Q: You’ve mentioned that the All Asset funds’ value-oriented,
contrarian investment process isn’t “fast-twitched.” Can you describe
how Research Affiliates’ models inform day-to-day, week-to-week and
We’ve designed our tactical allocation process in accordance with our core
investment belief that the largest and most persistent active investment
opportunity is long-horizon
mean reversion. Because investor preferences are far broader than a simple optimization
of return versus risk, market prices tend to vary substantially around fair
value. These recurring deviations create the potential to add value by
trading against these price movements until long-run mean reversion occurs.
If this long-horizon value opportunity is obvious, why don’t investors
actively position their portfolios accordingly? Buying what most investors
wish to sell and selling what most wish to buy is far easier to say than to
do. While valuation tends to provide a reliable long-term return
prediction, it’s a poor short-term timing tool. The severe discomfort of
the unavoidable multi-year periods of underperformance that must be endured
to seek to profit from long-run mean reversion, combined with the limited
patience of clients, discourages most professional investors from
implementing the contrarian trading strategy necessary to potentially
profit from long-horizon mean reversion.
With long-term contrarian investing, the right trade may seem obvious after
the fact, even though it rarely was at the time. For instance,
opportunities to shun technology stocks in favor of cheaply priced old
economy companies during the tech bubble, to buy junk bonds and financial
stocks at bargain-basement prices following the global financial crisis,
and to rotate into depressed emerging market currencies in 2016 all
required an uncomfortable willingness to ignore the prevailing narrative of
By intentionally orienting our investment process toward this deeply
uncomfortable long-horizon opportunity, we believe we can avoid competing
with the vast pools of capital deployed by higher-frequency traders who
chase short-term opportunities. Rather than liquidity takers, we are
liquidity providers. We don’t worry about prices moving away from us as we
trade. Typically, we’ve found that what we are buying continues to get
cheaper and what we are selling gets more expensive.
Recognizing that being early is the bane of value investors (since being
early may be indistinguishable from being wrong to end clients!), we employ
several techniques to avoid reacting too quickly to changes in prices.
Most importantly, we employ a proprietary business-cycle model to measure
risk aversion and refine our mean reversion assumptions. We observe that
investors’ risk appetites tend to rise with an improving economic outlook
and fall when the outlook darkens. Using leading economic indicators, our
business-cycle model produces probabilities of economic acceleration or
deceleration to assess changing risk aversions, and our models adjust our
expected asset class returns accordingly. When forecasting asset class
returns, we find this economic approach meaningfully superior to simple
That said, because we observe the existence of price momentum across
markets, we also explicitly incorporate price momentum to avoid trading
early. Essentially, we stagger the implementation of our optimal allocation
targets over 12 months, which our research indicates is the appropriate
span for balancing long-horizon mean reversion with shorter-horizon
momentum. This technique ensures we only gradually increase exposures to
cheap assets and pare exposures to expensive assets, further allowing price
momentum to run its course.
We also drift our target allocations with market prices until live
portfolio positions deviate from our model portfolio widely enough to
prompt a significant and intentional change to move target allocations
toward the model. This practice is designed to prevent us from trading on
inconsequential day-to-day market volatility, which offers the potential
benefits of lowering portfolio turnover, reducing transaction costs and
avoiding trading against short-run momentum.
Despite our long-horizon focus and manifold efforts to avoid trading too
early, we still run our models daily, and for good reason. Mutual funds
have daily flows, and our up-to-date daily model output allows us to use
these flows to efficiently trade toward our target allocations.
More crucially, capital market price changes are not smooth and continuous.
On occasion, an asset class will experience what amounts to years of
“normal” price changes in a matter of days. When such abrupt market events
occur, we seek to capture the resulting changes in expected returns and
implied changes to target allocations with our model output on the
following day. Recent examples of our ability to target return
opportunities arising at times of heightened volatility include our
increased exposure to emerging markets in 2016, adding to international
equities after the Brexit vote, and increasing duration after the U.S.
Q: How might Donald Trump’s presidency alter the outlook for U.S.
inflation, and how is the U.S. Federal Reserve likely to respond?
Mazzoleni: From today’s vantage point, the Trump administration’s influence on U.S.
inflation will depend in large part on its success in implementing the
economic policies it supports. While there is substantial uncertainty
surrounding their actual implementation, the spirit of the professed
policies increases the possibility of future inflation surprises to the
upside. An additional variable to consider is the Federal Reserve’s
response to these policies, which will be influenced by new board members
that President Trump is likely to appoint.
Taken together, the Trump administration’s campaign promises of
protectionism, tax cuts and infrastructure spending, if enacted, should
place upward pressure on consumer prices. The dynamics of the two major
long-term drivers of overall inflation – core services and goods – provide
an indication of how the effects of such policies could affect price levels
(see Figures 1 and 2).
Figure 1 plots the relationship between the unemployment gap and subsequent
year-over-year services inflation. An economy working at close to its full
potential has a lower unemployment gap and tends to be associated with
rising costs of services. A tighter job market today may lead to subsequent
wage pressures, which in turn could translate into higher prices for end
consumers in the months to come. Consistent with this interpretation, the
December 2016 observation, represented by the red dot, indicates an economy
running near full capacity and with a corresponding year-over-year rate of
services inflation just above 3%.
