All Asset All Access: Positioning Portfolios for Ongoing Inflationary Pressures

Rob Arnott, chairman of Research Affiliates, explains their inflation outlook and why they are cautious about conventional views on inflation. Brandon Kunz, head of multi-asset solution distribution at Research Affiliates, discusses how the All Asset strategies have historically performed well after notable periods of drawdown. As always, their insights represent Research Affiliates’ views in the context of the PIMCO All Asset and All Asset All Authority funds. All Asset All Access is published quarterly.

Views expressed here are from Research Affiliates as of 24 June 2022. U.S. inflation data discussed is through 31 May 2022.

Q: With consumer prices recently hitting a fresh 40-year high, what is Research Affiliates’ near-term outlook on U.S. inflation?

Arnott: As we have discussed in past editions of All Asset All Access,^Footnote1 Research Affiliates is on the record stating our forecast that inflation will surge. To the shock of many, the U.S. CPI (Consumer Price Index) headline reading hit a new 40-year high in May 2022, topping economists’ estimates. Even from these high levels, we expect near-term annualized inflation to rise further before it recedes. We see two reasons for this. Firstly, as we at Research Affiliates have argued for months, shelter – which constitutes roughly one-third of CPI – has to rise sharply to catch up with soaring property values. Secondly, during the summer months, incoming CPI data will replace relatively low inflation months from 2021, so inflation readings will almost certainly rise further.

Digging deeper into Research Affiliates’ view: Shelter has two main components, owners’ equivalent rent (OER) and rent of primary residence (RPR). Both are smoothed and lagged, by design. In May 2022, shelter was the single largest contributor to the CPI increase, climbing 5.5% from a year earlier, the greatest annual increase since 1987. With 8.6% headline inflation, why is 5.5% a problem? OER is based on survey data, and homeowners are generally behind the curve on the rental value of their homes – they tend to anchor on previous estimates. So, when home prices soar or tank, it can take years for OER to catch up.

To a lesser extent, RPR is smoothed and lagged. Surveyors ask renters how much they are paying, and what the change has been in the prior 6–12 months. But only renters who have renewed their leases recently will have experienced the recent surge in rental pricing. Many leases were priced in past years; these renters are probably in for a rude awakening when they renew.

We expect it to get worse. Research Affiliates forecasts OER to rise over the next three years by 6% to 9% per year, and RPR to play catch-up, rising as much as 10% in the next 12 months. As shelter determines about one-third of U.S. CPI, and current year-over-year (YOY) home price appreciation tends to drive subsequent three-year rises in the OER, we expect shelter to show high-single-digit overall inflation for the balance of this year and next, possibly continuing into 2024. Only a deep recession would – in Research Affiliates’ view – rein this in.

It bears mention that the rate of reported inflation is affected by what’s called the “base effect,” as changes are measured against the year-ago number or base. Even so, when we apply various assumptions to forecast potential paths of U.S. CPI (i.e., 1-, 3-, and 10-year historical trailing month-over-month averages), we find the projected range of CPI outcomes by year-end 2022 remains worryingly high. Cast your eyes on Figure 1, and you will notice that a trailing 3-year assumption suggests that by year-end CPI may rise by 8.5% YOY, and a trailing 1-year assumption implies a YOY increase of 10.8%!

Note also that each monthly CPI report adds a new month, and drops an old month. We cannot know with any precision what the new month is going to look like, but we know exactly what’s about to be dropped. June 2022 (reported in early July) will replace a high-inflation month from June 2021, of 0.93%. The good news is that anything less than 0.93% (equivalent to well over 11% per annum) may create an illusion that inflation is moderating. The bad news is that the Cleveland Fed’s “nowcasting” tool is currently (as of this writing) projecting June 2022 inflation at 0.98%, which would mean that YOY inflation through June would hit another new high. Then in the ensuing months of July, August, and September – the third quarter – we will replace three relatively low-inflation months from 2021 (0.48%, 0.21% and 0.27%, respectively). If inflation in those months is anything above 4% on an annualized basis (1% for the third quarter), it may create an illusion that inflation is breaking out to the upside, even if the monthly figures are lower than they’ve averaged in the last year.

Suppose inflation stabilizes in the coming months, with each monthly inflation rate matching the average of the prior 12 months. Figure 1 shows that – because we’re replacing milder inflation months from 2021 – headline inflation would still reach 9.9% by end-September and 10.8% by year-end. If this happens, then we can reasonably surmise that inflation could be the utterly dominant issue in the November election.

Q: How do you reconcile the disconnect between market-based forecasts for expected inflation and Research Affiliates’ inflation outlook?

Arnott: A prevailing narrative is that inflation will abate and then remain under control. As measured by breakeven inflation rates,^Footnote2 the market’s expectation for annualized inflation over the next five years is roughly 2.6%, having fallen from its 3.7% peak in March 2022. Similarly, the market’s 10-year inflation expectation, as measured by breakeven inflation rates, registers at 2.3%.

