Q: While most investors understand the long-term value of diversifying assets in a portfolio, can you give them a sense of where we are in the market cycle, and when that diversification is likely to pay off?
Rob Arnott: When will diversification pay off? My usual response is a non-answer. The
quest for a catalyst that can turn markets around is a waste of time: catalysts are, by their very nature, unexpected. They are surprises. This time, however, we may have four catalysts that are self-evident. Before I dive into these, let me first address the root cause of our investors’ (completely natural) impatience with diversification.
Diversification is least wanted when it is most needed: after our core investments have soared, especially if our diversifying investments have faltered. Human nature conditions us to seek comfort, to want to buy whatever has performed well and to shun whatever has performed badly. We too easily forget that whatever has performed well is now priced to give us diminished future returns, and whatever has performed badly is priced to give us the potential for better future returns. For this reason, diversification always tests our patience in the late stages of a bull market.
Over the past 41 years, the Third Pillar delivered a better return than a conventional 60/40 portfolio (60% S&P 500 Index/40% Barclay U.S. Aggregate Index), outperforming in 63% of all calendar years, as seen in Figure 1. When do the greatest shortfalls occur? During huge bull market years: 1975, 1985, 1995, 1997, 1999 and 2013. As we discussed last month, the Third Pillar is highly correlated (0.78 correlation!) with changes in inflation expectations.1
While an extended disinflationary bull market (1975-76, 1984-86, 1995-98, 2013-14) is a trying environment for the Third Pillar, it can set the stage for multiple years of strong subsequent outperformance. Why? Because it leaves 60/40 at lofty valuation levels, with lousy forward-looking yields, while leaving the Third Pillar at bargain-basement prices. When paired with very low inflation expectations, as is the case today, we have the added prospect of a likely rise in inflation expectations to fuel the potential success for Third Pillar investing.
As noted at the outset, I think diversification may pay off sooner rather than later,
for these four reasons.
- Quantitative Easing (QE), which has shown no evidence of stimulating the economy but ample evidence of fueling asset bubbles, especially in stocks, is now in full force in Japan, Europe and China, after ending in the U.S. This suggests upward pressure in emerging and developed stocks outside the U.S.
- Seeking to debase their currencies and reduce the real cost of their national debt burdens, QE in non-U.S. countries has the added impact of pushing up the dollar. A strong dollar weakens the earnings power of our exporters and strengthens the earnings power of their exporters. Look for continued adverse earnings shocks in the U.S. (finally noticed by the pundits in the media in the last 60 days or so), and positive earnings shocks in Europe, Japan and the emerging markets (still unnoticed by the punditry).
- Stocks are cheap in Europe and the emerging markets (EM) (though not in Japan or the U.S.). Bond yields are very good relative to debt service capacity in EM, though not in Europe, Japan or – to a lesser extent – the U.S.
- Finally, the 10-year break-even inflation rate rebounded from 1.7% at the start of the year to 1.9% at the end of April. No wonder April treated our funds kindly! But, a 1.9% expectation for future inflation is still low.
To address your question about the market environment, I offer a few thoughts: QE, which stoked an asset bubble in U.S. stocks since 2013, has led to low rates, which means savers have nothing to spend.
Uncertain future rates and mercurial, adverse changes in the regulatory or tax regime have discouraged businesses from investing in long-horizon risky ventures. As such, it’s no wonder that businesses grab low-hanging fruit with stock buybacks. I see this as a bearish, not a bullish sign, for longer-term macroeconomic growth.
People are too reliant on the “Yellen put,” as a reason to stay committed to U.S. equities. But, the “Yellen put” is now on hold. Meanwhile, in many non-U.S. markets, we have active QE programs, plus the possibility of positive earnings shocks, plus cheap valuation levels. That’s where we’re investing.
EM stocks and bonds have faced some challenges during prior Fed hiking cycles. Can you talk about EM exposures in the portfolio – equity, debt and currency – and how you view those positions in light of the prospect of a hiking Fed in 2015 and beyond?
Arnott: Before discussing our EM exposures, I’d like to draw a
distinction between the expectations versus the reality of a prospective Fed rate hike. As we saw in the “taper tantrum,” the fear of the taper did serious damage to a wide array of markets, not least to the various EM asset classes. The reality of the taper however did essentially no such damage. The same is likely true of a rate hike.
