to stocks, Third Pillar assets largely shrugged off these drawdowns, losing no more than 5% and delivering gains in two of the cycles. These observations are consistent with the truism that diversifying Third Pillar markets tend to shine when mainstream stocks struggle.

The current cycle, beginning with the 2007 peak just prior to the global financial crisis, was different. The drawdown for stocks was worse than most, falling by half, which works out to 41.4% per annum. The drawdown for Third Pillar strategies collectively was almost as bad. However, our All Asset and All Authority strategies fared far better during the market drawdown because we entered the financial crisis with a deeply defensive posture; All Asset All Authority’s inverse S&P 500 position as a risk hedge was particularly beneficial at limiting downside participation. In the subsequent recovery, Third Pillar markets have lagged S&P returns by half, instead of the 20% haircut typical in previous cycles. Most of this shortfall has occurred during the post-taper-tantrum period (after May 2013), in which we’ve seen the S&P 500 outpace most other liquid markets by a wide margin. Of course, this is what makes the Third Pillar markets collectively so very cheap today, especially compared with U.S. stocks.

The current cycle we’re in today will not last forever. As Keynes once said, “Trees don’t grow to the sky.” Mean reversion is relentless in the long run. When this cycle eventually peaks and turns downward, we believe that All Asset investors will be handsomely rewarded. Our investment approach has long relied on a variety of mechanisms in pursuit of meaningful long-term real returns. By design, our strategies tap into a deep toolkit of liquid alternative asset classes that offer diverse and diversifying risk premia, sources of structural alpha2 potential, and PIMCO’s decades-long track record of adding value across multiple asset classes. We then seek additional incremental return from tactically contra-trading across assets and trading against the markets’ most extreme bets.

When – not if – the cycle turns, we believe the All Asset strategies have the potential to minimize losses and give diversification in the very market environments in which investors may need it most.

Q: How are macroeconomic variables integrated into the allocation process of the All Asset strategies?

Masturzo: Along with asset fundamentals, macroeconomic variables are an important part of the allocation process within the All Asset strategies. In particular, global economic growth and inflation regimes are top-of-mind considerations for altering strategic positioning within the funds, as different asset classes respond differently to the different combinations of high/low growth and high/low inflation environments. Only by incorporating a perspective on these regimes into the models can the All Asset strategies be responsive to shifting conditions that ultimately drive investment opportunities.

Painting with a broad brush, let’s consider a few examples of asset class opportunities within four combinations of environments using qualitative categories of high/low economic growth and high/low inflation. Note that while these are not the only asset classes to consider in these environments and other dynamics can arise in any individual regime, Figure 2 is intended to provide theory-based context to each environment.

Figure 2 is a table that shows four growth and inflation environments, with text detailing favored assets in four possible scenarios within the table: high growth and low growth, vs. high inflation and low inflation.

As with our other models within the All Asset strategies, namely our modeling of global asset class return expectations, we estimate both growth and inflation expectations at the individual country level. By considering over 20 individual countries in our models, we capture cross-sectional nuances which would often be missed with a U.S.-centric or global top-down approach.

Let’s begin with our inflation models, before turning to our economic growth models. Our models are based on recent inflation trends within countries combined with our confidence in each central bank’s ability to reach its publically stated inflation target (see the August 2019 All Asset All Access for details). Instead of diving deep into the design of the model, let’s focus on how we use the model’s output to inform allocation decisions within the All Asset strategies.

The primary usage of our inflation model is to forecast the future trajectory of nominal yields across countries. Although we focus our portfolio allocations on real returns, consistent with a stated objective of the All Asset strategies, nominal variables can and do have a large impact on the valuation of some assets. As we have discussed recently (see the January 2020 All Asset All Access), our forward-looking return models capture both cash flow expectations and expected changes in prices. As the change in price of a nominal bond is affected by nominal yields, our view of inflation – and, more importantly, our view of changes in inflation from today’s levels – is paramount to determining this value. To put a finer point on this, our expectations of real rates largely help us determine allocations between nominal government bonds and other assets, while our expectations of inflation changes directly affect our choice of nominal government bonds versus U.S. TIPS.

The other major macroeconomic variable considered within the All Asset strategies is a growth estimate. Like inflation, growth is measured at the individual country level and aggregated into the regions that map to our investment opportunity set. Our growth model, which focuses on a country’s business cycle, captures growth relative to recent trend growth, which has been shown to affect asset returns (see the October 2019 All Asset All Access for details). Because it’s impossible to know whether growth is above or below trend in real time, our model uses a set of indicators to estimate the probability of below-trend growth in the next one to two quarters. For example, our most recent estimate in the U.S. is of a 67% probability of slowdown (33% probability of acceleration) in the coming three to six months. Taken in isolation, this reading would indicate a preference for U.S. assets that tend to do well in low-growth environments and, at times and depending on global growth estimates, a preference for non-U.S. assets.

In actuality, our growth estimates are not taken in isolation. Instead, they are just one component of the All Asset strategies’ process and are used to refine our expected returns of assets based on their expected response to growth and slowdown regimes. By adjusting long-term expected returns in this way, the model increases responsiveness to short-horizon factors such as lower (higher) fair value P/E ratios3 for equities that are more natural in slowdown (growth) periods. Similarly, our growth model provides adjustments for expectations of future yields, the default and recovery rates that are crucial in pricing credit assets, as well as cycle-aware fair value commodity and currency price estimates.

