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Asset Allocation Takeaways: Building Resiliency Amid Uncertainty

In this abridged version of our July 2020 Asset Allocation Outlook, we discuss how we are positioning multi-asset allocation portfolios in light of our outlook for the global economy.

These are unprecedented times. The challenge facing investors is how to construct portfolios in an environment where asset prices appear disconnected from the real economy and the resolution of the health crisis is murky.

Our analysis, discussed in greater depth in our Asset Allocation Outlook publication, suggests that valuations of risk assets (equity and credit) are approximately fair, after adjusting for easy financial conditions and assuming a gradual economic recovery. Nonetheless, the distribution of potential economic scenarios over the next 12 months is unusually wide.

As such, we believe investors should maintain a moderate risk-on posture in multi-asset portfolios with a focus on companies with strong secular or thematic growth drivers that are positioned to deliver robust earnings in a tepid macro environment. As always, robust portfolio diversification is critical, but achieving this requires a multi-faceted approach. Duration, real assets, and currencies all can play an important role.

One silver lining is that volatility and uncertainty often lead to great investment opportunities. We believe the next few quarters will present a great backdrop for active management as the nature and the pace of the recovery will create many winners and losers. That should provide a plethora of opportunities to add value through sector selection and tactical asset allocation. Portfolios that are thoughtfully constructed, well-diversified, and sufficiently nimble should be in the best position to navigate the months ahead.

Investment implications

Global equities: We are overweight U.S. equities given the higher share of high quality and growth companies. We are also overweight Japan, which has improving quality characteristics, attractive valuations, and cyclical exposure that is more tilted toward sectors we favor. We are underweight emerging markets and European equities, as these regions are more cyclical and therefore less resilient to a downside scenario.

From a sector perspective, we favor technology and healthcare where innovation is occurring. We believe disrupters in these industries have the potential to deliver high earnings growth in an otherwise low-growth world.

Traditional credit: We prefer high quality investment grade (IG) corporates that we think may provide attractive risk-adjusted returns across a range of recovery scenarios, while being cautious about exposure to highly levered entities. We also see opportunities in select senior financials and bank capital, as well as noncyclical BB rated high yield credits.

In other credit sectors, we are overweight agency mortgage-backed securities (MBS). Agency pass-through securities appear to be trading at attractive valuations and stand to benefit from ongoing policy support. They also provide an opportunity to go up in credit quality while offering similar yield and better liquidity. We also favor European peripherals given their current spreads and because we expect the policy support to continue.

Nontraditional credit: Dislocations in other parts of the credit markets have created attractive risk/reward opportunities.

We continue to find value in structured credit markets, particularly AAA rated senior securities backed by a diversified pool of assets; examples include commercial MBS, residential MBS, and collateralized loan obligations (CLOs). Legacy non-agency MBS remain attractive from a valuation perspective given supportive U.S. housing fundamentals.

In emerging markets (EM), we are emphasizing external debt over asset classes that tend to be highly growth-sensitive, such as EM equities, currencies, and local debt.

Private debt: Private markets take longer than public markets to show signs of stress. We are starting to see compelling opportunities in segments such as commercial MBS and private loans. We expect further repricing to occur in private debt markets over the next 12 months, reflecting weaker economic conditions and less competition from lenders. Additionally, companies previously able to access traditional sources of financing may be forced to turn to private capital sources.

We believe opportunistic strategies will play an increasingly important role in many portfolios in the coming years as investors seek to achieve their long-run return objectives.

Portfolio diversification: Similar to the procyclical portion of a multi-asset portfolio, the risk mitigation component calls for a nuanced approach in the current environment. Instead of relying on duration as the sole anchor to windward, we believe investors need to employ a much broader toolkit consisting of diversifying assets with explicit or implicit government support, risk-off currencies, and alternative assets and strategies.

While term premia are low across the board, we favor the U.S. and Australia given higher yield levels and therefore more room to fall in a flight-to-quality event. At the same time, we believe a well-diversified and targeted duration position should be complemented with other risk-mitigating assets.

The opportunity set can consist of risk-off currencies such as the Japanese yen and Swiss franc, high quality assets receiving policy support such as agency MBS and AA/AAA rated IG corporates, as well as diversifying alternative strategies. Investors can also consider allocations to gold, which tends to be a resilient asset and has delivered diversification in many past recessions and periods of high macro uncertainty.

For detailed insights into our views across asset classes, please read our July 2020 Asset Allocation Outlook, “Building Resiliency Amid Uncertainty.”

READ HERE

Erin Browne is a managing director and portfolio manager in the Newport Beach office, focused on multi-asset strategies. Geraldine Sundstrom is a managing director and portfolio manager in the London office, focused on asset allocation strategies.

The Author

Erin Browne

Portfolio Manager, Asset Allocation

Geraldine Sundstrom

Portfolio Manager, Asset Allocation

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results.

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 low interest rate environments increase this risk. 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. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Private investment strategies involve a high degree of risk and prospective investors are advised that these strategies are appropriate only for persons of adequate financial means who have no need for liquidity with respect to their investment and who can bear the economic risk, including the possible complete loss, of their investment. Diversification does not ensure against loss.

The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.

Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manger in connection with managing the strategy.

There is no guarantee that these investment strategies will work under all market conditions or are appropriate 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.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

PIMCO Asset Allocation Outlook Midyear Update
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