Q: All Asset Fund seeks to achieve CPI + 5% and All Asset All Authority Fund seeks CPI + 6.5%, both over a full business cycle; beginning today, are these return aspirations achievable?
Rob Arnott: While no one can know the future, I believe our prospects for achieving
these long-term real return outcomes are better now than in recent years. These are long-term goals. From the top of a bull market, they’ll be tough to achieve, but from the trough of a bear market, it would be deeply disappointing to merely match these targets! The question is bull or bear market in what? Third Pillar assets!
At the start of 2013, when many Third Pillar assets – those that are designed to diversify away from mainstream stocks and bonds – were fully priced, I acknowledged that CPI+5%/+6.5% targets were stretch goals. Everything – including most Third Pillar assets – was somewhere between fully priced and expensive. That’s no longer true. Even as mainstream markets are now priced to deliver well below these targets, the
Third Pillar has become cheaper. Pairing that fact with our value-oriented, contra-trading approach gives me confidence that these long-term return expectations are once again sensible targets.
Our current outlook is better than ever, especially as many historically diversifying inflation-hedging markets have been in extended bear markets, some of them rather severe, pushing their yields and expected returns even higher. Bear markets feel miserable but they have a wonderful attribute that is easy to overlook: the aftermath is typically attractive pricing and prospective returns – marvelous rebalancing opportunities for the forward-looking and opportunistic investor. For U.S. equities, think back to late
2002 or early 2009. In those moments, we felt terrible. But the long-term future held great promise.
Our approach, in which we deploy assets into out-of-favor markets that we believe offer premium yields, allows us to translate today’s low yields into meaningful long-term real returns, consistent with our stated goals. Here is how we think about this. In light of today’s dismal yields, core bond indexes, such as the Barclays U.S. Aggregate, are priced to offer us roughly 0.5%1 net of inflation, and U.S. stocks are priced to deliver about 1% over inflation. So, a reasonable expectation for a conventional 60/40 balanced portfolio (60% stocks/ 40% bonds) investor may be less than 1% above inflation, give or take, over the coming decade.
Let’s see how this would compare to the Third Pillar based on our forward-looking return expectations. In the tail end of a grinding bear market, emerging market (EM) stocks and bonds – our core multi-year positions – have return expectations between 5%–8%, after inflation, over the next decade. Commodities and developed ex-U.S. equities currently have forward-looking, long-term real returns between 3%–5%. We believe a Third Pillar strategy would have a prospective blended average real return potential that is closer to 4.5%. And that’s for passive indexes, on a buy-and-hold basis!
If we factor in the excess return potential from both actively managing the asset mix and PIMCO’s underlying strategies, as well as our exposure to the structural excess return potential of the Fundamental IndexPLUS strategies, then I believe our strategies’ real return estimates for the long-term investor are comfortably in line with our long-term objectives.
Q: How are you preparing for the potential for rising rates in the U.S.?
Rob Arnott: The overwhelming consensus is that interest rates will rise this year. The median forecast of 74 strategists and economists in a Bloomberg News survey is that the 10-year yield will rise to 3.0% by the end of this year.2 When 90% of Wall Street economists agree, they’re usually wrong. While we have no clairvoyant ability in predicting when rates will rise, our work on demography suggests that real interest rates throughout the developed world are likely to remain very low or negative for years to come. In addition, if the Fed does begin raising rates later this year, we think the magnitude of those moves will be small and the pace will not be rapid. So concerns about large return headwinds to fixed income from rising rates are largely overblown.
To us, this question also presupposes renewed inflation. If bond yields are to rise, either at the Fed-controlled front end or for market-driven longer maturities, rising inflation will be a key reason why. In fact, in their March 18 statement, the Fed stated that their decision on raising rates will be contingent on being “reasonably confident” that inflation is increasing toward their 2% target. To the extent inflation and inflation expectations move higher, we would expect that to benefit our clients given All Asset’s focus on Third Pillar investments, and the inflation hedging characteristics they tend to bring.
Our strategies have always favored assets that provide implicit protection from a rising U.S. Treasury yield curve. With a core exposure to floating rate strategies, local-currency EM debt, EM stocks, real estate, commodities, Treasury Inflation-Protected Securities (TIPS) and high yield bonds, our approach is to choose which ones are sensibly priced and offer respectable yields. A focus on premium yields can act as a cushion to initial shocks in inflation and a corresponding rise in Treasury yields. Our toolkit also includes alternative strategies, which are designed to be return-agnostic to interest rate environments, and have the potential to benefit us in a rising rate environment.
Currently, the total duration in both the All Asset and All Asset All Authority Funds is just over two years, which is below our historical average. Furthermore, the composition of our duration is decidedly
outside of the U.S. As seen in Figure 1, less than half of our total duration comes from allocations within the U.S., and all of such exposure is concentrated in long maturity issuance. In fact, both the All Asset and All Asset All Authority funds are tactically short U.S. duration for shorter maturities (less than 7 years), which is where we would expect the greatest impact to be if the Fed raises rates. As such,
we believe we are well positioned for the potential of rising rates.
