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
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 New Neutral
For the next three to five years, even as monetary policymakers seek to normalize
interest rates they will generally set short-term rates at levels below the rates that
prevailed before the global financial crisis. Also in this New Neutral world,
countries will converge to slower trend growth trajectories. Since PIMCO introduced
The New Neutral secular view in May 2014, the construct has been priced in to
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
Forecasting long-term returns
If asset valuations are full and price returns are likely to be
lower overall, where do we find attractive opportunities? The New Neutral hypothesis
offers a guide. Weaker growth potential and waning tailwinds from demographic trends
will likely incentivize central bankers of highly levered, developed economies to
raise rates in a slow and prudent manner, not veering far from the zero bound and
keeping policy rates below previous long-term averages. We believe this will
contribute to a longer economic cycle.
In this scenario, investors should expect low but positive
returns from most developed market asset classes, with equities and credit
outperforming government bonds and cash. Therefore, despite corporate bond yields
seeming low and equity multiples seeming high, we do not see either market as
overvalued or primed for a lasting correction. Investors may wish to add emphasis to
the riskier asset classes in their overall allocation given our belief that lower
yields and higher valuation multiples should be viewed through the lens that rates
will be lower than in previous decades even as they creep upward.
For example, as we consider equities in our asset allocation
portfolios, we estimate the current equity risk premium in the U.S. to be 3.9% in real
terms, 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 to
U.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 even
countries where earnings growth can positively impact prices and valuations.
Next, consider U.S. investment grade credit: Spreads relative to
U.S. Treasuries, a measure that shows the additional premium bond investors demand as
compensation 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), slightly
narrower than the 40-year average of138 bps but wider than levels typically observed
during economic expansions (132 bps on average in first half expansions, and 110 bps
on average in second half expansions).
For global markets, our general estimates for long-term returns
based upon our New Neutral thesis are shown below. These estimates take into account
current valuations, carry and where we believe valuations may be headed based upon our
Turning to emerging markets (EM), we believe that on average
these sectors should outperform comparable developed market sectors over the secular
horizon, but are likely to do so with higher volatility and other risks that must be
As in the developed markets, lower yields have been a tremendous
supporter of performance for EM assets following the financial crisis. However, in the
past few years, emerging markets have gone through numerous challenges that have led
to generally disappointing performance. Lower growth, lower commodity prices, weak
exports and a strong U.S. dollar recently have been serious headwinds. The silver
lining of the recent challenges, however, is that EM assets generally offer more
favorable starting valuations.
EM growth, which is expected to be higher than in developed
markets, also helps valuations appear attractive. Add in the higher level of
investments and productivity enhancements, and we have a favorable backdrop for
attractive secular returns from emerging markets.
Thus far we have described the likely impact of The New Neutral
on 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 more
attractively priced securities that may deliver more attractive risk/return tradeoffs.
In developed markets, to name a few examples, we believe global equities outside of
the U.S. offer better forward return potential than those within. Across credit
sectors we see superior opportunities in European financial and U.S. housing sectors.
With respect to government debt, we generally find inflation-linked securities more
attractive than their nominal counterparts.
In EM, our theme of differentiation and dynamic management of
portfolio positioning is even more important. No single EM country or asset class is
likely to deliver these "average" long-term returns. Secular winners and losers will
be decided as a function of initial conditions as well as country-specific monetary
and fiscal policies. For countries or companies in emerging markets to attract scarcer
global capital, they will need to demonstrate superior return potential that helps to
compensate for their lack of liquidity and greater volatility. Policymakers and
corporate managers will need to take the steps necessary to lead their countries and
companies toward sustainable economic expansion. Successful investors will have to
work 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 going
Capital Market Return Assumptions for Strategic Asset
Our long-term estimated returns are based on a structured
internal survey, which queries senior portfolio managers (both generalists and
specialists) for their forecasts for key markets. The survey is overseen by the asset
allocation and the analytics teams.
