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Investors have enjoyed economic stability and positive market returns for years, but stretched valuations and a changing macroeconomic backdrop suggest a change is coming.
As our colleagues detailed in the essay “Pivot Points,” which summarized our views from our Secular Forum in May, there are potential catalysts for change on the horizon. We discuss those factors and other secular themes in this section, and in the next section we will update our nearer-term views for asset allocation in 2017, including a key change: our move to a more defensive stance. But first, as a quick reminder to readers, the goal of our annual Secular Forum is to determine our outlook for the next three to five years, allowing us to position portfolios for long-term shifts in global trends and asset valuations. At the forum, we debated and analyzed potential outcomes related to the following pivot points:
Monetary policy: We expect Fed balance sheet and policy rate normalization, but less than many think, with a lower New Neutral destination for the fed funds rate. We expect the European Central Bank (ECB) to follow with a couple of years’ lag.
Fiscal policy: We expect that any U.S. fiscal package that passes will be tilted to tax cuts, but light on reform; we see limited fiscal space in Europe.
Trade policy: We expect the U.S. to focus on bilateral deals (e.g., China, NAFTA) and aggressive use of existing authority within the WTO.
Exchange rate and geopolitical policies: Amid populist movements in Europe and beyond, we expect the euro to survive and Italy to remain in the eurozone. The Chinese yuan is likely to grind weaker.
While the direction of some of these policy pivots may be known, the path that the policies actually take, their impact on the global economy and markets and their ultimate destination are today all highly uncertain. Although we don’t foresee an imminent recession, we estimate its chances are roughly 70% in the next three to five years.
Secular asset allocation considerations for investors
To anchor our secular asset allocation outlook, we start with assessing long-term valuations across major U.S. asset classes – rates, equities and credit – since these tend to drive moves in other global markets. Combining starting valuations with the macroeconomic conclusions outlined above will allow us to set the stage for long-term portfolio construction.
While the Fed has hiked its policy rate four times since December 2015, U.S. interest rates remain low by historical standards. However, PIMCO’s New Neutral thesis indicates that a combination of debt overhang and modest global growth is likely to keep rates range-bound around these lower levels over the secular horizon, with an expected neutral real policy rate of around 0% rather than the historical 1.5%. Indeed, as Figure 1 shows, while rates may be low, they are currently in this New Neutral range. In this framework U.S. rates remain one of the more attractive portfolio hedges against risk-off events or an economic slowdown, despite the Fed’s hiking path. However, we are keeping our eye on a key risk to this outlook, which is a possible change in term premium as the Fed begins to reduce the size of its balance sheet, even as fiscal deficits are expected to grow.
It is important to look at equity valuations in the context of the current low-rate environment. Within equities, we accomplish this by looking at the real equity risk premium, which measures the excess long-term return expectation of equities after normalizing for the level of yields. When viewed from this lens, U.S. equity valuations are beginning to become richer than historical averages and, in fact, are approaching the highs typically observed in the second half of expansions. This points to caution in the popular and crowded U.S. equity market. Moreover, long-term valuations on this measure remain more attractive in select global equity markets.
Similar to equities, even when adjusting for the current low-rate environment, credit spreads have also become rich compared with their long-term averages (see Figure 3). Furthermore, the underlying risks may be further understated as this simple history does not account for increased riskiness of spreads due to a higher average maturity today versus the “bubble years” of 2005–2006.
In summary, U.S. rates are low but fair in the New Neutral context. Accounting for the low-rate environment, U.S. equity valuations are slightly rich relative to history, with credit spreads trending even richer. Globally we see similar forces driving low-rate environments in developed markets, though we see greater pockets of value in non-U.S. equity markets and select credit sectors. Overall, the result of lower rates and tighter risk premia across most markets means lower forward-looking returns.
