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The global economy and markets have come a long way since thefinancial crisis. Output in most major economies (in nominal terms) is higher than itwas pre-crisis, as are asset prices. The specter of deflation is starting to fade aseconomic slack decreases and commodity prices stabilize. Extraordinary central bankpolicies, while controversial, have played a significant role in getting us here.
Looking forward, it is our view that the world remains in The New Neutral,and importantly that asset markets now broadly reflect this development in theirprices.
All this has significant ramifications for the evolution ofasset prices and for how investors should approach multi-asset portfolios over thenext three to five years, which we refer to as the secular horizon.
We reaffirmed the New Neutral thesis in May, when our investmentprofessionals from across the globe gathered in Newport Beach for our Secular Forum todebate the long-term outlook for the global economy and to identify and assess keyvariables, trends and catalysts that may affect valuations and returns across globalasset classes. We came away from the forum with some important insights, which DanielIvascyn, Richard Clarida and Andrew Balls describe in PIMCO's SecularOutlook, "The New Neutral Revisited."
At the center of our New Neutral thesis is the belief that evenas central banks raise rates, they will do so slowly and prudently, and that theneutral rate over the coming cycle – meaning a rate that is neitherstimulative nor contractionary – will be lower than in cycles past (a roughbenchmark for the U.S. is closer to a 2% average policy rate than the traditional 4%assumed by many). We also don't foresee an inflation problem, even as we move awayfrom an era of extremely limited price increases. Low interest rates and moderateinflation together support a muted but prolonged business cycle, and we believe thiscombination helps to sustain current asset valuations.
So why does our New Neutral thesis have significantramifications for multi-asset investors over the secular horizon? We would argue thatthe tailwind from ever-lower policy rates and contracting term premia witnessed overthe past 30 years is largely past us. Moreover, current valuations – asmost assets already price in the reality of lower rates – are likely toconstrain potential returns going forward.
Therefore investors must adjust to a world where returns onasset classes and the paradigm for constructing optimal portfolios over the next fiveyears are unlikely to resemble those of the last five or even 30 years. Investors willneed to be more dynamic and tactical in their overall asset allocations, and theyshould approach portfolio construction with even more differentiation as they allocaterisk to individual positions. It is still possible to achieve compelling returns, butwe believe the role of active portfolio management has become more important, and morenecessary, than ever.
The New Neutral
For the next three to five years, even as monetary policymakers seek to normalizeinterest rates they will generally set short-term rates at levels below the rates thatprevailed before the global financial crisis. Also in this New Neutral world,countries will converge to slower trend growth trajectories. Since PIMCO introducedThe New Neutral secular view in May 2014, the construct has been priced in tofinancial markets.
The fading discount rate boost
Let's start with restating the essential point: Thetailwind to asset classes from ever-lower interest rates is largely behindus. Over the past several years, lower risk-free rates from aggressivecentral bank policies accompanied by dropping inflation created a ''denominatoreffect" by pushing discount rates lower, which in turn led to higher valuations ofassets. The discount rate applicable to future cash flows, regardless of the assetclass, starts with the real "risk-free rate." The appropriate discount rate for eachasset class can be modeled as the risk-free rate with an additional risk premiumassociated with its position in the capital structure and exposures to risk factors:for example, inflation and term premia for sovereign bonds, default and liquiditypremia for credit, and equity risk premium for equities – each building offthe risk-free discount rate. As risk-free rates drifted lower over a period of manydecades, not only did the present value of future cash flows increase in the sovereignbond market, valuations increased broadly across all asset classes asgrowth expectations declined by less than the drop in risk-free rates.
So where are we headed? In fixed income, we do not seesignificantly higher bond yields over the next three to five years. Rather, policyrates are expected to rise gradually over the secular horizon. This change, fromsteadily falling discount rates to stable or, in many cases, modestly rising discountrates, will likely have substantial consequences:first, via lower expected returns,and second, on portfolio construction.
