All Asset All Access

All Asset All Access, January 2017

Rob Arnott, founding chairman and head of Research Affiliates, shares his insights on the PIMCO All Asset funds and the outlook for 2017.

Q: At the start of each year, we like to begin with a discussion of your outlook across all global asset classes. As you look at the broad opportunity set for 2017, what are your return expectations, and where are you seeing opportunities for attractive returns?

Arnott: Before we look to the future, let’s reflect briefly on 2016, a year that seems to have marked the end of a nine-year drought for value stocks and a three-year drought for most “Third Pillar” asset classes (inflation-linked assets, credit and emerging markets). In 2016, as in 2012, the PIMCO All Asset funds delivered attractive returns, with very light equity holdings. But as the saying goes, “Don’t mistake a bull market for genius.” In 2016, as in 2012, the Third Pillar fared well,1 with an average real return of 5.9% for unhedged U.S. dollar investors, representing a healthy bounce back from the depressed levels at the start of the year (see Figure 1, which shows the trailing one- and three-year returns for passive exposure to a host of global asset classes sorted by 2016 performance).

Figure 1 is a bar chart that shows the real U.S. dollar returns of 17 different asset classes year-to-date through 30 November 2016, and their three-year annualized returns. Asset class proxies are detailed below the chart. The assets are arranged in order of the highest to lowest year-to-date returns, from left to right. U.S. small caps had the highest performance over the YTD time frame, with a return of about 15%, followed by high yield, at about 12%, and emerging markets equity, at about 8%. Eight other asset classes had positive returns in 2016 year to date. EAFE (Europe, Asia, Far East) equity, on the far right, had the most negative YTD performance, posting a 4% loss. While REITs (real estate investment trusts) posted a modest YTD return of about 2%, the chart shows that they had the highest three-year annualized return of 10%, far higher than the next best-performing category, long-term U.S. Treasuries, which had a three-year annualized return of 6%. Commodities fared the worst for three-year returns, posting a 12% annualized loss.

The recent performance may cause some investors to ask whether the upswing in many Third Pillar markets has run its course. We think not. Consider emerging market (EM) equities and local debt, for instance: Even after returns of 9.0% and 6.3% through November 2016, respectively, three-year past returns for these asset classes remain negative, leaving room for further appreciation. (We recently published a white paper, “The Emerging Markets Hat Trick,” that shows how compelling EM investments have become as a consequence of their grinding bear markets.) Today, the combination of attractive valuations, depressed currencies and positive price and economic momentum increases our confidence that these and other Third Pillar markets still have substantial runway as we enter 2017.

Digging a bit deeper, we see a current dividend yield of 2.6% for EM equities, representing a spread of 50 basis points (bps) over the S&P 500. Similarly, the J.P. Morgan GBI-EM local bond index has a nominal yield of 7.7%, 490 bps above U.S. corporates (as measured by the Barclays U.S. Intermediate Corporate Index) and 110 bps over U.S. high yield bonds (as measured by the Barclays U.S. Corporate High Yield Index). EM yields exceeding U.S. high yield? That’s interesting, especially given that half the EM market is investment grade. Yields are often strong indicators of future performance. Still, looking at yields alone can be misleading, as they ignore other important factors that can influence performance, such as credit losses, currency risk, capital gains or losses from shifting yields (often driven by mean reversion), and shifting fundamentals, to name a few.

Research Affiliates’ capital market expectations, which incorporate all of these return drivers using robust modeling, may help provide a more complete picture. (Our real returns web application at offers these forecasting models free of charge.)

In the case of EM, the path suggested by yields – i.e., that EM stocks and bonds are projected to outperform other assets – holds true in our more thorough estimation (see Figure 2). In fact, relative valuations that are symmetrically opposed between EM and the U.S. complement the information derived from starting yields. For example, the current Shiller P/E valuation ratio in the U.S. is 27 (versus a long-term average close to 16), which implies a near 70% overvaluation of the S&P 500, all else being equal; the cap-weighted EM index, on the other hand, is trading at a Shiller P/E of under 12, implying a near 30% undervaluation.

Figure 2 plots 10-year real estimated forward-looking returns versus volatility for 17 asset classes, assuming a mean reversion. Asset class proxies are the same as those in the previous chart. Returns are on the Y-axis, and volatility on the X-axis. Plots for core bonds, in blue, are mostly grouped above zero percent return estimates, between 2% and 6% volatility, but long-term Treasury is an outlier, showing a forecast loss of 0.6% and volatility of about 12%. Plots for equities, shown in orange, have volatility of about 15% or higher, but only EAFE (Europe, Asia, Far East) equity, at 6%, and EM (emerging market) equity, at 7.5%, show moderate return potential. Among credit asset classes, shown with brown plots, EM local debt has the highest performance forecast, with a return of 4%, but with volatility around 18%, much higher the 7% to 9% estimated volatility of bank loans, EM non-local debt, and high yield, whose returns are around 2% to 3%. Among alternative asset classes, shown in green, the return forecasts are relatively modest: 1% to 4%, but all have relatively high volatility.

