Maintaining a cautious stance, sticking to active management and buying inflation protection are among the ways investors can protect their savings and generate outperformance over the next three to five years, according to PIMCO’s ‘Secular Outlook’. 
A recent FE Trustnet poll highlighted that the majority of readers believe it has never been harder to build a diversified portfolio than today – and it’s easy to see why.
After all, risk assets have been on a seven-year bull run since the end of the global financial crisis, meaning valuations are high in most cases and yet global growth remains relatively weak, suggesting central banks are beginning to lose their firepower.
PIMCO’s ‘Secular Outlook’, which is authored by chief investment officer of global fixed income Andrew Balls, global strategic adviser Richard Clarida and group chief investment officer Daniel J. Ivascyn, also highlights that investors face a very challenging backdrop.
“Global leverage is again exploding via government budget deficits in the rich countries and private sector borrowing binges in some major emerging market economies. Asset prices in some markets are distorted and traditional metrics of valuation are case aside in a world of QE infinity, negative interest rate policies and sub-zero seven-year sovereign yields,” the report said.
“Although global imbalances have declined and are shrinking, they have been replaced by ballooning central bank balance sheets and as a source of liquidity and cheap finance for the chronically indebted.”
“We believe it makes sense to position ourselves with this elevated risk in mind.”
As such, Balls, Clarida and Ivascyn highlight five tips investors may wish to consider when building their portfolio for the next three to five years.
Prioritise capital preservation
For most of the period following the global financial crisis, investors have had a relatively easy ride with most major asset classes posting decent returns.
Performance of indices since the global financial crisis
Source: FE Analytics
Balls, Clarida and Ivascyn say this is because most areas of the market have been “riding a wave of central bank interventions” and with such policies now having a lesser impact, they say investors should have a different mindset when building a portfolio.
Indeed, they say investors now need to have capital preservation firmly at the front of their mind rather than trying to chase past returns.
“Overall, we expect to have more cautious positioning in our portfolios and to make capital preservation the number-one priority,” the team said.
“It will be critical to target high quality income-generating assets in our portfolios but not necessarily the highest yielding assets – we will tend to look for structural seniority and want to see sufficiently strong fundamentals or hard asset coverage to help the investments weather the uncertainties over the structural horizon.”
“We cannot rely solely on central bank support. The secular timeframe is likely to remain a very difficult environment for investing and we will seek to avoid investments where there is a real risk of permanent loss.”
Keep to active management
Though many will no doubt disagree with this tip, Balls, Clarida and Ivascyn says that the next three to five years could prove painful for investors who simply track indices.
While this strategy has worked well in some of the major areas of the market since the crisis (notably in US equities and fixed income), they say finding alpha will be the key over the medium term.
“The combination of fixed income markets that price in ‘The New Neutral’ and fairly fully equity valuations means we are operating in a low return environment,” the PIMCO team said.
“This reinforces the importance of active management, with alpha set to be a higher proportion of total return than during the secular bull market. We see this as an environment where active managers can improve on 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 ‘what’ to own.”
Avoid the eurozone
Turning to individual investment ideas now and Balls, Clarida and Ivascyn say investors shouldn’t follow the crowd into European assets.
At the start of the year Europe was the most preferred region with FE Trustnet readers due to low relative valuations and the expectation of further stimulus from the European Central Bank – a decision which is yet to pay off given the MSCI Europe ex UK index is behind global equities with a small gain of 0.83 per cent.
Performance of indices in 2016
Source: FE Analytics
However, having backed the region over recent years, the team at PIMCO is reversing its positioning due to various factors.
“The eurozone secular outlook in particular is subject to a series of risks – economic, political and regulatory – and significant uncertainty over the reliability of property rights and the protection of the rule of low (recent examples of the latter include Portugal and Austria).”
“In recent years we have favoured eurozone markets with a secular bias to be overweight but, at current valuations and given the risks to the outlook, we expect to be cautious and very selective on eurozone holdings in our portfolios.”
Focus on emerging markets
On the other hand, Balls, Clarida and Ivascyn say investors should turn their attention to emerging markets.
The developing world has been plagued with headwinds over the past five years thanks to slowing Chinese growth, falling commodity prices, geopolitical tensions and a strong US dollar. All told, it means developing world have had tough half a decade from a relative return and absolute return perspective.
Relative performance of indices over 5yrs
Source: FE Analytics
However, there are signs that the trend of emerging market underperformance has started to reverse in recent months and the PIMCO team thinks it’s an opportune hunting ground for investors over the medium term.
“Our secular outlook of broad stability for the US dollar, in part owing to China’s constraint on Fed policy tightening, along with commodity markets that have largely repriced to China’s reduced and less commodity-intensive growth path suggests that two key negatives for emerging markets have been removed.”
“While there are of course country-specific challenges in emerging markets and liquidity conditions have deteriorated, we will look on a country-by-country and sector-by-sector basis for good investment opportunities in emerging markets.”
Buy inflation protection
Finally, Balls, Clarida and Ivascyn say now is a good time to buy inflation protection within portfolios.
The consensual view is that central bank attempts to generate higher inflation have largely failed, with current bond yields (and recent investor positioning) suggesting a world of deflation or disinflation thanks to an ageing population, high debt levels and sluggish economic growth.
While PIMCO isn’t expecting economic growth to spike massively, it says that investors cannot right off higher inflation from here – especially given central banks will do anything to generate it.
“Inflation, along with default risk, constitutes in our opinion the biggest risk to fixed income portfolios, particularly at very low levels of real and nominal yields,” Balls, Clarida and Ivascyn said.
“Given the extent of increasingly experimental monetary policies in place globally (with the potential for more to come), all with a core objective of boosting inflation rates, we find inflation protection is attractively priced.”
“Different countries face a range of potential inflation outcomes, but we see US treasury inflation-protected securities [TIPS] as offering both good value and valuable protection against the possibility of higher in the US.”
