Our key investment themes
As the year progresses, markets are displaying a strange dichotomy. Thirty percent of sovereign debt globally now offers negative yields, suggesting investors are increasingly focused on certainty and capital preservation even as several major central banks seek to stimulate growth and risk-taking. Yet, on the other hand, measures of implied volatility in both stock and bond markets globally are close to all-time lows.
This seemingly improbable combination – investors’ search for security amid an eerie calm in markets – is likely a symptom of what our colleagues described in PIMCO’s latest Secular Outlook: a global status quo that is “Stable But Not Secure.” Distilling conclusions from our Secular Forum in May, our colleagues argued that systemic risks are rising due to experimental central bank policies and expanding leverage. However, while the long-term economic outlook might not be secure, it is likely to remain stable over the cyclical horizon. The dissonance between the near- and long-term outlooks is playing out in markets, and we expect periodic bouts of volatility until the tension is resolved.
We believe that finding refuge in negative-yielding bonds or gold is not the optimal way to navigate the current environment as our base case remains that a global recession is not imminent. A modest risk-on bias is still warranted, in our view. However, in light of stretched valuations and complacency across many assets, we are maintaining ample dry powder and remain focused on portfolio liquidity, and we anticipate low market returns will be the norm for the foreseeable future.
This paper is a mid-year update to key asset allocation themes being expressed in our multi-asset portfolios (we previously published ourAsset Allocation Outlook for the year: “Altitude Adjustment”). The following themes are a result of our evaluation of short-term opportunities and risks, coupled with the output from our Secular Forum, which guides our long-term thinking and provides a strategic investment framework.
- We continue to favor equity-like risk higher up in the capital structure as we believe risk-adjusted returns on select credit sectors are more attractive. In particular, non-agency mortgage-backed securities can provide an attractive, high quality source of income.
- We are more bullish on emerging markets (EM) as headwinds against EM investments are fading.
- In the U.S., we maintain a small overweight in bank stocks. We have reduced the overweight to European equities.
- We believe U.S. TIPS are an attractive stand-in for defensive high quality government bonds given low levels of inflation expectations.
- REITs (real estate investment trusts) appear attractive in a world of persistently low long-term interest rates.
- We are being more tactical in managing currency exposures,currently favoring a basket of higher-yielding commodity-linked currencies versus a basket of Asian currencies.
- Finally, we are increasing exposure to structural alpha oralternative risk premia strategies that can act as enhanced diversifiers by delivering attractive potential returns that tend to be uncorrelated to traditional assets.
In addition, given our expectations of lower future returns and rising volatility, we think there are two key secular implications for investors that we have long stressed at PIMCO, but take on additional importance now:
- Investors should consider broadening their investment opportunity set beyond traditional stocks and bonds into real assets and alternatives.
- In addition to diversifying betas, investors also should consider diversifying sources of alpha to include not only skilled, but also structural strategies.
To elaborate on this last point, structural alpha strategies, popularly known as alternative risk premia, seek to isolate well-known and time-tested sources of excess return including value, carry, momentum and volatility across asset classes. We believe they deserve increased consideration within an allocation now that the tailwind to asset prices from falling interest rates is largely behind us.
Over the years PIMCO has expanded the opportunity set for investors from traditional asset classes into real assets, alternatives and “smart betas.” While we are well-known for active alpha-seeking strategies through “skilled” sources – for example, bottom-up security, sector and country selection – we have for decades paired these strategies with structural alpha strategies. A substantial portion of PIMCO’s alpha can be attributed to those structural strategies.
While we include exposure to structural alpha strategies across PIMCO portfolios, including our multi-asset portfolios, we believe investors should also consider allocating to them on a stand-alone basis and view them as a strategic policy allocation.
Asset allocation themes for multi-asset portfolios
Overall risk: Moderately overweight
As we were at the beginning of the year, we remain moderately overweight risk, in line with PIMCO’s secular thesis of “Stable But Not Secure.” However, in light of stretched valuations and complacency across many assets, we are maintaining ample dry powder and remain focused on portfolio liquidity. While we don’t foresee an imminent global recession, the pace of economic recovery remains mediocre and central banks are running out of policy options. Stock-bond correlations are likely to be less stable and reliable than in the past decade. This outlook warrants a focus on well-diversified and high quality sources of income, with the anticipation of adding back risk as bouts of volatility present attractive investment opportunities.
We are modestly underweight equities, with a focus on country and sector selection. While equities appear relatively fairly valued versus fixed income, we believe further expansion of price-to-earnings ratio multiples is unlikely.
While high quality government bonds can be effective volatility dampeners, at current low yields we are underweight interest rate risk. Across global rate markets, we are underweight both German Bunds and Japanese government bonds.
Income is very much at the core of our multi-asset portfolios, and we still believe that high quality spreads are a good way to escape negative-yielding assets without taking excessive risk at a time when we believe recession probabilities are still fairly low.