This backdrop, coupled with increased uncertainty driven by our key secular pivot points, argues for reducing risk and increasing focus on relative value within and across sectors and risk factors.Passively allocating to broad asset class exposures is unlikely to produce the attractive returns and modest volatility experienced over the last several years; in fact, we expect quite the opposite. Both outcomes relied in part on globally coordinated easing across central banks, which boosted valuations and reduced risk. Not only do central banks have less room to ease in order to blunt the impact of the next recession, many are declaring victory on the major dislocation from the financial crisis and have already begun to reduce accommodation. This change in central bank behavior is one of the major pivots investors need to focus on.
Against this backdrop, there are still opportunities for patient investors. For example, within credit markets, security selection becomes all the more important to find names that can withstand a slowdown or correction without inflicting permanent capital losses on investors – and this is just one example of a sector where the benefits of an active, rather than passive, approach to investing become clear. Alternative risk premia strategies may add value as return generators and diversifiers when traditional risk premia are compressed. And one can take advantage of the low implied volatility still being priced by markets today through option strategies.
In summary, here are five secular asset allocation conclusions:
- Reduce risk amid richer valuations and removal of central bank accommodation
- U.S. Treasuries are still attractive defensive assets as the New Neutral anchors rates
- Expect better equity returns outside the U.S.
- As credit has turned to the rich side of fair, focus on active management and security selection
- Continue to favor securitized debt, again with an active approach
More timely themes in multi-asset portfolios
Shifting from long-term asset allocation considerations to more pressing investment themes, our cyclical view on risk and valuations underscores our cautious long-term view, which points to selectively taking risk off the table. In our 2017 Asset Allocation Outlook “Tails and Transitions,” we explained that even in the near term there is significant risk of extreme events both to the downside (left tail) and upside (right tail). Considering where valuations are today, investors should take extra care to assess the downside potential. Indeed, this is the first time in the last several years that we are advocating a defensive stance. (For a quick take on our near-term positioning, see the graphic illustration of our views across asset classes).
The last several months have seen strong performances by global equity and credit markets aided by a combination of fundamental macroeconomic tailwinds along with the dissipation of some (not all) political risks and anticipation of future reform. Key highlights:
- Global recovery has continued with modest sustained GDP growth.
- Q1 2017 earnings season beat all expectations by a wide margin, producing the best vintage in 15 years in Europe; the cycle is globally synchronized with few disappointments. Q2 is shaping up to be strong as well.
- Oil prices have generally remained range-bound between $45–$55/barrel, which has helped to stabilize inflation expectations (versus early 2016), adding further support to emerging market (EM) assets and earnings.
- Benign or even positive market reactions followed key political events including Brexit and the U.S. and French elections. Market participants viewed the Brexit vote as a localized issue, while the results of the U.S. and French elections were viewed favorably for business conditions and corporate earnings.
However good the backdrop, one cannot help but notice that all these positive developments are widely discussed and well-known by most investors – and therefore already reflected in asset prices. As usual, markets will want more good news to fuel the rally. And this is where the problem lies – there aren’t any obvious positive catalysts on the near-term horizon to surprise markets in a good way, and while our base case is for many of the known tail risks to remain at bay, clouds have started to gather again on the horizon – too many to ignore:
- Little progress on tax reform or healthcare policy while the deepening of the Russian investigation further draws into question the ability of the U.S. administration to deliver on its agenda
- Untested tightening through balance sheet reductions by the Fed and a potential slowing of purchases by the ECB
- China’s financial sector regulatory reforms to rein in risk and credit growth amid a downgrade by Moody’s that reminded markets of the accumulating debt pile that is becoming a growing challenge.
- Brazil’s political scandal, which abruptly halted a yearlong recovery
- Rising earnings-per-share (EPS) consensus estimates, which will make positive surprises more difficult from the third quarter onward, all the more so due to the strong baseline of recent quarters
- A broadly disappointing inflation profile globally, which has appeared to plateau after rebounding from 2016 lows
Balancing the risks against a backdrop of buoyant markets, it is a good time to pause and scan the horizon for new directions the markets may take. And after reviewing the landscape, we conclude that the lack of near-term positive catalysts combined with current valuations does not offer sufficient margin of safety to support a risk-on posture. While we wait for clarity on key risks or more attractive valuations, we are focused on quality sources of yield to increase portfolio carry while still keeping some dry powder.
