Arnott on All Asset

Arnott on All Asset September 2015

Rob Arnott, head of Research Affiliates, shares his firm's market insights and allocation strategies for PIMCO All Asset strategies.

Q: Have the recent policy decisions in China impacted your asset allocation views of emerging markets?

Arnott: No. At the end of 2007, when emerging market (EM) stocks were priced at a Shiller PE of 35, I was skeptical of the “not a cloud in the sky for EM” scenario. Now that the Shiller PE has dropped to 12.5, I’m just as skeptical of the “assured road to ruin” scenario. And with a Shiller PE lower than 9 for the FTSE RAFI™ Emerging Markets Index and less than 8 for PIMCO’s RAE Fundamental Emerging Markets Fund, value is even more stretched! Even after a significant rally in RAE EM, the Shiller PE would be below 12! Geopolitical disturbances create both uncertainty and bargains. There are no bargains in the absence of fear. Those who fear the risks, without noticing the valuation opportunities created by those risks, will miss opportunities.

In the 2000s, I never fully bought the narrative that China’s growth was inevitable and would be unimpeded. In the 2010s, I don’t buy the narrative that China’s shadow banking system is on the verge of failure, its growth rate is in danger of imminent collapse, and its leaders are seeking currency debasement to maintain competitiveness. Both then and now, reality lies between these two extremes.

Did China “devalue” the yuan? Not really. The soaring U.S. dollar caused currencies that were not pegged to it to fall 20% in dollar terms. As a result, a bit of “float” took a formerly pegged currency down 4–5%. So what? To achieve China’s goal of becoming one of the reserve currencies, its currency has to free float.

It’s fascinating to me that countries often favor a weak-currency strategy to boost their exports’ competitiveness—odd, because it reciprocally increases the costs of their imports. Exporters are large, visible, and politically powerful producers of goods and services, whereas importers are legions of largely invisible, near-powerless, individual consumers. By improving export terms of trade, profits of exporters rise when measured in the diminished local currency, but the nation’s GDP shrinks when measured in world purchasing power parity (PPP) terms. The best monetary policy for long-term economic growth is a strong, stable currency, not a weak one. History conclusively demonstrates this truism. The question of why a government would choose to shrink its footprint in the global economy by diminishing its real PPP-adjusted GDP to appease a short list of politically powerful exporters answers itself, while starkly illustrating the fallacy of this choice.

Fluctuating exchange rates also have a noteworthy impact on earnings. History suggests that the modest drop in the yuan is likely to bolster yuan-denominated earnings, roughly in proportion to the magnitude of the drop in currency value relative to China’s trading partners. Positive earnings surprises should approximately match the drop in currency value. Positive earnings surprises can boost markets.

Q: Are there any catalysts that should lead to the outperformance of diversifying asset classes in the months ahead?

Arnott: Catalysts, by definition, are surprises, unexpected and best observed after the fact. It’s often unproductive to try to identify them in advance: After 15 years, for example, does anyone really know what proximate catalyst ended the tech bubble?

Like most investors, my short-term forecasts aren’t worth much, though I like to harbor the illusion that I might be right 52% of the time.1 I’d rather focus on what we believe is our comparative advantage. We assess when long-term market prospects, which are surprisingly easy to objectively assess, are at odds with market perceptions. We then respond in a contrarian fashion and remain steadfast during bouts of growth-dominated momentum until mean reversion transpires. Our approach of averaging into inexpensive, out-of-favor markets and averaging out of expensive, beloved markets inspires our confidence that we can harvest incremental return over the long term. It’s what we do.

An extended disinflationary bull market, such as we are experiencing now, has always meant tough sledding for the currently unloved Third Pillar. It was true in 2006–07 and, to a far greater extent, in 1998–99. In the latter period, a value focus that favored diversification away from mainstream stocks put several remarkable players out to pasture: Gary Brinson, Julian Robertson, and almost, Jeremy Grantham. Managers who stayed the painful course were amply, and surprisingly quickly, rewarded. A momentum-driven, anti-value market like today’s can sow the seeds for multiple years of generous harvest. Those seeds are the bargain basement prices of Third Pillar assets.2

When should we expect the harvest? My preference is not to guess, but diversification may pay off sooner rather than later for a few reasons. Catalysts are uncharacteristically in evidence.

