Secular Outlook: Policy Confusions & Inflection Points (PIMCO)

Tuesday, August 7th, 2012

Secular Outlook:
Policy Confusions & Inflection Points

by Mohamed El Erian, PIMCO

• During this important annual event, PIMCO colleagues from around the world debate the major trends that will play out over the next three to five years, focusing not on what should happen, but what is likely to happen. Based on the 2012 Secular Forum discussions, we expect three themes to play out: continued policy and political confusion, overly incremental public and private sector responses and, therefore, greater potential for inflection points.
• In terms of regions, the status quo is no longer an option for Europe. The higher probability outcome – though not dominant – is a smaller and less imperfect eurozone. The journey would be bumpy and expensive; and it would require much more responsive and agile policymaking. Thus, the horrible risk of eurozone fragmentation is not de minimis.
• The U.S. will look good relative to Europe, outperforming in terms of growth and financial stability; but, amid political scrimmages rather than grand bargains, concerns will remain about growth, jobs, inequality, debt and deficits. Financial repression will persist as growth proves insufficient to quickly and safely delever segments that are over-indebted.
• Emerging economies, meanwhile, will continue to outpace both Europe and the U.S. over the secular horizon. Their path of expansion and convergence will be more volatile, especially as some countries undertake needed and tricky transitions in their growth models (including China).
• Portfolio implications: Maintain a sizable quality bias for sovereigns and corporate credits; supplement high-quality equity positioning (low financial leverage, high operating margins, and growth exposure) with dividend streams, where possible, as a means of de facto shortening duration; consider real assets to guard against confiscation risk; expand risk management to include cost-effective tail hedging; and evolve strategies, guidelines, dividing lines and mindsets that have guided investing in the past but will likely be challenged in the context of inflection dynamics.

This year’s Secular Forum was particularly interesting and, also, very challenging. For 2 ½ days, we debated a range of issues, with lots of time spent on the familiar – such as the twin problem of too much debt and too few jobs, and the related austerity versus growth debate – but also on the less prominent but equally consequential – including the game theoretics of large debt overhangs, as well as how technology is redefining economic, political and social interactions. In the process, we iterated to findings that, we believe, are both consequential and actionable for investment strategies including … but, wait, I am trying to fast-forward a summary write-up that warrants proper introduction and context.

The Secular Forum has proven enormously important for PIMCO’s ability to deliver consistent value to you, our clients. Indeed, if we were to pick the handful of factors that have enabled us to serve you well for more than 40 years, this annual event would certainly be among them. It gathers investment professionals from PIMCO’s 12 offices around the world. Collectively, we engage in a lively debate aimed at identifying the major trends that will play out over the next three to five years (and, critically, not what should happen but, rather, what is likely to happen). Think of the outcome as providing medium-term guardrails for where and how we invest the funds that you have entrusted to us.

It is never easy to take an individual – let alone a group – out of the day-to-day routine and focus on issues that are not urgent now, but will prove both urgent and important over the next few years. To help us do so, we turn each year to thought leaders from outside PIMCO to act as catalysts and to challenge our views, thus also reducing the risk of groupthink; and again this year we were privileged to interact with terrific thinkers who brought lots of interesting ideas to the table. We also listened to our brilliant new class of MBAs and PhDs; and, once again, they provided us with valuable, fresh and provocative perspectives. And all this was mixed with quite a bit of background work and back-and-forth discussion.

Context
To provide context for our discussions, we explicitly started with our priors – the conclusions of previous Forums, adjusted for recent developments, new information and additional analysis.

A year ago, PIMCO concluded that the world would continue to exhibit multi-speed characteristics. Specifically, advanced countries would appear to cyclically recover. But, with lagging policy mindsets, growth would prove insufficient to overcome problems of unusually high (and persistent) unemployment, large budget deficits, rising debts, and worsening income and wealth inequality. For some countries with acute economic and balance sheet stress, we postulated the “virtual certainty of at least one (and probably more) sovereign debt restructurings” during our secular horizon.¹

We painted a different picture for emerging economies. Because they are powered by higher growth, we argued that they would continue to close the global income and wealth gap, lifting millions more out of poverty in the process. We recognized that this would not be linear as countries confront inflationary concerns, disruptive surges in capital inflows and tricky internal transitions (including what Mike Spence, Nobel Laureate in Economics and author of the recent book on “The Next Convergence,” calls the “middle income transition”).

At the global level, we anticipated that the international monetary system would experience stress in accommodating these historic global realignments. Remember, not only would emerging economies grow faster, but they would also have an increasing and ultimately defining influence on the structural behavior of the global economy. Yet, due to deeply entrenched entitlement mindsets in advanced economies and outdated mechanisms in multilateral organizations, global governance would find it difficult to catch up with the evolving new reality, let alone get ahead of it.

This, of course, is what PIMCO had labeled the “new normal” back in early 2009 – one that spoke to delevering
in advanced economies, structural imbalances, and global convergence.² It thus portrayed, as reiterated in last year’s write-up, a post-2008 global financial crisis world that “heals only slowly and unevenly,” “transitions … in a rather messy and uncoordinated fashion,” becomes “increasingly fragmented in terms of cognitive recognition,” and in which “social cohesion is uneven.”

Our medium-term baseline was seen as being subject to two-sided risk scenarios. It could tip into a much better equilibrium if policymakers came up with three “grand bargains” – in Europe, the U.S. and China. But it could also fall victim to a more rapid and disorderly delevering.

These two scenarios were important enough for us to argue for a gradual morphing in the distribution of expected outcomes that underpins many investors’ behavior (and analytical constructs): away from the traditional bell curve that exhibits a dominant mean and thin tails (both very comforting), to a flatter distribution with much fatter tails that, in certain circumstances (Europe), could even go bimodal.

Much of what has transpired over the last 12 months is consistent with these priors. Indeed, at times it has felt as if the fast-forward button had been pressed on our secular themes.