As contrarian investors, we at Research Affiliates always ask where conventional thinking may be amiss. Inflation has many moving parts, and assessing its sources and their impact is complex. To put it simply, prices are a function of supply and demand, and inflation is a function of falling supply and/or rising demand. We see several causes of this round of inflation: unprecedented deficit spending, supply chain disruptions, the Ukraine war, and fiscal stimulus putting money directly into consumers’ bank accounts. In our view, demand for goods and services is increased by the first and last of these; supply is constricted by all but the first – and the Federal Reserve can influence none of these. To a person with a hammer, everything looks like a nail. The Fed’s tools are loosening or tightening short-term rates, and quantitative easing or tightening. Neither addresses any of what we see as the direct causes of the surge in inflation.

At Research Affiliates, we worry that the Fed can indeed rein in this inflation, but only by crushing demand, and always with a lag. We do not believe the Fed’s hammer will work until and unless it creates a serious recession. So, our outlook is that either market inflation expectations will rise or inflation will recede because of a Fed-initiated recession. An uptick in inflation expectations, in turn, likely bodes well for the diversifying and inflation-sensitive “Third Pillar” markets (real assets, high yield bonds, and emerging markets) emphasized by the All Asset funds. As we’ve discussed many times in All Asset All Access, returns of these Third Pillar markets historically have tended to be strikingly correlated with changes in inflation expectations.

Q: Why haven’t All Asset investors profited from elevated U.S. inflation in 2022?

Kunz: As U.S. headline CPI inflation rose from 1.4% to 7.0% over the course of 2021, the All Asset and All Asset All Authority funds delivered one-year returns for 2021 of a respective 15.58% and 15.51% (net of fees, institutional share class). On a risk-adjusted basis, this placed each fund in the top decile of competitor funds within Morningstar’s U.S. Tactical Allocation category. (See Figure 2 for fund performance through 30 June 2022.)

For the most recent quarter-end performance data for the All Asset and All Asset All Authority funds, please click on the links below:

• PIMCO All Asset Fund
• PIMCO All Asset All Authority Fund

In 2022, headline inflation’s incremental rise to a 40-year high of 8.6% (as of May) has led to increasingly hawkish rhetoric from the Fed, which has us witnessing a movie we’ve seen many times: Almost every risk asset class has suffered a drawdown roughly proportional to its trailing volatility. This year’s movie comes with a painful plot twist; bond markets are in the midst of their worst calendar year on record. The result? A global 60/40 stock/bond portfolio has seen losses of −15.98% (and −16.11% for a U.S. 60/40 portfolio) year to date through 30 June 2022.^Footnote3 The All Asset Fund hasn’t been immune from this “take no prisoners” sell-off, but its return of −12.13% (−14.23% for All Authority; returns are net of fees for the institutional share class) outpaced mainstream U.S. stock and bond markets over the same time frame. We’ve sought to mitigate much of the broad market damage as we’ve tactically repositioned the All Asset portfolios into what we believe are increasingly attractive areas.

As this largely indiscriminate sell-off subsides, market participants will review the carnage and look to disentangle the asset classes that remain overvalued from those that have been oversold. As this sorting-out process ensues, and with history as a guide, we believe the All Asset strategies stand poised for attractive potential returns in the coming year.

Q: What gives you confidence in the prospects of a performance rebound in the All Asset strategies?

Kunz: We’ve analyzed the largest drawdowns and the subsequent 12-month returns of the All Asset Fund during its 20-year history (an anniversary milestone we achieve this month) – see Figures 3 and 4. (Returns shown are net of fees for the institutional share class.) Because most drawdowns have been in the single digits, we’ve separated the largest three from the average of drawdowns ranked 4–10 (which includes this year’s drawdown). Note that all of these drawdowns historically were followed by positive returns the next year. Further, in nine out of nine instances for All Asset (seven of nine for All Authority), the previous high water mark was exceeded within 12 months. With history as a guide, and given the increased return prospects provided by our tactical repositioning, we believe the All Asset strategies are poised to offer similar return potential, including outperformance of conventional stock/bond portfolios, in the coming year.

The All Asset strategies, including All Asset Fund and All Asset All Authority Fund, represent a joint effort between PIMCO and Research Affiliates. PIMCO provides the broad range of underlying strategies – spanning global stocks, global bonds, commodities, real estate, and liquid alternative strategies – each actively managed to maximize potential alpha. Research Affiliates, an investment advisory firm founded in 2002 by Rob Arnott and a global leader in asset allocation, serves as the subadvisor responsible for the asset allocation decisions. Research Affiliates uses their deep research focus to develop a series of value-oriented, contrarian models that determine the appropriate mix of underlying PIMCO strategies in seeking All Asset’s return and risk goals.