Arnott on All Asset

Arnott on All Asset, August 2016

Rob Arnott, head of Research Affiliates, and Chris Brightman, Research Affiliates’ Chief Investment Officer, share their firm’s market insights and allocation strategies for PIMCO All Asset funds.

Q: What is the likelihood “Third Pillar”1 markets deliver a meaningful positive real return over inflation over the coming cycle?

Arnott: This is a question we get regularly, and have for several years. Our answer three years ago was quite different from today’s answer. While no one can know the future, we believe the simple building blocks of return – yield, growth and the potential for higher or lower valuation levels – for some of the individual Third Pillar markets would point to potential real returns well over 5%, over and above inflation, while a passive investment in a diversified roster of Third Pillar asset classes may be priced to offer roughly 4% real returns. This wasn’t true two to three years ago. In 2013, we said there were no bargains, that everything was fully priced, and that we were watching and waiting for some of the Third Pillar markets to be priced at bargain levels. We speculated that these bargains would emerge when inflation expectations were at a low ebb, and when fears of deflation were common. Back then, despite our concerns, money was pouring into these asset classes.

It’s the nature of the markets, and often the nature of what we like to call “bargains” or value securities (securities that our analysis suggests are priced to offer the potential for positive future returns) – that they may underperform, as they did until recently, even when they are priced below their intrinsic value. From market peaks, prospective returns are uninspired; from troughs, they can be excellent. While mainstream stocks and bonds are clearly at historical highs (and near historically low yields), we’ve seen a three-year bear market in most of the Third Pillar markets. We think the silver lining in a bear market is that assets tend to be priced to offer better future returns, after they have become cheaper.

Inflation fears have recently evaporated, creating a protracted bear market in inflation-sensitive Third Pillar markets, pushing some of them well into what we believe is bargain territory. It is sadly predictable that, when these markets are cheaper, we’ve seen redemptions. Most of these redemptions are moving out of bargains and back to mainstream markets that we think offer nosebleed valuations and near-record-low yields. Our stance is thatsuccessful asset allocation involves diversification across time, rather than across markets; this naturally challenges investor patience.

Let’s delve into why we view a meaningful positive real return over inflation to once again be reasonable for Third Pillar market indices. Figure 1 shows our forecasts for ten-year real returns for many asset classes. First Pillar (mainstream stocks) are in orange; Second Pillar (mainstream bonds) are in blue; Third Pillar diversifiers are in green.

A casual glance at Figure 1 suggests that according to our forecasts, the conventional 60/40 stocks/bonds approach in mainstream asset classes3 is currently priced to give investors just over 1% above inflation over the coming decade. Ouch! The typical U.S. pension plan (see endnotes for details) has an asset allocation approach yielding a blended average return forecast of 2.8% – only slightly better. The long-term real return estimate for an equally weighted blend of Third Pillar market indices4 is more favorable: Currently that blend is priced to offer a prospective real return that’s about 1.5x higher – at 4.1% – for passive investments in these asset classes versus the typical pension plan allocation.

This is a reasonable starting point for setting our market expectations, one that’s based on passive indices, invested on a buy-and-hold basis, and held for the coming decade.

Q: You often say the All Asset strategies are managed to offer Third Pillar real return solutions for investors. How might these strategies add value in the coming years?

Arnott: Back in early 2013, we acknowledged that All Asset’s secondary benchmark of U.S. CPI + 5% (6.5% for All Authority) was – from those valuation levels – a “stretch goal,” possible but not probable. From market peaks, these real return targets are difficult; from troughs, they can more readily be exceeded. In 2013–2014, we had a “risk-off” stance, seeking to mitigate our downside risk, then ramping up our risk appetite from early 2015 to date. Since the lows of January and February this year, after a three-year bear market in many Third Pillar markets – some of them quite severe – we think it is reasonably likely that we can exceed these objectives.

Our All Asset strategies invest in PIMCO funds, which come with the alpha potential of a deep specialized bench of investment talent. This, coupled with structural alphas from our exposure to the Fundamental Index methodology in the PIMCO RAE funds, and adding a bit more from tactically managing the asset mix to a shifting opportunity set and deploying assets in markets that offer premium yields and high return potential, gives us confidence that we can seek returns above passive Third Pillar markets with estimated volatility only slightly higher than a 60/40 benchmark (60% S&P 500, 40% Barclays U.S. Aggregate).

