Secular Outlook: Implications for Asia-Pacific Investors?

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1 Secular Outlook: Implications for Asia-Pacific Investors? July 21, 2015 by Eric Mogelof, Alan Isenberg of PIMCO We hope you have had the opportun ity to review the summary from our secular forum in May: The New Neutral Revisited, written by PIMCO s Group CIO Dan Ivascyn, Global Fixed Income CIO Andrew Balls an d Global Strategic Advisor Rich Clarida. In this analysis, the authors identify the six key themes that emerged from our discussion, as well as six risks (see box below). These themes and risks have unique implications for Asia-Pacific investors First, as Asian economies transition from savers to spenders and from exporters to consumers, they are contributing meaningfully to the narrowing of global imbalances a potential driver of sustainable regional growth. Second, Asian fiscal and monetary policymakers from Japanese Prime Minister Abe to People s Bank of China (PBOC) authorities in Beijing are keenly focused on tailoring economic policies to specific objectives, including Japan s goal to reflate to its 2% inflation target and China s efforts to see the yuan included in the IMF s special drawing rights (SDR) basket of currencies. On this theme of economic policy, we expect the opening of the Chinese capital account to be a seminal part of the secular economic story, with significant implications for investors around the world. Some of the risks noted in our secular outlook will likely have an impact on the Asia-Pacific region: We need look no further than Chinese equity markets over the last few weeks to see that enormous volatility exists; indeed, the possibility of bursting bubbles, and even recessions, cannot be ruled out. Moreover, while many Asian economies are focused on increased regulatory oversight, convergence between regulatory frameworks has been limited, creating challenges in cross-border initiatives. Given these long-term themes and risks, we see several implications for Asian investors to consider: 1. Explore better betas and customized multi-asset solutions 2. Combine secular sovereign and corporate winners with the strength of the U.S. dollar Page 1, 2017 Advisor Perspectives, Inc. All rights reserved.

2 3. Be thoughtful about income 4. Consider alternatives and harvest illiquidity premiums 5. Keep a secular eye on India 6. Gain strategic (not just tactical) exposure to China PIMCO's 2015 Secular Forum SIX THEMES DRIVING GLOBAL MARKETS 1. Converging to New Neutral potential growth rates in developed and emerging economies 2. Evolving to a re-regulated, better capitalized global banking system 3. Moving from energy scarcity to energy abundance unlocked by the shale revolution 4. Accelerating from deflation toward targeted 2% inflationin the major economies 5. A narrowing in global imbalances as the global savings glut abates 6. Implementing better economic policy in key emerging as well as developed economies TAIL RISKS 1. A global recession as few countries can maneuver to deploy countercyclical policy 2. Flash crashes, air pockets and trading volatility, which have a greater likelihood amid diminished liquidity 3. Weaker aggregate demand as winners from declining commodity prices save their windfall gains 4. A breakout of inflation to the upside of central bank inflation targets 5. Disaster risk relating to geopolitical conflicts 6. Policy failures due to fractured politics or implentation challenges Better betas and customized multi-asset solutions Absolute return, benchmark-agnostic and smart beta strategies have increased in popularity throughout Asia-Pacific (and globally) as investors gain awareness of the limitations of market capitalization-weighted equity indexes and debt-weighted bond indexes. Traditional indexes can be reactive rather than proactive, and investors in a multi-speed world demand a higher degree of agility. PIMCO has been a pioneer on this front, offering both unconstrained strategies across asset classes (including credit, mortgages and commodities) and indexes that account for fundamentals rather than simply market-cap or debt weights. In addition, PIMCO s customized asset allocation solutions utilize both qualitative best ideas models and quantitative mathematical analysis in seeking to outperform traditional stock/bond combinations. These strategies can serve as prudent first steps for investors who Page 2, 2017 Advisor Perspectives, Inc. All rights reserved.