The key inputs that are obtained through the survey process are
forecasts 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 and
- Sovereign credit spreads
A set of robust, well-established valuation models that map
current market variables to expected returns serves as an anchor for the inputs in the
survey process. For equities, country-specific cyclically adjusted earnings yields and
estimates of equity risk premia over the local real interest rate relative to
historical levels provide the most important analytical valuation anchor. Expected
earnings 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 alongside
model-based estimates of long-term fair value for nominal and real yields are the most
important analytical inputs which guide the expected long-term yields and model-based
returns. For credit, the level of the current credit spread relative to history
(adjusted for leverage ratios and composition across sectors and ratings quality) and
historical defaults and downgrade losses are combined into a model-based forecast of
future spreads and returns for both investment grade and high yield. For
FX/currencies, real interest differentials are combined with a mean reversion toward
purchasing power parity (PPP)-based fair value across countries to determine a model-
based FX spot appreciation/depreciation and overall FX return.
Themes 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) refocus
portfolio construction, (2) revisit sources of value through active management and (3)
be judicious in asset allocation decisions. We believe investors will be best served
if they consider opportunities across asset classes and throughout the globe.
ASSET ALLOCATION PORTFOLIOS
In our asset allocation portfolios, our investment decisions are
a four-pronged framework:
- We begin by gauging where in the globe macroeconomic conditions or policy
actions are likely to produce the biggest surprises. These factors interact with
macroeconomic fundamentals in ways that can have meaningful effects on asset
- Then we conduct a rigorous analysis of cross-asset valuations and risk premia
to inform our decisions on what to own long-term. This helps us determine our
strategic 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 incorporated
to scale exposures.
- Despite the waning tailwind of declining discount rates on asset
class returns, we believe investors should not only stay invested, but look for
opportunities to strategically overweight risk positions over the long term. Moderate
global growth and a gradual upward path to interest rate levels lower than in previous
cycles should be supportive of asset classes, though support is more tilted to
providing a floor than providing a boost.
- A global survey of equity risk premia suggests fair to attractive
valuations relative to bonds and recent history
- Exposure in Europe and Japan appear attractive given policy
efforts that are stimulating growth, the levels of dividend yields and current
- Emerging markets, particularly those in Asia, offer attractive
opportunities for strategic overweights given macro trends, supportive policy and
reforms, and levels of equity risk premia particularly when compared to recent
- Core fixed income retains its important role in a multi-asset
portfolio to provide diversification and income
- We are wary of exposure to interest rates in developed markets as
rates 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 above
government rates remain within fair to attractive levels
- We find specific opportunities such as European financials and
U.S. housing-related credits most attractive
- A deeper appreciation for potential liquidity is needed given less
inventory capacity at banks due to global banking regulations
- Global inflationary trends may be poised to reverse and gain
positive momentum, bolstering the case for real assets
- Inflation-linked bonds are particularly attractive as their prices
continue to imply very low inflation premia when compared with nominal bonds
- Differentiation and tactical agility will be necessary to extract
attractive returns from commodities as we believe supply and demand are generally
- We remain bullish on the U.S. dollar, and thus underweight
international and emerging market currencies, given the divergence of Fed policy with
most global central banks
- There are select opportunities in higher-yielding EM currencies
like the Indian rupee; investors should nevertheless be wary of the potential for
Positive long-term outlook
We are generally constructive on the potential for equities to
deliver long- term returns, though (as noted above) our 10-year forecast for developed
market 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, an
extended business cycle and low discount rates which, if they move up, will likely do
so slowly and to levels still low by historical standards.
Looking around the globe, European equities appear attractive
over the secular horizon. In addition to the broader developments discussed, the trend
toward increased dividend payout and a higher equity risk premium provide a good
backdrop for superior returns. European equities offer high levels of earnings yields
and valuations are lower relative to history. We think a resolution of the Greece
crisis would remove a source of uncertainty and allow the market to outperform.
European financials may be a good secular choice in equity
space, as well as hybrid securities or subordinated debt. We believe European banks
are now far advanced in raising capital and in reaching some degree of normalization
in yields, and the shape of the yield curve should lead to higher profitability, which
is already buoyed by the cheap funding the European Central Bank (ECB) continues to
provide through sustained quantitative easing.
In Asia, Japanese equities also offer strong secular return
prospects. They have some of the best earnings growth momentum in the developed
markets and stand to further benefit from the quantitative easing and structural
reforms that are improving corporate governance and profitability.
