In this issue, Chris Brightman, chief investment officer of Research Affiliates, discusses how the coronavirus pandemic is likely to drive a sharp contraction in economic growth, with critical implications for asset classes around the world. As always, these insights are in the context of the PIMCO All Asset and All Asset All Authority funds.
Q: How does the global impact of the new coronavirus disease (COVID-19) affect Research Affiliates’ assessment of economic growth, asset class return expectations, and positioning within the All Asset strategies?
Brightman: Working from home on Tuesday, March 17, I’m rewriting this note. Information available today has dramatically changed from earlier drafts. Any statistics that I might share about the pandemic – numbers of infections, hospital admissions, contagion and death rates, etc. – will be out of date before publication. I’m not a public health expert and here is not the place for speculation about COVID-19. In this note, I share Research Affiliates’ assessment of the impact on economic output, investment returns, and the coming repositioning of the All Asset and All Asset All Authority funds.
Rapid global economic contraction
Let’s start with the economy. Much of global humanity is now engaged in a seemingly unprecedented process of intentionally and immediately reducing travel, personal interaction, and many forms of consumption in an urgent effort to “flatten the curve.” By slowing the surge of infections and pneumonia cases, we collectively aim to keep hospital admissions to manageable levels. Simultaneously, policymakers are acting to mitigate the economic impact.
What do leading indicators tell us? Leading indicators of the economy include capital market signals, which are available in real time, and real economy measures, which arrive over weeks and months. Capital market signals include stock prices, real bond yields, commodity prices, credit spreads, slope of the yield curve, and implied volatilities. While today’s observations will be out of date before this piece is published, most if not all will probably still be pointing to a deep economic contraction.
We must wait for leading indicators from the real economy to estimate the magnitude of this contraction. These indicators include unemployment claims and average hours worked, building permits and manufacturers’ new orders, and purchasing managers’ indices and consumer confidence surveys. Later this month and into April, we will begin to see new data releases and analysis of many if not all of these indicators, which will then reveal a picture of the magnitude of the present contraction.
At Research Affiliates, as Rob Arnott said, we believe that “this too shall pass.” In coming months, after the surge in hospital admissions has peaked, the economy should begin to recover. People will return to work and begin to travel. Consumption and production will resume. Unfortunately, by then many individuals will have lost their jobs as their employers’ loss of revenues precludes making payroll. Some companies will go bankrupt and their stock prices will go to zero.
Immense policy response
Public policy will have a strong influence on how long the economic contraction will last, how many companies go under, and the number of people who will lose their jobs. Fortunately, we now see an immense policy response – monetary, fiscal, and regulatory.
Monetary stimulus is here now and will grow. Contrary to assertions that when interest rates hit zero central banks are out of ammunition, the Federal Reserve can and is providing additional liquidity. This crucial support to credit markets includes not just zero-cost funding for banks and whatever-it-takes QE (quantitative easing; i.e., asset purchases) and swap lines with other central banks. We now see the Fed coordinating with the U.S. Treasury to buy commercial paper to provide credit directly to nonfinancial companies. Expect more from the world’s central banks.
Fiscal stimulus is also on the way. The headline today (Tuesday) on my Bloomberg screen reads, “Trump says ‘We’re going Big.’” Newsweek reports that “Republicans, Democrats and White House officials have said everything is on the table – travel industry bailouts, payroll tax cuts, and even cash straight into Americans’ pockets have all been floated as proposals.” And fiscal stimulus will be global. The Financial Times reports that the new Chancellor of the Exchequer in the U.K., Rishi Sunak, “has announced a £330 billion emergency rescue package for U.K. business, saying the U.K. government will do ‘whatever it takes’ to protect companies and incomes on a huge scale.” The New York Times reports that the Japanese Economy Minister Yasutoshi Nishimura said Tuesday that “We’ll look into a wide range of options on tax, fiscal policy, and deregulation.
Deregulation is likely to be a key policy response. We think about the need to waive bank capital requirements and liquidity stress tests. More important now is providing legal protection for private laboratories administering coronavirus tests, pharmaceutical firms developing vaccines, and ER doctors making difficult triage decisions. We think the Trump administration will embrace such deregulation.