First, the commonly held perception that the U.S. equity rally can persist has been severely strained. In August, market concerns were reflected in the volatility of risk assets, pulling the U.S. stock market into its first 10% correction in nearly four years. This recent shift in risk aversion, coupled with lofty valuations, a strengthening dollar, sharply lower oil prices, and the Fed’s signaling of rate hikes, all are serious headwinds that are likely to add downward pressure on U.S. stocks.

Second, value strategies across the board—within stock markets and in global tactical asset allocation—have been savaged. In the case of EM equities, EM value stocks’ trailing three-year underperformance against EM growth stocks is over 4% a year, the worst since the tech bubble. Fear has driven EM equities to highly attractive valuations. EM value stocks, using a fundamental index, are priced at less than 9 times their 10-year earnings and a similar multiple to last year’s earnings. A potential trigger to their regaining favor is an interest rate hike or the start of a bear market, reminding investors of the perils of chasing speculative growth illusions based on a too-tenuous foundation of value.

Third, EM currencies have faded relative to the dollar. The probable effects could be a surge in sales, especially for exporting companies, and positive earnings shocks that ripple across the EM economies, likely pushing their stocks’ earnings multiples higher.

Lastly, U.S. inflation expectations have fallen following the recent sharp decline in commodity prices and concerns about the yuan’s depreciation. Could inflation expectations decline more? Perhaps. But we believe inflation expectations are poised to rebound. With the inevitable “nowcasting” centered on deflation, inflation expectations stand well below the Federal Reserve’s target rate, which is based on core inflation levels that continue to rise amidst continued economic growth and declining labor slack. If the Fed is committed to delivering on their target rate, inflation expectations will rise. With respect to inflation itself, while a drop in oil and commodities leads to a decline in headline inflation, the effect is likely temporary, as falling oil prices tend to boost aggregate demand, both globally and in the U.S.

BEI levels have been below 2% for the last 11 months. While past is not prologue, a slight reversion of BEI from the current 1.6% seems reasonable over the coming year. If that happens – and we believe it will sooner rather than later – the Third Pillar is in a position to take advantage of these trends.

Q: We all hear the mantra “buy low, sell high” so often that it’s a cliché. What does it mean, and what is its relevance to the All Asset suite?

Arnott: To state the obvious, it means buying what’s cheap and selling what’s dear; what’s cheap is feared and what’s dear is beloved. This usually means buying the markets that have hurt us badly and selling the markets that have treated us most kindly; it means buying what others fear to buy and selling what is doing very well. Unfortunately, this goes profoundly against a human nature that has been conditioned by the need to survive on the African veldt. We inherently shun near-term risks and sources of recent pain— such as a stalking lion.

Contrarian investing can be frightening and painful, particularly for investors “anchored” on a 60/40 strategy during times marked by short-termism and nowcasting. The All Asset suite of strategies is specifically intended to diversify away from the classic 60/40 portfolio that dominates most investment portfolios. The 60/40, especially the U.S. equity allocation, has fared quite well since 2009, while virtually all diversifying markets have struggled since the end of 2012. Predictably, many investors are ditching their real return assets in favor of the perceived safety of conventional assets. For the contrarian, we believe this presents numerous bargains. We’re like kids in a candy store.

Emerging market (EM) equities, today’s sow’s ear, can potentially be tomorrow’s silk purse with the help of a bear market. Although a bear market feels awful, it boosts the long-term forward-looking rate of return for every incremental dollar invested at the lower level. As of June 30, 2015, we believe EM equities are priced to an attractive real return, the highest across a wide spectrum of major asset classes. We believe a contrarian strategy will reward the patient investor who doesn’t mind living with the maverick risk. I am confident in our strategy. Soon enough, the markets will remember the truism that valuation matters.


1Please see my article “The Fiduciary Time Line: Implications for Asset Allocation” in the March 2006 Financial Analysts Journal “Editor’s Corner.”

2Research Affiliates’ 10-year real return outlook for both mainstream U.S. stocks and bonds is 1% above inflation. Do many investors truly want to settle for that bleak real return in exchange for comfort and familiarity? Yes, they do. Meanwhile, the majority of Third Pillar markets are priced from 2.0% to 6.5% above inflation. Please see http://www.researchaffiliates.com/assetallocation/Pages/Core-Overview.aspx for all of our long-term return forecasts.

The Author

Robert Arnott

Founder and Chairman, Research Affiliates

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