Asset class volatilities and cross-correlations also vary during growth and slowdown periods. When economies are slowing, asset volatilities across the risk spectrum often rise, while correlations, on average, also rise. Our business cycle model also injects these dynamics into the allocation process by adjusting the risk metrics used in the All Asset strategies’ optimization processes.

Overall, our asset allocation approach remains grounded in strategic expectations, as shorter-term regime dynamics can be noisy to estimate and may lead to unnecessary turnover in the portfolio. That said, when readings on various regimes flash red, our strategies are capable of positioning themselves accordingly. As such, complementing our long-term expectations of risk and return with adjustments for expectations of growth and inflation regimes is essential, allowing the All Asset strategies to take advantage of the dynamics that take place during different regimes, for the benefit of investors.

Further reading

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

  • The outlook for 2020 and where Research Affiliates sees attractive return opportunities across the globe (January 2020)
  • Why we believe value investing is still alive and well despite rumors of its “death,” and how changes to the display of expense ratios seek to enhance clarity for investors (December 2019)
  • How partnerships with academic thought leaders inform methodology and positioning and a look at the All Asset strategies’ beta-adjusted performance versus peers (November 2019)
  • Why Research Affiliates’ contrarian philosophy may add value over the long term and how the growing likelihood of a global economic slowdown is affecting positioning (October 2019)
  • Asset class bubbles and “anti-bubbles,” factors driving yields, and the benchmark change for All Asset All Authority (September 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.

The basket of Third Pillar asset classes in Figure 1 represents six diversifying, real-return assets: real estate investment trusts (REITs), high yield bonds, commodities, emerging market (EM) local bonds, EM equities, and U.S. long Treasury Inflation-Protected Securities (TIPS).
2  Structural alpha strategies seek to exploit certain market inefficiencies; examples include targeting interest rate differentials or financing bond positions through reverse repurchase (“repo”) agreements or forward settlement transactions (i.e., deferred settlement).
3  The price-to-earnings or P/E ratio is often used to assign value to a company. It is the ratio of a company's current share price to its earnings per share (EPS).
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Jim Masturzo

Head of Asset Allocation, Research Affiliates


Related Funds


Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting Please read them carefully before you invest or send money.

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Investments made by a Fund and the results achieved by a Fund are not expected to be the same as those made by any other PIMCO-advised Fund, including those with a similar name, investment objective or policies. A new or smaller Fund’s performance may not represent how the Fund is expected to or may perform in the long-term. New Funds have limited operating histories for investors to evaluate and new and smaller Funds may not attract sufficient assets to achieve investment and trading efficiencies. A Fund may be forced to sell a comparatively large portion of its portfolio to meet significant shareholder redemptions for cash, or hold a comparatively large portion of its portfolio in cash due to significant share purchases for cash, in each case when the Fund otherwise would not seek to do so, which may adversely affect performance.

Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the Fund and the index.

There is no assurance that any fund, including any fund that has experienced high or unusual performance for one or more periods, will experience similar levels of performance in the future. High performance is defined as a significant increase in either 1) a fund’s total return in excess of that of the fund’s benchmark between reporting periods or 2) a fund’s total return in excess of the fund’s historical returns between reporting periods. Unusual performance is defined as a significant change in a fund’s performance as compared to one or more previous reporting periods.

A word about risk:

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.

Portfolio structure is subject to change without notice and may not be representative of current or future allocations. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Correlation is a statistical measure of how two securities move in relation to each other. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

The FTSE Nareit All REITs Index is a market capitalization-weighted index that and includes all tax-qualified real estate investment trusts (REITs) that are listed on the New York Stock Exchange, the American Stock Exchange or the NASDAQ National Market List. The Barclays U.S. Corporate High-Yield Index the covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. The index excludes Emerging Markets debt. The Bank of America BB-B U.S. High Yield Index contains all securities in the ICE BofAML U.S. High Yield Index rated BB+ through B- by S&P (or equivalent as rated by Moody’s or Fitch). The S&P GSCI® is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The Bloomberg Commodity Index (previously named the DJ UBS Commodity Index) tracks prices of futures contracts on physical commodities on the commodity markets. The index is designed to minimize concentration in any one commodity or sector. JPMorgan Emerging Local Markets Index Plus tracks total returns for local currency-denominated money market instruments in 24 emerging markets countries with at least U.S. $10 billion of external trade. The JPMorgan Government Bond Index-Emerging Markets (GBI-EM) indices are comprehensive emerging markets debt benchmarks that track local currency bonds issued by Emerging Market governments. MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Bloomberg Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation-Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $500 million par amount outstanding. Bloomberg Barclays U.S. TIPS: 1-10 Year Index is an unmanaged market index comprised of U.S. Treasury Inflation-Protected Securities having a maturity of at least 1 year and less than 10 years. CPI + 500 and CPI + 650 Basis Points benchmark is created by adding 5% or 6.5% to the annual percentage change in the Consumer Price Index (CPI). These indexes reflect seasonally adjusted returns. The Consumer Price Index is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Bureau of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.

The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2020, PIMCO.

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All Asset All Access: Investment Implications of Inflation Expectations
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