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All Asset All Access

All Asset All Access: Preparing Portfolios for Longer‑Term Risks and Contrarian Opportunities

Research Affiliates shares their outlook on inflation and value investing, along with perspectives on their long-term asset class forecasts.

Founder and chairman of Research Affiliates, Rob Arnott, and CIO Chris Brightman discuss their outlook on inflation and value investing. Brandon Kunz, partner and lead on multi-asset strategies of Research Affiliates, offers his perspective on the historical accuracy of Research Affiliates’ 10-year return forecasts of asset classes. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.

Q: What is Research Affiliates’ near-term and long-term outlook on inflation, and what informs this view?

Brightman: While fear of inflation may be premature Footnote 1 from an economic policy standpoint, in the coming decade, high and volatile inflation may be a toxic side effect of today’s experimental economic medicine.

Five years ago, we explained Footnote 2 why quantitative easing was not inflationary. Quantitative easing is simply shuffling bank reserves for U.S. Treasury bills both paying about the same rate of interest. However, the risk of inflation escalates when the government chooses the path of monetization to fund real purchases of government goods and services.

So are we at Research Affiliates worried about the potential near-term inflationary impact of stimulus payments that the Treasury and the Federal Reserve are sending directly to people’s bank accounts? No. Emergency stimulus is likely not inflationary while the economy is operating far below potential, and when precautionary savings are soaring. Accordingly, we do not expect to see this lead to materially higher inflation numbers reported over the coming months and even quarters.

What concerns us is that our politicians may be learning the wrong lesson. If monetization is a tool for addressing today’s problems, why not apply it to other problems? Why not use it to solve the problem of inequality? Why not fund huge investments in infrastructure or climate transition using monetization? Such is a path that could certainly lead to inflation. It points to a policy that resembles what we saw from the mid-1960s through the 1970s. In turn, we believe the risk of above-target inflation in the coming decade is highly elevated.

Q: Is inflation hedging relevant for investor portfolios today?

Brightman: Yes. When inflation and inflation expectations become untethered, mainstream stocks and bonds tend to crash. Accordingly, we believe it is prudent to consider moving a portion of one’s portfolio into inflation-hedging asset classes, so that they are in place when needed and not when it is too late. Historically, inflation expectations often have rebounded significantly after large declines. During those rebounds in inflation expectations, diversifiers have tended to deliver strong returns (see Figure 1). Moreover, as detailed in Research Affiliates’ proprietary Asset Allocation Interactive tool that we use to calculate long-run estimated returns, many inflation-fighting asset classes appear considerably cheaper and offer higher long-term estimated returns relative to mainstream stocks and bonds.

Figure 1 is a table listing changes in 12-month breakeven inflation (BEI), measured monthly from September 1998 through September 2020, along with the average returns of diversifying asset classes during the 12 months of rebound after a change in BEI. Data are listed in the table, with definitions below the table.

Q: Along with their real-return orientation, the All Asset strategies embed a value-based, contrarian philosophy. What are your views on the deep rout of value stocks versus growth stocks?

Arnott: Let’s begin with a truism. Value investing is inherently uncomfortable: It requires us to buy whatever is most out of favor, contrary to our instincts, and to act objectively on future expectations and not simply chase what’s worked in the past. It takes discipline and a tolerance for “maverick risk” – winning (or losing) unconventionally – to shrug off the temptation to chase peer groups and recent performance.

Value stocks have been savaged this year. Year-to-date through their trough on 31 August 2020, value stocks (proxied by the Russell 1000 Value Index) lagged their growth counterparts (proxied by the Russell 1000 Growth Index) by 41.4%, representing the largest meltdown since 1931. Since that date, as of 11 November 2020, value stocks have beat growth stocks by 8.4%, with the majority of gains occurring in the early days after news emerged about the effectiveness of Pfizer’s vaccine in development.

Value stocks are struggling for a whole host of reasons. The COVID-19 lockdown has created an outsized demand for technology stocks that leverage our time, consume our human bandwidth, and reshape our behavior in ways that will long outlast the pandemic. Investors also naturally fear that value companies, with thinner profit margins than their growth counterparts, may go bust in a disrupted economy. Indeed, only massive stimulus has prevented this from already happening to many companies.

