Q: At the end of April, you had over 41% exposure to Emerging Market (EM) stocks and bonds, in the All Asset Fund, and 47% in All Asset All Authority. Have you shifted to an Emerging Markets-centric structural focus?
Robert Arnott: Not at all. We have always had a real-return, inflation-protection structural focus. The best way to achieve this goal will change over time.
These funds aim to: 1. diversify your investments in mainstream stocks and bonds; 2. counter the mainstream assets’ vulnerability to any risk of rising inflation expectations (falling inflation expectations have fueled the outstanding returns on these mainstream markets over the past 34 years); and 3. improve long-term real returns by taking advantage of markets that are trading cheap. Our strategies were explicitly built for these purposes, as relevant today as they were since the launch of or strategies nearly 14 years ago. Recently, the most attractively priced markets that serve these needs are in emerging market (EM) stocks and bonds.
Our allocation to EM stocks is the highest since the inception of our strategies. It bears mention that any bargain in investing is, almost always, something that has inflicted pain and losses. Because we’re in one of the few businesses where customers hate a discount, we owe it to ourselves to remember that the beauty of a bear market is that it creates opportunities priced to offer the potential for lofty yields and impressive forward-looking real returns. We’ve had a three-year bear market in “third pillar” diversifying markets, concurrent with a continuing bull market in your allocations to mainstream stocks. This is not without precedent; it’s the nature of diversification. Also, past is not prologue.
Recently, we’ve suggested that EM equities could possibly represent the trade of a decade. High yields, strong productivity growth prospects, and compelling valuations – not to mention favorable long-term trends in demography and credit quality – all serve to make emerging markets even more attractive. Where does this leave us? We’ve said regularly that valuations matter. An attractive yield and strong growth prospect aside, the boost from valuations in emerging equities can be tremendous. Today, EM equities are priced to deliver a nearly 8% real return per annum over the next ten years, the highest across major global asset classes.
As with any bargain, we can find endless reasons (excuses?) to not pull the trigger on a purchase. And of course, we can’t know whether a “third pillar” bull market has already started in January or, perhaps, we may test the January lows. Note that this lofty 8% real return reflects passive cap-weighted investing. The rubber band between value and growth in EM stocks is also stretched remarkably far. If we add in potential sources of alpha from the Fundamental-Index-based RAE and PIMCO’s portable alpha bond collateral, we believe there is a possibility for double-digit real returns from our EM equity investments.
Currently, the valuations of EM equities are attractive, both relative to its individual history and also relative to other opportunities. Four days after the January 21 lows for EM stocks, a famous bond manager said that EM stocks were poised to fall another 40%. As of May 31, 2016, the MSCI EM stock index had rebounded nearly 20% from these lows. Even with this terrific rally, these stocks collectively are priced at a Shiller price-to-earnings valuation multiple of 11.8x, a discount of 56% relative to the Shiller P/E of 27x for the Russell 1000. This falls well into the bottom quintile percentile of relative and absolute valuation over the past quarter century. But, we’re not buying the MSCI EM index. Most of our EM investments are in the now-deep-value RAE strategies. These strategies have rebounded from the lows and are – even now – at a Shiller P/E ratio of 6.1x; the Shiller P/E was well under 6x at the lows. The U.S. stock market was cheaper than this only once in the last 200 years, for a few days in June of 1932.
As for the bond side of the coin, the forward-looking opportunity set is also compelling. EM local bonds are priced to deliver a real per annum return of 4.5% over the next ten years as of April 30, 2016, as compared to a mere 0.5% expected from global core bonds. The ratio of EM real yields to US or global real yields has never been higher than at the January lows. Nor is this merely a consequence of collapsing developed economy yields: the absolute yield spread is wider than at any point since the so-called “Asian Flu” of 1998, with the Russian default and the currency crises rippling from Indonesia to South Korea. Are emerging sovereign bonds that much riskier relative to the wildly over-extended developed economies? We think not.
Our strategies haven’t always had a substantial positioning to EM asset classes. At the end of 2010, at the start of the grinding five-year bear market in EM stocks, we had 11% in EM stocks, bonds and currencies, combined, in both All Asset and All Authority. At that time, our EM allocations – in total – were smaller than our allocations to commodities and REITs, to high-yield bonds, to defensive positions in “alternatives” (typically long-short and absolute return strategies that seek to earn alpha with little or no beta), or to ordinary mainstream domestic bonds. Given the tumult (the US downgrade, Europe crisis) that hit in 2011, this was a fortuitous allocation.
We have always opportunistically focused on whatever is cheapest – offering the best long-term forward-looking return potential – among assets that provide inflation protection and a real-returns bias. Contrary to our reputation, we’re not perma-bears. We’re bullish on whatever is most out of favor and priced to offer the best potential long-term real returns. We are willing to own US stocks, but only when they’re cheap. We own mainstream domestic bonds, but only when they’re cheap, or, as was the case at the end of 2010, we want a defensive reserve that we can eventually redeploy into riskier markets at cheaper prices.