3 are making initial offshore allocations, as well as for clients seeking higher return targets with explicit downside risk management. Secular winners and the U.S. dollar Dollar-hedged strategies offer investors the opportunity to take advantage of the secular theme of continued U.S. dollar strength. As the Federal Reserve begins to raise rates while other global central banks continue easing, we see the U.S. dollar continuing to appreciate. PIMCO offers strategies with established track records to Asia-Pacific investors seeking to access credit markets while mitigating potential currency loss versus the U.S. dollar. We also expect central bank accommodation to broadly support credit markets, and as PIMCO s Global Credit CIO Mark Kiesel notes in the secular credit outlook, we anticipate this phenomenon particularly in China as the PBOC considers quantitative easing measures. Our credit team is focused on identifying companies that can benefit from our secular themes, including rising consumption in Asia, housing growth in the U.S. and export growth (given a weak yen) in Japan. Being thoughtful about income Asia-Pacific investors have long been focused on income-generating strategies, and we expect this trend to continue over the secular horizon. We follow a disciplined approach to income investing, aiming to outperform our return targets and achieve sustainable yields. PIMCO s income team has been recognized for its performance, including in 2013 when portfolio managers Dan Ivascyn and Alfred Murata were honored as Morningstar Fixed-Income Fund Managers of the Year (U.S.). PIMCO also offers strategies that provide access to bank capital instruments, which have the potential to perform like traditional high yield bonds or bank equities. The secular theme of intensifying regulation is supportive of this type of strategy, as recent regulations are meaningfully strengthening the banking sector. Alternatives and less liquid investments Asia-Pacific investors are keenly focused on alternatives, recognizing that these allocations may reduce portfolio volatility, achieve differentiated returns and capitalize on unique market opportunities. In Asia ex-japan alone, institutional investor allocations to hedge funds and private equity have grown from 2.7% in 2010 to 9.9% today; high-net-worth investors in Asia ex-japan and Japan allocate 14.0% and 13.1% to alternatives, respectively. 1 Similarly, in Australia, institutions have increased their allocations from 7.2% in 2010 to 10.2% today. 2 Over the secular horizon, we expect this investor demand for alternatives to continue expanding. From bank deleveraging-based investments to relativevalue sovereign and credit arbitrage, PIMCO s alternatives strategies encompass hedge funds (global macro, relative value, commodity) and private equity (opportunistic real estate and credit). Critical to our alternatives approach is our belief that the illiquidity premium the reward investors receive for investing in less liquid assets over an extended period will remain attractive over the secular horizon. We plan to continue growing this important business. A secular eye on India To date, India s growth story has been challenged by unfavorable business conditions, insufficient infrastructure and obstructive fiscal policies (e.g., the tax code). With the election of pro-business Prime Minister Narendra Modi last year and the 2013 appointment of Raghuram Rajan as governor of the Reserve Bank of India, PIMCO is closely watching for indications of higher sustainable future growth, including infrastructure development, more stable macroprudential policies, deeper financial Page 3, 2017 Advisor Perspectives, Inc. All rights reserved.

4 markets and simplification of the tax codes. Raja Mukherji, head of Asia credit, and Luke Spajic, head of Asia ex-japan portfolio management, recently returned from a trip to India encouraged by the new policymakers and awaiting additional reforms, which could set the stage for deeper exploration of the investment universe in the country over a secular horizon. Strategic exposure to China Whereas India may present an opportunity in the future, the Chinese capital account liberalization story is imminent. On a near-daily basis, we see Chinese policymakers and regulators opening new doors for offshore investors to access Chinese fixed income and equity markets and global index providers evaluating Chinese stocks and bonds for inclusion in their benchmarks. As evidenced by recent volatility in China s stock market, security selection remains crucial, and liquidity can still be challenging. That said, the PBOC and the central government in Beijing remain committed to attempting a smooth landing for the economy. So, we think China will continue to grow in importance for the global markets. Indeed, China is already the world s largest economy in purchasing-power-parity terms and the third-largest fixed income market. We therefore believe that investors should begin to consider the place of stand-alone strategic allocations to China, while remaining mindful of volatility and liquidity dynamics. For PIMCO, building a thoughtful presence in China is a critical secular objective to bring both China-based solutions to global investors and global solutions to local investors. Evolving with investors and the global markets PIMCO has established a strong track record of delivering value to investors both in and beyond traditional fixed income; importantly, our secular outlook supports continued growth in non-traditional fixed income, as well as in multi-asset, smart beta and alternatives solutions. We have built worldclass portfolio management and client servicing teams focused on these strategies and welcome the opportunity to exchange views on asset allocation, economic developments and portfolio solutions to navigate this New Neutral world. 1 Source: Greenwich Associates; Preqin; Capgemini and RBC Wealth Management Global HNW Insights Survey 2 Source: Australian Trade Commission All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower s obligation, or that such collateral could be liquidated. Investing Page 4, 2017 Advisor Perspectives, Inc. All rights reserved.

5 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. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available to all investors. Please contact your PIMCO representative for more information. 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 investment professional prior to making an investment decision. The Morningstar Fixed Income Fund Manager of the Year (2013) award is based on the strength of the manager, performance, strategy, and firm's stewardship. This material contains the opinions of the manager 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. PIMCO is a trademark or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. 2015, PIMCO. Page 5, 2017 Advisor Perspectives, Inc. All rights reserved.