Getting in Gear for The New Neutral
The world’s economies have been operating in a lower gear since the financial crisis, constrained by high debt levels, unfavorable demographics and pendulum shift toward reregulation, with the result being subpar recoveries and much lower growth relative to prior cycles. Yet many investors have been handsomely rewarded during this period, thanks to hyper-aggressive central bank policies, including direct asset purchases, which have pushed government bond yields to new lows and equities and other risk assets back toward record highs.
There were certainly potholes along the way, most notably Greece and other European peripherals during the heart of the eurozone crisis, not to mention last year’s Federal Reserve-induced ‘taper tantrum’. Indeed, these are all straight out of the New Normal playbook, which we first introduced in 2009, with structural impediments to global growth, speed bumps, S-curves and potential T-junctions all being part of the mix.
Are we past the extremes? We think so. In fact, at PIMCO’s latest Secular Forum where we look three to five years down the line, our global team of investment professionals called for an outlook we term The New Neutral: As detailed in our most recent May 2014 Secular Outlook, we still see structural headwinds, multi-speed economies and restrained, New Normal-style growth in the years ahead. This means that, even as they move toward policy normalisation, the Fed, the Bank of England (BoE), the European Central Bank (ECB) and other major central banks will target New Neutral real policy rates closer to zero rather than the normal 1%-2% that’s currently priced into the markets.
Bond and equity market returns will likely average a more modest 3%-5% in this environment, though risks will be lower as well. This doesn’t signal an end or volatility; it just means bond yields are unlikely to increase much above current forward rates, while equities and other risk assets remain relatively range-bound. So what’s an investor to do in this environment?
Be smarter about beta
This should be a statement of the obvious, though many still view ‘smart beta’ as a clever marketing ploy rather than as a serious investment strategy – who, after all, would even invest in ‘dumb beta’? Yet in a world of lower expected market returns, or beta, every basis point matters. Just look at figure 1, which compares historical returns on a 60/40 blend of global equities and bonds over the past 10 and five years with a lower future return 60/40 blend portfolio, we are more likely to see over our secular horizon. The analysis is simplistic, but our concern is that future returns will not only be lower than in the recent past but will also fall short of what most investors need and expect.
Smart beta comes in several forms. For many, it means creating more targeted benchmarks or portfolios that exclude certain countries, sectors or issuers that are perceived as either being too richly priced or having excessive risk. This is obviously an active decision and one that needs to be regularly revisited. But we’ve seen a number of examples of this over the years: global bonds ex Japan (yields too low), emerging markets ex Argentina and other countries (volatility too high), corporates ex financials (post-Lehman concerns) and European governments ex peripherals (eurozone crisis). And we’re currently seeing a variation of this in the UK, with pension funds de-risking out of equities into diversified, low-turnover ‘buy and maintain’ credit portfolios structured to achieve specific yield targets while actively avoiding securities with default risk.
The second means to be a smarter beta is through the use of derivative-based overlay strategies, which combine beta-replicating futures or swaps with an underlying portfolio of cash and/or other securities. This is a common approach for pension funds employing LDI (liability-driven investment) techniques, with long duration swaps providing the liability hedge and cash equivalents, short duration bonds or an absolute return portfolio providing the backing. And it’s also one that has been successfully applied over the years to a number of other markets, including equities and commodities. The approaches can vary, ranging from simple beta replication, with the derivative positions being back by pure cash; to enhanced beta, or ‘portable alpha’, with the derivatives being backed by an alpha-focused portfolio of cash equivalents and short duration bonds; to higher-return-seeking forms, with derivatives backed by more aggressive alpha-focused portfolios. But, in all cases, the underlying objective is to create a better, if not higher returning, form of beta.
The third and perhaps purest means toward a smarter beta is simply to adopt more forward-looking benchmarks. There are literally dozens, if not hundreds, of widely available benchmarks across the various asset classes, some very straight forward, others more complex. Yet most come with the same inherent disadvantage: They are backward-looking and market-capitalisation-weighted. For fixed income investors, this pushes allocations more toward countries, sectors and issuers with high and growing amounts of debt as opposed to those with healthier balance sheets – which, other than for liquidity reasons makes little sense. For equity investors, this forces a momentum-driven approach with larger allocations to countries, sectors and issuers that have already increased in price and correspondingly smaller allocations tot hose where prices have already fallen – which, again, seems counterintuitive. In both cases, we believe investors would be better served by adopting smarter, more forward-looking benchmarks – using say, GDP-weighted indices for bonds and more fundamentally driven indices for stocks.
Take advantage of active management
Investors face a stark choice in a world of 3%-5% market returns: They can go active, employing a multitude of tools in an effort to generate higher returns; or they can go passive, essentially locking in ‘beta-minus’ net of fee performance. Active management obviously comes with risks – even the best managers will experience periods of underperformance. Yet passive has risks too, particularly in this environment where ‘beta-minus’ in a low-beta world is unlikely to meet most investors’ return needs. We obviously come at this as an active manager – and I having spent 28 years with the firm, have active in my blood. But, if ever there was a time for active management, this is it.
