Isn’t it possible for the Third Pillar to see a test of the lows? Of course, but we think this is unlikely. Mean reversion is unreliably reliable: we cannot know when the pendulum will decisively swing back. The Third Pillar, having endured a rare and grueling three-year bear market, has been long overdue for a reversal. Only one other Third Pillar bear market (1995 to 1998) was longer and deeper than the current one. What followed after that rout? A portfolio of Third Pillar asset classes beat U.S. 60/40 investors in eleven of the next twelve years (including a run of nine consecutive wins). As with the late 1990s, a seven-year bull market in mainstream U.S. stocks, the second longest sustained bull market run over the last 200 years, is stretched and tired. So, the recent environment, barring many similarities to the late 1990’s, has set us up for the prospect of multiple years of outperformance. As with the late 1990s, the stretched rubber band of relative valuations might be all the catalyst we need to bring this to fruition.

Like us, you’ve chosen to invest in the All Asset strategies as a complement to diversify your investments in mainstream stocks and bonds, in an effort to protect against environments that can devastate mainstream holdings – such as rising inflation expectations – and to potentially exploit attractive relative valuation. We’ve had a wonderful three-month recovery in results. With Third Pillar markets still priced to offer impressive real return prospects, we want to be positioned for the possibility of a multi-year bull market, the early stages of which – like those in mainstream stocks and bonds – can be fast and impressive!


Q: Do you think inflation expectations will rise from today’s levels? Why is a change in inflation expectations important when considering the return prospects of the All Asset strategies?

Brightman: Yes. We anticipate rising inflation expectations. Before we delve into the reasons, let’s discuss why inflation expectations are important for the All Asset strategy. The relationship between the returns of the All Asset strategy and changes in break-even inflation is striking: the correlation is 80%! Over the life of the strategy, each 10 bps move in break-even inflation has been worth about 150 bps in Third Pillar returns and almost as much in AAF strategy returns. So, when expected inflation ticks higher, we expect our strategies to benefit, and vice versa.

These results are in line with our objectives. Since the launch of the All Asset strategy over 13 years ago, our mission has been to complement your mainstream investments by serving as a real-return-oriented diversifier. Our specific objectives are three-fold: 1) to improve long-term returns when mainstream assets offer low yields and low prospective returns; 2) to diversify exposure away from equity market risk; and 3) to favor assets positively correlated with inflation. With mainstream stocks and bonds yielding less than 2% today, any material increase in inflation can be devastating.

To provide context for our expectations of the future, we review the recent past. First, let’s look at wages, the most powerful domestic driver of long-term prices. The unemployment rate has dropped to 5.0%. This tightening of the labor market is creating wage pressure. The year-over-year percentage change in average hourly earnings, which bottomed at 1.6% in 2012, has now risen to 2.3%.

Next, consider the relationship between the U.S. Dollar, energy prices, and inflation expectations. The trade-weighted dollar soared by 25% over the past five years, peaking this January. Dollar appreciation lowers the cost of commodities and other imported goods. As oil prices collapsed from over $100 per barrel of WTI crude in 2014 to a low of $34 in January, inflation expectations fell to an historic low. The 10-year break-even inflation (BEI) hit bottom in February at 1.2%. The BEI has been lower only twice in history: following the Global Financial Crisis and the emerging markets’ debt and default crisis of 1998.

The trade weighted dollar peaked at the end of January and then, in March and April, dropped by 5%. At the same time, energy prices have rebounded. The price of a barrel of WTI has recovered to $46 by month-end April from its low of $34 in January. As the dollar peaked and energy prices have climbed, inflation expectations have recovered. Since its February low, BEI has risen by 0.5% to 1.7%, as of April 29th. Accompanying this recent rebound in inflation expectations is an impressive two-month performance run for our All Asset strategies.

With wages and energy costs both rising, inflation expectations have room to run higher. The Fed targets 2% for its preferred measure of inflation, the personal consumption expenditure (PCE) deflator within our national income and product accounts. The Fed has a long history of hitting its inflation target and we expect that they will continue to do so. The Fed’s 2% target for PCE inflation translates into a CPI inflation target of 2.4%. With the 10-year BEI for CPI at 1.7%, we expect inflation expectations to continue higher and possibly even overshoot.

1 We just issued a white paper and webinar, entitled “How Can Smart Beta Go Horribly Wrong?” that warns against this very mistake. We show that these recent trends have been helpful to their clients *only* because some of these strategies have become very expensive. http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/442_How_Can_Smart_Beta_Go_Horribly_Wrong.aspx

2 The 10-year expected return of an equally-weighted blend of Third Pillar asset classes (Local EM bonds, high yield, U.S. TIPS, REITs, commodities, and EM equities) went from 3.73% as of December 31, 2015 to 3.58% as of March 31, 2016. These can be calculated on our Asset Allocation site: http://www.researchaffiliates.com/assetallocation/Pages/Portfolios.aspx

3 While we’d much rather use a longer time horizon for this analysis, the yields of most Third Pillar asset classes, which the exception of high yield and REITs, are unavailable prior to 1995.

4 This expected excess return does not take into account the value-add from continual rebalancing into active positioning, PIMCO funds’ alpha potential, and additional return achieved from leverage. Given this, we’d ascribe a higher expected excess return for the All Asset strategies, relative to U.S. 60/40.

5 We believe that the extreme parallels observed in both December 1998 and today are the drivers of future outperformance for the most hated asset classes as well as the drivers of disappointing return prospects for the most popular and comfortable markets. I discuss these parallels and implications in my recent Fundamentals, “Echoes of 1999: The Tech Bubble and the ‘Asian Flu’” http://www.researchaffiliates.com/Our%20Ideas/Insights/Fundamentals/Pages/543_Echoes_of_1999_The_Tech_Bubble_and_the_Asian_Flu.aspx

6 As we discussed in last month’s Insights, over the last 20 years when starting yields were stretched to 2.8% or more, spreads subsequently narrowed nearly 70% of the time over the next three years, and in 98% of all five-year spans.

Robert Arnott is the founder and chairman and Christopher Brightman is chief investment officer of Research Affiliates, a subadvisor to PIMCO.

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