In this new regime, rigid ''buy-and-hold" strategies may notwork as well as they did in the past. A prime example is the recently popularized"risk parity" approach to asset allocation, a strategy by which portfolioallocations are sized in order to ensure the risk contribution from stocks, bonds andinflation-related assets is equal, or at parity. Given bonds generally have lowervolatility than stocks and other assets, risk parity strategies systematically useleverage to increase risk exposure to the bond component. Over the past several years,markets have been generally friendly to these strategies as bond term premiacompressed and volatility became subdued. However, they may now face headwinds asvolatility resets and interest rate trends reverse, necessitating an active approachwhen managing these strategies. Moreover, studies have shown that the negativecorrelation between stocks and bonds (one of the key tenets behind this approach)tends to be greater when yields are falling than when yields are rising, which hassignificant implications for portfolio construction and diversification.
It seems clear that in the market environment we are facing,tactical asset allocation and robust portfolio construction will become evenmore important as correlations become increasingly unstable and dispersion increasesacross asset class returns. In this new regime, region, country and sectorselection and bottom-up relative value strategies will have to do more of the heavylifting to help offset either the end or reversal of the tailwind of decliningdiscount rates.
Forecasting long-term returns
If asset valuations are full and price returns are likely to belower overall, where do we find attractive opportunities? The New Neutral hypothesisoffers a guide. Weaker growth potential and waning tailwinds from demographic trendswill likely incentivize central bankers of highly levered, developed economies toraise rates in a slow and prudent manner, not veering far from the zero bound andkeeping policy rates below previous long-term averages. We believe this willcontribute to a longer economic cycle.
In this scenario, investors should expect low but positivereturns from most developed market asset classes, with equities and creditoutperforming government bonds and cash. Therefore, despite corporate bond yieldsseeming low and equity multiples seeming high, we do not see either market asovervalued or primed for a lasting correction. Investors may wish to add emphasis tothe riskier asset classes in their overall allocation given our belief that loweryields and higher valuation multiples should be viewed through the lens that rateswill be lower than in previous decades even as they creep upward.
For example, as we consider equities in our asset allocationportfolios, we estimate the current equity risk premium in the U.S. to be 3.9% in realterms, which is very close to its long-term average of 4.0% and higher than the 3.5%average observed during economic expansions. This suggests a fair premium relative toU.S. bonds and one with room to compress as economic strength continues to improve.Moreover, in seeking to outperform, one can always look for companies, sectors or evencountries where earnings growth can positively impact prices and valuations.
Next, consider U.S. investment grade credit: Spreads relative toU.S. Treasuries, a measure that shows the additional premium bond investors demand ascompensation for default risk, are not especially narrow relative to history,particularly for this stage of the business cycle. The current spread over the risk-free rate (option-adjusted spread, or OAS) is 137 basis points (bps), slightlynarrower than the 40-year average of138 bps but wider than levels typically observedduring economic expansions (132 bps on average in first half expansions, and 110 bpson average in second half expansions).
For global markets, our general estimates for long-term returnsbased upon our New Neutral thesis are shown below. These estimates take into accountcurrent valuations, carry and where we believe valuations may be headed based upon ourmacroeconomic outlook.
Turning to emerging markets (EM), we believe that on averagethese sectors should outperform comparable developed market sectors over the secularhorizon, but are likely to do so with higher volatility and other risks that must beconsidered.
As in the developed markets, lower yields have been a tremendoussupporter of performance for EM assets following the financial crisis. However, in thepast few years, emerging markets have gone through numerous challenges that have ledto generally disappointing performance. Lower growth, lower commodity prices, weakexports and a strong U.S. dollar recently have been serious headwinds. The silverlining of the recent challenges, however, is that EM assets generally offer morefavorable starting valuations.
EM growth, which is expected to be higher than in developedmarkets, also helps valuations appear attractive. Add in the higher level ofinvestments and productivity enhancements, and we have a favorable backdrop forattractive secular returns from emerging markets.
Thus far we have described the likely impact of The New Neutralon asset prices and their forward return potential, but as we mentioned at the outset,it is imperative to survey the markets and identify pockets of potentially moreattractively priced securities that may deliver more attractive risk/return tradeoffs.In developed markets, to name a few examples, we believe global equities outside ofthe U.S. offer better forward return potential than those within. Across creditsectors we see superior opportunities in European financial and U.S. housing sectors.With respect to government debt, we generally find inflation-linked securities moreattractive than their nominal counterparts.
