Editor's note: Seeking Alpha is proud to welcome PIMCO as a new contributor. It's easy to become a Seeking Alpha contributor and earn money for your best investment ideas. Active contributors also get free access to the SA PRO archive. Click here to find out more »
There are ample signs of change in the wind for investors. The Federal Reserve is raising short-term interest rates, and U.S. inflation is at target for the first time since 2012. The global trade order that has existed for decades is being disrupted. Several economic indicators are running hot (see Figure 1) even as the current U.S. expansion has begun its tenth year. Volatility is higher as some investors price a dire outcome while others are more sanguine, creating relative value opportunities.
In this midyear update to our outlook, detailed in our paper “Singles and Doubles,” we discuss some medium- to longer-term themes relating to late-cycle investing as well as some shorter-term opportunities arising from current market dynamics.
Four key themes
We see significant risk of an uptick in inflation, as detailed in our paper, “Inflation Awakening.” We believe investors should understand the inflation sensitivity, or “inflation beta,” of their portfolios. Traditional stocks and bonds tend to respond negatively to inflation surprises (see Figure 2), while real assets not surprisingly tend to respond positively; investors should verify and be comfortable with the inflation betas of their portfolios. In our view, many investors are underexposed to real assets – such as commodities and inflation-linked bonds – and that strategy has generally worked well over the last several years as shocks to risk assets were accompanied by fears of deflation, vastly diminishing the diversification properties of real assets. However, this may not hold true going forward.
When above-average inflation starts being a bigger risk than below-average inflation, bonds become a less reliable diversifier for equities and other risk assets. To be sure, high-quality bonds remain a crucial component of a portfolio allocation, in our view, because they are likely to be the best-performing assets in a recession. Also, as mentioned above, inflation-linked bonds are attractive before inflation accelerates. However, investors who count on large bond overlays to damp volatility of portfolios of risk assets may be in for some surprises. (See Figure 3. Also, recent PIMCO research focuses on the underlying mechanisms of the stock-bond relationship. For more, read “Treasuries, Stocks and Shocks.”)
For the last several years, investors have been paid for being long just about any asset (other than commodities) as the exceptional influence of central bank liquidity and lower long-term rates boosted valuations. At this stage in the business cycle, however, with the Fed actively hiking rates and reducing the size of its balance sheet, valuations have become stretched and we should start to see greater dispersion in returns across sectors, regions and factor styles. As is well-known in equity markets, the momentum factor tends to underperform and the quality factor outperform late in the cycle. Similarly, credit spreads tend to underperform equities on a risk-adjusted basis and commodities tend to do well overall as demand starts to outstrip supply. Some of these themes have already begun to play out. Investors should, in our view, stress-test their portfolios at the factor level rather than asset class level to truly understand how it is likely to behave as this cycle plays out. This also underscores the importance of rigorous global research capabilities to pinpoint attractive opportunities in any sector while managing risks. The ability to better analyze the relative value between assets, countries and factors becomes more important than large beta bets.
Market volatility has been increasing for a number of reasons. To begin with, there is general uncertainty around a possible turn in the cycle. Another reason is the potential for implicit portfolio hedges (such as bond overlays) to become less predictable amid greater inflation risk, leading many investors to de-risk by selling assets and reducing leverage. In addition, the Fed is normalizing policy and perhaps re-striking the put (i.e., reassessing the state of economic downturn that would warrant a shift to easier policy or extraordinary measures). And all this is accompanied by something new: a potential change to the framework for global trade that has been in place for decades. These reasons suggest reducing portfolio volatility either explicitly or implicitly by going up in quality, reducing leverage, raising liquidity or purchasing downside hedges. Many investors avoid these strategies in the belief that they all mean reducing yield and giving up potential returns. However, in light of the uncertainties across many markets, we believe return potential over a two-year horizon will likely be better if these strategies are judiciously employed.