If each of these three additional sources of potential gain (PIMCO alpha, structural smart beta alpha and contrarian asset allocation choices) adds just 50 to 75 basis points above estimated Third Pillar market returns of about 4%, net of fees, trading costs and inflation, we would achieve All Asset’s secondary benchmark objective. All Asset All Authority adds in leverage, with the intent to lightly short the U.S. stocks we believe to be expensive, in an effort to bring down both the portfolio risk and the correlation to our clients’ existing equity market exposure. That leverage, if successful, should help us to achieve or exceed the more aggressive secondary benchmark objective for All Asset All Authority of 6.5% real.

Of course, anything can happen; what’s cheap can become cheaper (as it most assuredly did in 2015!). No one knows when the turn will happen, though we think it may already be behind us. Perhaps we will see another test of the January lows. It’s also entirely possible we may already be five months into the next Third Pillar bull market. Since the 21 January lows through 30 June, All Asset returned 15.83% and All Authority returned 16.45% (Institutional class shares, net of fees), outpacing the U.S. 60/40 by 567 and 629 basis points, respectively (see Figure 2). Even after this substantial rebound, we think Third Pillar markets today are still trading at attractive valuation levels relative to their own historical norms. Boasting compelling multi-year return prospects, these markets remain bargains, especially relative to mainstream asset classes. We are excited about what the next few years will bring!

Q: Markets plunged in the immediate aftermath of the Brexit vote in June. Do you anticipate long-term implications for your strategies of the UK leaving the EU?

Brightman: Brexit, the British vote to leave the European Union (EU), caught pundits and markets by surprise. Its immediate aftermath caused a spike in volatility, hammered the British pound, jolted European stock market valuations and pushed the yield on developed market government bonds to record lows.

Brexit is just one manifestation of a populist backlash against an arrogant and out-of-touch political leadership across the developed world. Asking whether immigration is economically beneficial or not misses the point. Brexit reminds us that, for good or ill, most people are naturally tribal. Perhaps British voters rejected the imposition of rights, along with corresponding obligations, to those they feel are outside of their own tribe.

Despite assertions of catastrophic long-term consequences by experts who share the policy preferences of the EU elite, the long-term economic impact of Brexit is unknowable. As of this writing, it’s not entirely certain that Brexit will actually happen. More obvious is that the economic problems confronted by many of the countries on the Continent are more severe than the problems in Britain, as indicated by unemployment rates, fiscal positions and the health of banking systems. Recognizing this, markets punished Continental stocks more harshly than British stocks.

Brexit may surprise the punditry by proving to be beneficial over the long term by prompting economic reform – not just in Britain, but across Europe. A win-win outcome would leave the UK with negligible incremental trade barriers, allow the British to chart their own course on immigration and regulations and prompt reform of the EU and its monetary union.

While we have no way to reliably predict shocks of this sort, our beliefs – about the interactions of politics, economics, and capital markets – guide the design of our quantitative models. Economic variables, including GDP and productivity growth rates, as well as related policy indicators of free and competitive markets, as published by the Organisation for Economic Co-operation and Development (OECD) and the Heritage Foundation, are inputs to our return forecasting models. These variables influence our forecasts of real interest rates, foreign exchange rates and inflation, and help us to benefit from market shocks, like the post-Brexit shock.

While we can’t predict the long-term impact of Brexit on these inputs, and by extension our capital markets forecasts, we are watching with great interest. In the interim, we respond to Brexit as we do with any exogenous shock: We seek to take advantage of new bargains. On the second trading day after the Brexit vote, as world stocks hit their post-Brexit lows, we were already boosting our allocations to newly cheaper stocks in emerging markets and non-U.S. developed markets.

1 Third Pillar asset classes are represented by a sampling of traditional and stealth inflation-fighting asset classes. These include real estate investment trusts (REITs), high yield, emerging market (EM) non-local debt, EM currency, bank loans, commodities, U.S. Treasury Inflation-Protected Securities (TIPS), EM equities and EM local bonds.

