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