The post-crisis global economy is growing just fast enough to avoid stalling but there is little evidence of the emergence of enough demand to support a “more robust expansion” says PIMCO, one of the world’s largest bond managers, in its latest secular outlook.
The paper was written by PIMCO’s chief investment officer of global fixed income Andrew Balls, global strategic adviser Richard Clarida, and group chief investment officer Daniel J. Ivascyn. They say the fact that growth remains so sluggish, even if somewhat stable, is problematic for investors.
The trio say that’s because “with the global recovery about to enter its eighth year, with central banks pushing even further into the realm of diminishing if not negative returns to unconventional policy, and with our secular window now open to the year 2020 and beyond”, the risk of adverse outcomes for the economy – what statisticians, PIMCO, and finance geeks call fat left-side tail events – has grown materially.
Put simply, PIMCO is saying there is a heck of lot more risk than there used to be in the global economy and, as a result, for investors and investment returns. That colours its investment thesis which we’ll get to a little later.
Why has the “left tail gotten fatter”?
PIMCO says it’s because “monetary policy exhaustion and an overhang of debt in some major economies pose material threats to the sustainability of the global recovery and financial stability”.
Now it’s not PIMCO’s base case, but the increased risk means that investors need to be compensated in market prices.
“Our secular thesis is that with risks to global economic stability rising, investors should be compensated up front for the growing and heightened uncertainty and potential consequences of monetary policy exhaustion they face,” PIMCO said.
PIMCO asks: “In a world in which stability is becoming increasingly unsustainable, how do we invest?” then lays out a set of guidelines it will be using in managing its client’s money.
PIMCO says it is going to “make capital preservation the number one priority” by targeting “high quality income producing assets”.
That’s not to say the investment manager is going to be seduced by return and yield alone. They want high “but not necessarily the highest-yielding assets”.
The firm does see some risk that all this unconventional monetary policy, quantitative easing and negative rates might actual achieve its goal of increasing inflation, so it warns also that “there is a clear asymmetric risk toward higher yields than those priced into forward curves”.
Its approach then, taking the above two issues of capital preservation and a potential shock to the system, is that the economic and return landscape requires active asset selection and management.
“We see this as an environment in which active managers can improve upon low passive returns. We believe critical decisions have evolved beyond the straightforward how much of a given asset class, sector or region to own in a portfolio, and instead see a need for greater discretion in selecting what to own.”
In stock market terms, PIMCO is saying it believes an active, bottom up, stock picker will outperform the overall market as represented by benchmarks like the ASX200, the S&P 500, FTSE, DAX, Nikkei and so on.
Theoretically this could also be done with lower overall risk in the portfolio.
But its investment thesis also means that periods of stability can quickly morph into periods of high volatility which investors should be ready to take advantage of.
“The experience of the past years has shown that it does not take much in terms of policy actions and mistakes to prompt repricing in markets,” PIMCO says.
“While maintaining overall fairly cautious portfolio positioning, we will seek to benefit from periods of volatility in which assets have the potential to cheapen significantly.”
Crucially they added “to be in a position to benefit, we will need careful portfolio construction and rigorous risk management of our positions”.
There was one important part of the thesis that cut to the very heart of the home bias most investors have. That’s the reality that most investors tend to feel they know their own backyard a little better than the rest of the world and allocate more of their capital in their local market than might be prudent – either in a return or risk management sense.
PIMCO says “we will scour the world for investment opportunities across sectors”.
Granted they can do that with a “global team of 295 portfolio managers and analysts” in a manner not open to your average investor. But it’s a good example that the best return for risk may not always be in the asset investors are naturally most used to or invested in.