I know that many of you are feeling deeply unsure in the current market environment. Your portfolios have likely taken a hit and major changes are occurring in the global economy. The combination of these two things is making it difficult for you to know how to move forward. In fact, there’s a strong case that the economic and geopolitical landscapes are going to look different in the long term. I believe that these changes will have a significant effect on how we need to invest going forward, that what we are looking at is a NEW REALITY. Today I’ll tell you about what this new reality will look like. Then, we’ll talk about why this “new normal” should have you rethinking your strategy. And finally, I’ll share an action plan to help you repositioning your portfolio to reflect the new investment reality. The views that I’m sharing with you today were developed by Allianz Global Investors, whose investment firms include such well-known asset managers as PIMCO, NFJ and RCM. Allianz Global Investors is the asset management arm of Allianz, one of the world’s leading financial services firms.
If you’re feeling confused and unsure of how to proceed, you’re not alone. Many investors are asking the same fundamental questions: How will I meet my financial objectives? Some of you are sitting on the sidelines holding significant amounts of cash, yet you need growth to help finance a retirement, pay for college or meet other important goals. Will traditional strategies work? The market turmoil affected all asset classes; what does that say about traditional stock and bond diversification? Do I need a new strategic mindset? Are things going to be different in the future, or will we return to “normal”?
So what will this “New Reality” look like? These are some key characteristics which we expect to see not tomorrow, but over the medium to long term. We’re going to see a rebalancing of global power, in which emerging countries play a major part. Eventually, we believe inflation will re-emerge as an issue. We are entering a prolonged period of restrained economic growth, which will have a dampening effect on corporate profits. This process is bound to be messy, and we can expect to see more frequent market shocks. Some of these developments look a little scary, but as you’ll see later on, there are strategies that can not only help you accommodate these changes, but also potentially benefit from them.
Emerging economies have not been spared from the recession but we believe that many of them will hold up better than industrialized countries. More importantly, over the long-term wealthier countries like China, Brazil and India, will come to dominate global economic growth. These economies are becoming larger, younger and more affluent. As the chart shows, the world’s middle class is expected to triple in size, predominantly from places like China and India. This will be happening even as developed country populations age and shrink. This growing wealth will spur demand for goods, services, infrastructure and natural resources such as fuel and clean water. Importantly, these trends will present new investment opportunities. Another indication that the balance of power has shifted is that China has become creditor to debtor nations such as the U.S. and other developed countries. This debt will become an additional “speed bump” to U.S. growth. Finally, emerging countries have built up huge reserves of foreign currencies. This has driven up the development of sovereign wealth funds, which will also influence capital markets. For example, we may see a shift away from fixed-income to higher-risk investments, as well as those deemed to offer inflation protection.
Inflation may not appear to be an issue in today’s recessionary environment, where falling commodity prices and Fed attempts to jump-start the economy have created temporary deflationary conditions. Indeed, as you can see in the chart, we have experiencing an extended disinflationary trend. However, we believe this trend is due to reverse in the medium-term, for two reasons: Rising labor costs in emerging markets, as well as growing demand from those quarters, which will drive commodities prices back up. The current fiscal policies being used to stimulate the U.S. economy and end the financial crisis, which have the potential to increase global inflationary pressures in dollar-linked economies. From an investment perspective, these trends would suggest that real return assets will become increasingly important for long-term investors.
Next, we can expect to see a period of relatively weak economic growth. This chart from the IMF shows GDP for advanced and emerging economies, and the world overall. As you can see, the recovery is not expected to begin until early 2009, will proceed somewhat slowly and will not reach previous highs for some time. That restrained growth is likely to put “speed limits” on corporate earnings growth. Dampening factors include: the pullback in consumer spending in the midst of the recession lower borrowing available to companies as a result of the credit crisis dampened “animal spirits,” or investor willingness to take risk collateral damage that may result from increased government intervention during the bailout. The upshot that investment returns, particularly on stocks, may be constrained for some time. For investors, that means that they may need to consider other types of investments for the growth potential they need.
Finally, an important feature of this new global economic reality is that the transition will not be a smooth one. This will be a messy process, as we have already seen. This has heightened the risk of major shocks – or “tail risks” – to our financial markets that can have a significant impact on investment returns. Let’s look at an example of a major dislocation that has occurred in our credit markets. As this chart shows, since the summer of 2007, spreads – or the difference between yields of various bonds versus U.S. Treasuries -- have widened dramatically, as investors have avoided any perception of risk in the marketplace. Yields on Treasuries have been exceedingly low, while prices for higher risk bonds have fallen dramatically. We have likewise seen unusual strong shocks in the stock markets, as you know. Consider that from October 1987 through March 2003, the Dow dropped 300 points or more on 15 occasions. During the six months from September 2008 through February 2009 alone, that has happened 19 times. Depending on when these shocks occur and when you’ll be needing your money, being prepared can make the difference between meeting and not meeting your goals.
