Arnott on All Asset

Arnott on All Asset, October 2016

Rob Arnott, head of Research Affiliates, and Mike Aked, Research Affiliates’ head of asset allocation, share their firm’s market insights for the PIMCO All Asset funds.

Q: You mention that one of the goals of the All Asset suite is to hedge against inflation, yet your allocation to core inflation-fighting asset classes such as commodities, U.S. Treasury Inflation-Protected Securities (TIPS) and real estate investment trusts (REITs) totals just 9% in All Asset and 11% in All Asset All Authority as of 31 August 2016. Can these funds maintain their inflation-hedging characteristics with these low levels of exposure to traditional inflation-linked asset classes?

Aked: The All Asset funds have far more ways to fight inflation than just the obvious inflation hedges. There are a host of “stealth inflation fighters” in our toolkit. Importantly, the funds are managed with the aim of hedging against positive inflation surprises, rather than merely expected inflation. After all, no one wants to pay for the status quo! One of the best ways to judge the effectiveness of a fund’s inflation-hedging capabilities is through its reaction to changes in inflation expectations. Figure 1 displays the correlation of the All Asset and All Asset All Authority funds’ returns to changes in 10-year breakeven inflation (BEI) (i.e., the difference between 10-year U.S. Treasury bond yields and 10-year TIPS yields, a convenient and objective market measure for inflation expectations). The figure plots the rolling one-year net-of-fee excess returns of the two funds versus concurrent rolling one-year changes in BEI.

Some observations from Figure 1: Both funds have high correlations of around 0.8 with changes in 10-year BEI, and thus tend to exhibit an elevated return profile when inflation hedging is most needed. Also, when year-over-year inflation expectations do not change, the line-of-best-fit excess returns (above Libor) for both funds generally hover around 5% historically, indicating return targets were also achieved within a static or subdued inflationary environment. Finally, line-of-best-fit excess returns of the All Asset funds have historically gone negative only when inflation expectations are falling dramatically.

Historically, the All Asset funds have delivered these inflation-hedging characteristics through meaningful allocations to traditional inflation-fighting asset classes. Assets such as TIPS, commodities and REITs generally can hedge the owner against changes in prices. With TIPS, the hedge is directly through either coupon or principal. Commodities and REITs, on the other hand, form factors of production and become part of the inflation price series either directly or indirectly through rents.

While these direct and indirect price relationships enable these traditional inflation-fighting assets to continue providing the potential benefit of inflation protection, their forward-looking real return potential (i.e., returns above inflation) may be limited given today’s initial conditions. For example, while TIPS may remain attractive relative to Treasuries, their absolute real return potential is limited given 10-year real yields of just 11 basis points as of the end of August. Essentially, a buy-and-hold investment in TIPS today would do little more than maintain real purchasing power – simply keeping pace with inflation as they’re designed to do, but not providing meaningful incremental real returns. Regarding commodities, while their spot prices are attractively priced today versus their 10-year real averages, the process of rolling forward the futures contracts nullifies most, if not all, of the benefit given contango in most commodity term structures. Lastly, REITs have rallied by more than 400% from March 2009 through August 2016 (source: Dow Jones U.S. Select REIT Index and FactSet), a tremendous performance record among global asset classes as these levered property investments shook off the specter of being the epicenter of the 2008 collapse. However, our work at Research Affiliates suggests that returns to this sector over the next decade will be much lower, since prices in the underlying properties now appear elevated, which has lowered their associated cash flow yields (as outlined in our recent article, “ Next Season’s Meager Harvest in Commercial Real Estate”).

Recall that in the context of the All Asset and All Asset All Authority funds, we are seeking to achieve long-term real returns of CPI+5% and CPI+6.5%, respectively, while also maintaining strong inflation-hedging characteristics. So in addition to Research Affiliates’ view that traditional inflation-fighting assets are fully valued and therefore offering lower real return potential than in prior years, we also believe that considering a broader range of inflation-hedging options provides the potential for us to still achieve our real return and inflation-hedging goals.