Five investment opportunities
With market dynamics shifting and the potential for greater change ahead, investors may find it difficult to determine optimal portfolio positioning. Here are five investment opportunities we see.
Taking a simplified view, yield curves tend to flatten late in the cycle as the Fed hikes more than expected and then steepen in a recession as the Fed cuts rates. The yield curve has been following this playbook during this Fed hiking cycle, but for a number of reasons we think the flattening is overdone and the risk/reward trade-off favors fading this move.
Three main reasons for the flattening (in addition to late-cycle Fed hiking) are the U.S. Treasury’s decision to stop extending the weighted average maturity of its issuance, the anchoring effect of low long-term global rates, and the ability for U.S. corporations to currently deduct pension contributions at the 2017 tax rate of 39% rather than the new 20% tax rate, leading to a rush to buy long-dated bonds. We feel all of these are likely to reverse as the large U.S. deficit combined with the Fed’s balance sheet unwinding will supply plenty of long bonds to the market, the European Central Bank is expected to end its own quantitative easing program by the end of this year, and the Bank of Japan signals possible flexibility in its pegging of the 10-year rate at 0%. Finally, the window for the higher deduction rate for pension fund contributions ends in September.
Shorter-term U.S. corporate bonds are offering more attractive yields than they have in years.
A simpler expression of this trade is to simply invest in shorter-term U.S. corporate bonds, which are offering more attractive yields than they have in years due to a combination of Fed rate hikes, accompanied by wider Libor and credit spreads. Their shorter maturity not only makes them less sensitive to higher rates, but they may also be more defensive in the event of a slowdown or recession.
Basket of EM currencies
Emerging market (EM) assets came off a torrid 2017, but have had a tough run in 2018 as Fed hikes, fears of tariffs and trade conflicts, and political uncertainty in Mexico, Brazil, Turkey and Argentina have weighed on the market. Emerging markets are indeed highly geared to global growth and global trade. Moreover, institutions often aren’t mature enough to handle political change. Any unanticipated slowdown could lead to further underperformance. However, we feel the underperformance is overdone given current risks, and there are pockets of value in EM that rigorous research and an active management approach can uncover. As we discuss in the sidebar, there appears to be an unexplained risk premium associated with EM currencies, which leads us to conclude that a diversified and appropriately sized investment should be part of any long-term asset allocation.
Gold is a real asset that not only serves as a store of value but also a medium of exchange, and that tends to outperform in risk-off episodes. As such, one would expect gold to outperform during the recent period of rising inflation expectations along with rising recession risk. Yet counterintuitively it has been underperforming relative to its historical average (see Figure 6).
We believe this is because in the near term, gold’s properties as a metal and as a currency are causing it to drop amid trade tensions and the stronger U.S. dollar, dominating its properties as a long-term store of value. This leads, in our view, to an opportunity to add a risk-off hedge to portfolios at an attractive valuation.
Large cap versus small cap
Small cap stocks have had a good run, outperforming the S&P 500 by close to 5% so far this year. One of the rationales for this outperformance is that small cap stocks are more domestically oriented and hence less exposed to trade wars and tariffs. While this view has some merits, we feel buying lower quality, lower value, higher volatility small cap stocks is unlikely to lead to outperformance should a real trade war commence. Consistent with the theme for high quality to outperform at this stage of the business cycle, and given attractive entry points, we favor an overweight of large cap relative to small cap.
Alternative risk premia
Higher volatility and stretched valuations are likely to result in lower risk-adjusted returns from traditional risk premia like equity, duration and credit. While smart beta strategies have been proliferating recently, so far these have mostly focused on equities, an asset class that has been well-mined by academics but where it is still possible to find risk premia and alpha strategies that are uncorrelated to the business cycle.
Meanwhile, there is a rich universe of strategies available in the fixed income and commodity markets that can be combined with equities and currencies to form diversified portfolios that seek to harness the benefits of alternative risk premia. Including diversifying but liquid strategies is important, as many strategies that earn an “illiquidity” premium, such as private equity and venture investing, also have a high beta (correlation) to equity markets, which may not be desirable at the current phase of the business cycle.
Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment.
Lofty valuations, an aging expansion and changing rules for global trade are leading to a tricky investment environment. While recession indicators are not flashing a red warning signal that a downturn is imminent, which would imply a retreat to a defensive position, they are flashing a yellow “caution” signal. This coupled with expectations for higher volatility suggest a regime of careful portfolio construction and opportunistic investments. In this piece we have highlighted four themes to consider when constructing portfolios and five opportunistic investments across asset classes that we believe will position investors for attractive risk-adjusted returns in the uncertain times ahead.
EM currencies: A structural source of risk premium?
By Niels Pedersen
The classic foreign exchange carry trade has been studied extensively in academic literature since the late 1980s and tended to perform very well for a long period of time up until the global financial crisis. The trade relies on exchange rates not depreciating to offset the carry advantage of relatively high interest rate countries, and history has borne this out. Average currency returns over long sample periods line up with average real carry differentials versus the U.S. dollar (see Figure A).
After the crisis, nominal and real carry differentials compressed significantly in developed markets, and the G-10 FX carry trade has consequently performed poorly since 2010 with only a modest outlook given the current global developed market rate environment. However, real rates in several EM countries such as Brazil, Mexico, Russia, India, Turkey, South Africa and Indonesia typically continue to be several percentage points higher than developed market real rates – and exposure to a basket of such currencies has been a relatively compelling candidate as a “structural” source of risk premium.
Historical performance of the EM currency carry trade
Since 1995, an investment in a basket of the five highest real carry emerging market currencies has had an annualized excess return of 6.9% against the USD with volatility of 10% and a Sharpe ratio of 0.69, according to our calculations, which compares favorably with the G-10 FX carry trade. Performance has also been relatively robust after the global financial crisis despite significant volatility in commodity markets, backlash against global trade and political turmoil globally.
Only part of the return can be explained as compensation for systematic market risk. After controlling for the empirical equity beta to the S&P 500, the Sharpe ratio is only modestly reduced to 0.5, which suggests investors are more than fairly compensated (i.e., they capture an abnormal risk premium) for the embedded macro risks in the trade (see Figure B). This abnormal risk premium makes the EM FX real carry trade an attractive, scalable trade for otherwise diversified global macro investors, with the potential to be a “structural” substitute for equity and credit risk in a multi-asset portfolio – especially when these are expensive.
Since emerging market assets are more prone to sell-offs on sudden idiosyncratic risks or events, investors should size their exposures accordingly and employ a diversified approach that limits exposure to loss in a single country or event. Embedded indirect exposures to trade tensions, rising rates (e.g., the taper tantrum) and commodity prices can at times be mitigated by funding the EM real carry trade with short positions in currencies that tend to have similar risk exposures, but have less attractive valuations and real carry.
Disclaimer: Past performance is not a guarantee or a reliable indicator of future results.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (OTC:TIPS) are ILBs issued by the U.S. government. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Investments in private assets could be volatile; an investor could lose all or a substantial amount of its investment. Tail risk hedging may involve entering into financial derivatives that are expected to increase in value during the occurrence of tail events. Investing in a tail event instrument could lose all or a portion of its value even in a period of severe market stress. A tail event is unpredictable; therefore, investments in instruments tied to the occurrence of a tail event are speculative. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.
Management risk is the risk that the investment techniques and risk analyses applied by the investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.
Smart beta refers to a benchmark designed to deliver a better risk and return trade-off than conventional market cap weighted indices.
The terms “cheap” and “rich” as used herein generally refer to a security or asset class that is deemed to be substantially under- or overpriced compared to both its historical average as well as to the investment manager’s future expectations. There is no guarantee of future results or that a security’s valuation will ensure a profit or protect against a loss.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.