In EM, our theme of differentiation and dynamic management ofportfolio positioning is even more important. No single EM country or asset class islikely to deliver these "average" long-term returns. Secular winners and losers willbe decided as a function of initial conditions as well as country-specific monetaryand fiscal policies. For countries or companies in emerging markets to attract scarcerglobal capital, they will need to demonstrate superior return potential that helps tocompensate for their lack of liquidity and greater volatility. Policymakers andcorporate managers will need to take the steps necessary to lead their countries andcompanies toward sustainable economic expansion. Successful investors will have towork to identify these potential winners: In the New Neutral world of muted growth,the twin engines of export driven growth or terms-of-trade shock may not work goingforward.
Capital Market Return Assumptions for Strategic AssetAllocation
Our long-term estimated returns are based on a structuredinternal survey, which queries senior portfolio managers (both generalists andspecialists) for their forecasts for key markets. The survey is overseen by the assetallocation and the analytics teams.
The key inputs that are obtained through the survey process areforecasts for these data:
- Real GDP growth and inflation globally
- Equity valuations, dividend yields and earnings growth
- Nominal and real yield curves globally
- Foreign exchange rates against the U.S. dollar
- Investment grade and high yield credit spread levels, expected defaults anddowngrades
- Sovereign credit spreads
A set of robust, well-established valuation models that mapcurrent market variables to expected returns serves as an anchor for the inputs in thesurvey process. For equities, country-specific cyclically adjusted earnings yields andestimates of equity risk premia over the local real interest rate relative tohistorical levels provide the most important analytical valuation anchor. Expectedearnings growth is based on per capita real GDP growth estimates. For interest rates,the current yield level, the spread between current yields and forward rates alongsidemodel-based estimates of long-term fair value for nominal and real yields are the mostimportant analytical inputs which guide the expected long-term yields and model-basedreturns. For credit, the level of the current credit spread relative to history(adjusted for leverage ratios and composition across sectors and ratings quality) andhistorical defaults and downgrade losses are combined into a model-based forecast offuture spreads and returns for both investment grade and high yield. ForFX/currencies, real interest differentials are combined with a mean reversion towardpurchasing power parity (PPP)-based fair value across countries to determine a model-based FX spot appreciation/depreciation and overall FX return.
Asset AllocationThemes for Multi-Asset Portfolios
With the tailwind from ever-lower policy rates and term premia compression behind us,rather than see cause for alarm, investors should consider this a time to (1) refocusportfolio construction, (2) revisit sources of value through active management and (3)be judicious in asset allocation decisions. We believe investors will be best servedif they consider opportunities across asset classes and throughout the globe.
ASSET ALLOCATION PORTFOLIOS
In our asset allocation portfolios, our investment decisions aremade using
a four-pronged framework:
- We begin by gauging where in the globe macroeconomic conditions or policyactions are likely to produce the biggest surprises. These factors interact withmacroeconomic fundamentals in ways that can have meaningful effects on assetreturns.
- Then we conduct a rigorous analysis of cross-asset valuations and risk premiato inform our decisions on what to own long-term. This helps us determine ourstrategic allocations to various regions and asset classes.
- Next, we meet and debate often to assess short-term factors such as momentum,liquidity and investor flows, which
- Finally, correlation and risk management considerations are incorporatedto scale exposures.
- Despite the waning tailwind of declining discount rates on assetclass returns, we believe investors should not only stay invested, but look foropportunities to strategically overweight risk positions over the long term. Moderateglobal growth and a gradual upward path to interest rate levels lower than in previouscycles should be supportive of asset classes, though support is more tilted toproviding a floor than providing a boost.