In the run-up to the Forum, we found longer-term issues featuring more prominently in our cyclical discussions, as well as in the deliberations of the Investment Committee (which meets four times a week for two to three hour sessions). And with incrementalism dominating way too many policy reaction functions, these developments also help explain why the world/markets now face potential inflection points over the next three to five years – some probable and others possible.

Key Issues
It did not take us long last week to figure out that this would be one of the more challenging Secular Forums. After all, we were analyzing a global economy buffeted by complex realignments yet lacking proper historical precedents. Meanwhile, monetary policy is in full real-time experimentation mode, political anti-incumbency is growing, and extreme polarization is amplifying rising social tensions. And if this were not enough of a complex cocktail, let us not forget what our colleague Ramin Toloui called the disparate adherence to “alternate realities.” The resulting disagreements – which, increasingly, cover the past, present and future – further undermine any convergence to a common analysis of what ails individual countries, let alone the vision and sense of shared responsibility to solve it.

This combination results in what Jerome Schneider described as a self-reinforcing cycle of largely reactive partial responses, subsequent complacency and recurrent localized crises. The longer this persists, the greater the probability of a series of market inflection points in the next three to five years. Indeed, it should come as no surprise that both policymakers and economists are struggling with what has been oversimplified into the growth versus austerity debate. And the resulting confusion, together with a pronounced tendency for politicians to bicker and dither, has made the problems more complex and the solutions more demanding.

In such a world, we believe that it is particularly important to differentiate well between what one knows with a high degree of both foundation and conviction (the “knowns”), and where sufficient knowledge and confidence can only be built through additional data and analysis (“known unknowns”). This should be combined with enough intellectual agility to change the composition as more information become available; and also with the operational responsiveness required to evolve investment strategies accordingly.

Knowns
The knowns speak to the likely persistence of what has become a familiar combination for too many advanced economies – too little growth, too much debt, high joblessness (particularly among the young and long-term unemployed), excessive political polarization and growing calls for greater social justice.

Given current policies, none of these are likely to go away any time soon absent a major crisis and/or a big political pivot. Moreover, the adjustment processes in certain countries (with Greece being the lead example) have already been undermined by “policies that hurt but don’t work,” a phrase used by British politician Ed Miliband in a different context. As such, they risk a frightening economic, financial, political and social implosion.

This reality will continue to play out most distressingly in a few European countries where the institutional setup is already under strain. Indeed, politicians will find it increasingly difficult to reconcile what Andy Bosomworth labeled as the requirements of democracy, mutualization and conditionality – thus robbing the region of the type of mutual assurances that are critical to a cooperative orderly solution. With that, allocating balance sheet losses becomes even more difficult, both within and across countries.

Simply put, the status quo is no longer an option for Europe over the three to five year horizon. The higher probability outcome is that the eurozone will evolve into a smaller and less imperfect entity – namely, a closer political union of countries with more similar conditions. We believe that this smaller union would likely include the big four (France, Germany, Italy and Spain) which, together with other remaining members, would be underpinned by much stronger regional coordination and financing mechanisms.

We did not come to this view easily – especially as there is no orderly, easy and costless way to get there. Evolving into a smaller and less imperfect zone – as leaders need to do in order to save their important and historical European project, and thus also avoid a major disruption to the global economy – is expensive and uncertain. It requires a lot of proper coordination, a more balanced policy mix, stronger financial circuit breakers (well beyond the ECB’s lender of last resort facilities), less vulnerable banks, and quite a bit of luck too. It could even take a major fragmentation scare to force political leaders to act in a sustained manner.

All this also means that risk of a big derailment (an “existential risk” for the European project) is far from de minimis. Given the series of sustained negative shocks that this would entail – for individual nations, the region and the world as a whole – every political avenue should be pursued to avoid it. But we cannot count on that.

As Thomas Kressin noted, it is not just about the willingness of politicians to keep the eurozone intact. If it does fragment, it will most probably be because the population loses patience, resulting in political and social rejection that is aggravated by a tsunami of private capital outflows. Fortunately, politicians and policymakers still have the ability to get ahead of this, but they need to do so very seriously and very quickly. And for that, they also need a common analysis, a shared vision, and sufficient support.

Over the next three to five years, the U.S. will look good relative to Europe, outperforming in terms of growth and financial stability. That is the good news. The bad news is that Americans live in an absolute and not a relative dimension.

Our political analysis led us to conclude, using Libby Cantrill’s notion, that political scrimmages rather than grand bargains would dominate Washington – a forecast that reflects not only the reality of extreme polarization, but also the impact of significant disagreements among “technocrats” and related policy confusions. The fiscal cliff debate, which is certain to get louder in the coming months, will provide insights in this regard.

In a world that is so far away from any notion of a policy first best, look for the Federal Reserve to maintain its pursuit of financial repression for a number of years; and look for other regulatory bodies to pursue similar avenues in the context of a generally more restrictive regulatory environment. The resulting policy mix, however, will do little to alleviate legitimate concerns about growth, jobs, inequality, debt and deficits. In the process, the underlying structural fragilities of the economy will grow, in both economic and financial terms.

Turning to the emerging economies, we expect them to continue to outpace both Europe and the U.S. over our secular horizon. But don’t look to them to compensate fully for problems elsewhere in the global economy. Also, you should expect them to deliver a more volatile growth path, especially as some countries undertake needed and tricky transition in growth models (including China). Along with all this, also look for greater differentiation among countries in what will become an increasingly heterogeneous grouping.

Yes, we expect emerging economies will account for more than 50% of global GDP in the next three to five years (in purchasing power parity terms). And yes their size and growth rate will influence even more the functioning of the global economy. But this will not overwhelm developments in the advanced countries anchoring the core of the international monetary system. Moreover, with advanced economies attempting to hold on to outdated entitlements, the undeniable shift in economic gravity will not be accompanied by sufficient changes in the manner the global system is governed, wired and interconnected – changes that are important for laying a proper foundation for more balanced global growth and a more robust international system in the future.

So, turning to illustrative numbers, we expect growth in advanced economies to average some 1% annually over the next three to five years (compared to 2’ish% at the 2011 Forum); and some 5% for emerging economies (6% previously). Meanwhile, look for the inflation versus disinflation debate to continue unabated as the tug of war between stimulus and debt deflation plays out.

