PIMCO’s Asset Allocation Outlook 2017: Tails and Transitions

Key Points:

1. Handoff from monetary-led to fiscal-led policy
2. Transition from globalization to de-globalization
3. China’s currency regime shift
4. Pivot from disinflation to reflation

Asset allocation themes for multi-asset portfolio:

• Equities (neutral): While we are more constructive on equities relative to other risk assets, in light of the recent rally we are maintaining a neutral view overall and an underweight to U.S. equities. Yet potential changes to U.S. tax policy and regulation may provide further support to domestically oriented U.S. corporations. We are moderately bullish on European equities, with growth in the region above trend and an accommodative ECB. We currently have a small positive allocation to EM as a long-term value play.
• Global rates (underweight): We remain defensive on interest rate exposure. In the U.S., we prefer TIPS (more on that below). Beyond the U.S., we find UK Gilts and Japanese government bonds rich, and we believe valuations of bonds by “peripheral” countries in Europe are not sustainable without ECB support.
• Global Credit (overweight select sectors): This late in the cycle investors should appreciate the limited spread tightening potential of corporate bonds as well as the downside potential for defaults or spread widening. Our overweight to credit is focused on non-agency mortgage-backed securities, which will likely continue to benefit from an ongoing recovery in the U.S. housing market and remain well-insulated from many global risks.
  – Global Real Assets (overweight): We maintain an overweight to real assets, with a focus on U.S. TIPS. Inflation expectations have risen recently, yet we believe there is still value in TIPS as the market is underpricing inflation risk. Inflation is on course to reach and possibly exceed the Fed’s 2% target over the coming months. (The Fed watches the PCE measure of inflation, not CPI. The latter recently surpassed 2%.)
• Global Currencies (neutral): We continue to favor the U.S. dollar against a basket of Asian currencies – a region that has benefited inordinately from global trade. We also have a modest underweight in the euro, anticipating continued dovish monetary policy from the ECB. We are holding small tactical positions in some of the higher-carry “commodity currencies” given the excessive cheapening seen post elections.
• In light of stretched valuations and complacency across many assets, we are maintaining ample dry powder and remain focused on portfolio liquidity as well as tail risk hedging strategies.

Despite substantial uncertainty surrounding the global outlook, our final suggestion is to avoid sitting on the sidelines. Solid options remain for investors to plot a path to their objectives, especially as inflation risks are rising across many developed markets, threatening to dilute the wealth of those waiting it out in cash. Of course, one should not get off the sidelines merely at the beginning of the year. 2017 calls for vigilance and flexibility over the full 12 months.

Our recipe is to look beyond the passive market exposures that delivered returns early in this economic expansion. In addition to tactically shifting allocations, an investor’s toolkit might include actively managed strategies targeting structural alpha, smart beta strategies, or strategies that hedge the beta exposure and focus entirely on alpha sources. Furthermore, in an era of higher uncertainty, the ability to protect capital during unforeseen market shocks through carefully selected tail risk hedges is going to be critical.

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