Today’s crash
I’ve worked through many crashes in my four decades in this business. This is a big one. As I write, volatility has spiked, commodity prices have crashed, government bond yields have dropped to or near all-time lows, credit spreads have widened, and global stock markets are firmly in bear market territory. Changes in stock prices, rates, and spreads will have almost certainly moved wildly from here, and in both directions, before you read what I just wrote. Nonetheless, as market sentiment has turned from greed to fear, we believe bargains are and will become available.
What returns do we expect from here? Let’s start with equities. Just last month, the U.S. stock market was hitting new all-time highs.1 The Research Affiliates Asset Allocation Interactive (AAI) website, with data as of month-end February, displays a point estimate real return of zero percent for the U.S. market for the coming decade (with an approximate two-standard-deviation2 confidence band around this long-term estimate of plus or minus 4%). The U.S. stock market was priced at a cyclically adjusted price/earnings multiple (CAPE)3 of 31. The dividend yield was less than 2%. If the market has declined by 30% when you read this note, its estimated real return as we calculated on AAI will have risen to 2%. Perhaps not bad compared with TIPS (U.S. Treasury Inflation-Protected Securities) with negative yields, but not the sort of real return required to meet many investors’ long-term plans.
Fortunately, in the All Asset strategies, we have a far broader opportunity set than U.S. government bonds and the U.S. stock market. We find assets in many markets to be attractively valued (we could say “cheap”), from the U.K. and Australia to Brazil and South Korea. To take an example, the AAI website displays a point estimate real return4 of 7% for the U.K. stock market for the coming decade, with data as of month-end February. The dividend yield for the U.K. market was 4.6% and its CAPE stood at only 15. If the U.K. market has also declined by a hypothetical (or actual) 30%, its estimated real return4 as calculated on AAI will have risen to nearly 10%. We believe that’s a fantastic opportunity in absolute terms and even better relative to negative real bond yields.
Calling market bottoms
Volatility is through the roof. With market prices gyrating from day to day, referencing more specific estimated returns using point-in-time price observations seems almost pointless. Today’s bargains may be better bargains by the next week and better still in the weeks and months to come. Calling market bottoms is a fool’s errand. And yet, as investors we must decide whether, when, and how much to rebalance out of what we think are expensive and low-yielding asset classes, such as developed market fixed income, into newly cheaper and higher-estimated-return asset classes, including foreign developed and emerging market equities.
Tactically rebalance we will; perfectly time the bottom we will not. My partner and co-portfolio manager, Rob Arnott, provides an important insight in a recent Research Affiliates publication, “This Too Shall Pass.” As Rob explains, we won’t wait for good news. By then, much of the opportunity may have passed. The time to buy is when markets are at peak fear.
We needn’t wait until the pandemic’s peak is obviously behind us. Everyone else will be buying then. When the media stops discussing stock prices because its audience loses interest in relatively abstract news about markets and instead becomes obsessed by the real bad news about the pandemic and the resulting economic contraction, then we may be repositioning the All Asset strategies into a more risk-on posture.
Because it is painful to act on such rebalancing decisions, at Research Affiliates we rely on model-driven processes to institutionalize the courage necessary to benefit from these uncomfortable but, we believe, potentially profitable trades. Recall that the All Asset strategies are designed to mitigate damage in times when a conventional portfolio is likely to struggle. If history is a guide, our strategies have thrived and buffered investor portfolios in weak and choppy market conditions. (For more details, we welcome interested readers to read the March 2018 edition of All Asset All Access).
The All Asset strategies represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate, and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the sub-advisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.
1 Asset class proxies for data shown are as follows: U.S. stocks = S&P 500 Index; U.S. TIPS = Bloomberg Barclays US Treasury US TIPS index; U.K. stocks = MSCI UK Index. Source: Research Affiliates Asset Allocation Interactive tool.
2 Standard deviation is a statistical measure of the dispersion in a set of data relative to its mean. It is calculated as the square root of variance, which is the variation between each data point relative to the mean. When applied to the rate of return of an investment, standard deviation can indicate historical volatility of that investment.
3 The cyclically adjusted price/earnings (CAPE) ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period in an effort to minimize variations due to the business cycle. The price/earnings (P/E) ratio measures a stock’s price relative to the company’s earnings per share. EPS is a company’s profit divided by the outstanding equity shares.
4 HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.
ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
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