Did we buy emerging market asset classes too soon? Of course. The only way to avoid pain and losses, while buying undervalued markets, is to buy at the exact low. As with most managers, we don’t have the clairvoyance to pick market peaks and lows. So, we buy what’s cheap; we buy more if it gets cheaper; and we buy still more if it gets even cheaper. By systematically rebalancing into the most unloved, attractively priced asset classes, we routinely accept short-term pain on the way down. We look foolish until the turn. But, by averaging in, we assure that we have maximum exposure when an undervalued market finally turns! The trade-off between short-term pain for improved prospective long-term returns is uncomfortable, but it has routinely served us well over a lifetime of contrarian investing. We are grateful for our clients’ patience during what has been a grinding and painful bear market in these diversifying asset classes.
Q: Prices can trend for long periods of time before correcting. How do you include momentum into your model, which is often described as valuation-based?
Mike Aked: We employ a value-oriented, contrarian discipline to ensure that we focus on cheap asset classes, and take additional risk when they are cheapest. The model underlying the All Asset strategies is anchored on our assessment of long-term, forward-looking return prospects across a global opportunity set. To achieve the potential for meaningful long-term real returns, we contra-trade, reducing risk and accepting lower returns when prices are expensive, so as to be in a position to re-risk considerably at far more attractive levels. So, our process is predominately a manifestation of our central investment philosophy: the most persistent active investment opportunity is long-horizon mean reversion.1
While history has reinforced the truism that value matters, we also recognize that momentum – a steady movement of prices higher or lower – can be powerful over the short-term.2 So, how do we remain true to our value-oriented philosophy, while also acknowledging that relative fair can take some time to be realized?
First, we trade patiently and slowly. This is deliberate. By slowing the contra-trading process, we naturally temper our strategies to the “momentum effect.” While early entries or exits can be painful in the short term, our discipline ultimately rewards over a full market cycle.
In addition, instead of blindly chasing price momentum, our model includes a forecasting component founded on fundamental drivers that cause markets to trend in one direction or another for longer periods of time. We believe investors exhibit time-varying risk aversion, and, as such, we refine our assessment of fair value by gauging the macro-economic environment investors are faced with. When the economy is growing faster or slower relative to its historical trend, temporary changes in the fundamental cash flows and riskiness of investments occur, and can persist.
For instance, as the economy grows increasingly stronger, investors experience better company fundamentals and tend to be more willing to pay higher P/E ratios and progressively tighter credit spreads. Conversely, economic slowdown phases support lower average valuations as investors become increasingly more risk-averse in a more distressed corporate environment. Our refinement assesses the justified price impacts of the macro-economic cycles globally, and adjusts our assessment of future return accordingly. This assessment helps reduce the tendency of a contra-trading strategy to immediately trade out of an asset class after its valuation moves higher than its long-term average.
Past price movements can generally be a reasonable source of information for future market fundamentals, which, in turn, can perpetuate further price movement. As reflected in Figure 1, there is a striking similarity between a market price measure (last 12 months real price performance) and the definition of the macro-economic environment we use at Research Affiliates. Our macro-economic environment measure is calculated as the probability of a slowdown constructed from two proprietary indices, one containing key macro-economic indicators and the other containing relevant monetary policy indicators. Unlike many “Recession Prediction Indices” we consciously exclude the equity market as a variable. The purpose of our macro-economic indicator is to calculate what investment markets should be pricing and compare them to what they are factoring in.
However, our findings suggest there are limitations to relying on historical prices alone. This, in turn, leads us to believe an approach that assesses when the economy is growing faster or slower relative to trend is a better predictor of a continuation in current trends.3 Why is it dangerous to solely rely on prices, as a forward-looking indicator? Investors’ assessments of fundamental trends are inherently unstable. The use of market prices to assess the fundamental environment leads directly to bubbles and crashes that have real wealth impact on investors.4 Macro-economic measures, while very similar to the momentum measures used by many, are inherently more stable. In addition, we have no desire to weaken our contra-trading strategy by allowing prices to dictate our assessment of fair value. We strongly believe a fair, independent, assessment of value should be the basis of future prices.
Long-term mean reversion is the most persistent active investment opportunity we face. Temporary deviations from longer-term value can exist and persist due to macro-economic and investor-driven trends. By allowing our contra-trading activity to be conscious of – and take account of – these cycles, we can improve the timing of our entry and exit points. That said, markets often drift from their fundamentally justified levels, even after accounting for the macro-economic environment they face. In these moments of unjustified euphoria and fear, we are willing to accept a bit of discomfort, in exchange for a portfolio positioning that harvests meaningful, longer-term gains.