Q: In the second half of 2014, we saw a collapse in oil prices and a significant decline in inflation expectations across developed markets (as represented by market implied U.S. and European break-even inflation rates). With inflation risks seemingly contained, do inflation-oriented tactical asset allocation strategies like the All Asset strategies make sense for investors today?
Rob Arnott: Let’s save oil for the moment and focus on inflation expectations. Isn’t it
interesting that with inflation moderating, there’s such an overwhelming consensus that the world faces a long-term threat of deflation. Over the last six months ended January 31, the 10-year break-even inflation dropped from 2.3% to 1.6%, a decline of nearly 30%, one of the sharpest declines ever!
No wonder inflation-sensitive Third Pillar assets have struggled. Long (Treasury Inflation- Protected Securities) TIPS’ 16% shortfall against long Treasuries, in the past 12 months, is the second worst since 1998 (the Global Financial Crisis was, of course, the worst).1 Commodities and emerging market (EM) bonds are now 20 months into a bear market. And commodity-sensitive EM stocks wallow in the fifth year of a grinding bear market.
With the inevitable “nowcasting” centered on deflation, I’d like to make a distinction between disinflation and inflation expectations.2 Disinflation – a drop in the pace of inflation – is already baked into the cake for the short term; it will continue to drop for the next couple of months. A 50% drop in oil prices will naturally lead to a decline in headline inflation, as automotive fuel accounts for 4.5% of the Consumer Product Index (CPI).
Inflation expectations, driven by sentiment, are focused on the longer term; they’re already settled in to a lower level, reflecting the drop in oil prices. And yet, even with a global meltdown in the price of oil, arguably the key commodity for global prices, inflation remains low but positive in most of the developed world!
Note that inflation expectations stand well below the levels that the Federal Reserve has set as its target. If they are determined to deliver on that target rate of inflation, then inflation expectations will rise. If this happens, the All Asset strategies have the potential to deliver strong returns even if inflation itself remains low in the near term.
The current environment has a number of similarities to the latter half of 2011, both in terms of inflationary expectations and our portfolio positioning. Amid fears of slowing global growth, eurozone’s slump and debt downgrades, a Greek debt crisis, and a moribund job market, 10-year inflation expectations plummeted by 27% from April to September 2011, comparable to today’s plunge in expectations. Also similar to recent experience, Third Pillar assets across the spectrum sold off, especially commodities and EM equities, with double-digit losses over that period – massively trailing the 60/40 portfolio (60% U.S. stocks/40% U.S. bonds), which was down 6.1%.
So we bought more of these Third Pillar assets, a little bit at a time. By early 2012, inflationary expectations began to revert, increasing by 20% through the year. But the
change in official inflation levels, as measured by the unadjusted Headline CPI index (CPI-U), was far more subdued at 1.7% year-overyear in 2012. Even as inflation moderated and remained low for the remainder of the year, Third Pillar assets rebounded with the recovery in inflation expectations. All Asset returned 15.4% and All Asset All Authority returned 17.7% in 2012, outpacing the conventional 60/40 balanced portfolio and S&P 500 Index, respectively.
Low absolute inflation levels, already assured for early 2015, don’t automatically imply tough sledding for our strategies. Especially with the lofty yields of our favored assets, an inflationary environment is not a prerequisite for outperformance. Even a modest uptick in inflation expectations from current lows, can add to those high yields, delivering impressive results, while dealing a blow to mainstream stocks and bonds.
Bull markets feel wonderful, but they do terrible things to our forward-looking long-term returns. Bear markets feel horrible, but they do wonderful things to our forward-looking long-term returns. Diversification is typically most needed when it is least wanted. For those who have only a modest allocation to Third Pillar assets, with their high yields and low correlations, now is a time to consider ramping up, not down.
If this material is used after 31 March 2015, it must be accompanied by the most recent Performance Supplement. Performance quoted represents past performance. Past performance is not a guarantee or a reliable indicator of future results. Investment return and the principal value of an investment will fluctuate. Shares may be worth more or less than original cost when redeemed. Current performance may be lower or higher than performance shown. The All Asset/All Authority Funds maximum offering prices (MOP) returns take into account the 3.75%/5.50%, respectively, maximum initial sales charge. The All Asset/All Asset All Authority class A gross/net expense ratios are 1.495%/1.365% – 2.40%/1.68%, respectively. The All Asset/All Asset All Authority Institutional gross/net expense ratios are 0.995%/0.865% – 1.95%/1.23%, respectively. For performance current to the most recent month-end, visit PIMCO.com/investments or by calling 888.87.PIMCO. The net expense ratio reflects a contractual expense reduction agreement through 31 July 2015 and the accounting treatment of certain investments (e.g., reverse repurchase agreements) but do not reflect actual expenses paid to PIMCO. The minimum initial investment for Institutional class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors.
Returning to oil, not only did oil sell off significantly, but several other commodities followed suit. Is now the time for investors to consider adding to commodity exposures in their portfolios and what role are allocations to commodities likely to play in the All Asset funds?
Arnott: When commodities cratered late in 2014, continuing the severe bear market that began in 2013, we averaged into a larger allocation at lower prices. Our exposure to commodity funds in All Asset Fund rose from 2.4% at the start of 2013 to 4.1% at the start of 2014 to nearly 7% at the end of January 2015, about in line with our average historical allocation. We are always watching for inflation hedges on the cheap. Commodities are interesting, but not necessarily the best bargain in inflation-land.
