Rob Arnott, chairman and head of Research Affiliates, discusses the 2020 outlook across a global opportunity set, while Research Affiliates’ asset allocation and research specialists offer insights into key asset classes. Jim Masturzo (equities), Omid Shakernia (bonds), Chris Brightman (real return assets), and Brandon Kunz (alternative strategies) discuss the opportunities they’re seeing as we start the year. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: What are your return forecasts spanning the global opportunity set as we enter 2020, and where are you finding opportunities for attractive potential multi-year returns?
Arnott: We believe the majority of market and economic predictions offered by the investment community can be more aptly termed “nowcasts” rather than “forecasts.” By presenting a cogent thesis for what’s already happened, masquerading as a forecast, nowcasters have come out in droves.1 As U.S. capital markets enjoy the longest equity bull market in their history, nowcasting has become increasingly easy and popular, for three reasons. First, a cogent description of whatever has already happened, presented as a forecast of more of the same, sounds intelligent and informed. Second, our memories often trick us into thinking the forecast was made before the history that created the nowcast. And last, a nowcast is also less likely to damage one’s reputation if it turns out wrong, partly because it will have so much company. But such “predictions” tell us nothing.
Not only does nowcasting rarely offer insights, but it can also encourage short-termism and anchoring, both of which drive performance chasing, chasing fads, and avoiding bargains. How so? A focus on the recent past, and a quest for immediate rewards, seduces many investors into buying today’s darlings and resisting potential bargains. Of course, today’s darlings continue to perform well, and the laggards continue to lag … until they don’t! One consequence is that we look and feel foolish when we sell what’s beloved or buy what’s unloved and feared, until the markets inevitably turn.
Likewise, anchoring on a popular strategy, like a 60/40 mix of mainstream stocks and bonds, gives investors a false sense of safety, because we instinctively gauge performance relative to conventional alternatives. When “Third Pillar” markets (diversifying assets, including real assets, emerging markets, and high yield bonds) had their 2013–2015 bear market, results for the All Asset strategies were well behind the S&P 500. I was repeatedly asked why we were ramping up portfolio risk, when in reality we were doing the opposite. Why did people think our funds were so risky? Because the return difference from 60/40 or from the S&P 500 was large. A volatile performance gap was perceived as high risk.
Predictably, because diversification feels so uncomfortable in a bull market (and this one is the longest on record), many investors who are anchored on a 60/40 strategy are ditching their diversifying assets. As a result, many investors now lack any serious diversification away from U.S.-centric equity risk, and this means they face low prospective returns on their conventional holdings and are vulnerable to renewed inflation. These issues are as urgent today as they were at the launch of the All Asset strategies in 2002. Since our launch, our mission has been to serve as a real return-oriented, diversifying solution to complement investors’ mainstream holdings.
Importantly, our approach to estimating long-term capital market return expectations helps ensure we avoid the ills of nowcasting that afflict many in the financial media and punditry. By relying on a model-based investment approach that is both intuitive and objective, we gauge long-term return expectations and pay close attention when comparative valuation levels are at odds with market perceptions. Our models use a building block approach, which informs long-term buy-and-hold asset class forecasts by summing current yield and estimated long-term real growth in income. We then offer a mild nod to mean reversion; valuation multiples, yields, and spreads have shown a powerful tendency to eventually mean-revert toward historical norms. Our valuation assumptions are not aggressive: We assume current multiples revert toward fair level over 20 years.
These models guide us to “average into” what we deem to be cheaply valued asset classes at times when they are feared and shunned, helping us take the uncomfortable trades required to profit from mean reversion. These same models also ensure we gradually shift away from richly valued asset classes with fading return prospects in environments of unwarranted comfort and complacency. In addition to gauging forward-looking long-term returns, we seek additional layers of return within the All Asset strategies by tapping into a) a deep, diversified set of liquid asset classes to counter headwinds in the form of low yields, b) PIMCO’s skill in seeking structural alpha, net of all fees and trading costs; and c) tactical shifts into recently out-of-favor markets offering premium yields.
Over the past year, we’ve increased our exposure to what we view as attractively valued emerging market (EM) equity and diversifying absolute-return equity strategies in the All Asset funds. As yields have fallen, we’ve reduced allocations to U.S. bonds, EM local bonds, and high yield bonds. Looking forward, our models suggest that our strategies are positioned to potentially generate potential long-term real returns, just based on the current valuations and yields for our chosen markets. Importantly, that’s before PIMCO adds their alpha potential in the individual funds that we select, and before we add alpha potential from our tactical shifts in asset mix returns.