We also favor equities in China and India: Both countries have
embarked on secularly far-reaching reform agendas that should diminish vulnerabilities
and unleash value. In particular, we should point out that the "bubble" and extreme
valuations are confined to a small part of the Chinese market and recent volatility
affords attractive entry for long-term investors into the more reasonably valued HSCEI
Global Fixed Income
Differentiation Is Critical in Anchor Asset
Fixed income should remain a cornerstone of multi-asset
portfolios for the foreseeable future as The New Neutral remains an anchor for fixed
income valuations. However, ahead of the first Fed hike in almost 10 years, we are
cautious on developed market duration in our portfolios and encourage investors to
consider the full spectrum of global opportunities in fixed income.
In the developed markets we are likely to see term premium
return to yield curves. There are two potential scenarios that could lead to higher
long-term rates. The first would be the decline of fears of deflation and the end of
the strong bid for high quality bonds that markets experienced when developed
economies recently teetered on the edge of recession. A second scenario, more likely
to manifest toward the latter part of our secular horizon, may be the unwinding of the
global savings glut. Brought on by cheaper oil and commodity prices resulting in less
petrodollars and/or a Chinese economy balancing away from export-oriented to
consumption-oriented growth, both possibilities lead to fewer dollars recycling into
U.S. Treasuries and other safe-haven government bonds.
Further, we could see the re-injection of "credit risk" into the
government bonds of Italy and other peripheral European countries. Current yields and
spreads compared to German government bonds may be attractive given the backdrop of
ECB support. However, when asked to stand on their own, these bonds should not be
trading at yields close to U.S. Treasury yields unless debt burdens are reduced and
the economy is made more competitive.
We are secularly positive on Mexican interest rates as inflation
has been reined in and Mexico has built significant fiscal and monetary policy
credibility over the past several years. While Mexico's central bank is expected to
raise rates in tandem with the Fed, we believe the market has priced in too many
hikes. Credibility and institutional stability should see the spread of Mexican Bonos
(Mexican government bonds with a fixed interest rate) to U.S. Treasuries compress in
our secular horizon; we favor the intermediate part of the curve.
We are also hopeful that Brazil will move past its recent
challenges to see better prospects ahead with a better mix of monetary and fiscal
policies and more investor-friendly policies. The extremely high real interest rates
would be very attractive if inflation were tamed and political and economic volatility
As mentioned earlier, we believe credit spreads are broadly fair
and provide adequate compensation for default risk. In such a scenario, and with no
expectations of an elevated default cycle any time soon, one should earn the credit
risk premium by investing in privately issued debt. However, credit differentiation
and the identification of broad themes become more important in a world of diminished
liquidity for specific industries and sectors that we find attractive on a secular
basis (see the Secular Series publication, "Picking U.S. Energy, Housing and Other
Credit 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 and
In a world of diminished liquidity and mostly fair valuation for
corporate bonds, it is perhaps appropriate to talk about a broad sector that still
offers attractive return potential at the cost of sacrificing liquidity: private
opportunities that require capital to be locked up for a period of time. There is a
role for investors to take advantage of these as sources of financing from banks and
other traditional lenders fade. These deals are often complex, and illiquid as
advertised, but can be rewarding to institutions and investors who have the expertise
to decipher the intricacies and unlock value. At PIMCO, we believe that this sector
offers a win-win as investors seek higher returns than those offered by publicly
traded 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 return
approximately 2% more than equities, with lots of room for differentiation and
opportunistic investment leading to potential outperformance.
Key Opportunities as Inflation Gradually
As we see inflation accelerating, albeit gradually, over the
secular horizon, we suggest investors consider an allocation to real assets, meaning
assets that directly or indirectly hedge inflation risk (see the Secular
Series 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 an
asset carrying only one risk, real rate risk (unlike nominal government bonds that
carry both real rate and inflation risks), but we also view them as attractively
valued relative to nominal bonds. The large amount of slack in the global economy over
the past few years as well as the recent commodity price correction have resulted not
only in a drop in inflation expectations (and fears of possible deflation until
recently), but also in a near complete removal of inflation risk premium from the
markets. Under these conditions, we think TIPS are an attractive choice for the core
fixed income component of a multi-asset portfolio.
Commodities are another asset class that embodies the greater
differentiation within asset classes that we expect going forward. During the
supercycle of the early 2000s, when demand growth outpaced supply growth, most
commodity sectors rose together. Then, as supply caught up over the last few years, we
saw declines across most commodities. Going forward, supply and demand should be
better matched and investors will have to be more selective in order to generate
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 thermal
units) trading close to prices where it is economical to substitute gas for coal in
U.S. power production and significantly below the prices where natural gas trades in
the 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 sources
and the political process in the U.S. possibly allows for greater energy exports.
