All Asset All Access

All Asset All Access: Positioning Portfolios for Opportunity in Stormy Markets

Research Affiliates discusses how the All Asset portfolios seek to capitalize on opportunities amid pandemic-related market volatility and a strengthening U.S. dollar.

Rob Arnott, founder and chairman of Research Affiliates, shares his thoughts on recent market conditions and describes how the All Asset strategies were positioned leading up to and during the COVID-induced market crash. Omid Shakernia, senior vice president of asset allocation at Research Affiliates, discusses the link between asset classes’ sensitivity to the U.S. dollar and their long-term return prospects. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Beginning with this edition, All Asset All Access will be published on a quarterly cadence.

Q: What are your thoughts about the market environment?

Arnott: The COVID-induced market crash followed by an unprecedented policy response has led to market volatility and uncertainty. At the close of the first quarter of 2020, nearly all assets, with the exception of the most liquid and seemingly safe-haven U.S. Treasuries, were savaged. Returns in March alone of U.S. stocks, EAFE stocks (i.e., developed markets in Europe, Australasia, Far East), high yield bonds, EM (emerging markets) non-local debt, REITs (real estate investment trusts), EM stocks, and convertible bonds fell within their worst 1st percentile historical rank.1

With most markets producing historic losses in March, asset allocation was largely futile; our diversified and value-oriented posture provided little downside benefit. But outsized volatility has a silver lining. Severe market adjustments have led to many asset classes now offering what we at Research Affiliates see as reasonable – and in several cases, impressive – forward-looking premiums for bearing risk. Asset prices in certain markets have moved into bargain territory.

The coming months should afford buyers some excellent opportunities to average into attractive asset allocation opportunities. And that’s what the All Asset strategies are designed and managed to exploit!

Q: How were the All Asset strategies positioned prior to the latest turmoil?

Arnott: Rewind the clock one year. Over 2019, our models increasingly suggested that 1) the odds of an economic global slowdown were rising, and 2) long-term return estimates across markets were dampening.

Consonant with our contra-trading approach, the All Asset strategies rotated away from high yield bonds and leveraged loans in order to increase exposure to defensive, countercyclical markets such as long maturity bonds, U.S. Treasury Inflation-Protected Securities (TIPS), and lower-beta liquid alternatives. Related, the short position to U.S. stocks rose in the All Asset All Authority strategy.

The All Asset strategies had thus shifted into a more defensive posture ahead of the latest turmoil. Although the take-no-prisoners crash in the first quarter exacted a surprising and indiscriminating toll on these strategies, we expect the markets will likely sort out the not-yet-cheap from the abnormally cheap in the months ahead.

Q: Fast forward to today. How are you managing the All Asset strategies through the current environment?

Arnott: We continue to take profits from our defensive positions that have outperformed. These include long Treasuries, core bonds, and a short S&P 500 exposure (in the All Authority strategy). Simultaneously, we are turning up the risk dial and selectively rebalancing into what we see as newly cheapened markets with now-elevated multi-year return prospects. These markets include EAFE equities, commodities, U.S. small cap equities, and REITs.

When turbulence and uncertainty loom, emotions and short-term reactions tend to prevail over long-termism and rationalism. Today markets are whipsawed as many investors skittishly react to headlines. A disciplined approach becomes more urgent than ever – especially when designed to capitalize on opportunities created by price dislocations.

For over 18 years, the All Asset strategies have allocated across global markets, rotating into unloved and feared assets with attractive long-term return prospects and away from beloved markets with uninspired rates of future return potential. Our contra-trading engine institutionalizes the courage and discipline to execute the trades that are emotionally difficult, but ultimately potentially quite profitable.

Q: How have the All Asset strategies reacted to the recent strengthening of the U.S. dollar?

Shakernia: The uncertainty associated with the extreme volatility across capital markets after the outbreak of COVID-19 triggered a flight to safety and outsized demand for the U.S. dollar. As the dollar is world’s reserve currency, demand for the dollar has a significant impact on global asset class returns.