For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:
In addition, the current SEC yield on the All Asset strategies is 3.50% for All Asset Fund and 3.71% for All Asset All Authority Fund, which we view as remarkable in a world of negative yields, and takes us well on our way toward our target real returns.
Our approach will inevitably be at odds with the pack – especially during the late stages of an equity bull market. When markets are trending as long as they have in this bull market, our discipline will test the patience of most investors, apart from those who really want a diversifier in their mix. This discipline helps us position our strategies to capture the often swift and powerful rebound when mainstream markets falter, and diversifiers “get some respect.”
I’ll now turn to my colleagues, who will address the specifics for each asset class.
Masturzo: After a rocky finish in 2018, global stocks came roaring back in 2019, with large cap equity indices posting double-digit gains (in U.S. dollars) in the U.S and across EAFE (Europe, Australasia and Far East) and emerging markets (see Figure 1). In the U.S, much of the gains in 2019 simply reversed the 19% market decline in the fourth quarter of 2018, yet equity investors continued to downplay historically high cyclically adjusted price-to-earnings (CAPE) ratios, currently at about 30. With prices again outpacing earnings growth, which came in at a paltry 0.8% (or -1.4% net of inflation) as of year-end, according to Shiller online data, multiples have not become any more attractive, causing us to eschew this asset class within the All Asset strategies in favor of other opportunities across our investment universe.
Although markets hit new highs multiple times throughout the year, 2019 was not without drama. We saw continued escalation of the U.S.–China trade tensions that began in 2018 (leading up to a fragile truce in the form of a Phase 1 deal), near-trillion-dollar deficits ($984 billion, to be exact), not to mention political upheaval with the release of the Mueller report and more recently the articles of impeachment brought against President Trump; however, the market has for the most part shrugged it all off. This is not to say there hasn’t been some short-term volatility. In fact, the VIX index sat above its 10-year average of 16.9 on 26% of the trading days this year (according to Bloomberg as of 30 November 2019), keeping all of us on our toes for big breakouts one way or the other.
From the perspective of the All Asset strategies, U.S. and global developed market equity exposure was mostly unchanged in 2019. In particular, All Asset Fund remained out of U.S. stocks and took advantage of appreciation in global developed market returns to seek profit-taking. Emerging markets were a different story, as they entered the year undervalued based on our models, which utilize the aforementioned CAPE ratio. The result was a 3%–6% net increase in exposure, resulting in all-time highs for All Asset exposure to this asset class.
Turning our attention to 2020, another result of price appreciation in equity markets outpacing earnings growth is a reduction in our forward-looking return estimates versus a year ago. As Figure 2 shows, on an absolute basis, our annualized return estimates across equity markets are 0.8%–1.3% lower than last year, although the relative ranking across markets remains the same. This is aided by global dividend yields that continue to be 1.5x (or more) greater than the dividend yield on the S&P 500.
From an earnings multiple perspective, the U.S. is expected to have a strong headwind as CAPE ratios revert back toward more historically normal levels over the next five to 10 years. This past year also brought about a milestone with respect to the U.S. CAPE ratio. In particular, the earnings drag from the global financial crisis, often interpreted as artificially inflating the CAPE, has fallen off with the crisis now more than a decade in the rearview mirror. The effect of this roll-off was a 2-point reduction in the CAPE ratio; nevertheless, the CAPE stills stands higher today than a year ago (at 30.9 vs. 28.5)2 due to increasing prices.
Global developed and emerging markets, in contrast, continue to be more fairly valued from a CAPE perspective, with emerging markets getting a modest additional valuation bump from undervaluation in their currencies versus the U.S. dollar. This all leads to a 3.2% and 5.3% annualized return tailwind for EAFE and emerging markets relative to the U.S., owing to valuation differentials. Therefore, from the perspective of estimated total returns, it’s easy to see why the All Asset strategies are positioned as they are; and while we expect positioning to continue to favor emerging over developed markets, opportunities to tactically jump into those markets may arise amid the election in the U.S, the continuation or possible finalization of Brexit, and other developed market events.