Any asset that increases in price when expected inflation rises can be used to gain better real price performance. Interestingly, many Third Pillar assets provide a more positive relationship to changing inflation expectations than do traditional inflation hedges, as Figure 2 shows.

These stealth inflation-fighting asset classes in the Third Pillar all tend to possess the characteristic of improving debt-service capability when inflation depreciates purchasing power. The performance of lower-quality debt, such as bank loans and high yield bonds, is based on timely payment of debt service. Because coupons and principal are denominated in nominal, rather than real, dollars, higher-than-expected inflation makes the payments easier for the debt servicer. Nothing improves the prospects of lower-quality debt better than rising inflation.

Likewise, emerging markets stocks, bonds and currencies historically have provided surprisingly powerful inflation hedging. For many reasons, emerging economies’ trade, debt and equity assets are generally linked to hard rather than soft collateral (e.g., commodities versus goodwill). The larger than normal direct-inflation-linked asset base of emerging market economies affords investments in this arena potentially strong inflation hedging; this is supported by historical data. High commodity exposure, lower-quality debt and currency exposure outside the developed markets may provide great, and cheap, hedges against developed world governments’ or central banks’ choices.

A few times in the past, the lion’s share of the All Asset funds’ inflation-hedging exposure has been allocated to traditional inflation-linked sources, but typically both funds have averaged between 30% and 40% invested in a broad group of stealth inflation fighters. In order to maintain the historical inflation-hedging characteristics of the All Asset funds despite low allocations to traditional inflation-fighting asset classes of 9% in All Asset and 11% in All Authority, we’ve increased exposure to these stealth inflation fighters, which make up 50% of the All Asset Fund and 59% of the All Asset All Authority Fund as of the end of August. Our confidence in delivering both high real return potential and inflation hedging, particularly versus traditional pro-deflationary assets, remains intact.

Q: You mention above that emerging market assets – currencies, bonds and equities – offer similar inflation-hedging characteristics and real return potential that outpaces core inflation-fighting assets, but is now the time to own such exposure given uncertainty in the political and economic landscape of many emerging market countries?

Arnott: It feels somewhat disingenuous to say “now is the time” to own emerging market assets. It’s impossible to know when markets – or inflation – will turn, or to know what catalysts will trigger the turn. It’s more accurate to say these markets are currently priced to offer impressive long-term real return potential for the patient, long-term investor. We try to focus on our competitive advantage – gauging which markets are attractively valued, while being mindful of shorter-term momentum.

As contrarians we buy more as our preferred markets get cheaper, gradually averaging into our positions. Then when the market does turn, we should be positioned to earn back the shortfall with room to spare as momentum works in our favor. That’s what’s happening now. EM assets have rebounded powerfully since January. It’s possible we’ll test the January lows, but we may not see those bargains again. Few bull markets die after just six months, so we’re pretty optimistic.

Let’s dig deeper into the attractive valuations in EM stocks. U.S. stocks are currently priced at a Shiller price-to-earnings or P/E ratio (i.e., price relative to 10-year earnings) of 27x, matching the peak levels before the global financial crisis. True, the U.S. is the healthiest economy in the developed world. But it’s hard to make a case that economic growth is about to surge or that earnings should soar from current peak levels as a share of GDP, or any other measure. EM stocks are trading at a P/E of 14x – half off, relative to the U.S. – even after a 30% rebound since January (all P/E data according to FactSet).

It gets better. We buy EM strategies tied to our Fundamental Index™. It’s well-known RAFI™ has a value tilt, but it’s less well-known that the tilt is dynamic. When value is not so cheap, the tilt is mild, but when value is strongly out of favor, the tilt is very deep. Value stocks – dominated by financials and energy – are now very much out of favor in emerging markets. We’re paying 7.4x and earning a dividend yield over 70% higher than that of the S&P 500 (according to FactSet). And that’s after a 40% rebound since January! You can do the math: At the January lows, investors theoretically could buy half the world’s GDP, fundamentally weighted, for less than 6x the long-term sustained earnings.