2 The orange dots represent major First Pillar asset classes: U.S. large equities (represented by S&P 500 Index), U.S. small equities (Russell 2000 Index) and EAFE (Europe, Asia, Far East) equities (MSCI EAFE Index). The blue dots represent major Second Pillar asset classes: short-term U.S. Treasuries (Barclays US Treasury 1-3 Year Index), long-term U.S. Treasuries (Barclays US Treasury Long Index), U.S. core bonds (Barclays US Aggregate Index) and global bonds (Barclays Global Aggregate Index). The green dots represent Third Pillar asset classes: real estate investment trusts (REITs) (FTSE NAREIT All REIT Index), high yield (Barclays US High Yield Index), EM non-local debt (J.P. Morgan EMBI+ Index), EM currency (J.P. Morgan ELMI+ Index), bank loans (J.P. Morgan Leveraged Loan Index), commodities (Bloomberg Commodity Index), U.S. TIPS (Barclays US TIPS Index), EM equities (MSCI Emerging Markets Index) and EM local bonds (J.P. Morgan GBI-EM Index).

The triangles represent portfolios. The U.S. 60/40 portfolio comprises 60% U.S large stocks and 40% U.S. core bonds. The General Investor Allocation portfolio is derived using the average allocation of 75 U.S. public retirement plans as of 31 December 2015 based on data from an RVK survey. The Equal-weighted Third Pillar strategy is based on an equally weighted mix of the following Third Pillar asset classes: commodities, high yield, REITs, emerging market equities, emerging market currencies and bank loans as of 31 May 2016.

3 Our capital market return estimates and methodology are available on Research Affiliates’ Asset Allocation website. As a refresher, we use an intuitive framework to measure asset classes’ prospective returns based on the “building blocks” of long-term return: the current yield, an assumed long-term growth rate of an income stream and a presumption that valuation multiples, yields and spreads “mean-revert” to historical norms eventually. All three have shown to be highly correlated with future long-term returns.

4 Third Pillar asset classes are represented by a sampling of traditional and stealth inflation-fighting asset classes. We include commodities, high yield, REITs, emerging market equities, emerging market currencies and bank loans. Across all Third Pillar markets, the All Asset strategies currently have the largest exposure to these asset classes.
The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Christopher Brightman

Chief Investment Officer, Research Affiliates

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Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The index focuses on the Large-Cap segment of the U.S. equities market. Barclays U.S. TIPS: 1-10 Year is an unmanaged index market comprising U.S. Treasury Inflation-Protected Securities having a maturity of at least 1 year and less than 10 years. The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index. The MSCI EAFE Index (Europe, Australasia, Far East) is a free-float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. The MSCI EAFE Index consists of the following 22 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland and the United Kingdom. The Barclays US Treasury 1-3 Year Index consists of U.S. Treasury issues with maturities between 1 and 3 years. The Barclays Long-Term Treasury Index consists of U.S. Treasury issues with maturities of 10 or more years. The Barclays Global Aggregate Index provides a broad-based measure of the global investment grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. The FTSE NAREIT All Equity REITs Index covers US REITs and publicly-traded real estate companies. The FTSE NAREIT All Equity REITs index contains all tax-qualified REITs with more than 50%of total assets in qualifying real estate assets other than mortgages secured by real property that also meet minimum size and liquidity criteria. The Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate 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. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. The J.P. Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for traded external debt instruments (external meaning foreign currency denominated fixed income) in the emerging markets. EMBI+ covers US dollar-denominated Brady bonds, loans and Eurobonds. The J.P. Morgan Emerging Local Markets Index Plus (ELMI+) tracks total returns for local-currency-denominated money market instruments in 22 emerging markets countries with at least US$10 billion of external trade. The J.P. Morgan Leveraged Loan Index tracks the performance of U.S. dollar denominated senior floating rate bank loans. The Bloomberg Commodity Index is made up of 22 exchange-traded futures on physical commodities. The index currently represents 20 commodities, which are weighted to account for economic significance and market liquidity. The 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 $250 million par amount outstanding. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The J.P. Morgan Government Bond Index-Emerging Markets Index is a comprehensive global local emerging markets index, and consists of regularly traded, liquid, fixed-rate, domestic currency government bonds to which international investors can gain exposure. It is not possible to invest directly in an unmanaged index.

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