Shakernia: The past year was an eventful one for the bond markets. We began 2019 with the Federal Reserve having hiked the federal funds rate four times over 2018 to a target range of 2.25%–2.5%. Yields at the long end of the term structure had not followed suit, resulting in a nearly flat term structure at the beginning of the year. With slowing economic growth, the Fed hit the pause button on interest rate hikes and bonds rallied, resulting in an inverted yield curve, with spreads between 10-year and three-month Treasuries going negative in May and reaching a nadir of -0.5% in September before turning positive again in October. In response, the Fed cut interest rates three times between August and October as a measure to protect the economy against the fallout of an economic downturn and prolonged trade tensions. The falling interest rate environment was a boon for bond markets last year, but today’s lower yields portend lower expected real returns in the years ahead. Readers familiar with our investment process will not be surprised that the All Asset strategies have taken profits and trimmed exposures across the bond markets to rebalance into what we view as more compelling opportunities, such as liquid alternative strategies (as a complementary source of defensive, low beta “dry powder”) and EM equities (as we reduced exposure to credit and local EM bonds).
In the U.S. bond market, short-term bonds (as proxied by the Bloomberg Barclays U.S. Treasury 1-3yr Index) have returned about 3.4% over the past year, but with their low current yields, we expect this category to have a nearly zero real return in the years ahead. Unsurprisingly, we have reduced our allocations from the start of the year from about 6% to 3.5% in All Asset Fund, and from about 8% to 4% within All Asset All Authority Fund. We only maintain a small position in short-term bonds because they provide an important source of dry powder and liquidity that can be readily deployed in case buying opportunities arise in times of market stress.
U.S. core bonds (as proxied by the Bloomberg Barclays U.S. Aggregate Bond Index) returned a healthy 9% in 2019. However, from today’s starting yields, we now expect U.S. core bonds to provide a slim real return of 0.1% in the years ahead. Versus the start of the year, we have trimmed our exposure to this category from about 5% to 4% in All Asset Fund and about 7% to 4% in All Asset All Authority.
With their higher sensitivity to interest rate changes, long maturity bonds have benefited the most from the falling rate environment and were sizable contributors to the All Asset strategies’ performance in 2019. The Bloomberg Barclays U.S. Treasury Long Index provided a robust 15% return, while the Bloomberg Barclays U.S. Long Corporates Index provided a stellar 24%. We now expect long maturity bonds to provide a negative real return of −0.1% in the years ahead. Since the beginning of the year, we have reduced our exposures to long maturity bonds from about 10% to 7% in All Asset Fund and from about 7.5% to 6% in All Asset All Authority Fund. While our negative expected real return on long bonds does not sound attractive as a stand-alone investment, we maintain sizable positions because their negative correlation with equity markets provides valuable risk hedging properties, making them important and capital-efficient diversifiers in multi-asset portfolios.
The credit markets have also benefited from falling interest rates and continued (albeit slower) economic expansion in 2019. Bank loans (as proxied by the JPMorgan Leveraged Loan Index), investment grade bonds (proxied by the Bloomberg Barclays U.S. Intermediate Credit Index), and high yield bonds (proxied by the Bloomberg Barclays U.S. Corporate High Yield Index) provided returns of about 9%, 10%, and 14%, respectively, over the past year. We now estimate bank loans will provide an average real return of 0.1% in the years ahead, while we estimate real returns of 0.4% for investment grade bonds and -0.4% for high yield bonds. Credit spreads remain compressed at levels well below historical averages, and we believe the elevated probability of economic slowdown suggests that these spreads may mean-revert higher toward historical averages. Today’s low spreads do not offer a particularly attractive premium for the potential default risk, and the high correlation between credit risk and equity market risk means that these asset classes may not provide the portfolio with substantial diversification when most needed in the event of an economic downturn. Since the beginning of the year, we have reduced our credit exposure from about 8% to 6% in All Asset Fund, and from about 10% to 6% in All Asset All Authority Fund.
