Rob Arnott, chairman of Research Affiliates, and Chris Brightman, CEO and CIO of Research Affiliates, share their views on the near-term risks and opportunities in the global financial markets and explain why the current environment gives them confidence in the forward-looking prospects of the All Asset strategies. As always, their insights represent Research Affiliates’ views in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.
Views expressed here are from Research Affiliates as of 28 February 2022.
Q: What risks or opportunities are you seeing in the global financial markets?
Arnott: To some extent, observers can identify some potential market-moving risks and opportunities. To a far larger extent, they likely cannot. Generally speaking, current market prices should already reflect all that is known (or collectively believed to be true) about the economy plus all the current narratives and assumptions about upcoming risks and opportunities. Prices tend to move when the narratives change, or when what is “known” turns out to be incorrect.
In the midst of the tragedy and tumult of the invasion of Ukraine, elevated fear and market uncertainty seem inevitable in the near term. From an investment perspective, we believe it’s better to ask how current events will change the world as we know it, five years hence. It’s too soon to know. Speculating on future knock-on effects, which are usually only identifiable after the fact, is not usually a productive exercise. At Research Affiliates, our approach is not to seek to be smarter than other observers and investors in forecasting near-term geopolitical or global market shocks, but to be sensible in responding to them as they occur. Geopolitical shocks tend to create new mispricings – opportunities for the contrarian investor – more often than they tend to reward the trend-follower who chases the obvious. For example, we believe that five years hence, it’s hard to imagine that Ukraine will not be a major source of agricultural products for Europe, and Russia a major source of energy.
For the most part, we at Research Affiliates try to assess which markets are cheap and which are expensive and ask where the consensus may be in error. Our approach over the last two decades has been to gauge which markets appear to be overreacting to shocks, respond in a contrarian fashion, and assess which long-horizon opportunities may be under-recognized by most investors.
In these tumultuous times, many central banks are grappling with the implications of the Ukraine crisis on inflation and the potential for major economic disruption, both in Europe and globally. As uncertainty around geopolitical tensions and the path of U.S. Federal Reserve policy loom, are most investors prepared for choppy markets? Unlikely. If inflation in 2022 rivals or exceeds inflation in 2021, can the Fed continue to keep policy rates 5 percentage points or more below prevailing inflation rates? Not impossible, but deeply unwise, in Research Affiliates’ view: Negative real interest rates may serve as an enabler for reckless spending, both by the most creditworthy companies and for governments. Rising rates also appear to be creating a fear that growth stocks could be hit. Will value stocks shrug off weakness in tech? We believe relative valuation would suggest “yes, they can.”
I’m not minimizing the geopolitical importance of the events in Ukraine. They are truly awful. I’m merely suggesting that from Research Affiliates’ perspective, we believe it may be more profitable to look past these events, rather than react to a fast-changing landscape. I’d emphasize that while a choppy market environment exposes the vulnerability of many mainstream investor portfolios, these same conditions offer opportunities for All Asset investors. These strategies tend to do well in times of tumult.
Brightman: A high-inflation environment also introduces near-term risks for many investor portfolios, while creating opportunities for Third-Pillar-oriented strategies (which include investments in real return assets, high yield bonds, and emerging markets), in our view. Mainstream stocks and bonds both tend to be hurt by inflation shocks, but a defining attribute for Third Pillar markets is that they, by contrast, have tended to benefit from rising inflation expectations.
As we explained in a recent Research Affiliates paper,Footnote1 we believe monetary policy alone cannot restore price stability. While raising interest rates is the traditional monetary tool, central banks are constrained, given today’s elevated debt levels. While central banks can taper their financial asset purchases, quantitative easing (QE), in our view, is simply shuffling bank reserves for government bonds on the balance sheets of banks.
At Research Affiliates, we believe that to effectively tackle rapidly rising inflation, governments must also raise taxes to drain excess demand, just as advocated by Modern Monetary Theory (MMT). Slashing spending seems an unlikely choice, given today’s bipartisan embrace of deficit spending. Will legislators nimbly exercise their new responsibility to manage inflation with spending or tax policy? Sustained inflation may be the expedient political path to diminish the real value of excessive public debt.
Q: Where do you see conventional wisdom leading to potential mistakes in today’s market?
