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PIMCO Releases Asset Allocation Strategies for ‘New Neutral’

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PIMCO on Tuesday released its asset allocation strategy for the next three to five years, saying the world is in a “New Neutral” environment.

The authors, Mihir Worah, chief investment officer focusing on real return and asset allocation, and Geraldine Sundstrom, managing director, argue that central banks will raise rates “slowly and prudently” and that the neutral rate—one that is “neither stimulative nor contractionary”—will be lower than it has in the past.  

They predict inflation will not be a significant problem and that current valuations will “constrain potential returns going forward.”

Consequently, investors need to get used to an environment where returns and optimal portfolio construction doesn’t look like it has in the past. “Investors will need to be more dynamic and tactical in their overall asset allocations, and they should approach portfolio construction with even more differentiation as they allocate risk to individual positions,” the authors wrote.

The slow increase in rates will lead to a longer economic cycle with low but positive returns in most developed market asset classes, the authors predict. They estimate equities and credit will outperform government bonds and cash, with the current equity risk premium at 3.9% and the current spread between U.S. investment grade credit and Treasuries at 137 basis points.

“Therefore, despite corporate bond yields seeming low and equity multiples seeming high, we do not see either market as overvalued or primed for a lasting correction,” they wrote.

They recommended that investors overweight to riskier asset classes in their overall allocation to account for lower yields and higher valuation multiples.

European and Japanese equities are expected to do particularly well as increased dividend payouts and a higher equity risk premiums in Europe drive higher returns. Japanese equities have “some of the best earnings growth momentum in the developed markets” and quantitative easing and structural reform there is expected to improve corporate governance and profitability, too.

China and India are also bright spots, as both countries have implemented reform to reduce vulnerabilities. Regarding China, which has seen significant declines, the authors wrote, “we should point out that the ‘bubble’ and extreme valuations are confined to a small part of the Chinese market, and recent volatility affords attractive entry for long-term investors into the more reasonably valued HSCEI (H shares).”

In emerging markets, the authors predicted that the best performers will be based on “initial conditions and country-specific monetary and fiscal policies.” They wrote, “For countries or companies in emerging markets to attract scarcer global capital, they will need to demonstrate superior return potential that helps to compensate for their lack of liquidity and greater volatility. Policymakers and corporate managers will need to take the steps necessary to lead their countries and companies toward sustainable economic expansion.”

PIMCO predicts two scenarios for global fixed income that could lead to higher long-term rates in developed markets. One is less fear of deflation and a drop in demand for high-quality bonds. Alternatively, and they noted more likely at the end of the three- to five-year horizon, is the end of the “global savings glut.”

“Brought on by cheaper oil and commodity prices resulting in less petrodollars and/or a Chinese economy balancing away from export-oriented to consumption-oriented growth, both possibilities lead to fewer dollars recycling into U.S. Treasuries and other safe-haven government bonds,” according to Worah and Sundstrom.

As inflation slowly accelerates, Worah and Sundstrom recommend investors consider allocations to real assets like U.S. TIPS. “Not only are they an asset carrying only one risk, real rate risk (unlike nominal government bonds that carry both real rate and inflation risks), but we also view them as attractively valued relative to nominal bonds.”

Commodities, particularly U.S. natural gas, are also attractive, while gold is becoming less so as demand cools.

The U.S. dollar is expected to continue to be strong compared to other developed markets. In emerging markets, the Brazilian real and Indian rupee could show strong returns at the end of the secular horizon “if inflation rates are stable enough to attract outside capital.”

The authors noted that although they don’t anticipate another major recession on the horizon, an important risk to their outlook is that should one occur, central banks that have rates set near zero will have little room to maneuver. Higher inflation and geopolitical problems, particularly the evolution of the relationship between the United States and China, are also risks.  

“While risks to the base case are ever present, they are by definition uncertain in likelihood and timing. As such, robust portfolio construction, diversification and identifying investments with ‘positive convexity’ become particularly important in a world of lower expected returns,” the authors wrote.


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