On balance, we believe that over the next few years, inflationary pressures will slowly build in the global system due to several drivers. Too many cyclical dislocations risk becoming embedded as structural impairments to long-term growth potential, particularly when it comes to the labor markets in advanced economies. With other government entities doing too little, central banks will likely maintain highly accommodating policies for too long. And do not forget the political appeal of resorting to inflation as a means to delever.

Known Unknowns
What about the known unknowns? There are quite a few, including some with the potential to turn some of the slow burn dynamics into sudden shocks, either negative or positive.

Elections and transitions could certainly be game changers. According to calculations by our MBAs/PhDs, more than 50% of global GDP will face a potentially defining change in 2012. Moreover, eight out of 17 eurozone governments have been voted out of office in the last couple of years. So the potential for political upheavals is certainly with us.

Armed with strong new mandates, governments could deliver the “Sputnik moment” that acts as a catalyst for a series of beneficial grand policy bargains. And the impact would be amplified by the crowding-in of significant private capital that is now on the sidelines. More likely, however, is that elections result in a further polarization that complicates economic management. And, as illustrated recently in Greece, the mounting loss of credibility of traditional political parties facilitates the emergence of fringe parties that are eager to dismantle the past but have as yet no coherent and comprehensive plan for the future.

Over the next few years, elections will compound the pressures that governments feel from increasingly restless populations (especially in countries with high youth unemployment, including 51% in Greece and Spain and 36% in Italy and Portugal). As one of our new colleagues, Min Zhang, put it, her generation is looking for “hope and opportunity.” Instead, and also lacking control of the ballot box, they are being saddled by an older generation’s debt and growth impediments. And demographic trends will accentuate the challenges. Under such circumstances, we should not dismiss the possibility of unpredictable sociopolitical reactions that end up further complicating long-standing social compacts and the related functioning of an already stressed international monetary system.

What happens in advanced countries will be of more than passing interest to the healthier part of the global economy, namely the emerging world – a point that Francesc Balcells, Michael Gomez, Ramin Toloui and others stressed.

The longer it takes for the advanced countries to grapple with their growth and debt problems, the greater the imperative for emerging economies to transition to sources of domestic demand to sustain growth. Nowhere is this more important systemically than China.

History suggests that economic, political and social frictions are inherent to such transitions, requiring careful and responsive management. Moreover, as the emerging world itself starts with a set of different initial conditions among individual economies – and a few differences are quite pronounced – some countries will likely be more successful than others, with related surprises.
Have no doubts, the “concentric circle” construct underpinning the international monetary order will be pressured in significant ways in the next three to five years. This is not to postulate a different system. As Rich Clarida argued, there is no alternate system and, therefore, you cannot replace something with nothing. Rather, it is about an increasingly hobbled international order whose anchoring core is weakening on a daily basis, thus undermining the standing of global public goods over the secular horizon. Also, don’t be surprised to see countries in the outer circles (particularly some emerging economies) increasingly establish direct links that bypass the core. Indeed, changing clusters of global influence are likely to be a notable feature of the next three to five years; and the systemic impact is inevitably uncertain.

Technology also provides for meaningful two-sided tails for our baseline hypotheses, especially given that disruptions in this domain easily catch people by surprise.

You would have to be in North Korea to deny that the world is in the midst of empowerment advances that fundamentally alter the relationship between individuals, between states, and between these sets of global actors. As discussed, it is a changing ecosystem that results in two worlds operating simultaneously – but with different protocols, speeds and legal protections: a physical world with government and institutional control, and a virtual one with individuals dominating the creation, dissemination and sharing of content. Over time, the latter will have even greater economic, political and social impact – and do so at times through unanticipated channels.

This provides for the exciting possibility of leapfrogging structural impediments through what Mike Spence calls off-sequence development. Several specific examples were put on the table where technology could serve as a beneficial accelerator. And if we are really lucky (and we mean really, really lucky), perhaps this could also help in dealing with some of the real dangers of self-limiting growth patterns, including those associated with society’s past abuse of the environment. But, again, we should not count on that.

Yet this phenomenon has more than one potential outcome. Some of the empowering technical revolutions can be negatively used to undermine social cohesion and security. Others offer the likelihood of disruptive revolutionary dynamics that are easy to start but prove difficult to control and complete, especially in the absence of sustained leadership.

Implications – The “What”
Our 2012 Secular Forum discussion confirmed that the distribution of expected outcomes for the global economy is both flatter in its belly and fatter in its tails. This is a potentially unstable situation, especially when compared to the conventional bell curve. Moreover, its density has shifted unfavorably in the past 12 months as a result of growing uncertainty, complexity and policy risk premia. In Europe, it has already morphed into a bimodal distribution – a phenomenon that colleagues in our five European offices confront on a daily basis.

In such a world, investors need to retain a claim on the upside while protecting against the downside, including gap risk. They need to be highly differentiated, positioning portfolios for the knowns (both for return generation and for risk mitigation), while also maintaining the right level of optionality in the face of the unknowns. And they must ensure sufficient operational agility to evolve as more data become available, as will inevitably be the case.

In the short run, investors are well advised (indeed, urged) to supplement careful bottom-up security selection with macro, and in particular a deep understanding of the implications of the different policy approaches being used to deal with over-indebted economies generating insufficient growth – directly in advanced economies and indirectly in how this impacts the behavior of others. Specifically, and in the words of Bill Gross, they must seek to engineer a “great escape” from a range of actual and likely realities – be it financial repression in the U.S., default in Greece, or other forms of de facto confiscation elsewhere.³

This, of course, translates into a sizeable quality bias for sovereign and company exposures, the latter both in corporate credit and equity space. Focus on names with high cash balances, low financial leverage, high operating margins and exposure to growth areas. Higher quality sovereign exposure should be concentrated in parts of the yield curve that offer meaningful roll down and are anchored by credible central bank policies. Exposure further out the curve should be taken with caution, focusing on sovereigns with a lower risk of inflation and also utilizing inflation-protected securities. Meanwhile, higher-quality equity exposure should be supplemented, where possible, with a dividend dimension as a means of de facto shortening duration.