Arnott: While many wait with bated breath for each new monthly announcement of inflation over the last 12 months, hardly anyone likely pays attention to the 12-month-old data that is about to drop off. The surge in year-over-year U.S. inflation (as measured by the Consumer Price Index or CPI, published by the U.S. Bureau of Labor Statistics) over the last three months of 2021 was due to fourth quarter inflation of 1.6%, which replaced 0.0% inflation from 12 months before. What’s falling out of the year-over-year average over the next six months? We saw 4.2% inflation in the first half of 2021. (All inflation data here are from U.S. CPI.) So, unless CPI inflation is running at about a 9% annual rate, annualized inflation may seem to be abating in the next six months. Look for the narrative machine to crow about inflation getting under control.
Yet by summer, Research Affiliates forecasts we’ll be back on an inflation upswing, just in time for the election. Why? In the most recent All Asset All Access, we wrote about the inherent smoothing and lagging of rent and owners’ equivalent rent (OER), which together make up nearly one-third of CPI. So, with home prices up 32% over the past two years, and OER up a scant 6% (according to U.S. CPI), Research Affiliates forecasts that OER will rise rapidly (I would estimate 6%–10% per year) over the coming three years.Footnote2 So, there are a lot of moving parts here, most of which I think are largely overlooked in the narrative-spinning machines of Wall Street.
Q: How are the All Asset funds positioned to navigate these forthcoming market and economic conditions?
Brightman: To the extent that inflation and inflation expectations move higher, we believe investors in the All Asset funds should benefit, given these strategies’ inherent focus on Third Pillar investments and the inflation-hedging characteristics they tend to bring. Our strategies are designed to favor both real assets that should act as a cushion to inflation shocks and alternative strategies designed to be return-agnostic to interest rate environments.
Recall that one of the features of these strategies has been their historical correlation with changes in inflation expectations. Since its inception in July 2002, the All Asset Fund’s returns have exhibited an 83% correlation to movements in the 10-year U.S. breakeven inflation rate (over 12-month periods). On average since inception, each 0.1% rise in inflation expectations has historically corresponded to 1.63% in returns for the All Asset Fund and 1.54% for the All Asset All Authority Fund (returns are for institutional shares, net of fees; see Figure 1). To be clear, the All Asset strategies don’t need rising inflation in order to deliver real return potential, but rising inflation expectations historically have generally been a positive tailwind for these funds.
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I’ll also emphasize that along with their real return orientation, the All Asset strategies embed a value-based philosophy. At Research Affiliates, we are forecasting value stocks to deliver long-term annualized real returns exceeding 6% in the U.S. market and in the 8%–10% range for the Japanese, European, and emerging markets (albeit with higher volatility expected along the way).Footnote3 Not only do the long-term return prospects of value stocks around the world appear attractive relative to the investment opportunity set, in our view, but they also typically offer exposure to the cyclical sectors of the economy that tend to benefit from reflation.
Arnott: The All Asset strategies are designed to maximize real return, market conditions notwithstanding. So, if market volatility persists in the near term, we believe our strategies will fare quite well, particularly relative to conventional balanced portfolios. We manage these strategies to extract the benefit from diversification and rebalancing with a disciplined contra-trading mechanism that responds to market movements and reflects what we at Research Affiliates believe are the best long-term risk/reward opportunities. Volatility is our friend, because we believe it creates long-awaited opportunities.
Accordingly, the All Asset strategies have exhibited a history of outperformance during environments of elevated market turbulence – see Figure 2. When the average cross-sectional volatility level of 10 major global asset classes was within its highest historical quintile, the All Asset strategies outperformed a conventional 60/40 stock/bond portfolio; the average 12-month excess return was 3.79% for All Asset Fund, and 5.71% for All Asset All Authority Fund. Further, in such environments, these strategies historically beat an equally weighted Third Pillar portfolio by an average of 1.78% for All Asset Fund, and 3.97% for All Asset All Authority Fund. (All returns listed are for institutional shares, net of fees.)
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While past is not prologue and no investor can reliably forecast the future, any slight shifts toward elevated volatility, sustained inflationary pressures, and a nascent value cycle are reasonable expectations. If they happen, we believe the All Asset strategies are in a position to take advantage of these trends.
The All Asset strategies, including All Asset Fund and All Asset All Authority Fund, 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 subadvisor 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 Chris Brightman, “Inflation Is Here! What Now?” (Research Affiliates, January 2022) Return to content↩
2 Research Affiliates capital market assumptions may vary from those of PIMCO. Return to content↩
3 Research Affiliates capital market assumptions may vary from those of PIMCO. Return to content↩
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