Given the All Asset strategies’ emphasis on Third Pillar markets, 2 which tend to have negative correlations with the U.S. dollar, our core holdings were affected by the rapidly strengthening dollar. Although short-term exchange rates are notoriously difficult to predict, at Research Affiliates we believe there may be some natural retrenchment of the U.S. dollar as short-term stress abates. Looking ahead, the Federal Reserve’s dovish monetary policy and seemingly “unlimited” quantitative easing, together with multi-trillion dollar fiscal stimulus, may well ignite reflationary pressures that would drive U.S. dollar depreciation over the long term.

Q: How sensitive are the asset classes in our opportunity set to the U.S. dollar? 

Shakernia: Over the last quarter-century, defensive U.S. bonds have generally benefited from dollar strengthening, while credit and U.S. equities have exhibited modest negative correlations with the U.S. dollar. Third Pillar markets have larger negative correlations with the dollar, ranging from −30% for REITs to −85% for EM local bonds. Figure 1 displays the correlations between the 12-month returns of major asset classes and the U.S. dollar 3 from January 1995 through March 2020.

Figure 1 displays the correlations (on a scale of 1.00 to −1.00) of 14 major asset classes relative the Trade-Weighted U.S. Dollar Index over the period January 1995 through March 2020. It ranges from a maximum positive correlation of 0.25 for long-term U.S. Treasuries, to a midrange correlation of  −0.40 for U.S. Treasury Inflation-Protected Securities, to a maximum negative correlation of −0.85 for emerging market local bonds.

Q: How is U.S. dollar sensitivity related to long-horizon return estimates?

Shakernia: Third Pillar markets, which are negatively correlated to the dollar, currently trade at deep discounts to their average historical valuations. We believe the long-term return prospects for these markets are compelling.

Recent research argues that the U.S. dollar is a priced global risk factor.5 This view is consistent with and supported by Research Affiliates’ capital market expectations approach, which forms the basis of the All Asset strategies’ asset class allocations. Figure 2 displays the long-horizon estimated returns of major global asset classes versus their respective sensitivities to the U.S. dollar.

According to Research Affiliates’ forecasts, assets with a high beta to the U.S. dollar, such as defensive U.S. bonds, offer particularly low return prospects. Assets with a negative beta to the U.S. dollar, such as EM equities, offer high estimated future returns. These results support the theory that the dollar is a priced global risk factor. They also explain the current barbell positioning of the All Asset strategies that counterbalances the risks in our EM exposures with defensive U.S. bonds.

Figure 2 is a scatter plot chart displaying the estimated forward-looking real returns of 14 major asset classes versus their beta to the Trade-Weighted U.S. Dollar Index. It ranges from long-term U.S. Treasuries, with estimated real return of   −4.7% and beta of 0.4, to emerging market equities, with estimated real return of 8.0% and beta of −3.2. Other Third Pillar asset classes displaying positive real return estimates and negative betas include U.S. high yield bonds, real estate investment trusts, emerging market currencies, commodities, and emerging markets local bonds.

Could the U.S. dollar continue to strengthen against a broad global basket of currencies? Of course. The All Asset funds’ emphasis on Third Pillar markets means, as Figure 1 shows, the strategies are exposed to the risk of a strengthening dollar. However, less-dollar-risky assets are now trading at premium valuations that offer near-zero to negative real return prospects, in our view, while dollar-risky assets are trading at attractive yields and well-below-average valuations. At Research Affiliates, we believe the dollar factor is priced to handsomely reward those patient long-term investors willing to bear the exposure to its risk.