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What’s the big deal about a quarter-percent hike? I’m on record suggesting the first hike should have already happened years ago, and that we ought to be at 2% or 3% by now. So, I’m certainly not afraid of a rate hike. But, the market is. The sooner it becomes a reality, the sooner the market can realize that a quarter-percent hike is no big deal. We’re already seeing EM equity markets recover handily, up 11% in April, as investors begin to get their arms around the inevitability of an eventual rate hike, even as that hike gets pushed further back into the future.
As such, we are comfortable with our portfolios’ exposure to EM asset classes. Today, the All Asset and All Authority strategies have roughly 35% and 40%, respectively, in funds managed to a dedicated EM stock, bond or currency benchmark, somewhat above the historical average since the strategies’ inception. A noteworthy nuance is how we access our EM exposures. Across equities, we use the fundamental index approach, including the Low Volatility strategies (introduced at year-end 2013), which offers the potential for structural excess returns. Across bonds, we are tapping into hard currency bonds, local currency bonds, EM corporates and local currency, all accessed with PIMCO active management.
In the last 20 years, there have been three federal funds rate-hiking schedules: 1994-1995, 1999-2000 and 2004-2006. With the exception of 1994-1995, the rate hikes were accompanied by declines in EM bond spreads and strongly positive performance in EM equities. Rises in Treasury yields tend to precede the Fed’s actual tightening schedule, so we also observe how these asset classes fared during such times. Across all periods when the 10-year U.S. Treasury yield rose by at least 80 bps since 1991, EM currencies, local bonds and external bonds delivered average returns of 5% to 8% while U.S. bonds indexes fell by up to 8%. While past is not prologue, historical periods of rising U.S. interest rates have decidedly not been difficult for emerging market assets. As usual, the pundits have not studied their history.
Can you explain the rationale behind your regional equity positions? It appears you are bearish on U.S. stocks, yet you’re long EM and EAFE (non-U.S. developed) stocks. If you expect U.S. markets to decline, wouldn’t you expect the other markets to go down as well?
Arnott: While we have never been equity-centric by design, EM and EAFE stocks indeed comprise the bulk of our equity positions today. This is intentional. I’ve regularly reminded our clients that we serve as their investment away from mainstream asset classes. Today there are a plethora of tactical asset allocation programs, most of which are anchored on the classic U.S.-centric 60/40 balanced portfolio. While such positioning is well within their clients’ comfort zone, it fails to offer any true diversification: it merely mirrors what the clients already own elsewhere in their portfolios. Our strategy is intended to help preserve investors’ assets, when mainstream assets go awry.
Over the past 12 years since our launch, we have added value over the long-run by assessing return prospects and rotating across positions accordingly. Contrary to our reputation, we’re not permabears: we’re only bears on stocks when and where we feel they appear pricey; and bulls, when and where they are cheap. We do not anchor on mainstream stocks as a permanent core holding, but rather use them tactically, when they appear cheap. While our positioning today is defensive when it comes to the richest asset classes, like U.S. stocks, our overall risk posture is moderate. We are not positioned for a sweeping take-no-prisoners bear market across the whole spectrum of risk assets, as we were in 2008.
When assessing equities by region today, U.S. equities are among the more expensive in the world. As of April 30, 2015, the S&P 500 Index traded at a Shiller P/E ratio – price relative to 10-year earnings – of 27
times. It’s been higher twice in history, during the tech bubble and in 1929. In stark contrast, EAFE stocks are in line with historical norms: its current Shiller P/E ratio of 18 times. EM stocks are also mid-range, at a Shiller P/E ratio of 16 times. But, for EM value stocks, if you use a fundamental Index, they are priced at less than 11 times their 10-year earnings and barely 9 times last year’s earnings. That is cheap.
Why are EM stocks trading at very attractive valuations? Fear. While investment bargains are always frightening and difficult to consider, risk-taking is most rewarding when investors are most fearful and prices have bottomed. I’d much rather put my money there and wait patiently instead of playing the game of guessing how much further this U.S. equity bull market can run.
If U.S. stocks falter, will there be sympathy declines in EAFE and emerging market equities? Very likely yes. But, unlike in past cycles, such as the recent 2008-2009, these markets are not priced at a premium: They are trading at a deep discount. With their cheap valuations appearing to offer a margin of safety on the downside, our emerging and EAFE holdings could fall less than the U.S. in a bear market – during which we would expect to buy more – and could stage an impressive recovery. Conversely, if stocks in the U.S. do not fall for some time, then EAFE and EM have the potential to fare very well from current levels.
1 We measure inflation expectations using the “break-even inflation” rate, which is the difference in yield between 10-year Treasury Bonds and TIPS. It bears mention that the All Asset and All Authority Funds have an even higher correlation with changes in inflation expectations!