All Asset All Access

All Asset All Access, March 2017

Chris Brightman, chief investment officer of Research Affiliates, discusses the application of business-cycle models to investing; Michele Mazzoleni, head of macroeconomic research, assesses inflation potential under President Trump; and Rob Arnott, founder, chairman and chief executive officer, dissects conventional wisdom. As always, their insights are in the context of the PIMCO All Asset funds.

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 month-to-month trading?

Brightman: 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 the time.

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 price momentum.

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. presidential election.

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 is a scatterplot of U.S. core services inflation versus the unemployment gap over the time period 1995 to 2016. The graph shows most of the plots between -1% to 1% for the unemployment gap, shown on the X-axis, and 2.5% to 4% for year-over-year core services inflation, shown on the Y-axis. A red dot shows an average of to the right of 0% for the unemployment gap, and 3% inflation. The average is also shown by a downward sloping line from left to right, indicating that as the historical unemployment gap narrowed, prices generally rose. Figure 2 is a scatterplot of U.S. core services inflation versus the U.S. dollar valuation over the time period 1995 to 2016. The graph shows most of the plots between -20% to 25% for the six-month-lag dollar valuation, shown on the X-axis, and -1% and 2% year-over-year core services inflation, shown on the Y-axis. The average of the plots is shown by a downward sloping line from left to right, indicating that prices of goods tend to fall with a stronger dollar. 

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 surprises.

Q: Where do you see the conventional wisdom may be making mistakes in today’s market?

Arnott: 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 U.S. dollar.

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.

Further reading

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 Please read them carefully before you invest or send money.

The Author

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates

Robert Arnott

Founder and Chairman, Research Affiliates


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