So now that we have a sense of what the new reality make look like, what does this shift mean for you and your asset allocation strategy?
It means that history may no longer be a reliable guide and that traditional allocation strategies may be less likely to succeed. This chart shows how several types traditional asset classes – small-cap stocks, emerging markets stocks, international stocks and U.S. bonds -- have behaved versus large U.S. stocks. How these markets move in relation to each other is called “correlation.” In a diversified portfolio, you want asset classes that have low correlations to each other, so that declines in one may be offset by gains or lesser declines in another. What this chart demonstrates, however, is that over the past 15 years, different stock sectors and even U.S. bonds have often been highly correlated. These convergences have also occurred unpredictably – meaning that unpleasant surprises can occur if they all decline at the same time. Does that mean that diversification doesn’t work? No, but it means that you should think about diversification differently.
It means that you should be thinking of diversification not only in terms of asset classes, but also in terms of diversifying your risk. That would mean including investments that are influenced by different economic factors than traditional stocks and bonds, such as: international stocks and bonds, emerging markets stocks and bonds, inflation-hedging assets such as real estate and commodities and even alternative strategies such as private equity funds. These markets tend to be driven by different forces, which may help offset stock and bond declines. What’s more, because as we saw in the previous chart that risk correlations are unpredictable , it’s also very important to be well-diversified at all times in order to avoid suddenly finding yourself overly concentrated in a single risk factor. Of course, diversification does not guarantee a profit or protect against loss. This is a crucial point: It’s no longer a question of, “Should I be in this or that asset class right now?” but “Are my risks properly diversified? Do I have the optimal risk exposures for my return expectations? ”
So what should tomorrow’s portfolios look like?
Although our ultimate goal is risk diversification, I realize that some of you may have difficulty accepting the idea of increasing your exposure to an even broader set of asset classes, particularly at a time when virtually all capital markets have been so tumultuous. That’s why I’m suggesting a plan that takes into account your own stage of readiness to implement a new investment strategy. No matter where you are, there are things all of you can do to begin to create a prudent allocation strategy, one that diversifies risk without missing opportunities. Investment strategies are part of a continuum, and there are steps and actions you can take all along the way. I’ve identified three primary markers, or paths, along that road, and you can jump in at any point. Ultimately, your goal should be to travel along all three. The three paths are: One: Reinforce Your Core Two: Reallocate Your Portfolio Three: Respond to Opportunities Let’s look at each of these one by one.
Path One: Reinforce your core. If the market turmoil has left you so risk-averse that you’re holding significant amounts of cash, or if your portfolio is thrown off balance by the declines, you may have trouble achieving your long-term goals.
It’s important to re-examine your portfolio. Then, take your risk temperature, measuring not just market volatility but the risk of falling short of your goals. One of the things that you want to do is determine whether you’re under-allocated to bonds or other lower risk investments. You need a true core holding to anchor your portfolio, which will allow you to prudently take advantage of attractive opportunities while paying close attention to risk. You might also look to a diversified stock fund with a history of lower volatility. What do I mean by a true core holding? A fund that is properly diversified and not overly concentrated in one sector; a fund with disciplined risk management processes; a fund that has stuck to its mandate throughout the market crisis.
Path Two: Reallocate your portfolio. It’s important, as you revisit your current allocation strategy, to see how well positioned it might be to meet the challenges of the new reality we’ve been describing.
As you do that, ask yourself some questions: Am I appropriately exposed to potential opportunities in the bond market? Is there sufficient diversification into foreign assets, particularly those of emerging markets? How well is my portfolio hedged against inflation? Are the correlations of asset classes too high? Once you’ve gotten a sense of where you are, you might begin to assume prudent risks. As we talked about earlier, this means incorporating a broader opportunity set into your strategy – including international stocks and bonds, including those from emerging markets, inflation-hedging assets such as TIPS, real estate and commodities, and possibly even some alternative assets such as private equity funds or infrastructure funds. Of course, as you create an asset mix, it’s important to consider current market conditions as you make these decisions. Also remember that non-U.S. stocks and bonds can involve special political risk of instability and currency risks. Treasury Inflation-Protected Securities (TIPS) involve the risk that if real (inflation-adjusted) interest rates rise, the value of TIPS can decline. Commodities and real estate investments can be speculative.
Path Three: Respond to Opportunities. As I mentioned earlier, we believe that corporate profits are likely to be lower for some time, which means that stock returns are not likely to be as robust as they were before the crisis.