To gain a fuller understanding of what is driving expected returns for each asset class, it’s helpful to look at the relative impact of valuation compared with other key factors (see table). We rank-ordered the asset classes based on the impact of valuation from most positive (EM equity, with a 3.3% boost from valuation) to most negative (U.S. small cap, which takes a 3.7% hit). The more than 7% spread in the impact of valuations across asset classes indicates a substantial tailwind for strategies favoring cheap Third Pillar assets.

The figure is a table detailing the forecasts for 10-year return, yield, growth and valuation for 17 asset classes by Research Affiliates. Asset class proxies are the same as those in Figure 1. Forecasts as of 30 November 2016 for each asset class are detailed within.

Q: While valuation metrics like Shiller P/E are tested ways to identify whether assets are over- or undervalued, they provide little guidance as to when those valuations might revert. With expected annual valuation changes of more than 3% in each direction depending on the asset class, could you be putting too much emphasis on these metrics?

Arnott: What we pay for any given asset is, of course, of the utmost importance, given that the price hugely influences future returns. The “yield plus growth” parts of future returns are easier to model (though admittedly not precisely) because we know the yields of assets we choose to buy and we know their historical (or real) income growth. Future changes in valuation multiples (or yields) – and the length of time over which these changes take place – are far more difficult to predict. Full mean reversion is entirely possible, as are valuation overshoots (i.e., going from overvalued to undervalued and vice versa). A new normal is also possible, in which current valuations face no pressure to revert to a long-term historical norm. If we assume full mean reversion, the valuation “tail” wags the expected return “dog,” utterly dominating return forecasts.

For these reasons, we haircut our expectations for mean reversion. For example, we would need to see a 5% drop in the U.S. Shiller P/E ratio every year for 10 years to revert to historical norms; but maybe today’s valuations are here to stay and represent a new normal. To account for both eventualities, we split the difference: We project a more modest 2.4% drop in Shiller P/E each year for the next decade, which would leave us with a still-expensive Shiller P/E of 21x in the year 2026. Given our haircut, it’s hard to make a compelling case that we’re too pessimistic!

But what happens if current valuations really are here to stay? We can easily run the following thought experiment. By simply setting future valuation changes to zero in our model, we can see the potential impact of a steady state for valuations (see Figure 3). While this assumption is probably unrealistic, it may be useful to see what could be in store if we ignore valuations and focus entirely on yield and expected growth.

Figure 3 plots forecasted 10-year real returns versus volatility for 17 asset classes, assuming no mean reversion. Asset class proxies are the same as those in Figure 1. Return forecasts are on the Y-axis, and volatility on the X-axis. Plots for core bonds, in blue, all show above-zero percent return forecasts, but long-term Treasuries, despite the highest return forecast of near 2%, has much higher estimated volatility than others in its group, at a level of 12%. Plots for equities, shown in orange, have volatility of about 15% or higher, with U.S. equities showing return estimates close to 4%, not too far below those of EAFE (Europe, Asia, Far East) and EM (emerging market) equity. Among credit asset classes, shown with brown plots, EM non-local debt has the highest return forecast of 4%, but with volatility around 9%, comparable to those of bank loans and high yield, which both have lower return forecasts. REITs (real estate investment trusts) show very high estimated volatility of about 22%, but a return forecast of only 2.5%, while commodities have high volatility of 17%, but with almost a 2% negative return forecast.

Even under this extreme assumption, we see that EM stocks and bonds have higher expected returns than most other assets. The same goes for high yield and REITs – so all in all, a good showing for Third Pillar assets. The notable change in this scenario is the outlook for U.S. stocks, both large and small cap. If current valuations do represent a new normal, these assets begin to look more appealing.2

At the other end of the spectrum – full mean reversion – the changes play out in the opposite direction. In this scenario, we would expect a 12% return advantage for EM over U.S. equities over the next decade, with EM delivering 11% per year and the U.S. losing 1%.

There’s an old saying that a man with a watch knows the time, but a man with two watches can never be sure. By showing two models (for a halfway mean reversion and no mean reversion), have we simply muddied the waters? We don’t think so. Both views show us that assets like EM stocks and bonds, high yield and the like would do reasonably well whether or not valuations revert toward historical norms. Our All Asset strategies would likely only suffer in a world where expensive assets become more expensive and cheap assets become cheaper. That happens too, as it did most recently in 2015. We think the best response under such circumstances is to accept the inevitable psychological and monetary pain and buy more of whatever has become the cheapest! Eventually, years like 2016 will likely come around to reward us for this investment discipline.

While EM stocks and bonds appear positioned to win whether valuations revert to historical norms or not, U.S. stocks would require valuations to remain very high in order to earn even 3% above inflation. Ultimately, we believe it’s more prudent to invest in assets that are expected to enjoy valuation tailwinds but that don’t require them to deliver a nice return over a 10-year horizon.

Q: Thus far we’ve looked at a mean reversion model and a model that assumes no change in valuations, but what if price momentum continues? How would that affect expected returns?