Consider real assets when thinking of the range of responses to minimize the multi-faceted risk of financial confiscation, especially as inflationary pressures slowly mount. Again, differentiation will be essential, with emphasis placed on those with low supply elasticities and offering a degree of geopolitical protection.

Currencies are the hardest to call in the world we have described. On the one hand, emerging market currencies will likely be supported by continued productivity gains, strong balance sheets and capital inflows. On the other hand, policymakers there will be hesitant to see their currencies strengthen in a world that is so uncertain, especially if the appreciation is turbocharged by leakages from what they view as excessive liquidity creation in the U.S. Also, expect the U.S. dollar to continue to be the main recipient of flight-to-quality capital, at least for the first part of the secular horizon.

These considerations speak to relatively limited scaling of currency positions pending additional information. And they also shout for careful differentiation.
The bottom line here is a simple one: Wherever you are in the capital structure and in geographical space, be very alert to situations where valuations do not reflect the confiscation risk. And remember, confiscation is not just default. It is also a function of poor protection against inflation, nationalization or the large preemption of company and currency earnings by governments.

And…
The emphasis on minimizing exposure to financial repression will remain as long as central bankers are in control, including a Federal Reserve that is both able and willing to compress interest rates while underwriting the mounting collateral damage and unintended consequences. At some point during the secular horizon, however, investors will most likely need to pivot. Why? Because, absent a much more comprehensive policy response, central bank measures will prove insufficient by themselves to ignite growth dynamics and safely delever over-indebted segments in advanced economies.

Think of two corner solutions anchoring the range of possibilities in this pivot. At one end, central banks end up providing a bridge for other government entities with more effective measures, including on the structural front. And this serves to crowd in private capital currently on the sidelines. At the other end, central bank policies become not just ineffective but also counterproductive as the collateral damage and unintended consequences eventually overwhelm the intended benefits.⁴ In addition to the direct negative impact, this would encourage the private sector to de-risk further, thus sucking more oxygen out of the economy.

For investors, the essence of this pivot involves an overwhelming emphasis on capturing solid and growing value streams that reflect company and sovereign ability to “earn” them through sound fundamentals rather than to “buy” them through financial wizardry. Its exact nature depends on whether other policymakers, with better tools, finally step up to their challenges.

If they do, then an across-the-board risk-on posture would make sense; and government bonds would prove a bad place to be. But this requires the type of political decisiveness and effectiveness that sadly eludes most advanced economies; and it also necessitates better global policy coordination. Accordingly, the other pivot involves even greater emphasis on principal protection – or, to use Bill’s recent characterization, reinforcing the coming of age of investment defense.⁵ And, together, all this speaks to the need more than ever to allow for portfolio repositioning as new data come in and circumstances dictate.

Implications – The “How”
So far, we have discussed “what” investors should consider if they agree with our secular analysis. It does not stop here however. The analysis suggests that the “how” is equally consequential.

Given the likelihood of inflection points, investors will need to be extra careful of traditional market capitalization indices that underpin not just conventional benchmarks but also many passive investment approaches. These can be particularly counterproductive in fixed income when debt is growing beyond safe levels (remember, they encourage the allocation of large and rising sums to increasingly vulnerable credits). In equity space, many of the traditional indices and approaches risk missing out on disruptors that will thrive in dislocated and changing markets and ecosystems.

It is also high time to revisit a whole host of backward-looking labels and dividing lines that often lurk in asset allocation, investment guidelines and mindsets. Are “domestic equities” really domestic when a large and growing portion of company revenues and profits come from other countries? Are advanced government bonds really interest rate risk when countries continue to slip down the credit curve? And are all emerging market sovereign bonds as risky as the term is often seen to imply?

All this speaks not only to increasingly outdated historical distinctions, but also to correlations among asset classes and the flexibility to react to (and combine more optimally) different risk factors. Remember, as Josh Davis, David Fisher and Curtis Mewbourne note, it is about how an investment behaves rather than what it is called.

Led by our analytics and solution capabilities, PIMCO has done a lot of work on this. This particular effort was initiated back in 2006 and we now have encouraging results to share with you – from forward-looking indices (including “Global Advantage” that just celebrated its third anniversary) to solution methodologies and risk factor analysis.

Finally, and perhaps most disappointing for many, society will need to lower its return expectations in general, and particularly its risk-adjusted return expectations. Having produced what Scott Mather called a period of “false economic prosperity,” the enormous multi-year levering of both the public and private sectors in advanced economies also involved the front-loading of investment returns. This can only be maintained and enhanced now through additional leverage (and the set of binding constraints here is set to grow) or through the lifting of structural impediments to growth (a much better approach but unfortunately problematic, at least for now).

As return expectations come down, the asset side of the balance sheet will not be sufficient on its own to meet the objectives of many investors. An even stronger linkage to the liabilities side will be paramount. In many cases, this requires a concurrent evolution in portfolio construction. Moreover, as demonstrated by Vineer Bhansali and Jim Moore, an investment approach that places risk mitigation just on the shoulders of asset class diversification will suffer. It will need to be appropriately supplemented by more sophisticated asset-liability management, cost-effective tail hedging, and a solution (as opposed to just product) mindset.

Bottom Line
In July 2010, the Chairman of the Federal Reserve Board, Ben Bernanke, came up with an elegant term to characterize the United States’ cyclical outlook – he called it “unusually uncertain.” PIMCO’s 2012 Secular Forum suggests that this term could well prove as resilient as our May 2009 forecast for a “new normal.” Given our analysis, Bernanke’s unusual uncertainty applies to more than the cyclical timeframe, and to more than just the United States. It is both secular and global.

Now uncertainty, even of the unusual variety, does not – and should not – translate into investor paralysis. We believe that specific areas of the secular horizon are already clear and actionable today; others are subject to significant two-sided fat tails that should be detailed and managed accordingly.

