Asset Allocation Without Tailwinds – 2015 Outlook by PIMCO
The global economy and markets have come a long way since the financial crisis. Output in most major economies (in nominal terms) is higher than it was pre-crisis, as are asset prices. The specter of deflation is starting to fade as economic slack decreases and commodity prices stabilize. Extraordinary central bank policies, 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 their prices.
All this has significant ramifications for the evolution of asset prices and for how investors should approach multi-asset portfolios over the next three to five years, which we refer to as the secular horizon.
We reaffirmed the New Neutral thesis in May, when our investment professionals from across the globe gathered in Newport Beach for our Secular Forum to debate the long-term outlook for the global economy and to identify and assess key variables, trends and catalysts that may affect valuations and returns across global asset classes. We came away from the forum with some important insights, which Daniel Ivascyn, Richard Clarida and Andrew Balls describe in PIMCO’s Secular Outlook, “The New Neutral Revisited.”
At the center of our New Neutral thesis is the belief that even as central banks raise rates, they will do so slowly and prudently, and that the neutral rate over the coming cycle – meaning a rate that is neither stimulative nor contractionary – will be lower than in cycles past (a rough benchmark 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 away from an era of extremely limited price increases. Low interest rates and moderate inflation together support a muted but prolonged business cycle, and we believe this combination helps to sustain current asset valuations.
So why does our New Neutral thesis have significant ramifications for multi-asset investors over the secular horizon? We would argue that the tailwind from ever-lower policy rates and contracting term premia witnessed over the past 30 years is largely past us. Moreover, current valuations – as most assets already price in the reality of lower rates – are likely to constrain potential returns going forward.
Therefore investors must adjust to a world where returns on asset classes and the paradigm for constructing optimal portfolios over the next five years are unlikely to resemble those of the last five or even 30 years. Investors will need to be more dynamic and tactical in their overall asset allocations, and they should approach portfolio construction with even more differentiation as they allocate risk to individual positions. It is still possible to achieve compelling returns, but we believe the role of active portfolio management has become more important, and more necessary, than ever.
The fading discount rate boost
Let’s start with restating the essential point: The tailwind to asset classes from ever-lower interest rates is largely behind us. Over the past several years, lower risk-free rates from aggressive central bank policies accompanied by dropping inflation created a “denominator effect” by pushing discount rates lower, which in turn led to higher valuations of assets. The discount rate applicable to future cash flows, regardless of the asset class, starts with the real “risk-free rate.” The appropriate discount rate for each asset class can be modeled as the risk-free rate with an additional risk premium associated with its position in the capital structure and exposures to risk factors: for example, inflation and term premia for sovereign bonds, default and liquidity premia for credit, and equity risk premium for equities – each building off the risk-free discount rate. As risk-free rates drifted lower over a period of many decades, not only did the present value of future cash flows increase in the sovereign bond market, valuations increased broadly across all asset classes as growth expectations declined by less than the drop in risk-free rates.
So where are we headed? In fixed income, we do not see significantly higher bond yields over the next three to five years. Rather, policy rates are expected to rise gradually over the secular horizon. This change, from steadily falling discount rates to stable or, in many cases, modestly rising discount rates, 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 not work 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 portfolio allocations are sized in order to ensure the risk contribution from stocks, bonds and inflation-related assets is equal, or at parity. Given bonds generally have lower volatility than stocks and other assets, risk parity strategies systematically use leverage to increase risk exposure to the bond component. Over the past several years, markets have been generally friendly to these strategies as bond term premia compressed and volatility became subdued. However, they may now face headwinds as volatility resets and interest rate trends reverse, necessitating an active approach when managing these strategies. Moreover, studies have shown that the negative correlation 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 has significant 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 even more important as correlations become increasingly unstable and dispersion increases across asset class returns. In this new regime, region, country and sector selection and bottom-up relative value strategies will have to do more of the heavy lifting to help offset either the end or reversal of the tailwind of declining discount rates.
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