We maintain an overweight to real assets, with a focus on TIPS and REITs. While the commodity correction has largely played out, TIPS remain attractive in a world where inflation expectations are poised for a rebound. REITs offer attractive yields and valuations against a backdrop where rates are likely to remain low for the foreseeable future.
We continue to favor the U.S. dollar but maintain the view that major currencies will generally be range-bound now that the major central banks have understood the negative consequences of a dollar that is too strong.
We remain slightly underweight equities in multi-asset portfolios. While the equity risk premium does not appear to be particularly compressed versus history – making equities appear relatively fairly valued versus fixed income – we believe further expansion of P/E (price-to-earnings ratio) multiples is unlikely.
We also think there is higher uncertainty around future earnings growth as profit margins are quite elevated and will be difficult to sustain if wages continue to rise. Therefore, investors should approach equities with a lot of care and caution. Finally, as implied volatilities are generally low, investors could consider converting part of their equity exposures to “conditional” exposures using equity option markets to create a potentially superior risk/reward profile.
Across major equity market regions, we remain underweight U.S. equities. Valuations are richer than most global markets even after accounting for the higher-quality bias the broad U.S. S&P 500 index tends to have compared to other global markets. Within the U.S., we are overweight financial stocks that trade at inexpensive valuations and have been unduly penalized over concerns of shrinking net interest margins and profitability. While the Federal Reserve is likely to maintain an easy monetary stance, its next move is most likely a rate hike, and it is extremely unlikely to move to negative interest rates which can be particularly toxic for bank earnings as evidenced in Europe and Japan. Over time, we expect the Fed’s monetary stance should stimulate economic growth and lead to outperformance of cyclical sectors like financials.
We have reduced our overweight to European equities given increasing political uncertainty and growing concerns regarding the long-term viability of the eurozone project, along with the lower-quality bias in the EURO STOXX 50 index. We believe in being tactical here, responding to opportunities presented by periods of extreme pessimism or optimism, while watching for turns in the earnings cycle.
Combining value with quality to sidestep value traps
Value, the belief that cheap stocks outperform rich stocks, is one of the oldest and most popular investment styles in finance. Investors have used various measures of value, such as dividend yield, book-to-market value and P/E ratio, in making allocation decisions. While ascertaining value is important, it shouldn’t be investors’ sole focus. Assessing the “quality” of an investment is equally important, especially in the current environment, in order to sidestep value traps.
Quality investing, measured by metrics such as return on equity and gross profitability, is receiving a lot of attention lately. In fact, it is now very much regarded as a standard investment style alongside other popular styles such as value and momentum. Below we show the value and quality scores for U.S. and European equities. Our key finding: While European equities appear attractively valued relative to U.S. equities, they offer much lower quality.
Finally, we have increased our allocation to emerging market (EM) equities. The “three C’s” (China, commodities, currencies) that were a headwind to EM performance over the last three years have abated: The Chinese slowdown and rebalancing is now priced into markets, commodity prices seem to have bottomed, and the Fed understands that a stronger dollar tightens global financial conditions. In conjunction, inflation in emerging markets is starting to cool off and growth is accelerating. We think the elements are in place for earnings recovery and a re-rating of emerging versus developed markets (for more on investment opportunities in EM, including debt, please read these recent insights from our EM team ).
Income is very much at the core of our multi-asset portfolios, and we believe that high quality spreads are a good way to escape negative-yielding assets without taking excessive risk at a time when we believe recession probabilities are still fairly low.
In particular, we believe investment grade corporate bonds compensate investors well relative to liquidity risks and expected default rates going forward. From 1983–2015, cumulative defaults over any five-year period averaged 1.2% (according to Moody’s), accounting for the current ratings distribution in the investment grade universe. Demand for these securities should be supported by the large pool of negative-yielding government bonds and purchases of corporate bonds by the European Central Bank, which started last month at a robust pace, to which we should add upcoming purchases by the Bank of England as well.
We continue to favor non-agency mortgage-backed securities (MBS) in the U.S., which are supported by a robust housing market and offer attractive loss-adjusted yields across a range of scenarios. Unless there is a severe housing downturn in the U.S., which is not our baseline forecast, non-agency MBS should also be relatively uncorrelated with other risk assets. We also favor select short-maturity high yield bonds away from the commodity sector and where default risk is expected to be relatively low.
Assessing the risk premium offered by U.S. equities and investment grade bonds
Valuations of risk assets like equity multiples and corporate bond yields seem to have reached levels that have never been encountered before. Instead of looking at asset valuations on an absolute basis, we prefer to look at their relative valuation by assessing the level of risk premium, or incremental yield, supplied by these assets over perceived “risk-free” government bonds. We find that risk premia of both U.S. investment grade corporate bonds and equities are in line with long-term averages, which makes the point that although long-term risk-free rates are at levels we have not seen in the recent past, risk asset valuations are consistent with these and not unanchored from fundamentals.