As a result, investors will need to seek unique opportunities for outperformance in order to help them achieve their financial objectives. We’re recommending that you establish a specific allocation for these “special opportunities,” say, 5% to 10% of your overall portfolio. What might come under this category? These are asset classes that are uniquely poised to profit in the short-term due to sharp dislocations, or newer, long-term trends that are attractive but have not yet gained broad acceptance. For example: As we saw in an earlier slide, the credit crisis created historic dislocations among different sectors of the bond market. As Treasuries became very expensive, asset classes such as high-quality corporate bonds were very attractively valued from a risk/return perspective. A longer-term example would be environmental stocks. This is a trend that is likely to become increasingly popular; we are also in an opportune moment in which investments in environmental technology are going to increase thanks to a $100 billion commitment by the U.S. government. Another example of special opportunities could arise from the various bailout programs the government is implementing, making investments that come under “the government umbrella” very attractive right now.
So these are the three paths that can help you along the road to the new financial reality. I want to emphasize that you shouldn’t be doing one or two of them, or taking them on one-by-one. Rather you should, to the best of your ability, move down all three of these paths at the same time. So, let’s briefly recap and talk about next steps. We talked about a new reality, an era of economic change that will have a profound effect on capital markets and ultimately, investment returns. These changes will be fundamental, meaning that history may no longer be a reliable guide for creating an investment strategy. These changes will be messy and will occur unpredictably. That means that you should be looking at truly non-correlated investments and think about diversifying your risks instead of your asset classes. You can get there through a three-path journey: Anchor your portfolio with a core bond fund and stock fund. Reallocate your portfolio broadly to include inflation-hedging assets, international stocks and bonds, and alternative strategies. Create an allocation for “special opportunities” that are uniquely positioned to provide exceptional return. Remember, these paths can be approached incrementally, over time. I have provided you with a worksheet that you can go through. I’d also be happy to schedule a meeting with you so that we can review your portfolio together. Thank you. I’ll take any questions you might have.
Allianz Global Investors offers a number of products that can help you prepare your portfolio for the new reality. Here are some investment solutions to consider for each path.
What might an asset allocation look like that reflects the new reality? This is a sample created by PIMCO, which has a special asset allocation committee that constantly analyzes how investment strategies should dovetail with the outlook for the economy and financial markets. What you’ll see right away is that it contains many more asset classes than a traditional stock-and-bond allocation. It also contains a fairly large percentage in international stocks and bonds, including those of emerging markets. It also recommends committing a fairly large portion – more than 25%, in this example -- to real return, or inflation-hedging, assets, such as real estate, commodities, TIPS and infrastructure. I’m showing you this not because you necessarily need to follow it to the letter, but as a way to start thinking about how you might spread your risks more broadly. Each one of you has a unique situation, of course, which relates to many different factors, including your risk tolerance, how much money you have, how old you are or your long-term financial or tax objectives. All of these will have an impact on how your allocate your investments. This is not a financial plan, which you should discuss with an advisor. These varied asset classes involve different risks. Non-US stocks and bonds involve special risks of political instability and currency fluctuations. High-yield securities, commodities, emerging markets securities and real estate investments can be speculative and volatile. US stocks can fluctuate in value due to financial factors related to the issuer, its industry or market factors unrelated to the company or the industry. Inflation-protected bonds can decline in value if real (inflation-adjusted) interest rates rise.
Finally, before we wrap up, let me tell you a bit about Allianz Global Investors, the company that formulated this vision of the new financial reality. Allianz Global Investors has a uniquely broad perspective on market and economic issues, because of the intellectual capital of their investment firms. PIMCO, as you know, is one of the world’s most successful fixed-income managers. Its leaders, Bill Gross and Mohamed El-Erian, regularly share their market and economic insights with the public. The firm holds its annual Secular Forum to develop its 3-5 year outlook on trends that may have a lasting impact on investment returns. PIMCO made an early call on the bursting of the housing bubble, and was able to position its portfolios advantageously. Allianz Global Investors also draws on the perspectives of its equity firms, including NFJ, a deep-value manager that uses a time-tested, highly disciplined investment approach. Its 3-D process emphasizes diversification, dividends and discipline. RCM is a truly global asset manager, which offers an information advantage via its team-based, dual-platform research process: fundamental, bottom-up research coupled with its GrassRoots ® Research, which takes an investigative journalistic approach to confirm its investment theses. RCM also has tremendous expertise in sector and theme investing. Their other equity firms include Nicholas-Applegate, Oppenheimer Capital and Cadence Capital Management.
Allianz-Pimco - The New Normal
Reposition for a New Reality Moving Forward in Challenging Times Presenter Name Date