The well known bond manager PIMCO organises an annual forum (it is a 40 year tradition!) to discuss the key investment themes for the following 3 to 5 years. They typically invite a few outside speakers to contribute to the debate and this year's group included the former British prime minister Gordon Brown and the FT columnist Gillian Tett. I find it a useful framework to help develop a medium-term outlook on markets and have summarised below their outlook written by their Co-Ceo Mohamed El-Arian.
Their outlook from the previous two forums - of a "bumpy journey to a new normal" has largely played out as they expected with a sluggish G-7 recovery, persistent levels of high unemployment in the developed world, worsening debt and deficit indicators in the developed world versus the emerging world with the average credit spread of the advanced economies now exceeding that of emerging economies.
The aggressive fiscal and monetary policies pursued by the advanced economies in the aftermath of the financial crisis have fallen short in terms of their impact on the economy, but have had a major impact on markets by suppressing real interest rates and thereby pushing global investors to take on more risk resulting in higher prices of global equities, emerging market bonds, credit assets and commodities.
The policy action has led to "good" asset inflation in terms of making people feel richer and therefore spend more- but also has resulted in "bad" asset inflation by pushing up commodity prices and imposing a tax on input prices for production and on the consumer.
The last 12 months have also witnessed some serious and remarkable speed bumps - the possibility of default and restructuring in peripheral Europe, S&P putting the AAA rating of the US on a negative outlook, commodity prices urging despite a sluggish recovery in the developed world and a continued decline in the dollar despite a host of financial, political and environmental calamities.
Looking forward, there are signs to expect an accelerated healing of the global economy and therefore the ability to remove the exceptional level of stimulus in an orderly fashion. In addition, there are signs that emerging markets would be able to continue their strong growth trend and China should be able to navigate a complicated transition period.
The risk factors to the above benign scenario are the large debt overhangs in the developed world, the resolution of which would range from restructuring and socialization of losses (Greece) and a combination of inflation, austerity and negative real interest rates (US). Demographic transitions, commodity constraints and geo-political tensions are likely to complicate the picture further.
The critical issue remains that of the quality of balance sheets - of governments, companies and households. Balance sheets in some sectors (governments in advanced economies) remain out of equilibrium and would require a difficult process of resolution, while others (multinationals and consumers in emerging economies) remain healthy and robust.
A number of "long-term contracts" in the developed world are likely to be under pressure over the next few years - an undermining of the "real return" contract for savers due to negative real rates, a variety of social contracts like heath, pension and unemployment benefits and the role of the dollar as a reserve currency.
They therefore expect a baseline "hobble through scenario" for the foreseeable future where policy makers opt for gradualism and "mini bargains" to avoid bad economic outcomes, thereby leading to a slow and uneven healing process.
The investment implications of the above scenario are as follows:
There is a limit to how much investment returns can be brought forward from the future in the advanced economies, particularly given that interest rates are negative - therefore equity and bond returns in the developed world are likely to be muted going forward.
Exposure to negative real interest rates in the developed world should be minimized (i.e. government bonds and cash), hedge against inflation and developed world currency depreciation, and favour risk assets in multinationals and emerging markets with robust balance sheets.
More specifically, stocks and bonds of corporations with healthy balance sheets, high dividend (versus growth) stocks in advanced economies, growth stocks in emerging economies, currencies in emerging economies with surpluses (and ineffective capital controls) and supply constrained/store of value commodities.
Another important theme which is likely to play out over the next few years is a change in investment guidelines, asset allocation methodologies and construction of indices which have not kept up with the changes in the global economy - i.e. market cap approaches and well-entrenched home biases which are inconsistent with global re-alignments (the % allocation to EM equity in US investor portfolios is about 2.5% while EM share of global output is 33% and EM share of growth is 50%).
PIMCO provides a helpful framework to help navigate an investment portfolio over the next few years. Most of the themes presented above would be familiar to regular readers of this newsletter - gradually building a well diversified portfolio through funds/ETFs in EM currency bonds, US high quality credits and private mortgages, US high quality and global energy and natural resource equities, Greater China, India, and select EM equities, gold and cash should serve well over the medium-term. However, the road is likely to be somewhat rocky and it would require a good measure of discipline and patience to stay the course and not be swayed by market fluctuations. In addition, constant revaluation of the thesis to gauge secular changes in the fundamental trends would be important so as not to be blindsided by new developments. The last point made on the inevitable shift towards emerging markets in investor portfolios will be another powerful tailwind in favour of EM and commodity assets over time.
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