- A global survey of equity risk premia suggests fair to attractivevaluations relative to bonds and recent history
- Exposure in Europe and Japan appear attractive given policyefforts that are stimulating growth, the levels of dividend yields and currentvaluations
- Emerging markets, particularly those in Asia, offer attractiveopportunities for strategic overweights given macro trends, supportive policy andreforms, and levels of equity risk premia particularly when compared to recenthistory
- Core fixed income retains its important role in a multi-assetportfolio to provide diversification and income
- We are wary of exposure to interest rates in developed markets asrates are low and poised to rise
- There are interesting opportunities in select EM countries,including Mexico and Brazil
- Despite low all-in yields across credit sectors, spreads abovegovernment rates remain within fair to attractive levels
- We find specific opportunities such as European financials andU.S. housing-related credits most attractive
- A deeper appreciation for potential liquidity is needed given lessinventory capacity at banks due to global banking regulations
- Global inflationary trends may be poised to reverse and gainpositive momentum, bolstering the case for real assets
- Inflation-linked bonds are particularly attractive as their pricescontinue to imply very low inflation premia when compared with nominal bonds
- Differentiation and tactical agility will be necessary to extractattractive returns from commodities as we believe supply and demand are generallymatched
- We remain bullish on the U.S. dollar, and thus underweightinternational and emerging market currencies, given the divergence of Fed policy withmost global central banks
- There are select opportunities in higher-yielding EM currencieslike the Indian rupee; investors should nevertheless be wary of the potential forheightened volatility
Positive long-term outlook
We are generally constructive on the potential for equities todeliver long- term returns, though (as noted above) our 10-year forecast for developedmarket equities is in the modest 4%-5% range, and slightly higher for emerging markets(which include additional idiosyncrasies and risks).
The factors favoring equities include muted inflation, anextended business cycle and low discount rates which, if they move up, will likely doso slowly and to levels still low by historical standards.
Looking around the globe, European equities appear attractiveover the secular horizon. In addition to the broader developments discussed, the trendtoward increased dividend payout and a higher equity risk premium provide a goodbackdrop for superior returns. European equities offer high levels of earnings yieldsand valuations are lower relative to history. We think a resolution of the Greececrisis would remove a source of uncertainty and allow the market to outperform.
European financials may be a good secular choice in equityspace, as well as hybrid securities or subordinated debt. We believe European banksare now far advanced in raising capital and in reaching some degree of normalizationin yields, and the shape of the yield curve should lead to higher profitability, whichis already buoyed by the cheap funding the European Central Bank (ECB) continues toprovide through sustained quantitative easing.
In Asia, Japanese equities also offer strong secular returnprospects. They have some of the best earnings growth momentum in the developedmarkets and stand to further benefit from the quantitative easing and structuralreforms that are improving corporate governance and profitability.
We also favor equities in China and India: Both countries haveembarked on secularly far-reaching reform agendas that should diminish vulnerabilitiesand unleash value. In particular, we should point out that the "bubble" and extremevaluations are confined to a small part of the Chinese market and recent volatilityaffords attractive entry for long-term investors into the more reasonably valued HSCEI(H shares).
Global Fixed Income
Differentiation Is Critical in Anchor AssetClass
Fixed income should remain a cornerstone of multi-assetportfolios for the foreseeable future as The New Neutral remains an anchor for fixedincome valuations. However, ahead of the first Fed hike in almost 10 years, we arecautious on developed market duration in our portfolios and encourage investors toconsider the full spectrum of global opportunities in fixed income.
In the developed markets we are likely to see term premiumreturn to yield curves. There are two potential scenarios that could lead to higherlong-term rates. The first would be the decline of fears of deflation and the end ofthe strong bid for high quality bonds that markets experienced when developedeconomies recently teetered on the edge of recession. A second scenario, more likelyto manifest toward the latter part of our secular horizon, may be the unwinding of theglobal savings glut. Brought on by cheaper oil and commodity prices resulting in lesspetrodollars and/or a Chinese economy balancing away from export-oriented toconsumption-oriented growth, both possibilities lead to fewer dollars recycling intoU.S. Treasuries and other safe-haven government bonds.
Further, we could see the re-injection of "credit risk" into thegovernment bonds of Italy and other peripheral European countries. Current yields andspreads compared to German government bonds may be attractive given the backdrop ofECB support. However, when asked to stand on their own, these bonds should not betrading at yields close to U.S. Treasury yields unless debt burdens are reduced andthe economy is made more competitive.