EM local debt (as represented by the J.P. Morgan GBI-EM-GD Index) is also very attractively priced, trading at yields of 6.3%, compared to developed economy debt (Barclays Capital Global Aggregate Bond Index), which offers a scant 1.1% as of the end of August. This 5.2% spread is in the top decile of the historical range, well over the historical average of 3.9%. If the expected mean reversion toward developed market yields occurs, we’re looking at large capital gains on top of a rich starting yield.

Finally, based on our relative purchasing power parity (PPP) model, EM currencies tumbled from 25% above fair value in 2011 to a January 2016 low of 30% below fair value. Today they trade at about a 20% discount to the U.S. dollar compared with historical norms. Just going halfway back to historical PPP norms would give us an additional 1% a year – for a decade – on top of the impressive short-term yield spread. That recovery could come from mean reversion toward historical norms, a fast-growing working-age population, and continued productivity growth as EM economies borrow technological advances from developed economies.

I mentioned momentum earlier. I’m not a big fan of trading on momentum because trading costs can devour the entire momentum-based alpha, but I am a big fan of riding momentum. This year, emerging economies have seen a broad-based rebound in economic expectations and in their markets. From the January 21 low through the end of August, EM currencies (measured by the J.P. Morgan ELMI+ Index) are up nearly 10%, EM local bonds (J.P. Morgan GBI-EM-GD Index) are up nearly 19%, EM equities (MSCI EM Index) are up over 27% and the PIMCO RAE Fundamental PLUS EMG Fund, PIMCO’s active emerging markets equity strategy using the fundamental index as its base chassis, is up over 43% (institutional shares, after fees). This powerful price rebound suggests fundamentals are improving and that the EM bear market is probably over.

Some investors will use these recent price returns as their only source of information about improving fundamentals, but they run the risk of allowing random price fluctuations to drive perceptions. To avoid this pitfall, we consider a proprietary business cycle model based on select macroeconomic and monetary policy indicators. The model gauges the likelihood of an economic slowdown, and when business cycle slowdown probabilities and recent price momentum are in harmony with each other, it signals that current price trends are supportable. The recent article “ When a Storm Is in the Offing: Fundamental Growth in the US Equity Market ” discusses our approach in more detail.

Today, our business cycle model is in harmony with recent price trends. The probability of economic slowdown in emerging markets has fallen from 65% a year ago to 58% through August. This is not to say that emerging markets now possess low economic risk or that they are immune to future shocks. In fact, probabilities of economic slowdown are still well above their 45% neutral level. But we believe attractive valuations coupled with both improving economic fundamentals and strong price momentum is a best-case scenario for the long-term investor.

By the way, we’re not alone in being constructive on EM assets. In his August article, “A Constructive Case for Emerging Markets ,” PIMCO’s Michael Gomez (head of EM portfolio management) and his team express similar views:

“Growth is accelerating with high frequency variables pointing to stabilization and forward-looking indicators signaling a soft rebound in activity. On the inflation front, price pressures are muted with headline CPI prints generally contained, or starting to decline from a high base. Most importantly, there has been a significant adjustment in EM external balances aided first by currency depreciation and import contraction, and more recently by improved competitiveness and higher export volumes.”

Based on both attractive valuations and improved economic and market-based momentum, we’ve positioned the All Asset funds for peak exposure to EM assets this year. Only three years ago, all-in allocations to EM stock, bond and currency funds stood at 28% in the All Asset and 29% in the All Asset All Authority funds. By March 2016, the funds reached all-time peak exposures to these categories of 43% and 47%, respectively. EM exposure is still close to all-time highs in both funds, but just as we averaged in slowly while EM markets were falling because momentum could have worked against us, we’re now taking profits slowly as momentum looks to work in our favor.

The Author

Robert Arnott

Founder and Chairman, Research Affiliates

Michael Aked

Head of Asset Allocation, Research Affiliates


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