Q: The third quarter was challenging across most asset classes. How do you assess the strategies’ performance with respect to your objectives?
Arnott: It was a tough quarter. Stocks and bonds struggled, but inflation expectations cratered; so, the diversifying Third Pillar markets that are our core assets were hit just as hard.
When we see disappointing short-term results, it’s tempting to ask if the model is broken. The returns are definitely disappointing ... the bear market in diversifying assets and in inflation expectations continues. But are they alarming? Not really. From January 2013 to September 2015, 10-year inflation expectations have fallen from 2.5% to 1.7% by June 2015, and to 1.4% during the third quarter, representing a 44% collapse in inflation expectations. Third Pillar assets across the spectrum sold off – particularly commodities, emerging market stocks and bonds – returning double-digit losses.
When inflation expectations are tumbling, the inflation hedges that represent our core holdings get cheaper; they suffer a bear market. Our cautious stance during most of the last 2½ years softened the damage of this bear market for our investors. We err if we abandon diversification, when our diversifying markets have become cheaper or if we mistake a bear market for diminished prospective returns. Because we’re in one of the few businesses where the end customer hates a discount, few are tempted to trade into these markets. While bear markets are painful, we owe it to ourselves to remember that they create bargains – we’ve recently suggested that EM equities now represent the trade of a decade.
Our mission has always been to serve as your real-return-oriented diversifier away from mainstream assets. Our objectives are threefold: 1) to improve long-term returns when mainstream assets offer low yields and low prospective returns; 2) to diversify our investors’ exposure away from equity market risk; and 3) to seek assets positively correlated with inflation. The beauty of a bear market in these diversifying asset classes is that they are priced to offer lofty yields and impressive forward-looking real returns. The process of getting to these lower prices is not pleasant. But, we now earn a handsome yield premium to diversify, and an even more handsome premium in prospective long-term returns. We are getting paid to buy insurance against the risk that is most dangerous to our holdings in mainstream stocks and bonds.
Over the last 12 months, the S&P 500 posted a return of negative 0.6% – far milder than the decline in inflation-hedging Third Pillar assets – but this figure masks the sharp intra-quarter market plunge triggered by concerns of China. Peak to trough, the S&P 500 fell by more than 11% from August 20 to August 25, in a span of just four days. How did the All Asset strategies fare during this sharp equity decline? Both All Asset and All Authority performed far better, posting muted losses of -3.4% and -2.2%, respectively. Unlike the typical GTAA manager who is anchored on 60/40, our strategies have consistently displayed low systematic risk relative to the equity market. Since their respective inception dates, the beta to the S&P 500 is 0.39x for All Asset, and 0.36x for All Authority. These results are wholly consonant with our goal of diversifying our investors’ exposure away from equity market risk.
There have been two other times in the life of the All Asset products when the S&P 500 experienced these “mini-crashes” or a four-day decline of at least 10%. The first occurred in October 2008 during the height of the Global Financial Crisis; the second occurred in August 2011 when the U.S. lost its AAA status.1 Again, how did All Asset fare during those times? In these two previous mini-crashes, on average, the All Asset Fund returned -3.9%, less than one-third of the decline in the S&P 500. All Authority, offering more diversification away from classic 60/40 risk, while serving as a more extreme Third Pillar strategy, fell only 1.8%, representing one-sixth of the downside. The All Asset strategies provide downside protection during times of extreme U.S. market stress. It’s what we do.
Importantly, while past is not prologue, recoveries can happen quickly and vigorously once mean reversion transpires. When the pendulum turns, we are poised to benefit, as we had in 2008. In 2008, we had a peak-to-trough drawdown of 22% in A4 and 28% in AAF. What happened during that drawdown? Much like the third quarter of this year, and the mini-crash of 2011, Third Pillar markets were initially hit even harder than U.S. stocks. But by year-end 2008, the snap-back in Third Pillar markets, notably the ones we favored, brought us back to -7% and -15%. Our two-year returns for 2008–09 were modestly positive, in stark contrast to the experience of most investors.
We take comfort in the long-run efficacy of our valuation-based discipline, which I’ve practiced for 35 years. This is familiar territory. Our process was not as brilliant in 2009–2012 as was commonly perceived: Never mistake a bull market for brilliance. We had a bull market in Third Pillar markets. Nor is our process suddenly failing. Never mistake a bear market for idiocy. This is the same approach that guided us away from the expensive commodities and REITs in 2008, which were savaged during the global financial crisis, and led us to re-risk the portfolio after markets tumbled in 2002, 2009 and the summer of 2011.