However, there is an argument to be made that in a world of extremely low risk-free rates, a “reach for yield” should compress risk premia below historical norms, leading to a stronger than expected outperformance of risk assets over government bonds. One way of making the comparison starker is by comparing the “price-to-earnings ratios” of these asset classes, as we discuss in Geraldine Sundstrom’s recent post on the PIMCO Blog, which concludes that credit is the sweet spot in terms of earning incremental returns with a reasonable degree of certainty.
While acknowledging the importance of high quality government bonds as volatility dampeners in a multi-asset portfolio, at current low yields we hold a modest underweight to interest rate risk. This decision is primarily driven by two factors. First, we expect historically low levels of term premium in the bond markets to persist. Second, stock-bond correlation is likely to be less stable than in the past, even though we expect it to remain low.
Across global rate markets, we are underweight both German Bunds and Japanese government bonds (JGBs). Negative interest rate policy (NIRP) is a double-edged sword: It can potentially ease financial conditions and cheapen home currencies, but it also has the potential of decimating profitability and hence credit creation abilities of the banking sector. Given these trade-offs, we believe global central banks will take a very cautious approach with NIRP. Both the Federal Reserve and the Bank of England recently seem to have pushed aside this policy tool, and now other central banks are following suit and becoming more focused on easing credit and cooperation with the fiscal authorities to increase stimulus rather than taking NIRP to an extreme level. The Bank of Japan, for example, in a recent decision neither increased bond purchases, nor dropped policy rates deeper into negative territory. As a result, we might be reaching the limit of how low or negative global yields can go.
Among high quality government bonds, we find U.S. TIPS to be quite attractive. Markets are currently expecting that the Fed will fail to achieve its inflation target over the next several years, which in our view is unlikely. While core CPI (Consumer Price Index) is already close to the Fed’s target, we believe headline CPI will be there too by early 2017. Furthermore, long-term trends like the rise of populism, the reversal of globalization, moderation in U.S. dollar appreciation and the possibility of fiscal stimulus are likely to counter the deflationary trends of the last several years. In this environment, TIPS seem undervalued and particularly attractive as they embed many of the defensive aspects of high quality government bonds.
Real assets: Overweight
In our 2016 outlook “ Altitude Adjustment ,” we posited that the commodity correction has largely played out and argued real assets were particularly attractive in a world where inflation expectations were poised for a rebound. As such, as previously mentioned, we are overweight TIPS.
In addition, we are overweight REITs (real estate investment trusts), which we find attractive in a world of low long-term yields – especially as a high-dividend-paying substitute for equities, consistent with our preference for income over reliance on capital appreciation. For details on how we value REITs and equities, please read our Featured Solution, “ Finding a Real Return with REITs .” While real assets are attractive to us, we are not particularly enamored of gold as we believe gold prices are just a derivative of real interest rates and the U.S. dollar, and currently we find gold rich to its implied fair value. We seem to more often hear gold described as both a good inflation hedge and a good deflation hedge than we hear a framework to value it as such.
We continue to favor the U.S. dollar but maintain the view that major currencies will generally be range-bound now that the major central banks have understood the negative consequences of a dollar that is too strong. Further, monetary policy seems to be drifting toward new forms of easing – away from negative interest rate policy (NIRP) and toward credit easing, equity purchases or possible fiscal coordination.
With currency volatility likely to remain high, we remain cautious with the overall sizing of our positions. We continue to selectively use currency markets not only based on macro factors, but also to obtain indirect exposures to oil and equity risk factors.
Given the risks recently introduced by Brexit and the possibility of further political uncertainty in Europe, we have a small underweight to the euro.
We also continue to be short the Chinese yuan versus the U.S. dollar. Despite the relative calm in China and the recent stability of the yuan, it has drifted steadily weaker versus the dollar. A short position also serves as a potential diversifier in a portfolio with a tilt toward reflationary assets.
Finally, given our expectation of stability in commodity prices and a bias toward income generation, we have a small overweight to select EM currencies that offer high yields. After the correction over the past few years, a number of EM currencies now appear attractively valued according to our fundamental models, and external balances are healthier too.
All things considered, we should point out that while we still favor a moderate “risk-on” weighting, we have reduced the overall level of risk in our multi-asset portfolios over the course of this year, reflecting rallies across most asset classes even as growth remains slow, extremely low government bond yields persist and central banks are slowly approaching the limits of monetary accommodation.
Also, despite risks to the outlook for emerging markets, the positive catalysts for EM are considerable, including reduced external headwinds (from China, central banks and commodities) and internal restructuring, both leading to the possibility of higher returns. Finally, as we said in the beginning, structural alpha has been for decades important at PIMCO, but we feel it becomes more important as an uncorrelated return generator at a time when most asset class valuations are dominated by central bank actions.
Our modestly “risk-on” portfolio positioning reflects our baseline macro outlook that a version of the status quo continues to evolve gradually. Yet we recognize there are substantial risks to this baseline:
- Increasingly experimental monetary policy is creating greater uncertainty and stretching valuations.
- Global leverage is again on the rise via government deficits in developed countries and private sector borrowing in some major EM countries.
- Success is not assured for China’s transition.
- Political uncertainty is increasing.