Viewpoints

Asia: Focus Shifts to Returns and Volatility

Rising interest rates in the U.S. are no longer the biggest concern for investors in Asia ex-Japan.

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Frameworks matter. At PIMCO, our investment professionals gather in Newport Beach four times a year to develop our thinking on the macroeconomic and market themes most likely to influence portfolio performance across the secular (three-to-five year), cyclical (next 12 months) and tactical trading environments. We believe it is equally important to develop an informed framework to guide interaction with our clients. To frame our discussions, we recently asked investors across our Asia wealth management business what worries them most as they plan their asset allocations for the year ahead. In the following interview, Michael Thompson, PIMCO’s head of Singapore and head of global wealth management for Asia ex-Japan, discusses the responses as well as the conclusions from our latest sales forum and how they tie in with macroeconomic trends and investment strategy.

Q: It has been an eventful and unsettling time for Asia’s economies and markets. What are investors in Asia-Pacific most concerned about?
Michael Thompson: We recently surveyed our clients and distribution partners in the region and analyzed mutual fund flows in Asia and Europe in an effort to understand investors’ current goals and concerns. Looking closely at the results, we found that Asian investors’ concerns have shifted over the past year. While potentially rising interest rates in the U.S. were the biggest worry a year ago, our distribution partners are currently more concerned about meeting the return expectations of end-investors and the likelihood of lower returns across asset classes in the future.

We think this reflects a growing realization that global growth is likely to be positive but low in the years ahead, with Asia no longer disconnected from the slower global growth story. This is consistent with PIMCO’s forecast for the coming year: Our GDP growth projection for China is below consensus at 5.5%-6.5%, down from the current rate of about 7%; we also think Japan is likely to see very low inflation and further quantitative easing; growth in Australia’s economy is sluggish in the midst of a major, long-term transition away from the resources sector; and emerging Asia is reeling from China’s currency devaluation in August. All these forces facing investors will likely keep returns lower going forward.

A close second for Asia wealth management investors is concern over bubbles in various markets. We surveyed investors in July and August of this year, when China’s A-share market was dropping 40% and the yuan was devalued. So these developments were top-of-mind for investors. As China’s slowdown affects the region further, we think investors will remain concerned about the possibility that asset bubbles – from loans to property – could deflate suddenly, creating volatility and potentially, losses.

Concern over rising interest rates, meanwhile, fell to third on investors’ list.

Q: With the Federal Reserve even closer to raising the policy rate in the U.S., why do you think investors are not as concerned about rising rates?
Thompson: Rising rates are still on the list, but the fear has clearly subsided. There seems to be a broad acceptance among investors that the process of normalizing monetary policy in the U.S. is likely to be gradual and well telegraphed and that it will end at a lower rate than in previous rate-hike cycles.

Q: Do investors plan to change their portfolio allocations to reflect their concerns?
Thompson: Our survey revealed three big asset allocation calls. First, 80% of respondents are planning to increase their European and Japanese equity allocations. Second, 70% want to increase their overall portfolio allocations to liquid alternative investments. And finally, 56% and 31% want to increase allocations to Asian equity and Asian credit, respectively.

We would attribute the increasing focus on equity and liquid alternatives to the need for return drivers in portfolios amid expectations for lower returns overall and accommodative central bank policy, which is likely to keep interest rates low. Europe and Japan probably offer the most potential value in developed equity markets currently. In general, we would expect risk-on assets, such as equities and liquid alts, to feature more prominently in asset allocation decisions in the future. Whether investors prefer to make individual allocations to these asset classes or trust this decision to multi-asset portfolios remains to be seen.

The desire to increase allocations to Asian equity and Asian credit likely reflects the growth in these local markets as well as home bias. Among our clients in Asia ex-Japan, we found that 66% of financial assets are already invested within the region.

Q: What trends are you seeing in fund flows?
Thompson: Investors within Asia are well known for their love of equity, and it will come as no surprise that European equity gained the largest share of flows, with regional equities the runner-up.

Flows in public mutual funds (both European- and Asian-domiciled or registered) show that investors have had a clear preference for multi-asset strategies over the past year, with an emphasis on income. In fact, a little more than half of our clients now see multi-asset income strategies as a core allocation, which should establish this flow trend for some years to come.

This trend raises the question, are investors looking for income or the benefits traditionally associated with multi-asset strategies? We believe the answer is both. Investors’ preference for multi-asset strategies likely reflects the need for flexibility: As uncertainty and volatility across asset class performance have increased, so has the demand for strategies that have the flexibility to allocate to multiple asset classes. The preference for income strategies, in particular, is probably in part a reaction to the outlook for lower returns; if the prospects for capital appreciation have diminished, investors logically prefer to receive returns now ‒ in the form of income.

Q: With the strong preference for income among Asian investors, what trends are you seeing in fixed income?
Thompson: The overall view on fixed income was mixed – reflecting possibly a combination of uncertainty around a changing interest rate environment and the volatility in broad equity market performance through the summer.

Investors in Asia are using bond funds in addition to multi-asset funds to meet their income goals in their portfolios. Consistent distributions remain attractive in the lower-return environment as many investors in Asia use bank-provided leverage for their investments, and reliable distributions help service the financing costs on these loans.

In general, however, many portfolios in Asia are tilted toward equity and credit. As a result, they tend to be substantially underweight higher quality bonds. In a world of uneven or slow growth, potential asset bubbles and recurring bouts of volatility, an allocation to a high quality core bond strategy may help stabilize returns and diversify an investment portfolio. Although many might regard this as an out-of-consensus call, investors in Asia could benefit from revisiting the traditional role of high quality bonds in their portfolios in the years to come.

Q: How can PIMCO address investors’ concerns in Asia and help meet their investment goals?
Thompson: We have many different solutions with established track records that can help meet the needs of Asia investors.

For example, our Global Multi-Asset Strategy draws on PIMCO’s highest conviction investment ideas and invests in a very broad range of asset classes – from equities and bonds to real assets and PIMCO’s own mutual funds.

To meet investors’ need for added return, we offer several equity strategies that aim to outperform traditional approaches by investing in securities that are underpriced based on their fundamentals. For investors looking to boost returns through income generation, we offer strategies that target higher yields, such as the Capital Securities Strategy, which invests primarily in subordinated debt issued by banks, as well as approaches with a strong focus on risk management, such as Strategic Income.

Finally, in core bonds, we draw on more than 40 years of bond market experience. Our global bond and credit strategies invest in high quality fixed income around the world, which can help diversify investment portfolios and thus potentially smooth returns, important benefits for investors in Asia going forward.

The Author

Michael Thompson

Head of Singapore Office

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All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2015, PIMCO.