Does systematic rebalancing work in all markets, year after year? It simply doesn’t. Living in a 24/7 news cycle, that encourages trading and overreaction, investors are enticed into chasing fads or fleeing unloved assets, driving the markets to extreme. Sadly, it’s human nature to shun pain; but as Rousseau famously said, “Patience is bitter, but its fruit is sweet.” We believe that our current stance will reward our patient clients. Many of these markets are now cheap.
Q: What is your investment outlook for emerging markets and why?
Brightman: EM stocks and bonds have been among the hardest-hit Third Pillar assets, falling by nearly 20% over the last 12 months. A host of stories have contributed to this bloodshed – imminent fed tightening and the prospect of divergence in global monetary policies, slowing Chinese growth, falling commodity prices, and domestic unrest in many developing countries to name just a few. Capital outflows have accompanied declining prices. Investors are alarmed; we fully understand these fears. The risks are real; the fear, palpable.
Are these risks fully reflected in today’s prices? Have markets fairly reacted, underreacted or overreacted? To answer this question, we get beyond today’s headlines to study valuations and put them in context of history.
We believe that the exodus from emerging markets is a historic opportunity for the long-term investor. No one can know whether these markets will be massively profitable in the coming year, or will reach new lows. While one-year returns are very difficult to forecast, ten-year returns are much easier. Our annualized ten-year real (that is, after inflation) return forecast for EM equities is nearly 8%, the highest across all major global asset classes. That’s for passive investing in these markets, not including PIMCO’s skill-based alpha, nor the structural alphas embedded in our Fundamental Index®-based RAE strategies. Including these sources of alpha, a ten-year result of 10%, over and above inflation, would be utterly unsurprising.
Not only is this asset class compelling based on yield and growth potential alone, even if there is no revaluation upward, but the prospective boost from valuation expansion can be very powerful. We are in one of the few industries in which price cuts are greeted with dread, rather than with enthusiasm. In economics, this is known as a Giffen good, something for which demand increases when prices rise. By systematically rebalancing into the unloved, most attractively priced asset classes, we routinely accept short-term pain for the potential of longer-term performance – an uncomfortable trade that we choose consciously and deliberately.
Why are EM equities today trading at such remarkably deep discounts? In a word, fear. Risk-taking is usually most rewarding when investors are most fearful and prices have plunged. Warren Buffett tells us to be “fearful when others are greedy and greedy when others are fearful,” but most of us are fearful when others are fearful. If we can get past our fear, recent short-term price volatility creates opportunity, not risk, for the long-term investor. Fear creates bargains.
Figure 1: U.S. and EM CAPE, 1990–2015
Figure 2: Future 10-Year Returns, U.S. Equities
Figure 3: Future 10-Year Returns, EM Equities
By any valuation metric,3 EM stocks, both on an absolute basis and relative to U.S. stocks, are currently trading at historically attractive levels. As of 30 September 2015, EM equities traded at a CAPE of 11x, roughly matching the March 2009 lows, in the depths of the Global Financial Crisis, as compared with 25x for the S&P 500. U.S. valuations are in the top 10% of the historical record, while EM valuations languish at the bottom 7th percentile of the last 25 years. It bears mention that, when the All Asset strategies buy EM equities, we do not buy the cap-weighted index; we mainly invest in PIMCO’s RAE Fundamental Plus and Low Volatility strategies, which languish at 8.1x and 10.5x, respectively!
Today, U.S. stocks are trading at double that of the EM market, as shown in the shading in Figure 1. Figures 2 and 3 show that valuation and subsequent real returns are joined at the hip. High prices create a risk of performance well below what’s needed to meet long-term investment goals. When was the last time EM valuations were at current levels? 2003 and (briefly) at the market lows in 2009.
When was the last time EM valuations were half of U.S. valuations? In 1998, the dot-com bubble was inflating U.S. equity prices, while the Asian Financial Crisis and the Russian Default pushed EM stocks cheaper and cheaper. What were the subsequent returns of investing in U.S. and EM equities from that prior period? While buying EM when it was trading half off relative to the U.S. did not assure immediate rewards, the patient buyer earned a huge performance gap, averaging 1000 basis points per annum over the subsequent 10 years. This held true, almost regardless of when an investor bought EM, as long as EM was bought while it was still priced at half of the U.S. Shiller PE, or better.4
Relative value can take considerable time – long enough to test our patience – to be recognized. But as history has shown, expensive but seemingly safe assets usually provide lousy long-term returns, while fear-induced bargains mean opportunity.