Over the next few weeks, we will provide you with several more detailed notes from our specialists on how the Forum’s conclusions affect their individual sectors. We will also continue to fill out the secular topology, especially as we learn more about how the global economy is accommodating historic multi-dimensional changes – be they in advanced countries, in emerging economies or in the functioning of the international monetary system. And you can be assured that we will work very hard to do so well ahead of others.

Mohamed A. El-Erian

¹ “Secular Outlook: Navigating the Multi-Speed World,” PIMCO, May 2011.
² “Secular Outlook: A New Normal,” PIMCO, May 2009.
³ “The Great Escape: Delivering in a Delevering World,” PIMCO, April 2012.
⁴ “Evolution, Impact and Limitations of Unusual Central Bank Activism,” PIMCO, April 2012.
⁵ “Defense,” PIMCO, March 2012.

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 certain risks including market, interest-rate, issuer, credit, and inflation risk. 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. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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.

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 financial advisor prior to making an investment decision.

This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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Tags: Confiscation, Confusions, Emerging Economies, Financial Leverage, Financial Repression, Financial Stability, Forum Discussions, Growth Models, Inflection Points, Mohamed El Erian, Operating Margins, Policymaking, Political Confusion, Quality Equity, Real Assets, Risk Management, Scrimmages, Shortening, Sovereigns, World Debate
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Secular Outlook: Implications for Investors

Monday, July 30th, 2012

by William R. Benz, PIMCO

• For investors, the biggest challenge now is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.
• Key institutions, including governments and central banks, were previously stabilising forces but are now helping to accelerate underlying, destabilising trends in the global economy and financial markets.
• In this environment, investors need to invest for outcomes rather than simply for beta and diversification.

Perhaps the most important tradition at PIMCO is our annual Secular Forum in May. Since I joined 26 years ago and participated in my first forum with 16 other investment professionals, our forums have become much bigger and much more global. More than 300 of us descended on Newport Beach or tuned in via video in our most recent round. But the tradition continues, as does the intensity and excitement, with the output of our forum – our three- to five-year secular outlook – forming the cornerstone of both our longer-term investment strategy and our business positioning.

Mohamed El-Erian, our CEO and co-CIO, in his Secular Outlook commentary “Policy Confusions & Inflection Points,” summarized three themes that we expect to play out over the next few years: continued policy and political confusion, overly incremental public and private sector responses and, therefore, greater potential for inflection points. Mohamed also discussed the key investment implications of our outlook, noting that the strategies and guidelines that may have served investors in the past will likely be challenged in the context of inflection dynamics.

That point is worth revisiting and expanding upon because, in our view, investing is fundamentally changing. Previously, most investors simply aimed to beat their benchmarks and diversify among assets to mitigate risk. But today, as we face unusual uncertainty in the global economy and the financial markets, extreme events are not only possible but increasingly likely, and in this environment, we believe investors need to define their objectives and choose strategies that target specific outcomes.

Investors’ biggest challenge

The world is facing a number of very significant challenges for which there are no easy solutions. The eurozone faces high debt levels, a lack of structural growth and pressure to get the policy mix right to avoid contagion. The U.S. is suffering slow growth, high debt, a looming fiscal cliff and political polarisation. While enjoying higher relative growth, China and the developing world are also slowing and making difficult transitions from export-led to consumer-driven ‘emerged’ economies. And globally, a lack of policy coordination, increased income inequality and the growing use of social networks as communication tools also present long-term challenges.

Uncertainty is one common theme, and another is the potential for more extreme outcomes, good or bad. The eurozone, for instance, has to either find a path toward fiscal union or create a mechanism for orderly exit, with very little room to manoeuvre in between. Likewise, the U.S. needs to find a way to resolve its fiscal issues or face the consequences of a further downgrade and eventual loss of reserve currency status.

For investors, then, the biggest challenge is not continued volatility; that’s almost a given. The challenge is moving from a world of normal distributions, with expected occurrences around the mean, to one of bi-modal distributions where more extreme scenarios prevail.

Key institutions: once stabilisers, now accelerants

In the old normal, key institutions acted as stabilisers: They generally behaved in a counter-cyclical fashion to help enforce reversion to the mean. For example, governments and central banks enacted policies to stimulate growth and prevent deflation during economic downturns and did the opposite in upturns. Regulators tended to de-regulate during tough times and tighten the rules during times of excess, while financial institutions decreased and increased lending as interest rates rose and fell.

Their actions, individually and collectively, helped bring economic growth and the markets back to normal, back to long-term averages, back to the mean. They weren’t necessarily coordinated, but they were generally effective and helped create the Great Moderation of steady growth, strong returns and relatively low volatility that we witnessed from the mid-to-late 1980s until the global financial crisis in 2008.

But today, these institutions are acting as accelerants. Governments in Europe, the U.S. and Japan are under pressure to pursue fiscal austerity rather than stimulate growth, exacerbating the downturn. Central banks are largely going their own way, after a well-coordinated response to the financial crisis, and in some cases, are resisting stimulative measures, which is slowing, if not preventing, the healing process. Regulators, adopting a ‘never again’ mentality, are creating blunt instruments to solve complex problems, leading to unintended consequences, particularly in the banking sector, at a time when more rather than less lending should be the recommended medicine. And banks, especially in the eurozone, have been severely impacted by their holdings of sovereign debt, which, in turn, has led to a vicious cycle of falling share prices, credit rating downgrades, asset sales, reduced lending, slowing local economies, worsening government balance sheets and ultimately, an acceleration of, rather than a counterbalance to, the crisis.

Finally, investors are also acting as accelerants. Individual investors have always been more momentum-driven but had little aggregate impact on markets in the past due to their small size, lack of timely and direct access to information and lack of coordinated activity. But as they’ve grown in size and sophistication, accessing real-time information through their defined contribution plans, global platforms, multi-national distributors, private banks and independent financial advisors, their impact has become much more pronounced. When risk sectors outperform, flows into those sectors tend to increase; when they underperform, flows tend to diminish. In both cases, underlying trends are reinforced.