Figure 2 plots the relationship between the valuation level of the U.S.
dollar (with a six-month lag) and the subsequent level of goods inflation.
Goods are the largest component of international trade, so a stronger U.S.
dollar generally implies greater purchasing power (less expensive goods)
for U.S. households. Again, consistent with our narrative, the December
2016 observation indicates a year-over-year goods inflation rate of −0.5%,
subdued in part by a strong dollar. Because goods inflation makes up just
under a quarter of the overall index, the core inflation rate has still
been growing at a healthy pace, at just around the Fed’s target of 2%.
A look at how the effects of potential policies may flow through the
economy suggests that higher government spending, greater disposable income
through tax cuts and tighter immigration control may put further upward
pressure on U.S. wages and thus on the cost of services. But the effects of
the administration’s policies on goods prices may somewhat offset this. On
the one hand, an exuberant U.S. dollar currently presages a continued
subdued rate of goods inflation; on the other hand, import tariffs could
erode the real purchasing power of U.S. households, a scenario that could
be aggravated by the risk of a trade war with major trading partners.
Ultimately, the answers to these macroeconomic questions largely hinge on
what Congress is going to do. It remains to be seen whether the
Republican-controlled Congress will implement policies at odds with what
used to be seen as some of the Republican Party’s core beliefs, such as
smaller government and free trade. If Congress does move ahead with such
policies (increased public spending or trade barriers, for example), and
the inflation rate or the real economy shows signs of overheating, then the
Fed would likely take action by further tightening monetary policy.
While this possibility highlights the risk of potential conflict between
the White House and the central bank, in reality, a pragmatic relationship
between the two institutions appears more likely. The Trump administration
will likely nominate three new members to the Fed’s Board of Governors this
year and also name a new chair and vice chair next year. These appointees
may be dovish policymakers and inclined toward accommodative monetary
policies. For some time now, the Fed has been battling longstanding secular
demographic trends that have depressed the performance of the U.S. economy
and raised fears that the U.S., from a monetary perspective, could be going
the way of Japan. As a result, the Fed may tolerate some level of inflation
overshoot, allowing room for the central bank to move short-term interest
rates further away from the uncomfortable zero bound.
While a case can be made for a relatively benign inflation outlook, the
possibility remains that the rate of inflation may overshoot the official
Fed target when and if the White House rolls out some of its policies.
Additionally, some policies, such as tariffs and other trade barriers, may
raise the risk of strained international relations and the disruption of
essential global supply chains for some major industries.
As we’ve discussed previously, the mere presence of these new risks should induce investors to consider
diversifying toward assets that offer protection against inflation
Q: Where do you see the conventional wisdom may be making mistakes in
Whenever there is overwhelming consensus, there is a good chance it could
turn out to be wrong. Everyone was convinced that a “yes” vote on Brexit
would crash the global markets and hit the UK especially hard … it didn’t.
Everyone thought a Trump victory would crash the global markets and hit the
emerging markets even harder … it didn’t.
The current conventional wisdom is that a stronger economy will be great
for stocks. Many people think that stock market returns and economic growth
go hand in hand. And while this is generally true in the long run, it is
not necessarily so in the short or even intermediate term. An
underappreciated fact is that new start-ups and established businesses have
dramatically different impacts on the stock market and economic growth.
Economic growth is strongly driven by the creation of new enterprises, but
while successful start-ups enrich private equity investors, they tend to
have a minimal impact on the public markets. A surge in entrepreneurialism
and new long-horizon risk-bearing initiatives are great for long-term
economic growth. But in the shorter run, entrepreneurs divert money out of
existing stocks and bonds in order to fund these new initiatives. “Old
economy” stocks and new initiatives compete for capital; this leads to
lower current prices for stocks (and bonds), but at the same time prices
them to offer higher forward-looking returns.
Stocks aren’t an engine of economic growth, though they sure affect wealth
levels; more immediately, they’re a barometer for risk tolerance in established enterprises. This is why stocks often don’t
necessarily do badly under socialist leaders (François Mitterrand and
François Hollande, for instance, weren’t bad for French stocks); policies
that stifle innovation create disincentives to invest in long-horizon new
initiatives and lead people to park their liquid risk assets in stocks.
This is a nuance that fewer than one investment professional in 20 seems to
understand, even though it’s a major reason for the dichotomy between
economic strength and stock market performance.
Today, we see potential for a lighter regulatory environment in the U.S.
over the next few years. If that happens – still
a big “if” – we could see a sharp increase in entrepreneurialism and
long-horizon risk-bearing. That would pull money out of the “old economy” stock market.
We could expect other ripple effects as well: A stronger U.S. economy would
likely boost the emerging markets of the world; in addition, a
protectionist agenda would constrain, not strengthen, an already expensive
As with the views on Brexit and Trump, the beliefs underlying these three
parts of current conventional wisdom – a stronger economy will be great for
stocks, protectionism will strengthen the dollar, and in the process crush
the emerging markets – are (a) widely held, and (b) probably wrong.
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.
Recent editions of All Asset All Access offer in-depth insights from
Research Affiliates on these key topics:
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
PIMCO representative or visiting www.pimco.com. Please read them
carefully before you invest or send money.