All Asset All Access, January 2018

Chris Brightman, Research Affiliates’ chief investment officer, discusses the 2018 outlook across a global opportunity set, while Research Affiliates’ asset allocation and research specialists offer insights into key asset classes. Jim Masturzo (equities), Shane Shepherd (bonds), Michael Aked (real return assets) and Omid Shakernia (alternative strategies) discuss the opportunities they’re seeing as we start the year. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds.

Q: Let’s begin with a discussion of your outlook across global asset classes. What are your return estimates spanning the global opportunity set as we enter 2018, and where are you finding opportunities for attractive multiyear returns?

Brightman: Developing asset class return forecasts (as well as estimates of risk and cross-correlations) is central to our tactical management of the All Asset portfolios. We continually reposition the All Asset portfolios in response to changes in capital market prices to seek high long-term real returns, but in a way that also aims to help investors diversify away from mainstream equity risk and protect against rising inflation. Objectively forecasting returns using our disciplined, value-oriented modeling techniques enables us to systematically employ contrarian rebalancing – essentially seeking to buy assets that have fallen in price, sell assets that have appreciated and repeating this essential practice over time.

By contra-trading against the market’s excess volatility across a widely diversified collection of asset classes, we seek to create a long-term source of incremental wealth accumulation that goes beyond a simple buy-and-hold allocation.

Our approach to forming long-term return forecasts is undergirded by our “building block” model of capital market returns. This model provides long-term asset class real return forecasts by summing the fundamental components of all capital market returns: yield, real growth and changes in valuations. Because we believe today’s yields provide more information about future returns than do predictions of future price changes, we employ only a mild valuation reversion assumption: We assume a 50% reversion to equilibrium valuation within 10 years (or, equivalently, a 50% chance of full mean reversion and a 50% chance of none). Within our All Asset investment process, we further condition these valuation reversion assumptions for the current strength of the economy (i.e., accelerating growth or decelerating growth), which helps calibrate our longer-horizon views for near-term expected fundamentals.

As we scan capital markets today, we find that even after the strong returns of 2017, Third Pillar markets (diversifying markets – including real assets, emerging markets and high yield bonds) remain compelling opportunities, especially in contrast to lower-yielding mainstream stocks and bonds. Figure 1 provides our annualized 10-year real return outlook as of 30 November 2017 across a wide array of asset classes. The red band includes all markets with an estimated real return of 1% or less. A casual glance reveals this lowest band of estimated returns is home to most mainstream asset classes. Unsurprisingly, the conventional 60/40 portfolio (with 60% equities proxied by the S&P 500 and 40% bonds by the Bloomberg Barclays Aggregate Bond Index) is priced to yield a real return of only 0.5%, by our calculations.

As we move up the graph, the yellow band represents asset classes with real return forecasts of 1%–3%, and the green band, of 3% or more. Note that these higher-return areas are dominated by Third Pillar asset classes, trading at prices that provide high relative yields, which in turn position them for relatively attractive forward-looking rates of return. Over a span of 10 years, we forecast an equally weighted Third Pillar portfolio1 to deliver returns in excess of 2% per annum greater than that of 60/40.