What’s even more interesting is how the behaviour of institutional investors has changed. This began in 2000-01, after the technology bubble burst. The perfect storm of plunging equity markets and falling interest rates turned corporate and public pension plan surpluses into deficits and created big challenges for foundations, endowments and others seeking income and targeting specific absolute returns. The movement toward solution-based investing was born as investors began to shift toward liability-driven investing (LDI), absolute return, income seeking and other, more specific strategies. The momentum increased following Lehman’s bankruptcy and again in response to recent events in Europe. But with this shift has come a more activist (or re-activist) approach, as investors make larger and more frequent changes to overall strategy, tactical weightings, benchmarks and guidelines. Some still prefer to rebalance around their longer-term, normal policy targets, but as a group – and we see this globally across our client base – institutional investors have indeed become more active.

Governments, central banks, regulators, financial institutions and investors – each group is responding to the challenges they are facing in a logical and well-intentioned fashion. Yet in the current secular environment, we believe their actions are adding to, rather than smoothing, volatility. And instead of acting as stabilising forces, we believe they are actually helping to accelerate the underlying destabilising trends. (See figure below.)

Significant implications for investors

Global challenges combined with these market accelerants have created an environment of unusual uncertainty in which ‘muddle-through’ is a temporary state. We believe this has significant implications for investors, particularly those who are still investing simply for beta and diversification rather than for specific outcomes.

First and foremost, the new normal is here, and investors need to embrace it. We coined the phrase a few years ago to describe a multi-speed world on a bumpy journey of deleveraging, reregulation and eventual reflation. We can argue whether we’re still on the journey or we’ve arrived at the final (though still very bumpy) destination. But what’s clear is that what felt like a ‘new’ normal back then now just feels normal. Gone are the days of the Great Moderation, reversion to the mean and normal-shaped distributions, in our view; instead, continued (high) volatility, acceleration in trends and bi-modal outcomes have become the new norm. In an era when muddle-through is no longer a viable option – for Europe, the U.S. and potentially others – investors need to rethink their overall approach and brace for more extreme economic and market events.

Second, there is no free lunch. There never really was, but investors are facing even more difficult trade-offs today. If the objective is to enhance yield or upside potential through credit, high yield, emerging markets, equities or other risk sectors, the likely trade-offs in a bi-modal world are higher volatility and greater downside. If the goal instead is to own ‘safe haven’ assets for downside risk mitigation, such as U.S. Treasuries, U.K. gilts or German bunds, the trade-off is currently negative real yields. And if the need is to maximise liquidity through cash instruments, the payoff is truly negative real yields (with negative nominal yields on occasion). Even when seeking inflation protection, whether through inflation-linked bonds or hard assets – like gold, real estate and commodities – we believe the trade-offs in terms of real yields, volatility and downside risk are much less attractive in this environment.

Third, investors need to think differently with respect to allocations, benchmarks and guidelines. We’ve highlighted this in the past, but it’s even more important today. In our view, asset allocation should be risk-factor-based as bi-modal distributions and accelerants are not friendly toward traditional mean-variance methodologies, which aim to maximize returns for given levels of risk. Benchmarks should be GDP- rather than market value-weighted, particularly in fixed income space, to reduce exposure to those countries, sectors and issuers with the highest or fastest growing debt. And guidelines should be flexible, with more rather than less discretion, so as to allow managers to play both offence and defence in a bi-modal world.

Fourth, investors should be confident in their managers’ ability to understand and measure risk. Global challenges, market accelerants and unusual uncertainty put a premium on risk management. This includes understanding how the credit sensitivity of fixed income investments can affect their duration – i.e., ‘hard’ versus ‘soft’ duration – and help determine what is considered a ‘safe haven’ and what isn’t. It means performing credit analysis of sovereigns knowing they have more than just interest rate risk. It necessitates analysing the entire spectrum of the capital structure to pinpoint exact needs in terms of collateral, covenants and other forms of defence. Derivatives continue to be useful tools, but being able to identify and control counterparty risk is increasingly important. And leverage, while appropriate in certain circumstances, needs to be well understood. Bottom line: we believe in developing multiple risk measures and stress testing often.

Finally, investors need to develop specific objectives and invest for outcomes rather than simply for beta and diversification. Many investors traditionally started with risk/return targets and used historical mean-variance analysis as a framework to determine asset allocations across multiple asset classes, with benchmarks for each asset class and sub-category, and then found managers that aimed to provide returns above their benchmarks. In the days of normal-shaped distributions and reversion to the mean, this was a widely accepted strategy: Long-term realised returns and volatility came in largely as expected, and further diversification – across asset classes, within asset classes and across different managers and styles – helped to smooth short-term swings. It was a beta-driven strategy, aided by diversification. But the world has changed, and we believe investors need to deepen their understanding of their objectives and invest for outcomes.

Setting objectives and investing for outcomes

Every investor has a unique set of needs and circumstances that should form the basis for setting investment objectives. Yet it’s important to consider the secular context as well, particularly given the challenges and trade-offs we’re likely to face:

• Prolonged period of low real yields on high-quality assets, with negative real yields on traditional ‘safe havens’
• Increased potential for low and even negative real returns
• Continued high volatility with increased likelihood of bi-modal outcomes
• Eventual, though uneven, inflation pressures

Income-oriented investors should consider emphasizing high-quality fixed income spread sectors, such as covered bonds, mortgage- and asset-backed securities, investment grade credit and, depending on risk tolerance, upper-tier emerging market and high yield issues and higher dividend-paying equities.

Investors with specific return objectives should consider focusing more on absolute return strategies, ranging from unlevered LIBOR-plus approaches – essentially seeking to outperform cash – to alternative strategies, depending on their risk/return targets and liquidity needs. Credit, emerging markets, equities and other asset classes can also play roles, individually or grouped into a multi-asset approach, as long as risk factors and exposures are well understood and investors consider ways to potentially limit downside risk under more extreme ‘left tail’ scenarios.