Arnott: Momentum tends to exert its influence over months, not years, before running out of steam and changing direction. At the start of 2016, Third Pillar assets had poor momentum and were very cheap. After a three-year bear market, the tide finally turned on 21 January. Now, Third Pillar assets have great momentum and are a bit less cheap. So if momentum asserts itself in the usual way, we should expect good performance for the least expensive Third Pillar asset classes for some time to come. This is not the momentum scenario that has some investors worried. They’re wondering what happens if high-valuation assets resume their march toward ever-higher valuations and the cheap Third Pillar markets revisit their January 2015 lows (or worse).

Suppose this scenario were to prevail for an extended period, against all odds. Over time, ever-cheaper assets would look increasingly attractive from the perspective of future return expectations while ever-more expensive assets would have lower and lower expected returns. This is the obvious result based on the assumptions in our models. But we should consider a more important, if subtler, point. After the fact, a dollar of realized return is exactly the same whether it comes from yield or capital gains (taxes aside). Not so when we’re modeling future returns. Remember that our confidence in the ability of yield to predict future returns is high; we are less confident in the predictive powers of growth rates and default risk, and our confidence that valuations are predictive, particularly over shorter time horizons, is lower still. Since yield has generally proven dependable in expected return models, it needs no haircut, making returns from yield more reliable for investors considering their future plans and spending needs. On the other hand, since valuation changes may or may not happen, we haircut them.

When we put it all together, yes, declines in prices on already cheap assets can be painful as they happen; however, the future benefit can be substantial, not just because of the future valuation tailwind, but also because yields grow higher! So as you choose your preferred asset allocation mix to meet your future needs, remember this: The components of returns can be as important as the returns themselves. And negative momentum – the type that likely has some investors worried about cheap assets – sets the stage for healthy and reliable yields in the future. This should be comforting to those who fear that the march against a contrarian, value-oriented investment process may resume, despite the more recent and favorable reversal.

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 The reverse also holds true: “Don’t mistake a bear market for stupidity.” The optics weren’t inclined to make us look particularly smart in 2013–2015, a bear market for Third Pillar assets. We struggled, as these markets were becoming very, very cheap.

There’s danger in the view that “this time is different,” that reversion to historical norms won’t happen. Economist and Harvard Professor Irving Fisher famously said in October 1929, “Stock prices have reached what looks like a permanently high plateau … I expect to see the stock market a good deal higher within a few months” (New York Times, 16 October 1929). That said, there’s also danger in refusing to acknowledge that “this time is different,” because there are always some legitimate differences between past norms and today’s. We choose to split the difference: If mean reversion may or may not happen, it seems sensible to assume halfway mean reversion as a middle ground.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

View Profile

Latest Insights


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.

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, securitiesinvolve 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.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

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. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. 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 for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The Barclays U.S. Corporate High-Yield Index 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 MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. The Bloomberg Commodity Total Return Index is an unmanaged index composed of futures contracts on 22 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. The J.P. Morgan Government Bond Index-Emerging Markets Index is a comprehensive global local emerging markets index, and consists of regularly traded, liquid fixed-rate, domestic currency government bonds to which international investors can gain exposure. The J.P. Morgan BB/B Leveraged Loan Index is designed to mirror the investable universe of USD institutional leveraged loans, excluding the most aggressively rated loans (rated below B3/B- by either Moody’s or S&P) and non-rated loans. The Index is a subset of the broader JPMorgan Leveraged Loan Index, and as such follows all of the same inclusion rules, loan selection methodology and the rebalance process, with the sole exception being the tranche rating criteria. The Index is formed by the following inclusion rules: loans must be $200mn or greater at issue and have $100mn or greater currently outstanding, only institutional 1st lien loans which excludes revolvers, Term Loan A’s, letters of credit, bridge loans, mezzanine loans, 2nd or 3rd lien loans, loans. Only USD issuers from developed markets are included. The J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for traded external debt instruments (external meaning foreign currency denominated fixed income) in the emerging markets. EMBI+ covers US dollar-denominated Brady bonds, loans and Eurobonds. The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. Equity REITs. Constituents of the Index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property. The 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 $250 million par amount outstanding. Performance data for this index prior to 10/97 represents returns of the Barclays Inflation Notes Index. The J.P. Morgan Emerging Local Markets Index Plus (ELMI+) tracks total returns for local-currency-denominated money market instruments in 22 emerging markets countries with at least US$10 billion of external trade. The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays Global Aggregate Index provides a broad-based measure of the global investment grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. The Barclays Long-Term Treasury Index consists of U.S. Treasury issues with maturities of 10 or more years. The Barclays US Treasury 1-3 Year Index consists of U.S. Treasury issues with maturities between 1 and 3 years.  The 30-Day T-Bill Index measures the performance of one-month maturity U.S. Treasury bills. The MSCI EAFE Index (Europe, Australasia, Far East) is a free-float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. It is not possible to invest directly in an unmanaged index.

This material contains the current opinions of the manager and such opinions are subject to change without notice. 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. ©2016, PIMCO

PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019, is a company of PIMCO.