A relevant question is whether value companies are struggling worse than historical norms or whether they’ve become cheaper relative to their fundamentals. Are value stocks compromised in a lasting way? A recent Research Affiliates study Footnote 3 suggests just the opposite: that value stocks are not structurally impaired, but have underperformed simply by getting cheaper and cheaper. Suppose the relative valuation multiples (price/book, price/sales, price/cash flow) of value versus growth were the same as the relative valuations that prevailed in 2016, before the recent meltdown, or in 2007, before the long value winter began. Our research suggests that absent the erosion in relative valuation multiples, value would have beaten growth! This means that any mean reversion in relative valuation – which by some metrics is even more stretched than at the peak of the tech bubble in 2000 – would potentially deliver massive gains for today’s value investor. From 2007 through mid-2020, when we use the classic price/book definition of value, value stocks have underperformed their growth counterparts by 55% but have done so by getting 65% cheaper relative to growth (as represented by the Fama-French high minus low (HML) factor).

According to our study, the valuation spread of value relative to growth on a price/book ratio was 4.3 to 1 in 2007 (with growth stocks sporting an average price/book multiple just over 4 times that of value stocks) and 9.7 to 1 at the peak of the tech bubble. Where are we today? Nearly 12 to 1 – a ratio without any historical precedent. This breathtakingly wide valuation spread of value versus growth stocks today is unlikely to be sustained in the long run. If and when they revert, even if partially, patient investors stand poised to benefit.

Q: Finally, let’s discuss Research Affiliates’ return forecasts for asset classes, which inform the allocation decisions of the All Asset strategies. Historically, how accurate have your return forecasts been over time?

Kunz: We believe our forecasting methodology is differentiated relative to other approaches that all too often are detrimental to longer-term results. These other approaches include extrapolating past performance and assuming that future risk-adjusted returns will be the same for every asset class, insinuating that higher returns are only available through higher-volatility exposures.

Instead of adhering to these other approaches, we endorse a “building blocks” methodology to generate longer-term return forecasts. Such an approach decomposes the return of each asset class into three (or four) fundamental parts: 1) starting yields, 2) yield growth (or deterioration), 3) valuation changes, and 4) for non-U.S.-dollar exposures, exchange rate changes. Footnote 4

To assess the historical accuracy of Research Affiliates’ “building blocks” approach, we created a nearly 50-year retrospective of the accuracy of our return forecasts for 13 broad asset classes. In this analysis, we compared each initial 10-year return forecast range with the subsequent actual 10-year annualized returns. As shown in Figure 2, the median 10-year realized return is largely in line with our initial 10-year return forecast, and the interquartile range of realized returns almost universally encapsulates our initial expectations. Perhaps more importantly, we find it impressive that the realized returns for higher-return forecast ranges have always been higher than their lower-expectation counterparts, and vice versa. Said differently, while realized absolute returns were mostly in line with our initial absolute return forecasts, realized relative returns historically have materialized as our initial return forecasts would have indicated.

Figure 2 is a bar chart summarizing the historical accuracy of Research Affiliates’ 10-year forecasts for 13 broad asset classes as of June 2020. The X axis lists 10-year return forecast ranges, and the Y axis lists the subsequent 10-year realized returns. Data depicted includes expected outcome range, the median result, the 75th percentile result, and 25th percentile result. The median results for each range fell either within or slightly above Research Affiliates’ forecast. For example, for estimated 10-year returns above 10%, which had an expected outcome range of 10%–15%, the median result was 13.3%.

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 Brightman, Chris, “Too Soon? Pandemic Policy Response Raises Risk of Inflation.” April 2020

2 Brightman, Chris, “What’s Up? Quantitative Easing and Inflation.” Research Affiliates, January 2015

3 Arnott, Rob, Campbell Harvey, Vitali Kalesnik, Juhani Linnainmaa, “Reports of Value’s Death May Be Greatly Exaggerated.” Research Affiliates, August 2020

4 Capital Markets Expectations Methodology Overview, Research Affiliates, https://www.researchaffiliates.com/documents/AA-Expected-Returns-Methodology.pdf

The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Chris Brightman

Chief Executive Officer and Chief Investment Officer, Research Affiliates

Brandon Kunz

Global Wealth Management

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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 www.pimco.com. Please read them carefully before you invest or send money.

IMPORTANT NOTICE

Please note that the following contains the opinions of the manager as of the date noted and may not have been updated to reflect real time market developments Ail opinions are subject to change without notice.

Past performance is not a guarantee or a reliable indicator of future results.

A word about risk:

The All Asset and All Asset All Authority strategies invest in other PIMCO products, 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 low interest rate environments increase this risk. 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, securities involve 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.

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.

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.

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 appropriate 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 terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.

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