Investors concerned with volatility and ‘fat tail’ events should consider risk-mitigating strategies. If investors want to defend against downside, potential strategies would include positions in hard-duration, ‘safe-haven’ assets, explicit tail-risk hedges or a combination. Investors focused on liabilities may want a liability-matching or LDI program. Alternatively, if the goal is to maximise liquidity, cash and short-term strategies would likely play a significant role.

Lastly, for investors worried about reflation, the suggested focus is on potential inflation hedges, such as inflation-linked bonds, commodities and real estate.

In truth, many investors will likely want to employ more than one approach – income with an inflation-hedging component, absolute return with tail-risk hedges, LDI programs that include a combination of derivative-based overlays with LIBOR-plus strategies on the underlying collateral, or any of these with a cash buffer that can be used for liquidity or to invest tactically if the opportunity arises. And this makes sense. In our view, as long as investors focus on their objectives and their targeted outcomes, rather than fall into the old ‘invest for beta and diversification’ trap, they can navigate a world of secular challenges, accelerants and unusual uncertainty.

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 certain risks including market, interest-rate, issuer, credit, and inflation risk. Covered bonds are generally affected by changing interest rates and credit spread; there is no guarantee that covered bonds will be free from counterparty default. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Absolute return portfolios may not necessarily fully participate in strong (positive) market rallies. 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. 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. Certain U.S. Government securities are backed by the full faith of the 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. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Dividends are not guaranteed and are subject to change and/or elimination. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. 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. 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.
LIBOR (London Interbank Offered Rate) is the rate banks charge each other for short-term Eurodollar loans. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the author but not necessarily those of PIMCO 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. 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.

©2012, PIMCO.

Tags: Benchmarks, Central Banks, Confusions, Cornerstone, Diversification, Financial Markets, First Forum, Global Economy, Inflection Points, Investment Implications, Investment Professionals, Investment Strategy, Mohamed, Newport Beach, Normal Distributions, Occurrences, PIMCO, Political Confusion, Private Sector, Term Investment
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Three Years and Counting (Kashkari)

Thursday, June 14th, 2012

• In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.
• As heightened volatility persists, many equity investors remain on the sidelines. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.
• We believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term. Equity investors should continue to focus on
  higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

We recently concluded our Secular Forum, an annual event in which PIMCO investment professionals from around the world discuss and debate our three- to five-year outlook for the global economy and financial markets. The Secular Forum process demands that we focus on the long term and imposes a discipline on us that we believe makes us better stewards of our clients’ capital.

Mohamed A. El-Erian published a summary of our conclusions from the Forum, titled Policy Confusions and Inflection Points. And my portfolio manager colleagues are participating in a series of interviews discussing these conclusions.

My goal here is to discuss what our revised Secular Outlook means for equity investors. But first I think it is important to take a moment to review conclusions from prior Secular Forums and objectively consider what has actually happened in the intervening periods. What have we gotten right? What has surprised us?

In the spring of 2009, with the U.S. economy and financial markets still reeling from the financial crisis, PIMCO conducted its annual Secular Forum right on schedule. It was during this time that PIMCO first applied the term New Normal to its updated outlook for the global economy. It is important to note that I wasn’t at PIMCO at the time – I was still at the Treasury helping to fight the financial crisis. I only joined PIMCO six months after I left government.

As government officials consumed with trying to stabilize the global financial system, my colleagues and I were much more concerned about surviving the next few days or weeks than thinking about the next three to five years. It is noteworthy that an investment management firm had the poise to stop to think about the longer-term outlook during that stressful time.

The New Normal called for long-term deleveraging that would lead to lower growth than society had been accustomed to. It called for more modest investment returns across asset classes, as the leveraging of the economy reversed course. It called for increased regulation and reduced globalization. Most importantly, it said there would be no V-shaped recovery that is typically seen after a recession. It would be a long, hard adjustment period with sustained high unemployment. It also called for a transition of stress from private balance sheets to sovereign balance sheets.

These trends, unfortunately for societies, have played out as my PIMCO colleagues forecasted. I also observe that implicit in their forecast was the assumption that policymakers would be successful in stabilizing the financial system and preventing a collapse. In hindsight, they seem to have been more confident than we in government were at the time. I am glad they were right.

While this may seem self-congratulatory for me to pat my PIMCO colleagues on the back, as I noted above, I wasn’t at PIMCO at the time. I am just observing, with the benefit of hindsight, what has actually happened.

While PIMCO’s New Normal call has proven remarkably accurate, its implications for equities were less clear. PIMCO did not forecast that central banks would employ unprecedented aggressive monetary policy via quantitative easing with the specific goal of pushing up the prices of risk assets in an attempt to stimulate economic activity. The QEs have been effective in pushing up equities (see Chart 1 below) and staving off deflation, though the effect on real GDP is less clear. In addition, the New Normal did not forecast record corporate profits that many companies have enjoyed, especially large multinationals. In the past three years, equities have rallied more than the underlying economic fundamentals would have predicted on the back of extraordinary monetary policy activism and strong corporate earnings.

In addition to muted economic growth, record low interest rates, and sustained high unemployment, extraordinary equity market volatility has been a repeated feature of the past three years.

Chart 2 shows the VIX, or volatility index of the S&P 500 Index, over the past 10 years. You can see three fairly clear periods: “old normal,” financial crisis and New Normal. As the crisis has spread from corporate to sovereign balance sheets and from the U.S. to Europe, sentiment has repeatedly swung from fear to greed and back to fear, triggering wild swings in equity markets.

Many investors, both individuals and institutions, were truly shocked by the losses they experienced during the financial crisis: The S&P 500 fell 38% in 2008. After years of gains, many people couldn’t believe their nest eggs were being destroyed. This experience has left many investors both scared and scarred – and as heightened volatility persists, many equity investors remain on the sidelines.