Two to four years ago, I was telling our clients that we could expect to see inflation hedges – the Third Pillar – to be available “on the cheap” at some stage in the years ahead. I suggested that this would
happen when investors were unafraid of inflation risk, and perhaps even troubled by perceived risks of deflation. That time is now. In recent months, as people became more worried about deflation than inflation, the markets have handed us an opportunity to build an even more robust and aggressive Third Pillar portfolio – what I would call an inflation hedge on the cheap. As of February 28, our current allocation to these diversifying inflation-hedging assets is 81% in All Asset and 99% in All Asset All Authority, above our historic averages of 76% and 85%, respectively.
Two sources of demonstrated investment expertise
PIMCO All Asset is supported by the global resources of two industry-leading firms that work
together closely to pursue the funds’ objectives.
Research Affiliates’ Tactical Allocation
- Expertise in model-driven, asset allocation investment strategies
- 50 investment professionals (portfolio managers, researchers, support)
- Founded in 2002
Pimco's Active Fund Management
- Leader in active investment management across asset classes
- 400 portfolio managers and analysts
- Founded in 1971
If rising rates result from a rebound in inflation expectations, then such an environment could be favorable. Think back to late 2008 and late 2011, when inflation expectations tumbled and people over-extrapolated disinflationary trends, leading to attractive valuations for our core opportunity set. In the following year, as inflation expectations and Third Pillar assets subsequently rebounded, we benefited, delivering sizeable returns in excess of 15% both in 2009 and in 2012.3 A recovery in inflation expectations could be a wonderful opportunity for us, even if Treasury interest rates move higher as a result.
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 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 call 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.
Q: U.S. stocks have meaningfully outpaced other major asset classes for the past two years, including those in the Third Pillar. How long can these periods of high relative outperformance last, and what can be catalysts for reversals?
Arnott: The catalyst for a market turn is usually a shock, which – by definition – is usually only identifiable after the fact. Rather than forecast market turns or unexpected shocks, we prefer to focus on what we believe to be our comparative advantages: 1) assessing long-term market prospects,s 2) gauging when those prospects are severed from current market perceptions, 3) responding in a
contrarian way and 4) having the patience and discipline to allow momentum to carry markets beyond fair value, one way or the other.
While market turns are always best seen after the fact, widely held consensus-driven beliefs tend to be a breeding ground for catalysts. With advisory sentiment of U.S. stock bullishness reaching one of its most extreme levels on record,4 a commonly held perception is that the U.S. stock rally will persist, even though a wide range of reliable measures suggests valuations are at extreme historical highs. For instance, the Shiller CAPE (cyclically adjusted price-to-earnings ratio), a strong predictor of long-term returns, stood at over 27x as of February 28, ranking in the 96th historical percentile! What would knock current complacent expectations out of kilter? Any event resulting in a shift in risk perceptions, which could occur without any warning.
Like the rampant U.S. stock rally, another broadly held opinion that has come to be almost seen as a universal fact is that the U.S. dollar is headed higher. As I described in the last letter, a soaring dollar increases the risk of adverse earnings shocks in the U.S. and positive earnings shocks in Europe and emerging economies. This divergence in earnings could ripple across the macro-economy, creating surprises that propel stocks to do well in emerging and non-U.S. developed markets and to disappoint in the U.S.
Finally, there is an overwhelming belief that deflation is a far bigger concern today than inflation. Even a very small shift in that view could benefit the Third Pillar handily, while pushing up the yields for mainstream stocks and bonds. With BEI levels indeed very low today, at the 6th historical percentile and way below the Fed’s targets, it wouldn’t require renewed inflation to change inflation expectations; it would only require a small drop in deflation fears. If inflation expectations ratchet higher by just a quarter percentage point, then we could expect a Third Pillar strategy to rally in the coming year. Would stocks and bonds fare as well in that environment? Not likely!
Bull markets feel wonderful, but most investors forget that they can have a dark side: subsequent returns are lousy. Bear markets feel awful, but most investors forget the silver lining: they can set the stage for wonderful future returns. This is why investors almost never trade out of bull market assets into bear market assets. While we believe we are near the tail end of what has been a raging bull market for U.S. stocks and protracted bear markets across some Third Pillar asset classes, we don’t hold a strong opinion about the timeline, though we’re optimistic that the Third Pillar is pretty darned cheap. Whether this turn occurs in months or quarters, I have no idea. But I have conviction that when mean reversion transpires and the pendulum swings in the other direction, we stand poised to benefit handsomely.
1 All of our long-term expected asset class returns, along with the forecasted building blocks driving each return, are available on our
Asset Allocation site: http://www.researchaffiliates.com/assetallocation/Pages/Core-Overview.aspx
3 All Asset class A at NAV was 14.92% in 2012.
4http://www.hussmanfunds.com/wmc/wmc150302.htm, “Advisory bullishness (Investors Intelligence) shot to 59.5%, compared with only 14.1% bears – one of the most lopsided sentiment extremes on record”