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 Source: Research Affiliates based on data from Factset as of 31 March 2020. Asset class proxies are as follows: U.S. Treasuries = Bloomberg Barclays U.S. Treasury Total Return Index; U.S. stocks = S&P 500 Index; EAFE stocks = MSCI EAFE Index; high yield bonds = Bloomberg Barclays U.S. Corporate High Yield Index; EM non-local debt = J.P. Morgan EMBI+ Index; REITs = FTSE Nareit All Equity REITs Index; EM stocks = MSCI EM Index; and convertible bonds = ICE Bank of America U.S. Convertible – All Qualities Index. For many markets, the magnitude of losses was exceeded only by the crash of 1987 or the global financial crisis of 2008–2009.
2 Third Pillar markets include REITs (real estate investment trusts), TIPS (U.S. Treasury Inflation-Protected Securities), high yield bonds, commodities, emerging market (EM) equities and EM local bonds.
3 Our preferred proxy of the U.S. dollar is the Trade-Weighted U.S. Dollar Index: Broad, Goods and Services (from January 2006 through March 2020), backfilled with the Trade-Weighted U.S. Dollar Index: Broad, Goods (from January 1997 through December 2005). Source: Federal Reserve Bank of St. Louis Economic Data (FRED).
4 Asset class proxies are as follows: U.S. Treasuries, long term = Bloomberg Barclays U.S. Long Treasury Index; U.S. Treasuries, short term = Bloomberg Barclays U.S. 1-3 Year Treasury Index; U.S. aggregate bonds = Bloomberg Barclays U.S. Aggregate Index; U.S. large cap equities = S&P 500 Index; U.S. intermediate corporate bonds = Bloomberg Barclays U.S. Intermediate Corporates Index; real estate investment trusts (REITs) = FTSE Nareit All Equity REITs Index; U.S. small cap equities = Russell 2000 Index; U.S. Treasury Inflation-Protected Securities (TIPS) = Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index; U.S. high yield bonds = Bloomberg Barclays U.S. Corporate High Yield Index; Europe, Australasia, Far East (EAFE) equities = MSCI EAFE Index; commodities = Bloomberg Commodity Index; emerging market (EM) equities = MSCI EM Index; EM currencies= J.P. Morgan ELMI+ Composite (Unhedged) Index; EM local bonds = J.P. Morgan GBI-EM (Unhedged) Index.
5 A recent paper by Verdelhan (2018) argues that a dollar HML factor (i.e., long high dollar beta currencies and short low dollar beta currencies, or “high minus low”) is a priced global risk factor. Extending this work, Jiang, Krishnamurthy, and Lustig et al. (2019) have built a model to rationalize this empirical fact based on the special demand for assets with a positive beta to the U.S. dollar. According to the model, this demand causes such assets to trade at a premium and that these assets offer especially low future return potential, while assets with a negative beta to the U.S. dollar offer higher return potential.
6 Asset class proxies are same as those listed below Figure 1. Hypothetical example for illustrative purposes only. Beta of 12-month returns on 12-month percentage change on Trade-Weighted U.S. Dollar. Return assumptions are for illustrative purposes only and are not a prediction or a projection of return. Return assumption is an estimate of what investments may earn on average over the long term. Actual returns may be higher or lower than those shown and may vary substantially over shorter time periods. Research Affiliates return assumptions will vary from PIMCO’s capital market assumptions. Research Affiliates’ long-term expected real returns are calculated using a building block approach consisting of starting yields, capital growth estimate, and changes in valuation. More detail and information can be found in these methodology docs: Figure is provided for illustrative purposes and is not indicative of the past or future performance of any PIMCO product.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Omid Shakernia

Multi-Asset Strategies, Research Affiliates


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Third Pillar asset class proxies / indexes are as follows: Bloomberg Barclays U.S. TIPS Index is an unmanaged market index comprising 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. The Bloomberg 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. Bloomberg Commodity Index Total Return is an unmanaged index composed of futures contracts on a number of physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. The futures exposures of the benchmark are collateralized by US T-bills. 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 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. The index was launched in June 2005 and is the first comprehensive global local Emerging Markets index. The J.P. Morgan ELMI+ Composite (Unhedged) Index tracks total returns for local-currency-denominated money market instruments in a range of emerging market countries. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.

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