Finally, let’s turn from U.S. bonds to global and EM bonds. The prospects for realizing positive real return in the global developed bond markets continue to be bleak. With the European Central Bank (ECB) cutting interest rates into negative territory and printing money to relaunch its bond buying stimulus program, the All Asset strategies had no appetite for global bonds. On the other hand, our largest allocations within the fixed income category of the All Asset strategies opportunity set remain in EM local bonds and currencies. These assets (proxied by the JPMorgan GBI-EM Global Index and JPMorgan ELMI+ Index, respectively) provided returns of about 10% and 3.5% since the beginning of the year. Driven by their high real yields and expected currency appreciation, we now estimate EM local bonds and currencies will provide real returns in the years ahead of about 3.8% and 3.1%, respectively; prospective returns that are considerably more attractive than the low-single-digit expected returns for the rest of the fixed income category. Despite this attractive outlook, we have lowered our allocations to EM bonds from about 18% to 14% in All Asset Fund and from about 19% to 16% in All Asset All Authority Fund since the start of last year, to take advantage of EM equities, where we estimate an even greater return potential in our foreign currency allocation.
Real return assets
Brightman: Real return assets provide opportunity to build long-term wealth while also providing a hedge against the loss of principal from the corrosive impact of inflation. By definition, the value of real assets isn’t dependent on the nominal value of the currency in which they are priced. Inflation-linked bonds provide the most explicit inflation hedge. The real value of the principal of Treasury Inflation-Protected Securities (TIPS) is contractually guaranteed by the U.S. Treasury. Commodity futures contracts and real estate investment trusts (REITs) also provide opportunity for inflation hedging through claims on tangible real assets, but without a contractual guarantee. Together, these three asset classes constitute our real return assets opportunity set.
As economic growth in the U.S. and across the globe slowed during 2019, the real yield on 10-year TIPS declined from approximately 1% at the beginning of the year to just below 0% in September (as proxied by the Federal Reserve US TIPS 10 Year Constant Maturity), before modestly recovering to 0.15% at year-end. Falling yields produced capital gains and the index provided a nominal return of 7% for the year, well above its paltry real yield plus inflation. We added to TIPS positions during the year as our model forecasting economic growth predicted an economic slowdown and declining real yields. Further improving our present estimated return for TIPS, the real yield curve steepened – thus increasing roll returns. Also, the level of implied inflation (the “breakeven” inflation rate) fell below what our analysis suggested was likely over the coming quarters, which improved the attractiveness of TIPS relative to U.S. core bonds. For these reasons, over the year we added to TIPS positions by 6%, increasing weights from 2% to 8% and from 1% to 7% in the All Asset and All Asset All Authority funds, respectively.
Commodity futures, as proxied by the Bloomberg Commodity Index, provided a 7.7% return over the past year. From today’s prices, we estimate future annualized returns for this index of commodity futures are centered in the low single digits; significantly negative roll returns are likely to offset appreciation of spot prices from today’s depressed levels. However, commodities retain some attractiveness because the high volatility of commodity prices is uncorrelated with equity and interest rate volatility, which provides the potential for commodity futures to offer a rebalancing return within a portfolio, beyond their stand-alone returns. Largely for this reason, we hold modest but still impactful positions of 5.4% and 6.6% in commodities within the All Asset and All Asset All Authority funds, respectively – not much changed over the year.
REITs, as proxied by the Dow Jones U.S. Select REIT Index, delivered a return of 23%, trailing the 32% return of the S&P 500 but still an impressive level. Last year’s capital gains outstripped growth in cash flow, thus depressing REIT yields below our estimate of fair value. We now expect REITs to provide average low but positive real returns of roughly 1% annualized over the coming years. From a diversification perspective, while REITs are more correlated with equities than are commodities, the REIT asset class still provides opportunity for a rebalancing return within the portfolio. Primarily for this reason, we again hold modest but impactful positions of between 2.5% and 4% in REITs within the All Asset and All Asset All Authority funds, respectively – down only slightly from the beginning of 2019.
Because the All Asset strategies aim to deliver a strong real return over a market cycle, we consider the real return asset category a natural core holding. If we can assemble a portfolio of TIPS, commodities, and REITs that we expect to address our real return objectives, then we may choose to largely avoid the risks of other asset classes. However, in today’s low yield environment, we believe real return assets are priced to provide real yields well below All Asset’s real return objectives. Accordingly, we hold relatively modest aggregate real asset positions, of 16% and 18%, within the All Asset and All Asset All Authority funds, respectively.