We are secularly positive on Mexican interest rates as inflationhas been reined in and Mexico has built significant fiscal and monetary policycredibility over the past several years. While Mexico's central bank is expected toraise rates in tandem with the Fed, we believe the market has priced in too manyhikes. Credibility and institutional stability should see the spread of Mexican Bonos(Mexican government bonds with a fixed interest rate) to U.S. Treasuries compress inour secular horizon; we favor the intermediate part of the curve.
We are also hopeful that Brazil will move past its recentchallenges to see better prospects ahead with a better mix of monetary and fiscalpolicies and more investor-friendly policies. The extremely high real interest rateswould be very attractive if inflation were tamed and political and economic volatilityreduced.
As mentioned earlier, we believe credit spreads are broadly fairand provide adequate compensation for default risk. In such a scenario, and with noexpectations of an elevated default cycle any time soon, one should earn the creditrisk premium by investing in privately issued debt. However, credit differentiationand the identification of broad themes become more important in a world of diminishedliquidity for specific industries and sectors that we find attractive on a secularbasis (see the Secular Series publication, "Picking U.S. Energy, Housing and OtherCredit Sectors for the Long Haul"). Some of these include the consumer and housing-related sectors in the U.S. and financials, including bank capital, in Europe andJapan.
In a world of diminished liquidity and mostly fair valuation forcorporate bonds, it is perhaps appropriate to talk about a broad sector that stilloffers attractive return potential at the cost of sacrificing liquidity: privateopportunities that require capital to be locked up for a period of time. There is arole for investors to take advantage of these as sources of financing from banks andother traditional lenders fade. These deals are often complex, and illiquid asadvertised, but can be rewarding to institutions and investors who have the expertiseto decipher the intricacies and unlock value. At PIMCO, we believe that this sectoroffers a win-win as investors seek higher returns than those offered by publiclytraded stocks and bonds, and borrowers need capital that banks can no longer provide.(Please see our forward-looking return estimates for illiquid asset classes above.)Our expectations are for the average private-equity-type investment to returnapproximately 2% more than equities, with lots of room for differentiation andopportunistic investment leading to potential outperformance.
Key Opportunities as Inflation GraduallyRises
As we see inflation accelerating, albeit gradually, over thesecular horizon, we suggest investors consider an allocation to real assets, meaningassets that directly or indirectly hedge inflation risk (see the SecularSeries piece, "Inflation Outlook: Approaching Target").
For the core government bond anchor in a multi-asset portfolio,we like U.S. TIPS (Treasury Inflation-Protected Securities). Not only are they anasset carrying only one risk, real rate risk (unlike nominal government bonds thatcarry both real rate and inflation risks), but we also view them as attractivelyvalued relative to nominal bonds. The large amount of slack in the global economy overthe past few years as well as the recent commodity price correction have resulted notonly in a drop in inflation expectations (and fears of possible deflation untilrecently), but also in a near complete removal of inflation risk premium from themarkets. Under these conditions, we think TIPS are an attractive choice for the corefixed income component of a multi-asset portfolio.
Commodities are another asset class that embodies the greaterdifferentiation within asset classes that we expect going forward. During thesupercycle of the early 2000s, when demand growth outpaced supply growth, mostcommodity sectors rose together. Then, as supply caught up over the last few years, wesaw declines across most commodities. Going forward, supply and demand should bebetter matched and investors will have to be more selective in order to generatereturns.
For example, we think U.S. natural gas stands out as attractive,with long-dated natural gas prices around $3.00/MMBtu (millions of British thermalunits) trading close to prices where it is economical to substitute gas for coal inU.S. power production and significantly below the prices where natural gas trades inthe rest of the world. Supply is likely to drop with a slowdown in fracking.Meanwhile, demand is likely to increase as the world looks for cleaner energy sourcesand the political process in the U.S. possibly allows for greater energy exports.
We also believe gold is losing its shine. The two biggestdrivers of gold prices, U.S. real interest rates and the U.S. dollar, should both movemodestly higher over the secular horizon, affecting financial market demand. Physicaldemand from India could also cool as the financial markets mature and the governmentpromotes viable alternatives to gold for savings and wealth preservation.