We also believe gold is losing its shine. The two biggest
drivers of gold prices, U.S. real interest rates and the U.S. dollar, should both move
modestly higher over the secular horizon, affecting financial market demand. Physical
demand from India could also cool as the financial markets mature and the government
promotes viable alternatives to gold for savings and wealth preservation.
Finally, an important element of commodity prices is the
announcement of the anticipated agreement with Iran. While geopolitical risk in the
Middle East has been a source of supply disruptions leading to higher prices, peace
with Iran should bring additional oil into the global market, leading to a cap on
Continuing Strength in U.S. Dollar
Over the secular horizon, the major factors driving currency
returns are interest rate differentials and inflation surprises. We continue to expect
broad strength in the U.S. dollar over the early part of the secular horizon. We
expect the Fed to be the first major central bank to hike rates as the U.S. economy is
a few years ahead of other major economies in its recovery.
This divergence will lead to U.S. dollar strength versus most
developed economies where current policy is likely to further weaken local
In the latter part of the secular horizon we could see strong
returns from the higher-yielding EM currencies like the Brazilian real (BRL) or the
Indian rupee (INR) if inflation rates are stable enough to attract outside capital.
The offshore exchange market in the Chinese yuan (CNH) also bears watching for
possible appreciation as China further loosens capital controls; the CNH is more
widely accepted in global trade (including becoming part
of 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 a
move away from deflation or "lowflation" territory and toward central bank targets.
Inflation is a notorious lagging, late-cycle indicator. It is possible that central
banks misjudge the degree of slack in the economy and easy and unconventional policies
result in a period of higher-than-expected inflation. This would be negative for
returns in both bonds and stocks, positive for commodities.
Geopolitical risks also cast a shadow on our outlook. There are
several known potential flash points around the world, and many that cannot yet be
anticipated. A key development to watch is the evolution of the relationship between
China 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 by
definition uncertain in likelihood and timing. As such, robust portfolio construction,
diversification and identifying investments with "positive convexity" become
particularly important in a world of lower expected returns.
Finally, though one often thinks about "left tails" when talking
about 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 or
improved fiscal policy, both of which may lead to stronger growth rates than the muted
ones we expect in the U.S. and Europe. This development would obviously be positive
for risk assets like equities and credit.
Asset Allocation Best Ideas: A Secular
As our survey of the outlook for major asset classes
demonstrates, investors likely should reconsider their long-term paradigm to multi-
asset portfolio construction. This is not because we forecast a bear market in
equities or other dramatic turns. It is because The New Neutral has mostly been priced
in to asset valuations, and investors should be well-served by differentiating among
broad allocations and being diligent in examining specific opportunities to seek those
with compelling risk-return potential.
Broadly, our secular bias is to overweight equities and credit
fixed income and underweight government bonds. Patient investors may also benefit from
overweighting exposure to emerging markets, though they need to be careful about how
they execute and stay aware of the risks. Finally, while not suitable for all
investors, illiquid, private investments, if prudently chosen, can offer superior
return potential and diversification in an era of shrinking government and bank
The next step is to be tactical, which includes the perennial
admonition to "do your homework." Yet from a tactical standpoint, there is one aspect
of our New Neutral thesis to consider both for risk and return: We are likely to see
substantial bouts of volatility ahead. In the near term, we expect the Federal Reserve
will conduct its first policy rate hike later this year. While we expect the Fed to
move gradually over time to a lower "neutral" policy rate than in previous cycles, we
believe investors may be underestimating the volatility that could ensue from moving
off the zero bound. Longer term, we see greater likelihood of flash crashes and
general volatility resulting from the global banking system, which as a result of
post-crisis regulation allocates less of its balance sheet to making markets. The
banks 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. Portfolios
that appear well-diversified based on historical data may turn out to be less so in
Issues of liquidity and volatility should be of concern to
investors, but they can also be sources of opportunity when securities pricing becomes
divorced from fundamentals. There is reason for cautious optimism among investors
revisiting their approach to multi-asset portfolio construction for the long term.