On the defensive side, U.S. duration remains an attractive diversifier in our portfolios. Though U.S. rates are in the midst of a hiking cycle, they are likely to remain range-bound given the balance of downside risks and still have room to rally amid a risk-off event. Against a backdrop of low volatility, option strategies including tail risk hedges like put spreads provide an attractive downside profile while allowing for continued upside participation.
Offensively, we do see potential opportunities in Europe and emerging markets (EM) should policy surprise to the upside, given more favorable starting valuations. For example, a continued EU recovery coupled with exit trajectory for the ECB asset purchase program could help strengthen the euro and steepen the yield curve, providing a boost to EU financials. Similarly, a soft landing in China is likely to have broader positive implications for the region, giving new tailwinds to EM equities and EM currencies. Finally, a weaker U.S. dollar in either of these scenarios could provide a boost to sectors with large overseas exposures, like technology.
Asset class views
Here is how we are positioning our asset allocation portfolios in light of our broad near-term outlook for the global economy and markets.
With the macroeconomic backdrop evolving in the face of potentially negative pivot points and considering asset prices generally are fully valued, we are modestly risk-off in our overall positioning. Note this is a shift in our views from the start of the year. We encourage investors to consider actively managing their portfolios, emphasizing relative value and security selection. We recognize events could still surprise to the upside, but starting valuations leave little room for error.
While we are more constructive on equities relative to other risk assets, in light of the recent rally we are maintaining an underweight to U.S. equities. Potential changes to U.S. tax policy and regulation may provide further support to domestically oriented U.S. corporations, while continued USD weakness would support the export-oriented sector. We are moderately bullish on European equities, with growth in the region above trend and an accommodative ECB. We currently have a small positive allocation to EM as a long-term value play.
We remain defensive on interest rate exposure. However, in contrast to the equity market, we find the U.S. the most attractive. Beyond the U.S., we find UK gilts and Japanese government bonds rich, and we believe valuations of eurozone peripheral bonds are suspect without continued ECB support.
At this later stage in the business cycle, investors should appreciate the limited spread-tightening potential of corporate bonds as well as the downside potential for defaults or spread widening. Our credit allocation is focused on non-agency mortgage-backed securities, which will likely continue to benefit from an ongoing recovery in the U.S. housing market and remain well-insulated from many global risks. We also focus on bottom-up security selection informed by our rigorous global credit research.
We maintain an overweight to real assets, with a focus on U.S. Treasury Inflation-Protected Securities (TIPS). Inflation expectations have risen recently, yet we believe there is still value in TIPS as the market is underpricing U.S. inflation risk. While we expect U.S. inflation to remain muted in the near term, longer-term risks remain. We have increased our allocation to real estate investment trusts (REITs) as valuations are attractive given their recent underperformance.
We continue to favor small tactical positions in some of the higher-carry “commodity currencies” given still-attractive valuations. Asian economies have benefited inordinately from global trade, but are likely to weaken in the face of slowing Chinese growth.
Key risks to the outlook and conclusions
There are always risks when making projections at lengths of three to five years, particularly in the current environment, which offers no shortage of uncertainty. Some of these key secular asset allocation risks include:
- The global economy is “driving without a spare tire” ahead of the next recession, whenever it happens, as most central banks are not far removed from the zero lower bound
- The potential for the long-held geopolitical equilibria in the Korean Peninsula and Middle East to be shaken up
- Risks of missteps as China continues the attempt to rebalance its economy from an unsustainable export-oriented one to a more domestically supported one
These are just some of the important “known unknowns” that can drive a pause in risk-taking in the current environment, even before accounting for additional “unknown unknowns” that could disrupt markets. Therefore, a focus on valuations, portfolio construction and diversification will remain essential to weathering the many upcoming “pivot points.”
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