Kunz: Various strategies make up the All Asset funds’ alternatives category. While their investment approaches differ, they share common attributes that make them an important part of the All Asset opportunity set. Specifically, these strategies seek to provide an absolute-return orientation at modest volatility, with low beta to equity, interest rate, and other traditional risk factors. As such, we tend to view them as defensive strategies and complements to our more traditional defensive core bond allocations.
These alternative strategies include PIMCO’s Dynamic Bond Fund, Credit Opportunities Bond Fund, Mortgage Opportunities and Bond Fund, and TRENDS Managed Futures Strategy, along with two equity long/short strategies – PIMCO RAE (Research Affiliates Equity) Fundamental Advantage PLUS and PIMCO RAE Worldwide Long/Short PLUS, which systematically combine equity factor premia with absolute-return-oriented bond exposure. As is the case with every underlying PIMCO fund in All Asset’s opportunity set, these strategies are actively managed, daily-liquidity vehicles that seek to exploit opportunities in high-capacity markets, regions, countries, sectors, and securities.
Allocations to the alternatives category will shift with changes in the absolute and relative attractiveness versus other more traditional strategies within All Asset Fund’s broader opportunity set. In 2019, increased relative attractiveness was the predominant driver of All Asset’s 2.8% increase to the alternatives category (and a 3.2% rise for All Asset All Authority Fund). As highlighted previously, nearly every asset class delivered returns in 2019 that meaningfully exceeded the sum of their individual return building blocks (yield, growth, and potential valuation changes), which means these beta markets richened. Further, our models indicate that probabilities of economic slowdown have risen across the globe, with the largest increases occurring in the U.S. and developed ex U.S. markets, where decelerating growth probabilities have risen from the low 40% area to the mid-to-high 60s in the last 12 months. These and other considerations have led to falling return forecasts across nearly all global asset classes (particularly in procyclical areas), so the relative attractiveness of defensive, lower beta alternative strategies increased.
As we’ve highlighted previously (see the April 2018 and April 2019 editions of All Asset All Access), the All Asset strategies not only change compositional risk with changing relative return prospects across asset classes, but also absolute risk tolerance with changes in the steepness of the forward-looking efficient frontier. When the efficient frontier is flat and offering limited return compensation per unit of risk, as is increasingly the case today, the All Asset strategies have tended to increase exposure to alternative strategies with the goal of increasing dry powder and fund-level downside hedging characteristics until future opportunities to deploy capital into beta-one strategies present themselves. As of year-end 2019, allocations to the alternatives category accounted for 18.4% of each of the All Asset strategies, representing levels significantly higher than long-term average allocations of closer to 10% within each fund.
Moving forward, we at Research Affiliates estimate that the average alternative strategy within All Asset’s opportunity set could deliver strong real returns relative core bonds (and that’s using conservative assumptions for long-term alpha potential from active management by PIMCO’s portfolio managers). In addition, we expect these strategies will have an average equity beta rounding to zero.
The vast majority of the All Asset funds’ exposure within the alternatives category resides in the PIMCO RAE Fundamental and Worldwide Long/Short PLUS strategies. As mentioned, these strategies seek to harvest long/short equity risk premia (namely value and low volatility) from across the globe. Importantly, these strategies also aim to systematically increase their loading on the value factor as it gets cheaper and cheaper. With the value factor trading at bottom-decile valuations across the globe today, these strategies currently exhibit elevated value tilts. Historically, based on roughly 15 years of live results for the RAE strategies, elevated value tilts have been indicative of elevated return potential, so we anticipate higher excess return potential from these strategies in environments like today. In addition, PIMCO’s management of the “PLUS” fixed income collateral within these portable alpha strategies provides a second and uncorrelated source of excess return potential. Given these considerations, it’s no wonder these two strategies represent the lion’s share of our liquid alternatives exposure.
Of course, the liquid alternatives exposure may underperform the long-term real return goals for All Asset (CPI + 5%) and All Asset All Authority (CPI + 6.5%). Nevertheless, we believe these two PIMCO RAE funds within the alternatives category are the most likely to outperform traditional dry-powder and bond exposures in the coming years, making them an increasingly critical component of All Asset’s opportunity set as we await future dislocations to present higher real-return-seeking opportunities.
Recent editions of All Asset All Access offer in-depth insights from Research Affiliates on these key topics:
- 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)
- How the All Asset strategies have performed during inflation surprises and potential benefits of these strategies for defined contribution plans (August 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.