By going active investors can:
- Maximize flexibility to both play offence and defence in a multi-speed world. Top-down choices of which country, currency or sector, or more specifically for fixed income investors, what part of the yield curve to target, are highly dependent on relative growth rates, inflation levels, policy actions and valuations. This is not a world where one size fits all – which offers clear advantages for active management.
- Benefit from bottom -up credit and stock-picking skills in a world of slower yet differentiated growth. Credit and underwriting cycles are at varying stages depending on where you look, with company/issuers, including for credit, the currency of issue, and optimal choice within the capital structure all being extremely important determinants of performance in this government. And only active management can capitalise on the factors.
- Seek value in some of the more complex or credit-intensive markets, such as non-agency mortgages, high yield, bank loans and bank capital where a deep understanding of the underlying collateral, covenants and other provisions is critical to assessing risk and potential reward. These riskier, less liquid sectors-which are, or should be, off-limits to passive investors – can offer above-average return potential for active managers with the resources and expertise to weed out the increasing issuance with “lite” or “zero” covenants or other overly risky debt.
- Guard against spikes volatility, through direct or indirect hedges, and then take advantage of such spikes by adjusting over-and under-weights accordingly. Though we see fewer potential large, ‘left-tail’ risks in our secular horizon, historically low levels of current implied market volatility leave plenty of room for even minor surprises. And while the effects may wash out over time, there is potential for value that only active managment has the opportunity to capture.
Focus more on outcomes
Investing for market beta is a great strategy when market returns are strong and even better when risk markets are leading the way. Pensions become more fully funded, return-driven investors get amply rewarded and those with income need have little problem meeting their requirements. Most everyone is happy, as long as they’re fully invested with markets being the dominant driver of overall performance and alpha generation being viewed as an important, though secondary, factor.
Investors have clearly been shifting toward more outcome-oriented approaches in recent years, with more pensions embracing LDI and others choosing absolute return, real return or income-seeking strategies as part of their overall allocations. In a world of lower expected market returns, where beta can no longer be all things to all investors, emphasizing outcomes becomes even more important. Whether this means generating income, absolute or real returns, hedging liabilities, inflation or tail risk, or managing liquidity, investors will need to align their portfolios much more toward meeting their specific risk and return objectives.
Consider bespoke, multi-asset solutions
For some investors, a greater focus on outcomes will only mean minor tweaks to their overall strategy and allocations – such as adding a little more income, modest amounts of risk or additional hedges – which can be accomplished fairly easily. But for others, depending on their objectives, particularly for those with more aggressive income or return needs, moving to more bespoke, multi-asset solutions may be the better, if not necessary, route. These would be highly targeted portfolios, designed to meet specific income, absolute or real return, hedging and liquidity needs, with well-defined parameters for controlling risk and volatility. An income-seeker investor, for instance, would want a solution emphasising core fixed income, diversified credit and income-oriented bonds and equities, with specific allocations depending on agreed-upon income targets and acceptable levels of volatility. An investor looking for returns, on the other hand , would need a solution more geared toward absolute return fixed income and credit, smart beta global equity and opportunistic strategies – again, with allocations subject to specific return and volatility targets. Multi-asset solutions aren’t for everyone, but they can help.
What The New Neutral Means For Investors
We expect below-trend, New Normal growth to continue for the world’s economies over our three-to five-year secular horizon – which , in turn, means global central banks will target a New Neutral for real policy rates well below the historical norm. Given current market valuations, slower growth implies more modest returns for investors in the years ahead. The good news is risks and volatility should be lower as well, given reduced ‘left-tail’ risk and the fact that markets are currently pricing in higher, above-New Neutral real policy rates. Though this should help mitigate the downside risk for both fixed income and equity markets, investors will still face significant challenges meeting their income and return objectives in this environment. Being smarter about beta, taking advantage of active management, focusing more on outcomes and considering bespoke, multi-asset solutions well be increasingly important strategies ans investors get into gear for The New Neutral.
Written by William R. Benz, CFA, Managing Director, Head of PIMCO EMEA
Mr. Benz is a managing director in the London office and head of PIMCO Europe, Middle East and Africa (EMEA). He is a member of PIMCO’s executive committee, the chief of executive of PIMCO Europe Ltd., and the chairman of PIMCO Funds Global Investors Series plc. Having joined PIMCO in 1986, he was previously responsible for PIMCO’s European client servicing group and, prior to that, oversaw PIMCO’s U.S. client servicing efforts out of Newport Beach, California. He has 28 years of investment experience and holds an MBA from Harvard Business School as well as an undergraduate degree from the University of California, Berkeley. Mr. Benz has earned the certified public accountant designation.
You can find the full PDF and disclosures here: PIMCO Viewpoint June 2014