Our updated Secular Outlook calls for a continuation of the deleveraging we’ve experienced for the past few years. Slow real economic growth in America of 1% to 2%, a likely recession in the eurozone stemming from the ongoing debt crisis, and – and this is really important – slowing growth in the emerging markets of 5%, down from 6% previously. Remember, emerging markets have powered the global economy for the past few years; the U.S. will have to carry more of that load now. But with more moderate overall global economic growth in the next three to five years, markets will be more vulnerable to shocks.

The volatility that equity markets have experienced in the last few years is also likely to continue for the foreseeable future. The crisis in Europe will take years to resolve in part because policymakers there are trying to simultaneously achieve multiple, often-divergent objectives: 1) preserve basic eurozone stability, 2) keep pressure on fiscal authorities to make hard choices and 3) keep inflation in check. These multiple objectives prevent them from taking final, decisive action to quell the crisis. Our base case outlook is continued spurts of crisis and volatility coming out of Europe. These policy and macro factors will likely continue to overwhelm company-specific factors in the short term.

Many investors aren’t sure what to do – where to turn for “safe” investment returns in light of this volatility. As I regularly meet with clients and financial advisors, I repeatedly hear a few questions about how to navigate these choppy equity markets that are worth discussing here:

Given the volatility of the New Normal, why should I invest in equities at all? Why shouldn’t I just sit in cash and wait it out?
Unfortunately the final end-state for the global economy following this debt-induced crisis is unclear. If the global economy faces deflation, sitting in cash or fixed income instruments will probably be the best option. Purchasing power will increase as prices fall. While a deflationary scenario is not impossible, it is the least likely outcome given central banks’ actions to date. More likely is a moderate inflation scenario. Sitting in cash in such a scenario will see purchasing power degrade due to inflation. Equities should perform well in a moderate inflation scenario. This is our highest likelihood outcome.

A high inflation scenario can’t be ruled out either. It is possible that central banks could lose control of inflation expectations. In such a scenario cash and bonds will likely perform the worst, with equities next. Real assets and commodities would likely perform best, because prices for those assets should rise with inflation.

Because of the uncertainty regarding the end-state of the global economy and the fact that the only scenario in our view where cash performs well is the least likely, deflationary scenario, sitting on the sidelines is unfortunately not a good option for those who have future liabilities they need to meet. We think a better investment approach is to invest globally, across asset classes, reflecting the likelihood of the various outcomes.

Given our outlook that moderate inflation is the outcome with the highest long-term probability, we believe equities should be a meaningful part of a diversified investment portfolio. Equity investors should continue to focus on higher-quality companies with strong balance sheets that are selling into higher-growth markets, including those that pay healthy dividends.

My clients just can’t take the equity market pullbacks. What should I do as a financial advisor?
Many clients are in this situation. From May 2002 to May 2007, during the old normal, the S&P 500 experienced a 5% correction from a recent high five times, or on average of once per year, and a 10% correction four times. In the three New Normal years from May 2009 to May 2012, the S&P 500 experienced seven 5% corrections, more than twice as often, and a 10% correction three times. This increased downside volatility not only has direct financial implications for clients, but also has indirect effects that are important too: The emotional swings are scaring clients into sitting on the sidelines. As discussed above, this could prove very costly if central banks are successful in engineering moderate inflation, let alone high inflation.

We believe clients and advisors should focus on strategies that can be used to manage downside volatility. There are a number of ways to pursue this: 1) Buying higher-quality companies and those with strong balance sheets, because they tend to be more resilient against shocks, according to our research. 2) Buying companies at deep discounts to their intrinsic value. 3) Buying companies offering more immediate return on investment through dividends. 4) Actively hedging the portfolio, with tail risk hedging (which refers to taking a defensive position against extreme market shocks), or other means. 5) Investing in multi-asset solutions that provide diversification and include equities, fixed income securities and commodities in one vehicle.

Is passive or active management better in this environment?
We believe there is a place in client portfolios for both passive and active management. Each has advantages. Passive management tends to be cheaper than active management. But with each pull back in the equity markets, a passive strategy should fall in lock-step with the market. Passive index replication, by definition, has no downside protection against market moves. If clients are alarmed about market corrections, passive management won’t help them. A related point that I have written about previously (Teaching to the Test – September 2011) is that many managers associate index investing with taking less risk. Index investing is taking no benchmark risk, but clients are still taking risk – as the S&P 500’s 38% loss in 2008 so painfully reminds us.

We believe active management should aim to provide clients with a better experience. That means enabling clients to participate in much of the growth, appreciation and income potential provided by a vibrant equity market, while also actively managing against major pullbacks associated with macroeconomic shocks that we’ve been experiencing over the last few years. Achieving this – capturing most of the upside while limiting the downside – isn’t easy. It requires both deep company-specific analysis and a strong top-down, macroeconomic framework. And we believe it requires investing globally to take advantage of the best possible risk-adjusted return opportunities wherever they are. Limiting the downside likely requires giving up some upside in a rally – and in this environment especially – we think that’s probably a good tradeoff. It would be great to be able to limit the downside without sacrificing any upside. Unfortunately that’s not realistic – but we believe managing against downside shocks is enormously beneficial to compounding attractive returns over the long term.

Although markets are again focused on risks from Europe right now, sentiment will likely swing back to “risk on” again, and people will wonder what all the fuss was about. And then at some point it will swing back to “risk off.” Equity investing in this environment isn’t easy or for the faint of heart. With long-term risks of global inflation, sitting on the sideline isn’t an option for many people. We think the right approach is to focus on the right companies and to be willing to give up a little upside, while working hard to protect the downside. Call it the New Normal of equity investing: Three years and counting.

Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Investments in value securities involve the risk the market’s value assessment may differ from the manager and the performance of the securities may decline. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Commodities contain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. 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. 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.

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 financial advisor prior to making an investment decision.

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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. ©2012, PIMCO.

Copyright © PIMCO

Tags: Asset Classes, Attractive Returns, Balance Sheets, Confusions, Downside, Equity Investors, Erian, Financial Markets, Global Economy, Growth Markets, Inflection Points, Investment Approach, Investment Professionals, Low Interest Rates, Market Volatility, Portfolio Manager, Quality Companies, Sidelines, Stewards, Term Equity
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