Today, commodity prices across the board are indeed depressed. From energy to metals to agriculture, many commodities now trade near or below their long-term cost of production. Except for a handful of commodities (such as coffee, live cattle, hogs, and soybeans, to name a few) the majority exhibit a current real price, relative to the 10-year average real price, that falls well within its historical bottom quintile. From this standpoint, commodities look very appealing.
But valuation change is only one of the components we use to estimate commodities’ forward-looking long-term return potential.3 Another important element is the “roll yield,” the return from rolling a futures contract from one month to the next. Many commodities face sizeable headwinds from “contango,” which means that forward commodity prices are at successively higher prices. This means that inflation expectations are baked into the pricing of commodities. While this is far less of a problem than it was a few years ago, today’s negative roll yields are a drag on performance, which partially offsets the favorable impact from valuation changes.
Momentum also plays a role; with commodities, it’s dangerous to buy just because prices are low. In short, while commodities’ overall prospective risk-adjusted real return has improved sharply with the crash in prices, it remains lower than those of other asset classes in our opportunity set, such as EM bonds and equities. Our current allocation reflects a cautiously bullish posture, not outright optimism. If prices fall further, we would presumably average into a larger allocation, unless other markets offered still richer bargains.
In a recent issue, you spoke to the appreciating dollar, recognizing the short-term headwinds if momentum continues. Where do you think the dollar is headed and how should investors be worried about potential headwinds in relation to the funds’ non-U.S. denominated exposure?
Arnott: The overwhelming consensus is that the U.S. dollar is headed higher. When a consensus is so broadly and deeply held, it is often wrong. Nowcasting is easy: “the dollar will strengthen
because of a flight to safety, with the U.S. economy and markets the strongest and safest in the world, etc., etc.” That’s predicting what already happened. Nowcasting is also safe: by predicting what’s already happened, the nowcaster sounds intelligent, and is unlikely to be remembered if the nowcast is wrong.
I prefer to ask what could go wrong with that narrative. A huge rally in the dollar implies that our competitiveness in international trade is weakened, which means earnings for exporters could falter, diminishing capital expenditures already savaged by tumbling oil prices. Earnings shocks could ripple across the economy, with widespread implications, as more than two-fifths4 of revenues of S&P 500 companies come from overseas.
Reciprocally, the plunge in the yen, euro and in EM currencies improve their comparative advantage in international trade, which may deliver startling boosts in earnings across these markets. With the eurozone and EM already cheap, these markets could surprise us on the upside, even as the U.S. disappoints. Japan, which may enjoy similar earnings surprises, may be an exception, due to its alreadylofty equity valuations.
Will the dollar rally continue in the short term? Quite possibly. As long as we remain the world’s reserve currency and the dollar retains its “safe haven” status, inflows can continue to sustain the dollar. But I am a long-term dollar bear, not so much relative to the euro or yen, as relative to purchasing power, hence inflation. As I’ve said before, inflation may not be a short-term risk, but, as long as central bankers are determined to create inflation, it is a permanent threat that will never preannounce its arrival.
If there is some near-term continued U.S. dollar strength, I am not overly worried. Third Pillar assets, the bulk of All Asset’s exposure, historically decline only when U.S. dollar appreciation is particularly sharp, in excess of 2.5% quarter-over-quarter.5 Since 1997, this has occurred less than one-fifth of the time. For the remaining 80% of observations, Third Pillar assets on average have generated positive absolute and relative returns (as shown in Figure 1).
A trade-off exists between short-term currency moves, which may well favor the dollar if momentum prevails, and the significant long-term carry advantage favoring EM currencies. Our exposure to EM-denominated currencies is roughly 30% as of January 31. With a high yield and the potential for exchange rate appreciation, an investment in emerging market currencies is an attractive source of potential return. I’m willing to accept some short-term pain for the potential of longer-term performance. When market consensus derails and the pendulum swings, our strategies may be better positioned to benefit. This tradeoff is an opportunity that I welcome.
Data based on calendar quarter returns from March 31, 1997 – December 31, 2014. Third Pillar assets, including EM Equities, EM Debt, High Yield, REITs, Commodities, and TIPS act as core diversifiers away from mainstream equity allocations and offer the potential to deliver real returns, particularly in inflationary regimes. The Third Pillar is defined here as EM equities, represented by MSCI Emerging Markets Index; EM debt (local currency), represented by JPMorgan Government Bond Index-Emerging Markets Global Diversified Index; High yield, represented by BofA Merrill Lynch U.S. High Yield BB-B Rated Constrained Index; REITs, represented by Dow Jones U.S. Select REIT Index Total Return; Commodities, represented by Dow Jones-UBS Commodity Index Total Return and Long TIPS, represented by Barclays U.S. Treasury Inflatin Notes 10+ Year Index. To calculate Third Pillar returns, we equal weight the returns of the indexes above on a monthly basis.
1 The 16% underperformance is as of the last 12 months ended January 31, 2015.
2 “Nowcasting” is forecasting what has already happened, based on a rationale that has driven what already happened. Watch for it on your favorite cable channel, where 95% of the forecasts you see are nowcasts. It’s a game to listen to a pundit, then ask, “Was that a forecast or a nowcast?” If the latter, it probably sounded pretty smart, because everything was demonstrably already true, but it was useless, with at best 50/50 odds of being correct in the future.
3 Our long-term collateralized commodity futures and commodity index return expectations along with the forecasted building blocks driving the return can be found in our interactive asset allocation microsite https://www.researchaffiliates.com/AssetAllocation/ Pages/Commodities.aspx.
5 The change in the U.S. dollar is represented by the FRED Trade Weighted Dollar Index-Broad, which consists of 26 currencies that are annually re-weighted based on their bilateral share of U.S. imports and exports.