Finally, an important element of commodity prices is theannouncement of the anticipated agreement with Iran. While geopolitical risk in theMiddle East has been a source of supply disruptions leading to higher prices, peacewith Iran should bring additional oil into the global market, leading to a cap onlong-term prices.
Continuing Strength in U.S. Dollar
Over the secular horizon, the major factors driving currencyreturns are interest rate differentials and inflation surprises. We continue to expectbroad strength in the U.S. dollar over the early part of the secular horizon. Weexpect the Fed to be the first major central bank to hike rates as the U.S. economy isa few years ahead of other major economies in its recovery.
This divergence will lead to U.S. dollar strength versus mostdeveloped economies where current policy is likely to further weaken localcurrencies.
In the latter part of the secular horizon we could see strongreturns from the higher-yielding EM currencies like the Brazilian real (BRL) or theIndian rupee (INR) if inflation rates are stable enough to attract outside capital.The offshore exchange market in the Chinese yuan (CNH) also bears watching forpossible appreciation as China further loosens capital controls; the CNH is morewidely accepted in global trade (including becoming partof the International Monetary Fund's Special Drawing Rights (SDR) basket).
Risks to our outlook
Another secular risk is a bout of higher inflation. We see amove away from deflation or "lowflation" territory and toward central bank targets.Inflation is a notorious lagging, late-cycle indicator. It is possible that centralbanks misjudge the degree of slack in the economy and easy and unconventional policiesresult in a period of higher-than-expected inflation. This would be negative forreturns in both bonds and stocks, positive for commodities.
Geopolitical risks also cast a shadow on our outlook. There areseveral known potential flash points around the world, and many that cannot yet beanticipated. A key development to watch is the evolution of the relationship betweenChina and the U.S. as the former asserts itself more on the global stage.
While risks to the base case are ever present, they are bydefinition uncertain in likelihood and timing. As such, robust portfolio construction,diversification and identifying investments with "positive convexity" becomeparticularly important in a world of lower expected returns.
Finally, though one often thinks about "left tails" when talkingabout risks, there is also the possibility of "right tails" over the secular horizon.For example, strong upside catalysts might include the end of political gridlock orimproved fiscal policy, both of which may lead to stronger growth rates than the mutedones we expect in the U.S. and Europe. This development would obviously be positivefor risk assets like equities and credit.
Asset Allocation Best Ideas: A SecularPerspective
As our survey of the outlook for major asset classesdemonstrates, investors likely should reconsider their long-term paradigm to multi-asset portfolio construction. This is not because we forecast a bear market inequities or other dramatic turns. It is because The New Neutral has mostly been pricedin to asset valuations, and investors should be well-served by differentiating amongbroad allocations and being diligent in examining specific opportunities to seek thosewith compelling risk-return potential.
Broadly, our secular bias is to overweight equities and creditfixed income and underweight government bonds. Patient investors may also benefit fromoverweighting exposure to emerging markets, though they need to be careful about howthey execute and stay aware of the risks. Finally, while not suitable for allinvestors, illiquid, private investments, if prudently chosen, can offer superiorreturn potential and diversification in an era of shrinking government and bankbudgets.
The next step is to be tactical, which includes the perennialadmonition to "do your homework." Yet from a tactical standpoint, there is one aspectof our New Neutral thesis to consider both for risk and return: We are likely to seesubstantial bouts of volatility ahead. In the near term, we expect the Federal Reservewill conduct its first policy rate hike later this year. While we expect the Fed tomove gradually over time to a lower "neutral" policy rate than in previous cycles, webelieve investors may be underestimating the volatility that could ensue from movingoff the zero bound. Longer term, we see greater likelihood of flash crashes andgeneral volatility resulting from the global banking system, which as a result ofpost-crisis regulation allocates less of its balance sheet to making markets. Thebanks may be "safer," but markets are less liquid at times when liquidity is needed.Another area of focus should be on predicting forward looking correlations. Portfoliosthat appear well-diversified based on historical data may turn out to be less so inpractice.
Issues of liquidity and volatility should be of concern toinvestors, but they can also be sources of opportunity when securities pricing becomesdivorced from fundamentals. There is reason for cautious optimism among investorsrevisiting their approach to multi-asset portfolio construction for the long term.